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The Hedgeweek Interview - Magnus Olsson, head of funds, London & Capital: Identifying managers at their 'sweet spot'

Magnus Olsson, head of funds at London & Capital, says the company is looking to build on the success of its award-winning fund of funds by looking at new opportunities, such as alternative beta products that aim to replicate hedge fund returns and more focused products for investors willing to assume higher risks to achieve higher returns.

HW: What is the background to London & Capital and its fund of hedge funds?

MO: The London & Capital Group was established in 1986 and by 1992 the firm had USD100m under management. A decade after the launch of the group, it had a network of 100 intermediary introducer relationships worldwide. A real estate division was established in 1998 and a Mauritius joint venture initiated two years later.

London & Capital was awarded its first institutional mandate awarded in 2001. By the following year it had more than USD100m under management for its clients in commercial real estate, and in 2003 the company passed the milestone of USD1bn in total assets under management, with staff numbers now reaching 50. A further international office was established in Miami two years ago. Today London & Capital has USD2.7bn in assets under management.

The company is headed by managing director Daniel Freedman, with Ashok Shah as chief investment officer and myself as head of funds.

HW: Who are your key service providers?

MO: The key service providers are Royal Bank of Scotland Isle of Man as custodian, Citibank as administrator, Pinsent Masons as legal advisors and PricewaterhouseCoopers as auditors.

HW: Have there been any recent additions to your product range?

MO: Last year the company has recently launched a German real estate fund.

HW: What is your investment process?

MO: Our investment process utilises both a top-down and bottom-up approach to asset allocation. Strategy allocation is based on macroeconomics and the outlook for various hedge fund strategies blended with parameters such as investment objectives and restrictions.

We identify strategies where we believe our target return can be achieved and then allocate capital to managers who share our philosophy of risk and capital preservation. Asset allocation is maintained within the fund's risk management guidelines at all times.

The end result is a portfolio diversified across all the major hedge fund strategies. London & Capital divides hedge funds into three main styles: market neutral, event-driven, and opportunistic. This is based on the exposure/correlation to the overall market, going from very little (market neutral) to higher (opportunistic).

HW: How has your fund of hedge funds performed?

MO: Our US dollar-denominated master fund has returned more than 7.5 per cent every year since its launch in May 2003 - 8.7 per cent that year, 8.4 per cent in 2004, 7.8 per cent in 2005 and 10.0 per cent last year, with only nine down months out of 46 over that period. At the end of February the fund was up 1.4 per cent for 2007.

HW: How many funds and strategies are in your portfolio?

MO: Recently we added a new special opportunities segment with the aim of exploiting new ideas, themes or trends in the hedge fund industry. This brings the number of strategies to nine with 28 underlying funds.

HW: Are you linked to any hedge fund indices or have you launched products linked to hedge fund indices or do you have plans to do so?

MO: We do not supply information to any hedge fund index providers, nor have we launched any products linked to hedge fund indices.

HW: What makes a manager special enough for you to select them?

MO: Manager selection is a blend of both quantitative and qualitative selection criteria. First and foremost, though, we must have developed a level of trust with the manager.

Within the quantitative process we assess historical returns, where evidence of consistent alpha creation is crucial. We look at historical volatility and drawdowns both in absolute terms and relative to the peer group, and we analyse return targets and return drivers in order to understand return expectations both in good and more difficult market conditions.

Within our qualitative process, we undertake face-to-face meetings with key portfolio and risk managers in order to fully understand the investment process and risk management. We review the fund's prime broker, custodian, administrator and auditor, and we carry out background checks on the key individuals to make sure we are working with people of the highest integrity.

HW: What are your criteria for removing managers from the fund?

MO: Manager performance is under continuous in-house quantitative and qualitative review. The key factors that trigger deselection are performance, poor transparency, personnel issues and the emergence of new market trends.

Performance issues include poor returns relative to previous performance, targeted levels or other managers within the peer group. Poor transparency can range from failure to convey or adequately explain changes in strategy to inadequate provision of net asset value data or revisions of reported information.

The loss of key managers - and also support staff - often indicates that a fund is experiencing significant operational problems. As for market developments, the emergence of fresh trends may make alternative strategies and managers more attractive than an existing manager.

HW: How many managers do you have on the substitutes' bench?

MO: We generally aim to have a replacement available for every manager in the portfolio, and we ensure that we have a replacement available for every strategy. Currently the number of managers on the replacement bench is 20. Given that the turnover for the portfolio is approximately 20 per cent a year, we have had no problems ensuring that our fund of hedge funds has the desired strategy weightings.

HW: What events do you expect to see in your sector in the year ahead?

MO: In the year ahead we see increased allocation to alternative beta products that aim to replicate hedge fund returns in a cost-efficient way, but also the launch of more focused products to cater for investors preferring higher returns and the accompanying higher risk.

HW: How will these changes events affect your own portfolios?

MO: We are currently looking to use the current portfolios (or parts of them) for potential products both within the focused segment but also within the alternative beta space.

HW: What differentiates you from other managers in your sector?

MO: We believe that London & Capital offers investors advantages above our competition. Our innovative and flexible investment model allows us to design and manage our portfolios with an effective top-down input, and the model has been structured to incorporate investor requirements. The investment team has the expertise and the market experience to manage our fund of funds in this way.

In addition, London & Capital focuses on alpha-generating managers, which significantly increases the diversification value of including our fund of funds as part of an investor's asset allocation. London & Capital's size does not force us to invest with the largest managers but with managers who are at the 'sweet spot' of their return-generating potential.

Our model has been proven to generate high risk adjusted returns. The fund of hedge funds was chosen as the best diversified fund of hedge funds for one-year risk adjusted returns at the Hedge Fund Review 2005 European Fund of Hedge Funds awards.

HW: Some funds of funds complain that managers are not taking enough risks in the current environment. What are your views on this, and on risk in general?

MO: In line with our core focus on capital preservation, risk control is central to our fund of hedge funds.

Risk is generally defined in terms of volatility levels, but a volatility number, high or low, does not necessarily define all the risks that are inherent in a strategy. If a market gaps through a certain level a historical rolling 12-month volatility number that was very low can change to being very high very quickly. In general, if our managers are not taking on significant risk we believe that they have good reason.

Through our regular contact with our managers we discuss their strategy - where they see the markets, the environment and how they are positioned to make money and to protect against possible downside if things were to 'turn'. Generally we are more interested in receiving truthful and insightful responses on these topics rather than evidence of increased risk-taking for potentially higher returns.

HW: Are investors' expectations moving upwards and how do you deal with this?

MO: As cash rates around the world have risen, investor expectations of performance have also risen. Over the past year we have slowly adjusted the allocation mix of the strategy to improve the performance of the products whilst maintaining the excellent risk adjusted returns.

HW: How do you distribute your products?

MO: Our products are distributed through various IFA networks and via our internal sales department.

HW: Are you planning any further launches this year?

MO: We are looking at a couple of new products within the segments where we see a demand, namely focused funds of funds and alternative beta products.

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