The Hedgeweek Interview: Dr Glenn Baggley, Eddington Capital Management: "Investors have realised that low returns accompany low volatility"
Chief executive Dr Glenn Baggley says Eddington Capital Management aims to offer investors a high-octane fund of funds portfolio through the selection of talented managers capable of achieving outsize returns, rather than in timing the market or using leverage.
HW: What is the background to your fund/company?
GB: Eddington Capital Management was established in September 2003 as a specialist in high return target funds of hedge funds. It is a joint venture between its management (myself and chief investment officer Alex Allen) and Caledonia Investments, the UK investment trust.
We currently manage two high-octane funds of hedge funds. Our flagship, the Eddington Triple Alpha Fund, was launched on September 1, 2003 and has USD130m in assts under management. Our second fund, the Eddington Macro Opportunities Fund, was launched on July 1, 2007 with USD44m and is currently closed to new investors.
HW: Who are your key service providers?
GB: The fund auditor is KPMG, legal advisors are Solomon Harris in the Cayman Islands, the fund administrator is Custom House Administration, and the custodian is Citco in Dublin.
HW: What is your investment process?
GB: The Eddington Triple Alpha Fund is a high-octane portfolio that aims to significantly outperform the mainstream hedge fund universe, using a diversified multistrategy fund of hedge funds approach. Fund selection is our primary source of our return - we use a bottom-up approach, seeking exceptional managers and combining them through intelligent portfolio construction to form a robust and well-diversified portfolio.
We see far greater potential in the selection of talented managers than in timing the market through strategy allocation. The fund employs no additional leverage, beyond that used by the underlying managers, relying instead on the selection of those managers that we believe will achieve outsized returns over the medium to long term.
We seek out managers with exceptional skill or insight in their strategy, a unique approach, and a sustainable edge that should allow them to outperform throughout the market cycle. In-depth manager interviews, questionnaires, site visits, and background checks are combined with rigorous quantitative and qualitative analysis to select managers that we believe to be the most capable within their peer group, and complementary to our portfolio.
HW: How has your fund of hedge funds performed?
GB: The Eddington Triple Alpha Fund returned 77.73 per cent net for its investors from its launch in September 2003 up to the end of 2007, annualising at 14.59 per cent. In 2007 the fund returned 16.47 per cent, after 21.44 per cent in 2006 and 10.46 per cent in 2005. The fund does not use leverage at the portfolio level.
HW: How many funds and strategies are in your portfolio?
GB: At the end of 2007 the fund was invested in 25 managers across 13 strategies. We find that 22 to 25 managers is normally required to tap all the available sources of high return, and insulate the portfolio from all undesirable market risks. Beyond that we'd be merely duplicating something we already have.
HW: Are you linked to any hedge fund indices?
GB: No, and we have no plans to do so. We specialise in high return target products designed vastly to outperform such indices.
HW: What makes a manager or strategy special enough for you to select them?
GB: Each of our managers must have exceptional talent and offer something unique and complementary to our portfolio. They must specifically target high absolute returns and achieve them via investment skill - for example, through position concentration or broader directional exposure - rather than leverage.
They must demonstrate the ability to use a higher short-term volatility budget to generate significantly higher long-term returns, and in our view have the prospect of making around 100 per cent net over the next three years, equivalent to 25 per cent net annualised.
HW: What are your criteria for removing managers from the funds?
GB: The criteria for deselection of managers will vary from manager to manager, and from situation to situation. Criteria include returns inconsistent with our expectations or market conditions, style drift, excessive asset growth, breakdown in risk controls and loss of key staff.
HW: How many managers do you have on the substitutes' bench?
GB: Around 20 to 30 at any one time.
HW: What events do you expect to see in your sector in the year ahead?
GB: Hedge fund allocators will face a number of macroeconomic challenges in 2008. Contagion from the credit crisis has now spread to equities and will probably affect other asset classes over the year. The direction of equity markets (including the risk of a significant correction or prolonged bear market) is already being hotly debated, with speculation of recession or even depression ahead.
Central banks, especially the Fed, will probably reduce rates through the year as the outlook deteriorates, which will cause volatility but have little long-term impact. Against these headwinds, some hedge funds will see conditions improve for their strategy generally. Increased volatility, sustained trends (either up or down), and an increased focus on micro- or macroeconomic fundamentals will rekindle opportunities that have been largely absent in recent years.
HW: How will these developments impact your own portfolios?
GB: Our portfolio comprises high-octane managers specifically selected for their ability to do well in most market conditions, so our challenge is to insulate the portfolio from unusual or extreme market risks. At present the portfolio has a net short credit stance, so will benefit from further deterioration in the credit space, has substantial put protection against equity market falls, and has significant exposure to macro strategies that should do well in the coming years.
HW: What differentiates you from other managers in your sector?
GB: Eddington Capital Management fills a gap in an otherwise crowded marketplace, by exclusively offering high return target fund of hedge fund products. Our investment team has a fundamentally different investment approach from the mainstream competition. We select from a different universe of managers to our peers, tapping more security-specific and alpha-driven sources of return.
We accept managers with higher short-term volatility to achieve higher long-term returns, but combine them to reduce the overall portfolio volatility to very modest levels. Our focus on a small universe of the best high-octane managers allows us to research and monitor them in greater depth, including real-time monitoring of their underlying positions.
HW: Some funds of funds have complained that managers are not taking enough risks in the current environment. What are your views on this, and on risk in general?
GB: There are two factors here. First, a culture of equating volatility with risk has lead to many managers reducing volatility to ultra-low levels to satisfy a growing institutional investor base. Secondly, market volatility has been extremely low, presenting managers with fewer opportunities to take risk - look at the CBOE volatility index for a simple illustration,
But both of those situations are changing. Investors have realised that low returns accompany low volatility, so we're seeing an increasing number of investors specifically seeking out higher volatility products in their quest for higher returns. At the same time, low volatility market conditions are coming to an end, finally allowing managers to take on more risk.
HW: Are investors' expectations moving upwards, and how do you deal with this?
GB: Investors are increasingly looking for higher returns from fund of hedge funds investments (or at least from a portion thereof). We are well suited to cater to these increased expectations given our exclusive focus on generating higher returns, and an approach that is very different from any other fund of hedge funds investments they might have.
HW: How do you distribute your products?
GB: Via private banking distribution platforms and third party marketers, while our in-house marketing team organises product presentations regularly.
HW: Are you planning any further launches this year?
GB: We have plans to launch a UK tax-efficient product (subject to capital gains tax rather than income tax) around the end of March, and we will open the Eddington Macro Opportunities Fund to external investors later this year.
We may also launch an equity-related fund of hedge funds. This might seem like an inauspicious time to launch an equity-based product, but ours would be different to those on offer elsewhere. We have some highly innovative funds and managed accounts that would pay out handsomely in the event of a stock market crash or sustained bear market. With considerable uncertainty ahead, this fund would therefore offer a very attractive alternative to straight equity exposure, providing significant returns in both bull and bear markets.
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