Thu, 13/03/2008 - 20:28
Peter Ludvigsen, head of institutional business at Nedgroup Investments, argues that mainstream hedge fund strategies have become increasingly correlated to key risk factors and that a majority of generic multistrategy styles risk disappointing investors.
HW: What is the background to your company?
PL: The Nedbank Group is one of South Africa's leading financial organisations with assets under management in excess of USD20bn. The holding company, Nedbank Limited, is listed on the Johannesburg Stock Exchange and the majority shareholder in the group is Old Mutual, which is jointly listed in South Africa and London.
Founded in 1995, Nedgroup Investments is a highly experienced alternative investment provider with USD 920 million in assets under management. It has the advantage of being an independent and nimble investment manager while simultaneously benefiting from the group's strong financial standing and substantial business and corporate infrastructure.
We have a strong institutional focus in our fund of hedge funds products and are positioned to accommodate future industry growth and service the needs of this sector. The investment processes we apply in our various products share an important goal: the generation of stable, sustainable absolute returns and optimised risk-adjusted performance.
HW: Who are your key service providers?
PL: Our fund administrator is Fortis, KPMG are our auditors and we use Cains Advocates for legal advice.
HW: Have you launched any funds recently?
PL: On February 1 we launched Premium Portfolio, a new fund of hedge funds that is purely aimed at the institutional market and invests in niche strategies with a longer liquidity profile. The return objective is Libor plus 8 to 12 per cent with a volatility of only 1 to 3 per cent.
The product development behind Premium focused on creating a fund of hedge funds with a stable and predictable return profile, but even more importantly bringing genuine diversification to an institutional portfolio. The majority of mainstream hedge strategies have become increasingly correlated to equity markets and the supposed diversification has failed.
Premium has an equity market beta close to zero, currently at 0.04, and by applying an in-house tactical overlay, we can hedge out any equity market correlation that might creep into any of the sub-strategies.
HW: What is your investment process?
PL: Our manager selection process follows a bottom-up process. The effectiveness of this process lies in our global reach, with analysts always visiting potential managers on site, irrespective of their location in the world, rigorous quantitative analysis using industry models and proprietary tools, and the experience gained through 10 years of analysing hedge funds.
Our quantitative analysis includes comparative peer group analysis and an examination of performance under conditions of market stress. We gauge the versatility of managers by simulating their performance impact on our various funds of funds.
Our qualitative assessment includes an analysis of the manager's skill-set and ability to implement the strategy, risk management structure and capabilities, whether the manager invests alongside clients, and their honesty and integrity. We attach great importance to transparency and access to key personnel.
Our operational due diligence assesses the infrastructural capacity of the fund management organisation, judging whether the fund is operationally robust and capable of adequately supporting the stated trading activity. To be considered for approval, a manager must pass through all the due diligence stages and meet all qualitative and quantitative selection criteria.
HW: How has your fund of hedge funds performed?
PL: The tracking performance for Premium Portfolio since January 2006 is an annualised return of 18.97 per cent, with volatility of 2.4 per cent. Despite the market turmoil since mid-2007, the fund has not experienced any negative months.
HW: How many funds and strategies are in your portfolio?
PL: Premium is currently invested in 18 funds, which will gradually increase to about 25. The fund invests purely in sub-strategies - currently 10 - within what we call the Structured Finance space such as asset-backed finance, insurance, distressed debt and trade finance.
HW: Are you linked to any hedge fund indices?
PL: We measure performance against the HFRI Fund of Hedge Funds Index, but none of our funds aims to track or replicate an index. All our funds have an absolute return objective with a specific performance target range above Libor depending on the fund's risk profile. We measure our success in achieving those targets within set volatility bands.
HW: What makes a manager special enough for you to select him?
PL: We are looking for three things in a manager. First is a clearly demonstrable edge in his sector that will enable him to generate repeatable excess returns over a benchmark. Second is risk management skills, systems and disciplines that are appropriate to the strategy. Third is trustworthiness - we invest in managers whom we believe will tell us the truth in good times and in bad.
HW: What are your criteria for removing managers from the funds?
PL: A manager can be redeemed for a number of bottom-up reasons, including style drift, excess return volatility either up or down, key staff turnover, complacency or lack of focus. We will also redeem from a manager for top-down reasons if we perceive that the market environment looking forward is not conducive to the style.
Of course, a manager will be scrutinised if performance is below expectation, but we do not employ a mechanical redemption rule. A manager experiencing a drawdown could be a buy, hold or sell on a case-by-case basis.
HW: How many managers do you have on the substitutes bench?
PL: We have a large pipeline of funds under research in various stages. The majority are being monitored, while a minority are ready for investment subject to completion of operational due diligence. Priority for completion of this work is being continually assessed based upon our level of conviction in the prospective managers in light of the probable market environment.
Through this process we have a stable of funds eligible for formal approval; several of these are approved each month. We do not maintain a formal substitutes bench by strategy, nor do we automatically replace funds within strategies. Every prospective fund is assessed based on its likely contribution to the portfolio, no matter the strategy classification.
HW: What events do you expect to see in your sector in the year ahead?
PL: The balance of probabilities is that the current environment of downside volatility in risky assets may persist for some time. Though credit spreads have widened substantially and equity markets have fallen, we are not out of the woods yet. It is this universal appetite for risky assets that drives returns for the majority of hedge fund managers.
Further, mainstream hedge fund strategies have become increasingly correlated to these key risk factors and to each other. Therefore we see a risk that a majority of generic multistrategy styles will disappoint investors. We expect to see a higher than normal rate of hedge fund failures, especially among those who have utilised leverage imprudently.
HW: How will these developments events impact your own portfolios?
PL: In anticipation of a difficult market environment, we have reduced correlations within our portfolios to generic market risk. During 2007 we redeemed from some longer beta managers and replaced them with more market neutral styles.
Being now defensively positioned in most of our portfolios, we expect that most of our returns will be attributable to manager level alpha and less to market-induced volatility. We expect our increased weights to unleveraged, market neutral and niche strategies to stand us in good stead. Our market neutral portfolios can be expected to excel in this environment.
HW: What differentiates you from other managers in your sector?
PL: Our style is characterised by three key principles. First, we dig deep to understand the sources of returns and risks. Many in our team have a background in derivatives, which is essential to the ability to assess the types of styles that can excel in various market environments.
Our second principle is to invest in the future, not the past. There are thousands of excellent track records out there. The challenge is to figure out which were due to skill and which to luck, which to alpha and which to beta.
The third principle is avoiding mistakes. There are 9,000 hedge funds from which to choose; we need invest only in a tiny fraction. Although funds of funds are quite a safe investment, individual hedge funds can be very risky.
HW: What are your views on risk in general?
PL: Many managers are taking on too much risk. During the bull market years of gently rising equity markets and persistently tight credit spreads, too many managers geared up low-return trades in order to produce higher numbers. Over the past few months we have seen higher index volatility but also much greater dispersion in the returns of individual securities.
Relative value managers who use value at risk models with longer data windows are running more risk than they intend. Volatile markets foster higher levels of inefficiencies and greater opportunity sets for arbitrage managers. Some impatient managers are getting into trouble; the better managers recognise that smaller positions are warranted in the short term.
HW: How do you deal with investors' expectations?
PL: Investor performance expectations have generally moderated in recent years and institutions are now more concerned about the predictability of future returns when assessing their liability situation. Areas where expectations and demands are on the up are transparency and robust risk management. Full transparency is something we not only demand from our underlying managers but that we offer to our own clients.
At Nedgroup Investments, emphasis is placed on minimising risk in a proactive way. To us, risk management is not a distinct discipline but an attitude integral to the entire investment process. Our risk management philosophy can be summarised as the preservation of capital through rigorous due diligence and risk factor diversification, institutional-style culture and disciplines, and the identification of managers who are themselves good risk managers.
HW: How do you distribute your products?
PL: Our retail products are sold through Nedbank's distribution network in South Africa and through the Skandia platform in a number of regions outside the UK. Institutional clients are approached directly or through either consultancy firms or third-party marketing companies.
HW: Are you planning any further launches this year?
PL: No other launch is currently planned for 2008. However, we are looking at a number of ideas for both our retail and institutional clients that might move on to the development stage. In addition, if the current market volatility continues, it will create product opportunities in select niche strategies.
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