The Hedgeweek Interview - Robert Milroy, Corazon Capital: "Nothing, including bank deposits, is risk-free"

Robert Milroy, chief investment officer of fund of hedge funds manager Corazon Capital, says that having cut its ties to the fallen Dawnay Day group, the firm is planning to expand its geographic reach and target new platform-based institutional and retail distribution channels, with a target of reaching assets under management of up to USD6bn.

HW: What is the background to your company?

RM: Corazon Capital is an independent asset manager providing tailored investment solutions and a range of unitised investment products to private and institutional investors. Established in 1997, Corazon is a pioneer in the field of absolute return investing and manages USD1.2bn of client money.

Corazon is wholly owned by senior management based in Guernsey, Jersey, Geneva and London. The co-managing directors are Paul Meader as chief executive and myself as chief investment officer.

HW: Who are your key service providers?

RM: Grant Thornton is our accountant and Ozannes our legal advisor, both of them local Guernsey firms. Fortis undertakes our fund administration and Deutsche Bank acts as custodian.

HW: Have you made any recent launches or changes to the management team?

RM: This year has been an exciting one for Corazon. We have recruited key individuals to be cornerstones of our business going forward - Chris Trower has been recruited from Nedbank as director of sales and marketing, Barrie Duerden joined from Rothschild LCF to establish our recently-opened office in Geneva, and Ryan Mendy has been brought on board to develop relations in the UK intermediary/institutional marketplace. We have enhanced our research team with a specialist real estate analyst and also expanded our client services team.

Building on our experience in the absolute return arena, and encouraged by investor demand for a vehicle to focus purely on the alternative space, in September we launched new share classes of the Corazon Alternative Investment Fund.

HW: What is your investment process?

RM: The Corazon investment approach centres on an unrestrained multi-asset, multistrategy style. We have the flexibility to allocate across asset classes and investment styles to cash, bonds, equities, property, commodities, hedge funds and other alternative assets - but will only allocate to an asset class if we believe that it will generate positive returns, with the right risk characteristics in congruence with the portfolio. Our overall objective is to preserve capital, achieve high relative returns and limit risk through low or uncorrelated asset class and style blending.

Our investment process is twofold. Corazon's investment managers, who draw on a diverse range of experience, form the asset allocation committee. They meet regularly to review and debate tactical asset allocation. The asset allocation of a portfolio/fund is forward-looking and discretionary and based on top-down macroeconomic and modelled inputs, together with bottom-up manager-driven influences.

Taking this asset allocation framework, it is the responsibility of the fund selection committee, through quantitative and qualitative research, to approve funds for investment and to ensure there are sufficient quality funds to execute any modifications to the asset allocation strategy.

HW: How has your fund of hedge funds performed?

RM: The Corazon Alternative Investment Fund has returned minus 10.01 per cent this year up to the end of September. While admittedly not showing an absolute return for the period, it must be viewed in the context of equity markets down more than 50 per cent from their peaks, commodities down 50 per cent and more, property down around 25 per cent (and listed entities up to 90 per cent) and corporate bonds having been pummelled as well.

We believe this identifies the strength in our investment approach, and the skill of our investment managers. If we do not lose a great deal of value during difficult times, we do not have to take excessive risk during the good times to provide strong annualised returns to investors. Historically, this fund has provided consistent annualised returns in line with its target of cash plus 4 to 5 per cent with volatility of less than 5 per cent.

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

RM: We take an unconstrained approach when allocating to hedge fund strategies. This ensures true investment manager conviction in identifying suitable strategies and funds that contribute the appropriate risk and return characteristics to a portfolio. For example, our portfolios are currently positioned to benefit from non-correlated strategies that do not require capital markets to prosper to make money, such as a power trader in Norway, macro managers, insurance-based strategies and trade finance. Typically we allocate to between eight and 15 strategies, with 20 to 30 managers in each portfolio.

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

RM: No, all our portfolios are managed on an absolute return basis. While we do use typical indices for comparison, our primary benchmark is Asset Risk Consultants' Private Client Indices. These provide an accurate insight and comparison of the risk-adjusted real returns achieved by peer group investment managers for their discretionary portfolios.

Understanding the absolute return process and the levels of risk employed by individual managers is extremely difficult for investors. The ARC indices provide an impartial assessment of real value added and ranks our performance against that of our competitors.

HW: What makes a manager or strategy special enough to select them?

RM: Alpha, and I'm not being flippant. Alpha exists; to us it means the profits a manager can earn because they do at least one thing better than the competition. That may be security selection, although most stocks and bonds are so well picked over that security selection alpha is quite low; or it could be use of balance sheet, as in managers who know better than peers when to expand or contract gross and net exposures. That particular skill has separated the experts from the keen amateurs in the past year.

We have an ongoing search for strategy alpha too. It's easier to get excess returns if you can find a strategy that is undercapitalised, because even a third-quartile manager may deliver sufficient risk-adjusted return. With an overcapitalised strategy you have to be confident of picking a top-quartile manager or better. But eventually all industries with excess capital have to retrench. In industrial sectors capital destruction can take years, but in finance the capital degradation happens overnight. We like to be on our way out when that happens.

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

RM: We sell if we have an expectation of negative alpha in either the manager or the strategy. Nothing good lasts forever and we try to be long-term investors, but excess profits attract excess capital. As capital became easier to get and almost free, many strategies looked increasingly vulnerable to us.

Meyer Weinstein was the only investor hedging convertible bonds in the 1920s so he had all the manager and strategy alphas to himself. He published a book about it in 1931, creating his own competition. Our job is not dissimilar to that of a stock analyst; we try to find the marginal competitor in a strategy and decide whether they are creating or destroying value. Just because young merger arbitrageurs thought working a few big transactions at an investment bank was their competitive edge does not make them alpha creators.

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

RM: In strategies that we consider fully capitalised, we have one manager as an alternate to those in the strategy. This is natural because the strategy alpha is low and we want a manager that keeps his risk constant and lets the return vary. The majority of peers will try to keep return constant by varying risk, which exposes them to a so-called shock. The event is in fact predictable, capital destruction, unfortunately its timing is random, even chaotic.

With strategies that are undercapitalised, we will have smaller allocations to more managers and perhaps two or three alternates if we can find them. The logic behind increased diversification is that we know less about the strategy and what can go wrong, and often the managers aren't realistic about risks either. So as soon as a manager deviates from expectation we redeem in part or in full and allocate to the next best.

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

RM: The reallocation of capital between the financial markets and the real economy, from West to East, and from goods consumers to producers will continue until a new equilibrium is reached. The implication of these trends is there will be less financial capital to manage, so the world will need fewer financial experts of all types.

Reallocation of labour to more productive sectors always seems so benign in textbooks, but when you receive valedictory emails from people you have worked with in many institutions over the years, you cannot but be sympathetic. That is why we analyse our business processes regularly to ensure that we do not become the marginal producer. It is crucial we identify and buttress our own competitive advantages.

HW: How will these developments affect your own portfolios?

RM: The wholesale winnowing of financial services presents tremendous opportunities to us in terms of new business to be won and for higher returns from all investments in the future. We have recently invested a significant sum of money in the technology required to service clients' reporting needs and to help us manage larger assets under management without increasing bureaucracy. The result is that we can stay close to our clients and maintain real contact with our managers.

A current favourite investment thesis is the disparity between the earnings expectations priced into global debt versus the expectations for equities. Both can be wrong simultaneously, but both can't be right simultaneously. In brief, bonds are priced for a prolonged recession, whereas equities of the same entities are priced for slower growth. As the effects of monetary and fiscal stimuli become clearer, one must converge upon the other. In the meantime we carry some basis risk, but at some point the bonds will rise relative to equities, irrespective of the actual direction of markets.

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

RM: Corazon is a pioneer of absolute return investing, with a track record going back more than 10 years, and very few competitors are able to prove their methodology in this way. Sixty per cent of our 22 members of staff are investment professionals, and between them they average more than 25 years industry experience each. Being wholly owned by management and not restrained by the ties that encumber larger companies, coupled with our boutique size, means we are able to be nimble, dynamic and decisive.

HW: What is you attitude toward risk?

RM: We are not concerned by fund managers taking risk, but we ensure when we allocate to a manger that they are taking the right types of risk. Risk management is central to our process.

Correlations inevitably start to rise at times of material financial stress, such as the period since July 2007. In this regard, traditional VaR style analysis is too narrowly focused, is historic and provides no insight into other key variables, such as liquidity. Whilst we do use quantitative risk management systems, we believe that a qualitative overlay, based on the significant market experience of our investment managers, provides a robust and reliable risk management process.

We keep in very close contact with all our managers and modify our exposure or redeem where we perceive there are good reasons for doing so. As we all have learned, nothing, including bank deposits, is risk-free, yet many of our underlying funds are doing well in the current climate.

HW: How would you assess investors' expectations and how do you deal with them?

RM: We are very proud that our core business has been driven by private clients' word of mouth and personal recommendation. This speaks volumes. We take time to fully understand client requirements and carefully construct portfolios accordingly.

Throughout these difficult times, it has been more important than ever for us to manage investors' expectations realistically. We have made no false promises, but rather have been pragmatic and open about how we see the world and the decisions we have made to position portfolios to take advantage of the best opportunities for recovery.

HW: How do you distribute your products?

RM: Corazon has grown from a multifamily style firm in the early days to be in a position now to embrace 2009 and beyond with a focused international business development plan. This will be built upon the backbone of business derived by word of mouth and the strength of relationships we have locally in the Channel Islands with introducers such as financial advisors, trust companies and pension providers.

We will take measured steps over the coming months to expand our geographic reach across South Africa, the Middle East, Europe and the UK. In targeting new platform-based institutional and retail distribution channels, we would like to see our assets under management to grow incrementally to between USD5bn and USD6bn, which we see as our niche size.

HW: Are you planning any further launches in the near future?

RM: We are always looking for opportunities to add value to our product offering, and there are many interesting investment ideas out there in the alternatives sector. As an independent business we can be highly innovative in this type of environment. That said, for the time being we fundamentally believe it is important to continue doing what we do best, to forge a resilient path for our investors through the current turmoil.



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