The Interview - Martin Baxter, Collins Stewart Fund Management: "A consolidation of the industry will benefit those managers who survive"

Martin Baxter, portfolio manager of the Collins Stewart Absolute Return Plus Fund, says the hedge fund industry has suffered because managers have not been quick enough to reduce their risks, while his fund justified its focus on capital preservation by losing just 0.61 per cent in 2008.

HW: What is the background to your fund and company?

MB: Collins Stewart CI is a wholly owned subsidiary of Collins Stewart, a member of the London Stock Exchange with activities spanning institutional and private client stockbroking, market making, corporate finance, fund management and the supply of online financial information.

The business was founded in 1991 as a partnership with Singer & Friedlander and was part of that group until a management buy-out in May 2000. Collins Stewart now employs more than 700 staff in 12 jurisdictions. Collins Stewart CI currently has GBP2.47bn in assets under management.

The Collins Stewart Absolute Return Plus fund was launched on February 1, 2001, but Collins Stewart Fund Management employed the services of a US-based sub-advisor, Weston Capital, up to November 30, 2002. During this period the Absolute Return Plus fund acted as a feeder fund into the Wimbledon Class B Fund.

Collins Stewart Fund Management terminated the appointment of the sub advisor in November 2002 and liquidated the holdings in the Wimbledon B fund, with the proceeds reinvested in a portfolio of hedge fund managers that had been proven in client hedge fund portfolios. Since March 2003, the track record has been exclusively that of Collins Stewart Fund Management. The Absolute Return Plus Fund currently has USD86m in assets under management.

HW: Who are your key service providers?

MB: The fund's administrator and registrar is Northern Trust International Fund Administration Services (Guernsey), its custodian and banker is Kleinwort Benson, Butterfield Bank (Guernsey) provides banking services, Deloitte & Touche is the auditor and Carey Olsen is the fund's Guernsey legal adviser.

HW: Who are the management team?

MB: I have been the lead manager of the fund from October 2007, having been deputy manager from 2004. Richard Hodgetts joined the team in April 2007 as an analyst, and Nick Maunder joined as an analyst in December 2007. Paul Le Page left the firm in May 2005, Kevin Boscher in September 2007 and Neil Deacon, who was a research analyst in the team, in March 2008.

HW: What is your investment process?

MB: We believe the investment process for building and maintaining a superior fund of hedge funds should be dynamic and not simply a set of rigid steps. Our approach, while taking on the traditional characteristics of quantitative and qualitative research, has certain flexibility dependent on the impetus behind each selection.

We use a variety of sources for unearthing potential managers, in addition to more than 8,000 hedge funds in various databases. We take pride in our ability to go through each of the peer groups and strip out 'uninvestable' funds. First - with the exception of a single existing holding - we avoid US-based managers. We have found that the level of communication with US managers is below our required standards and the levels of liquidity offered are often unjustifiable. Secondly, in the vast majority of cases we will look to invest only with large established fund houses.

Investing with large established fund houses serves a number of purposes. The likelihood of operational issues such as fraud or poor risk controls is reduce, and we avoid the diversity risks associated with companies with a single fund as their only revenue stream. On a practical basis, due diligence on large established fund houses is more risk-effective than that conducted on a small operation.

Before applying more advanced analytics, we pass funds through a series of consistency and risk-return filters to get a flavour of the potential manager universe. Like our peers, we want to identify the managers that will perform next month, next year and in three years time, rather than the manager who is at the end of a good run. Therefore this is not a definitive decision-making step of our work.

There are a number of focal points within our process. We seek to look very closely to ensure that the returns and the strategy match up, identify what could go wrong with a fund or company, and understand the impact that the fund could have on our portfolio. We also need to ensure the fund is doing something not only different from our current managers, but also beneficial, and that we have faith that the fund will continue to perform as it has done in the past.

We will always have face-to-face interviews with the manager, always scrutinise the financials, and always compare the marketing story and the operational reality.

Our decision-making is driven by the hedge fund committee, although ultimately it is the lead manager that decides. Each member of the committee is mindful at all times of protecting the portfolio from undue risks and has a clear understanding of what purpose a manager has, or would have, within the portfolio. While aware of historic correlations and potential portfolio impact of funds, the committee is pragmatic and decisive in its manager selection and portfolio construction.

HW: How has your portfolio performed?

MB: The sterling class of the fund lost 0.61 per cent last year, following gains of 15.32 per cent in 2003, 9.02 per cent in 2004, 12.62 per cent, 6.07 per cent in 2006 and 8.83 per cent in 2007. Since November 2002 the annualised return has been 8.55 per cent, with a standard deviation of 4.32 per cent and a Sharpe ratio of 0.82.

HW: How many funds are in your portfolio? Which strategies do they represent?

MB: As at the end of December there were 23 holdings in the fund. Multi-arbitrage and macro-discretionary funds each account for 15 per cent of the assets, merger and event-driven funds 13 per cent, equity long/short for 37 per cent and market neutral for 20 per cent.

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

MB: We look to invest with managers with a number of critical characteristics: they work within a sound, established house, they demonstrate the ability to use the tools at their disposal, they can demonstrate that they are dynamic and opportunistic and that their liquidity matches their investment opportunity set, and they can demonstrate strict and realistic risk controls.

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

MB: A manager may be removed for one of a number of reasons including performance or volatility drift, reduction in transparency or reporting information becoming unavailable on a timely basis, loss of key personnel, strategy or style drift, excessive growth, trading beyond maximum capacity, loss of focus or 'hunger', and loss of integrity or trust.

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

MB: We currently have 15 managers on the sidelines.

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

MB: Whilst we do not profess to have a crystal ball we would not be surprised to see consolidation of the industry, an increase in regulation, further frauds coming to light, and more investors reducing exposure to the alternative sector.

HW: How will these developments impact your own portfolios?

MB: A consolidation of the industry will benefit those managers who survive, while an increase in regulation could well increase the levels of transparency received by investors, which would be beneficial.

Fewer investors in the sector and further frauds will increase the negative media coverage the industry has already suffered. By no means do we expect the industry to fail, but we do feel that it could be some time before investors are comfortable with what the industry has to offer.

To that end, we have been spending some time re-educating potential investors in the benefits of the industry and how a reasonable exposure to funds of funds is perhaps even more important now than it has been for some years.

HW: What is the split of your assets under management between institutional and private clients?

MB: The Collins Stewart Absolute Return Plus Fund has approximately 10 per cent of its assets from institutional clients and 90 per cent from private clients.

HW: What differentiates you from other managers?

MB: The team managing the Absolute Return Plus Fund has a clear understanding of the shape and direction of the fund at all times and, with a pragmatic and decisive mindset, is able to be swift and, due to the size, nimble.

We are naturally wary managers and are as much focused on ongoing operational risk as we are to monitoring how our managers are performing. The overwhelming majority of fund failures have been for operational rather than performance-related reasons, even with the extraordinary deleveraging effects of the credit crisis that began in August 2007.

Our competitive edge is our uncompromising dedication to picking and monitoring a diverse group of excellent single-manager hedge funds, run by highly talented and creative individuals, within the support of sound, and importantly safe, companies. Much of our fundamental approach is driven by our level of comfort in the manager, or management company. Although this could be described as instinct, we have an unflinching belief that it is far better to be safe, rather than the alternative.

HW: What is your attitude toward risk?

MB: Many managers have not been quick enough to reduce their risks and the entire industry has suffered because they left themselves exposed to market pressures and lost considerable amounts of their investors' assets. We feel this was down to a severe lack of appreciation as well as lack of understanding of risk.

The sooner managers stop thinking that risk can be quantified in metrics as simple as value at risk and standard deviation, and start appreciating that the most severe risks are those that a computer can not tell you, the better it will be for the end-investor.

HW: Are investors' expectations moving towards capital preservation? If so, how do you deal with this?

MB: Our recent experience is that investors are far more concerned with capital preservation. We were fortunate that our investment style is capital preservation and are pleased to have largely held on to our investor's capital over the past year, losing just 0.61 per cent. Moving into the next stage of the market cycle, we intend that our strategy will not change in any way - we will continue to target capital preservation and not attempt to chase returns.

HW: How do you distribute your funds?

MB: Our funds are distributed through our network of investment advisers, including professional intermediaries, trustees and consultants, in our core areas of geographic focus.

HW: Do you foresee problems in raising mandates from investors in 2009? If so, what factors will drive investors back to your funds?

MB: We have found that investors have become more careful when investing into the fund of hedge funds space following the problems of 2008. It is our experience that the market has become more discerning, and respects funds such as ours which managed to avoided the pitfalls that so many of our peers fell into last year.

HW: Are you planning any mergers or acquisitions this year, given the talk of consolidation in the industry?

MB: A number of fund managers in this sector have had a very bad time in 2008, and who are now actively seeking strategic relationships offering support, or even to be bought out. We believe the infrastructure that Collins Stewart Fund Management can offer such groups is tremendously appealing, and we welcome the opportunity to sit with potential partners to discuss potential synergies. We see a lot of opportunity in this area.

HW: Finally, are you planning any launches?

MB: We have no additional fund of hedge funds launches currently planned for 2009. Our objective is to capitalise on the excellent performance track record that we have built up since launch of this fund and to continue to raise assets under management from our target client base.



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