The Interview – Jesse Redmond and Justin Pawl, Evolved Alpha: “Many investors do not realise the hedge fund industry has a surprisingly high correlation to beta markets”
Jesse Redmond and Justin Pawl, founders and co-portfolio managers of multistrategy specialist Evolved Alpha, say the business is structured to provide investors with a portfolio of liquid, secure and transparent alpha-return strategies, retaining the diversification, nimbleness and sophisticated risk management of top multistrategy funds but expanding the universe of potential managers to several thousand rather than the small subset that would trade exclusively in-house for one firm.
GFM: What is the background to your company and funds?
JR/JP: We launched Evolved Alpha on 1 April as a next-generation multistrategy fund to provide investors with transparent, liquid and secure access to a portfolio of uncorrelated alpha return strategies. Previously we worked together for five years, most recently as co-portfolio managers of Alpha Titans, a fund of funds focused on dominant multistrategy managers.
During our tenure the Alpha Titans Multistrategy 1x share class outperformed the HFRI fund of funds index in 22 out of 27 months and by more than 16 per cent on a cumulative basis. More important than the outperformance for investors was the experience we gained in analysing premier multistrategy firms.
Specifically we appreciated the diversification, nimbleness and sophisticated risk management used by top multistrategy managers, but the challenge we witnessed was retaining and recruiting top talent to trade exclusively for one firm. We all regularly read about top teams moving from one dominant firm to another, or spinning out to run their own firms.
Evolved Alpha is a significant advancement as we retain the diversification, nimbleness and sophisticated risk management of top multistrategy funds, but expand the universe of potential managers to several thousand rather than the small subset that would trade exclusively in-house for one firm. Currently we have ten strategies in the portfolio run by nine proven external managers. Evolved Alpha is not an emerging manger fund – in fact two of the current strategies are hard-closed.
The flagship Evolved Alpha Multistrategy share class allocates exclusively to liquid financial instruments, primarily equities, futures, options and currencies. Investors can also tailor their exposures by investing exclusively in equities trading through the Global Equities share class or futures and currency trading in the Global Futures share class. In addition, a Total Return Fund offers a more sophisticated approach to portable alpha. Finally, we have seeded a Multistrategy Institutional share class with a risk/return profile and terms tailored to institutional investors.
GFM: What is the structure of your funds?
JR/JP: Evolved Alpha uses a dual master-feeder structure with onshore and offshore funds. The onshore funds are located in Delaware and the offshore funds in Cayman, providing the flexibility to accept investors globally.
GFM: Who are your key service providers?
JR/JP: We launched with multiple prime brokers and a separate cash management custodian, which gives us an edge in managing counterparty risk. Prime Brokerage and Custody is provided by Morgan Stanley, Bank of America Merrill Lynch and JP Morgan (for cash management).
Our administrator is SS&C Technologies, the world’s eighth largest with USD140bn in assets under administration. Our auditor is Rothstein Kass and our legal counsel are Walkers (offshore) and Pillsbury (onshore), while operations and compliance are provided by Blue River Partners and risk management by Investor Analytics.
GFM: What is the profile of your current and targeted client base?
JR/JP: The investor base is currently family and multifamily offices. After the initial launch, we have selectively accepted further capital from outside investors, but anticipate beginning to take broader additional investments in the autumn. We seeded the Multistrategy Institutional share class in May with volatility and return targets tailored toward the institutional community. We have created a foundation designed to appeal to a variety of market segments as our track record and assets grow.
GFM: How has your fund performed?
JR/JP: During the initial two months the flagship Multistrategy share class outperformed the HFRX Global Hedge Fund Index by more than 50 basis points and the MSCI World Index by about eight per cent. While we use benchmarks for ease of comparison, historically the fund has not been correlated to stocks or other hedge funds due to our emphasis on alpha-returns rather than beta.
GFM: What is your investment process?
JR/JP: A core tenet of Evolved Alpha is that the greatest value we can provide to investors is a truly independent stream of high risk-adjusted returns. Our emphasis on uncorrelated returns is emphasised in every step of the investment process. Independent returns are generated from alpha, which we define as a skill-based investment edge that is not derived from a persistent directional bet on a market, spread or asset class.
We have tailored our multi-phase investment process to screen out beta and hedge fund beta and emphasise alpha return strategies. Many investors do not realise that the hedge fund industry as a whole has a surprisingly high correlation to beta markets. For example, the HFRX Global Hedge Index since inception in 1998 has been more than 70 per cent correlated to the MSCI All Country World Index.
You can buy beta for basis points and we believe you should pay hedge fund fees for alpha. Many investors don’t recognise the emergence of hedge fund beta, which capture risk premiums of common hedge fund strategies. AQR has done an excellent job illustrating that strategies such as merger arbitrage can be replicated for low cost on a passive basis.
Our investment process begins with identifying market segments and strategies with the greatest alpha-generating potential. We then use a variety of resources to discover investment teams that are best suited to exploit those opportunities.
For example, our analysis shows on a relative-value basis the technology and consumer sectors have great potential for above-average returns in the coming years. We interviewed dozens of teams trading in these spaces and ultimately discovered a team that had great success running a portfolio internally at SAC, and eventually decided to spin out and launch their own firm. This is a prime example of the competitive advantage gained by Evolved Alpha’s open architecture.
The portfolio construction process blends complementary strategies, with strategy weightings based on a variety of factors with primary emphasis on correlation to existing strategies and expected risk-adjusted returns of the strategy. Underweight positions are often newer managers we expect to increase as we get more comfortable, and larger allocations are typically the most proven firms or those with limited capacity where we will act tactically to secure scarce alpha opportunity.
GFM: How many funds and strategies are in your portfolio?
JR/JP: We currently have allocations to ten strategies managed by nine independent managers. We intend to gradually further diversify the portfolio, but expect Evolved Alpha to be a more focused fund, with an emphasis on select strategies and deep relationships with top specialists in these areas.
GFM: Do you have plans to do launch products linked to hedge fund indices?
JR/JP: No, it is more likely that we would consider using our managed account structure to create customised solutions for larger investors or create alpha return products designed to a broader audience, not just accredited investors.
GFM: What makes a manager or strategy special enough for you to select them?
JR/JP: At the highest level, we invest exclusively in liquid alpha return strategies. Just being liquid and alpha return reduces the potential universe of hedge funds by more than 50 per cent. After these initial criteria, we seek specific areas that we feel offer the greatest risk-adjusted and most independent returns, and use a blend of qualitative assessment and quantitative analysis to identify the top specialist in each area.
For example, we recently added a global index arbitrage strategy to the portfolio that seeks to arbitrage equity indices in 24 developed markets on a beta-neutral basis. This type of strategy is much more appealing to us than what we refer to hedge fund beta, such as merger arbitrage and convertible bond arbitrage.
GFM: What are your criteria for removing managers from the fund?
JR/JP: We have several criteria that would cause a manager to be removed, including ethical issues or breaches in risk management. With daily position-level transparency and a sophisticated risk platform, we are able to monitor each manager’s volatility, correlation, overlap, concentration, and other metrics each morning before the market opens.
Therefore we can quickly identify if a manager adds a position to the portfolio that should not be there, or if a manager’s exposures are inconsistent with their pre-specified investment guidelines. Similarly we monitor each manager’s exposures relative to their performance, and evaluate whether performance is consistent with the market environment and their peers.
Although performance plays a role in monitoring, poor performance is not the most common reason for firing a manager. There are wrong ways to make money and there are right ways to lose money. During the due diligence process we spend a great deal of time with each manager understanding the market environments in which we should expect the strategy to outperform and underperform.
We then measure the performance of each strategy against the market environment and their peers to determine if the strategy is behaving as expected. Making money in an environment in which the strategy should lose money is as likely to cause us to remove a manager as is losing money in an environment in which the manager should be making money. Both circumstances indicate that the manager is trading differently than expected and warrant investigation.
GFM: How many managers do you have on the substitutes’ bench?
JR/JP: Currently we have some five managers on our short list. Following this group, an additional ten managers are currently progressing through a ten-step due diligence process but have not received final approval. We actively track an additional larger group of managers that have not been formally engaged in our due diligence process.
GFM: What events do you expect to see in your sector in the year ahead?
JR/JP: We expect hedge funds and alpha-return strategies in particular to play a larger part in investor’s portfolios, from the retail to the institutional level. The Madoff fraud, and the actions of many hedge funds in implementing gates and suspending redemptions, have elevated investor appetite for investments that provide transparency, security and liquidity.
From an objective perspective, hedge funds remain a solution far superior to traditional investments. For example, since 1990 the HFRI Fund Weighted Composite has delivered annualised returns of 12 per cent, compared with just six per cent for the S&P 500. Moreover, hedge funds have exhibited less than half the volatility and downside risk of stocks during this 20-year period.
We find it puzzling that investors still largely view hedge funds as risky, when the objective data shows that over 20 years USD1m invested in the HFRI Fund Weighted Composite would have earned nearly USD10m, while the same investment in stocks would have earned just over USD3m while enduring more than twice the volatility and drawdowns.
More recently, global concern over the potential for a double-dip recession may lead investors to seek uncorrelated returns and portfolios with the potential to perform in both bull and bear markets.
GFM: How will these developments affect your own portfolios?
JR/JP: Evolved Alpha is structured to provide investors with a portfolio of liquid, secure and transparent alpha-return strategies. By making all allocations via separately managed accounts, Evolved Alpha owns all the underlying assets and managers are delegated limited trading authority and cannot move assets into or out of the account, which removes potential manager fraud risk.
The position level transparency enables more sophisticated risk management techniques unavailable to traditional multi-manager funds, and we share both returns and risk reports with investors on a weekly basis. These benefits, combined with monthly liquidity and no lock-ups or gates, provide a structure we anticipate will attract investors.
From a return perspective, in the first two months since launching the portfolio, the flagship Multistrategy share class outperformed global equities by more than eight per cent, and the environment for alpha-return strategies is encouraging.
GFM: What differentiates you from other managers in your sector?
JR/JP: We are pursuing a multistrategy business model, allocating to outside managers in a range of liquid, niche spaces. Funds of funds cannot provide investors with transparent, liquid and secure access to these strategies. Pure multistrategy funds are limited to allocating to only those managers that they can retain to trade in-house, and must constantly compete to attract and retain that talent. Evolved Alpha retains the benefits of multistrategy funds, namely diversification, nimbleness and sophisticated risk management, but expands the universe of potential managers to several.
GFM: What is your attitude toward risk in the current environment?
JR/JP: The current environment has abundant opportunities, but must be approached with caution. Recently our gross exposure levels have come down by approximately 25 per cent and net exposures remain tight as we do not take persistent directional bets. This measured approach has paid off in outperforming our peers.
While we actively study the economic backdrop and have opinions, we do not claim an investment edge in macroeconomic forecasting. Our edge lies in identifying alpha opportunities, evaluating managers and constructing portfolios of uncorrelated returns. This approach removes the need to bet on markets or economies (which has historically proven very difficult), instead focusing on investments that can perform in a wide range of environments.
GFM: How would you assess investors’ expectations and how do you deal with them?
JR/JP: When speaking to investors, performance is always a key issue, and risk management is increasingly topical. Evolved Alpha’s different share classes have specific risk and return profiles that we explain to investors and strive to set appropriate expectations early in the process.
More than ever transparency, liquidity and security of assets are higher priorities. It is one thing to earn a return on your investment, but if you cannot receive your money back when you need it, what’s the use? Investors are looking more towards security of capital and transparency to understand their risk exposures.
GFM: Are you planning any further launches in the near future?
JR/JP: We have been approached regarding more tailored mandates for larger investors, and this may be an interesting longer-term business. At the other end of the spectrum our managed account structure is easily adaptable to hedged mutual funds or other solutions for non-accredited investors. We will continue to evaluate new opportunities as the industry evolves.