“Art and science”: Prime Capital’s flagship strategy thrives with ‘alpha-first’ approach to hedge fund manager selection

Tilo Wendorff, Prime Capital

Designed as a balanced portfolio of ‘best-in-class’ hedge fund managers, Prime Capital AG’s flagship fund of hedge funds strategy – the PCAM Blue Chip Fund – has built a formidable track record since launching in October 2007.

Though the USD700 million fund-of-hedge funds vehicle initially dropped around 14 per cent in 2008, its first full year of operation, it has since generated 12 consecutive years of positive returns. Last year, the fund recorded its best annual performance since 2009’s 30.7 per cent gain, surging 10.44 per cent in spite of the market turbulence brought about by 2020’s coronavirus crisis. In 2021, PCAM Blue Chip is up 1.1 per cent year-to-date.

The fund is run by Tilo Wendorff (pictured), managing director and head of absolute return at the Frankfurt-based firm, who oversees Prime Capital’s hedge fund of funds and hedge fund mandates business, which accounts for around USD2 billion of the firm’s total assets of EUR17.9 billion.

Portfolio processes

The aim of the PCAM strategy is to create a concentrated portfolio of blue-chip hedge fund managers, drawn from a universe of the 100 biggest hedge fund names globally, and positioned in a low-beta, market neutral, relative value space. Names are picked using a top-down and bottom-up investment process, producing for clients what Wendorff describes as a “sleep well” investment portfolio.

“It should have almost no market exposure, so the returns we provide through this product should be almost purely alpha,” he tells Hedgeweek.

“Being Germans, we love process. We focus on very strong processes in this fund – we’re not market-timers, we’re not chasing trends, we’re not trading around things. We just stick to finding the best managers which produce as pure-as-possible alpha. We have achieved that over the life of this fund.”

Wendorff joined Prime Capital two years ago, having started his investment career in 1995 at Deutsche Bank and Deutsche Asset Management. He then worked at the McKinsey Investment Office from 2001 until 2013, where he was a senior investment analyst focused on hedge funds other alternative assets. Later, he spent six years at the Max Planck Foundation as an investment manager running its hedge fund portfolios, before joining Prime Capital AG in January 2019. 

The firm is independently-run, owned by its employees and management, with a total staff of around 100 people.

Along with its flagship PCAM Blue Chip fund, the firm also has two additional products in the alternatives space: PCAM Select, which consists of smaller, more focused managers; and PCAM Alternative Credit, which targets the more liquid end of private credit, in areas such as trade finance, real estate, bridge financing, and SME lending, along with certain other niche credit strategies that offer high returns.

“We started with hedge funds only, but nowadays we are more diversified – we’re active in private debt and infrastructure as well, on the equity and the debt side,” Wendorff adds.

As a broadly concentrated fund of funds, PCAM Blue Chip’s portfolio is typically composed of between eight to 10 managers. The idea, explains Wendorff, is to not turn around the portfolio too often.

“In an ideal world, you would never change a manager,” he observes. “But in reality, we will probably change one manager per year, though we still have a lot of managers in the book who have been there since 2007.”

Breaking down the manager selection process, Wendorff says the team splits the broader hedge fund strategy universe into three buckets – defined as convergence, value, divergence.

Convergence is the biggest component, typically accounting for around 50 per cent of the fund, and made up of managers that offer equity market neutral, relative value, no market exposure, constant returns, with some tail risk involved.

Value, meanwhile, is “everything which has some market dependency”, he adds.

“This would tend to include something like equity long bias, though we do not invest in that space specifically. Instead, this bucket for us is mainly the distressed credit managers. We think that’s a very good strategy – you have market dependency, but you also have value and a lot of alpha in there,” he elaborates.

Finally, the divergence pool includes managers running strategies such as macro and CTAs “where you have this insurance premium” provided.

“We combine the fund in a way that gives us a constant return from the convergence bucket, another smaller return from the value bucket, and then in the divergence bucket, there is a small return in normal environments – but it should have an uplift in a crisis scenario that helps stabilise the overall portfolio.”

A methodical approach

While the PCAM fund has long eschewed certain specific strategy types – namely long-biased equity and structured credit – recent market developments have also sparked a rethink in the firm’s approach towards some trend-following funds.

“We don’t think long-biased equity makes sense because you’re overpaying for the beta component and you're not getting enough from the alpha component. That’s always my argument against long-biased equity,” Wendorff notes.

“The pattern of returns in structured credit is not something we like in our portfolio. When it works, they do very well, but when it doesn’t work, they really hit you very, very hard. That’s not what we’re doing. We want to build a stable, long-term book.”

Lately, the sizeable and sustained intervention in markets globally from central banks in recent times, continues to negatively impact the drawdown and recovery process, which Wendorff believes makes it increasingly difficult for traditional trend-following models to effectively capture market movements.

“Last year we came to the conclusion that the traditional CTA model does not work in this environment anymore,” he explains. “We divested from one of the traditional CTA managers and replaced it with some additional capacity we got from our existing managers. We were also able to add another additional new quant manager that we were happy with.

“So CTAs, we’ve exited for now, but we’re watching them because we think it's an important part of a portfolio. But we need to be sure of when those CTA models will work again.”

Delving deeper into the selection process, Markus Koch, managing director, client solutions, explains how PCAM’s methodical approach is ultimately an advantage for the strategy.

“We have a slow process, but it’s also a strong process; as a selector we need time on the manager due diligence,” Koch says. “Throughout the years we have definitely missed out on certain high-flying funds and the strong performance they have been generating. But we believe this is an advantage of our set-up – it helps us avoid the big mistakes.

“So far we have missed out on many problematic funds. We never had a blow-up in our portfolio. This is one of our key strengths of the process.”

When asked about cryptocurrencies, an asset class whose popularity is booming among many within the global hedge fund fraternity, the team remains cool about its potential inclusion in the PCAM model, with Koch highlighting the core market neutral, beta neutral philosophy underpinning its framework.

“If we stumble across a fund that has a very nice arbitrage or relative value trade in crypto, we definitely would have a look at it. But not stock-picking-type crypto fund – I don't think that’s a focus for us,” he indicates.

“There will always be niches where you can make interesting investments. But we’re definitely not chasing bitcoin to the next high. We’re happy to sell shovels to gold diggers, rather than be actively searching for gold ourselves.”

Wendorff adds: “For us, crypto so far is not an investment, it’s a bet, and we’re making investments, not bets.”

‘Art and science’

As the conversation draws to a close, the team predicts renewed spikes in volatility this year, which they feel will prove positive for low-beta, low market exposure hedge fund strategies such as theirs.

“It’s an environment where there are dislocations and you can make returns from these dislocations. Volatility and dispersion are always good for our managers in general,” notes Wendorff.

They remain confident that their particular blend of managers and strategies – described by Wendorff as “a combination of art and science” – will continue to pay off, having delivered consistent gains for more than a decade.

“It was a very difficult point to start at, and it’s been quite an interesting time period since,” he recalls of the fund’s launch amid the then-unfolding Global Financial Crisis and subsequent turmoil. “We have managed to survive and that’s primarily due to our superior performance.”

Reflecting on 2020’s economic upheaval, Wendorff says the firm was “cautious, but not worried” as the worsening Covid-19 pandemic sent markets into tailspin during the first quarter.

“We followed our managers closely over the course of the year and were happy that they were also able to pick up interesting additional spreads in March and April, so that helped bring the outsized performance over the rest of the year,” he says of the fund’s double-digit annual return on 2020.

He adds: “We don’t want to over-diversify the fund, but if we then see an interesting manager, we ask whether they are better than what we have in the book. Do they bring additional diversification?

“When I started in the industry over 20 years ago, I was young, I thought I knew everything. But over the course of the time you learn that grey hair and experience is important.

“Nobody has been able to come up with an algorithm of how to create a good portfolio and select good managers, and as long as nobody achieves that, our jobs are safe.”