Problems and Solutions in Investing with China-based Hedge Funds

This blog has been running for four months and this is the first posting to mention China. At the start of the year as strategists and economists gave outlooks for 2010 it was all about China. Anthony Bolton, after a career as a London-based fund manager at Fidelity dedicated to UK equities, has come out of retirement to run a Chinese equity fund and is to be based in Hong Kong. As a destination for investment, the popularity of China-focused funds is certainly on the rise. Sales of China-focused funds via Fidelity’s fund platform, FundsNetwork, increased by 59% in 2009, while sales into Fidelity’s China Focus Fund alone increased by 239%. That is how enticing China is as an investment destination. However, whilst  there has been a China theme to many investment portfolios, and the largest hedge fund companies have opened Hong Kong or mainland China offices, Chinese dedicated hedge funds have been something of a side show in the hedge fund industry. This reflects that China is much more developed as a manufacturing centre than a service and financial centre.

So China is recognised as  representing the largest global growth opportunity on a multi-year basis, but immature as far as the financial sector and capital markets are concerned. The Chinese equity markets represent a rich opportunity set, as do all frontier markets, but in this particular case, partly through cultural considerations, they can be difficult to access successfully and sustainably and with as much confidence in the execution as in the high concept. The practical difficulties were recently addressed by dedicated hedge fund site http://www.chinahedge.com.cn/, using comments by GFIA as a springboard.

The rest of this post is in two parts: the article from Chinahedge, which has been re-written but not changed in shape or substance, and in part two a full, considered response from London-based Fund of Funds manager Caliburn Capital Partners, which targeted exposure to the China theme some years ago, and which has supported exposure in the region through a Singapore office.

Part One - The Problems

The investability of mainland China based managers has become an issue, as reflected in the decision by Singapore-based research firm GFIA to stop covering and investing in hedge funds based in mainland China. It has largely shifted its coverage to western-trained managers based in Hong Kong. As an example of the issues investors face it cites that on a number of occasions China-based hedge funds would not reveal the identity of fund backers or the background of portfolio managers.

Compliance issues

The majority of offshore Chinese hedge funds are run from Hong Kong and the mainland China cities of Shanghai and Shenzhen, with very few in Beijing. For those with a Hong Kong office, almost all of them are Hong Kong Securities and Futures Commission-registered.


"At the very beginning of the due diligence process for investors allocating to China hedge funds investors should check to see if the investment manager is regulated, if the fund they manage have independent directors, if the fund is administered independently by a well known firm, and if the firm is audited independently by a top grade auditor." Andy Mantel, founder and CIO of Pacific Sun Investment Management (HK) Ltd, told China Hedge by phone. Andy is one of few offshore Greater China hedge fund managers who is non-Chinese but is fluent in Mandarin having been in the Greater China Region for about 20 years. “Basically all mainland headquartered hedge fund managers fail this initial due diligence test.”


Based on the statistics of China Hedge Fund Managers (Onshore) Database complied by China Hedge, most of the mainland managers (about 200 managers) are only managing local Chinese hedge funds denominated in RMB which are not accessible by global investors. Around 10% of them are running offshore Greater China hedge funds as well. Some have HKSFC-registered operation. Only a few of them have no HKSFC-registered operations which may cause some compliance issues.

Transparency and disclosure issue

GFIA mentioned in its report that those mainland-based managers show "a lack fundamental transparency and openness." It is an issue with some mainland-based fund managers that they are not willing to disclose their real holdings, and they do not have a disciplined risk management either, according to Kaikai Hua, director of a Shanghai-based wealth management company. He said, “normally they have a bet on one or two stocks or PE investments, and cover up the big loss or a liquidity problem until the stocks stop trading, or the IPO fails.”

Before selecting China managers for their US-based institutional clients, Bill Hunnicutt strictly required the Chinese managers must be willing to accept complete portfolio transparency which is now mandatory post-Madoff. Bill is the President of Hunnicutt & Co., LLC which is a placement agency based in the US. Bill said this means showing a current portfolio upon request. “Some larger US institutions require daily transparency via a dedicated website, while others will accept transparency via 3rd party vendors who then provide a general summary of the portfolio to the client.”

Business and cultural differences

There are clear cultural differences between local managers and global investors. Most local managers come from mainland mutual funds and securities firms. They are accustomed to running funds to a local standard, not those expected by global investors. “If the local managers do not tell you the companies they hold because they do not want others copy the idea. Knowing something early than the market is an important way for them to make money", Kaikai said.


The cultural differences may be exacerbated by communication problems. Most local managers are not comfortable to talk and write in English, so, the email reporting and newsletter that foreign investors in hedge funds expect may not be produced on a timely basis, if at all. “They would rather not say anything than express something badly. It takes a while for investors to fully communicate with these managers.” Kaikai said.


So local Chinese managers have something to learn in terms of the normal global practices and standards of running a hedge fund, as recognised by international investors. It has been suggested that mainland Chinese managers of hedge funds would benefit from getting together on a regular basis to share some thoughts of running a hedge fund business – a draft practice for participants would follow. Some managers recognize that there is a trend of increasing allocation to China-based managers, and in response they have recruited Chinese partners who are Western-educated and/or have worked for Western companies so that they can acquire that necessary knowledge about the standards expected by global investors.

Changing regulated status

The current Chinese law has regulated Chinese mutual funds, but these regulations do not apply to onshore Chinese hedge funds. According to MarketWatch published by Citi Securities and Investment Services dated 17 December 2009, the mutual fund law review workgroup, set up by the China Securities Regulatory Commission, has reached an agreement to include privately-raised funds as regulated mutual funds in the revised Mutual Fund Law.


Li, Zhenning, Chairman of Shanghai Rising Fund Management and the member of the mutual fund law review workgroup suggested that the regulator release licenses on privately-raised funds (commonly called local hedge funds) in the future. Investors, thus, can expect better regulation of local hedge funds in areas such as transparency issue and information disclosure.

Comparative advantage of Chinese-speaking CIOs

”Some local CIOs are sound managers. They know what they are doing, and what risk they face. Despite the lack of transparency and absence of rigid risk control systems, mainland-based managers have a big advantage in that they know the market well. They are more alert to the growth engines in the market, as well as problems in the companies. They spend more time talking to people in the street, and ask what they think of a product. It’s much easier for them to get access to companies too,” Kaikai said.

To combine both HK and mainland managers

“Hong Kong is by far the best place to manage a China fund. Aside from the unparalleled infrastructure and regulatory environment, the free flow of instant, uncensored information is vital when making investment decisions.” Andy Mantel said. “Research activities on the mainland can only add value if it is a supplementary research and information gathering office in support of the manager's headquarters,” Mantel emphasized.”


Kaikai Hua states that Western-trained managers based in Hong Kong have a different strategy. Most of their holdings are big names and liquid stocks. They perform better in a bear market or when market is in a correction. And they have a better understanding of tools for hedging. “We see that one side are stock pickers, and the others are portfolio manager.” Hua suggests that clients combine both, so that they can enjoy the advantages each offer in accessing the growth of Chinese market.

Chinese hedge funds are growing

There is a strong case to be made that the Chinese hedge fund sector is becoming more significant within the global hedge fund industry. Many institutional investors have started to monitor and even allocate to Chinese hedge funds in their global portfolios. “We should not neglect the China market” is the common belief of most global investors.


The booming equity market has helped the growth of industry assets. The industry recorded encouraging growth figures last year. Chinese onshore hedge fund managers launched 242 products in 2009, according to a report by Chengdu, Sichuan-based Sinolink Securities Co Ltd. The average size for every fund was about 90 million yuan ($13.2m), the report said. The 151 non-structured hedge funds returned 54% on average in 2009. As the end of 2009, the local China hedge fund industry reached around RMB 50 billion ($7.4bn). Zhang Jianhui, Director of Fund Research with Sinolink Securities, said at the Sinolink Hedge Fund Forum last Saturday in Beijing that the hedge fund industry of China would manage about RMB 100 billion as at the end of 2010.

Part Two - The Solutions

Thank you for giving us the opportunity to respond to Peter Douglas’s comments. Whilst we acknowledge that Peter is well respected in the industry and has a long track record as a specialist on the Asian hedge fund industry as a whole, we would take issue with his view that mainland based managers are not transparent enough for investors to assess them properly from a qualitative perspective.



For the sake of clarity, what we mean by “mainland based managers” are those where the Portfolio Manager is generally based in China, may or may not have a Western background or speak very good English, but will have a Hong Kong office (or other location outside the mainland) and will be registered with the SFC in Hong Kong (or equivalent in other jurisdictions). This group includes some of the most well known and longest established Greater China hedge funds and all of our comments below are based on this group of managers. (There is a second group of mainland based managers who don’t have an investment management company outside of the mainland but who offer offshore products. Caliburn does not invest in this second group of managers because the law is not clear if mainland based funds offering offshore funds should be classified as Permanent Establishments, which would mean the fund and firm would be subject to tax. Currently we are seeing the market leaders in China’s mainland fund management industry, who are in the process of launching offshore products, all setting up offices outside of the mainland in Hong Kong.)


Bearing in mind the definition above, we have built an extensive peer group of mainland based managers who we monitor and from whom we receive regular updates. In our view, some of the strongest Chinese research teams from both a bottom up and top down perspective are mainland based. Their research edge comes from their ability to pay significantly more than the established, large local mutual funds so they can hire the best research analysts. We also find that in these teams there are more analysts with direct industry as well as buy or sell side research experience which provides an additional research edge.


These managers generally provide monthly reporting which is of a high standard with good portfolio level data, and they are happy to speak about the portfolio composition and their market views in some detail. If there is a problem it may be that some of the larger managers ($300m AUM or above) may be reluctant to offer transparency to other than significant investors. Equally, bottom up stock pickers may be reticent to elaborate on their rationale for individual and current stock picks. However both of these observations can be made of hedge funds in general and are not particular to China. In general we do not encounter these difficulties with the majority of funds. Clearly, full transparency is always available through a managed account with most mainland based managers. Of course, just as in the Western hedge fund industry investors will again need to meet a certain minimum investment size to take advantage of this option.


Of the three mainland based managers with whom we are currently invested, one provides us with probably the greatest transparency of any manager that we follow, including providing the full portfolio twice a month and an enormous depth of insight directly from the CEO and senior investment team. From the remaining two we receive monthly portfolio information with very good transparency such that we are able to establish and monitor all of the key risks and sources of return of the funds.


There is no question that communication is not always easy with mainland based managers. There are often cultural and language difficulties to overcome and few are polished presenters. It is therefore important to have Mandarin speaking analysts but it is not just about language. For Caliburn as a thematic investor, research does not start with the manager; we do a lot of work to understand the underlying market and investment opportunity. This includes attendance at industry and corporate conferences as well as independent meetings with regional thought leaders. The natural result of these activities is that our research team is armed with a good understanding of the Chinese macroeconomic situation, policy news and sector news together with a general knowledge of stocks in key sectors. With this as background it is possible to establish a better relationship with managers. Our thematic work supports very specific and focused questioning and with this approach we have been very pleased with the level of disclosure we have received to date.


In relation to getting comfort with the risk management processes at these firms, as with all peer groups there are funds where we trust the risk management and there are funds where we remain cautious or sceptical. Without question a significant commitment of resources and time is required to regularly communicate with the funds and ask the right risk related questions to form a view. From an operational point of view, the mainland based funds that we have approved for investment have top tier independent 3rd party service providers (administrator, custodian, prime broker, and auditor) and in this respect reflect the best practices of their non-Asian counterparts.


In terms of performance in stress periods, broadly speaking most of the China based managers are bottom up investors and they did not protect the downside in 2008 as much as we would have hoped, though poor performance over this period is a common failing from across the hedge fund industry regardless of geography. We were pleased to see a number of managers sticking to a disciplined valuation approach which meant they were already running low exposure levels before the crisis unfolded. In general terms our invested China managers fared better in the second half of 2008 than in the first half of 2008 and China managers as a group performed much better than their BRIC peers over 2008 as a whole. Importantly, a number of China managers who lost 20% or more in 2008 subsequently made significant improvements to their risk management and their adherence to risk disciplines and this has served them well in months such as January 2010, during which they cut exposure and balanced their portfolio much more effectively than during the difficult Chinese markets of early 2008.


In conclusion, overall the standard clichés apply: you get out what you put in. We commit significant time and resource to achieving a detailed understanding of each manager’s approach. We routinely make multiple trips to interview a manager in his / her office and follow up these on-site visits with a number of conference calls before deciding to bring a manager forward for discussion at our internal approval committee. There are barriers to entry and the investment opportunities may be less accessible as a consequence. However this can make the opportunities more interesting and the barriers can be overcome with a commitment of analytical time and a consistency of approach that reassures the manager that you are serious and there for the long term.

Richard Howard
Caliburn Capital Partners

Podcast 3 - A Q&A with Two Third Party Marketers of Hedge Funds

Click on the emboldened header (e.g Part One) to link to the sound file. Clicking on the link will open a page containing the sound file - download or play in your browser

Part One
(8 minutes)

Clicking on the link above will open a new window with two choices available: download the podcast or play the podcast.

1.50 What are Third Party Marketers?

2.23 How was 2009 for Third Party Marketers?

4.05 Databases over Third Party Marketers?

6.00 Transactions versus Relationships

7.01 Repeat Visits to Targets

7.58 Decisions by Committees

Part Two

(13 minutes)

0.00 Branding in the Hedge Fund Business

2.48 Marketing Materials

4.16 Clarity of Materials over Logo Design

5.10 Boiled-Down Presentations

6.37 The Last Two Minutes of the Presentation

7.13 Matching Material to Territory and Investor type

8.22 Establishing Trust

8.55 Initial Assessment of Manager

9.40 Friends & Family Money First

10.47 More Established Manager for Institutional Investors

11.19 The Sourcing of Managers

Part Three

(6 minutes)

0.00 Next Stage after Identifying the Managers to Work With

1.50 Marketing Due Diligence

3.04 The Sweet Spot Now

5.18 Strategies to Appeal in 2010



My Thanks go to James Palmer of Red Sky Capital Solutions (redskycapsol.com)

And Barry Rogers of Alternative Investment Management (AIM) Partners (research@aimpartners.co.uk)

for their contributions to the discussion podcast above.

Excess Supply of Emerging Managers to Come?

One of the consequences of the growth of institutionalisation of the hedge fund business is that it has become a lot harder for small and start-up hedge fund managers to get commercial traction. In the late Nineties it seemed that a manager only had to turn up with a credible background and they could launch with $30 to 50m. In the early Noughties it was still fairly easy to set up and it was quite common for a large wealth management company or fund of hedge funds to put a manager they believed in into business. From 2003 onwards the bar was raised for start-ups – managers had to come to potential backers with much more of a complete package, including a preference for two portfolio managers and an analyst or two. "We expect start-ups to have a headcount of five or six," was a typical quotation at the time. It was not impossible to get going on either a bigger or smaller scale, but if it was smaller it was odds-against.

In the period 2005-2007 asset flows into the hedge fund industry became the dominant driver. The consequences included a break-away pack of winners amongst allocators of capital to hedge funds. The flows of new capital were dominated by institutional assets such that institutional imperatives dominated the processes and mind-sets of funds of funds businesses. Ticket sizes became bigger generally. And this was a problem to new and smaller funds – as investors in hedge funds commonly have prudence rules that limit the percentage of assets of a fund they can represent. In this era the second generation manager was the most successful route to hedge fund launches. This was a very safe route for the middle men of the business – as many more of the boxes could be ticked at launch, particularly if the second generation manager stayed under the same roof. The same can be said where additional strategies were launched by the management company for a successful large hedge fund.

Times since the middle of 2008 have been tougher for newly launched funds. There were far fewer of them, but redemptions across the industry made things very difficult. The outflows of capital across all funds left capacity at great and very good managers. Logically the first flows into the industry went to the best managers with available capacity, which was all of them.

New Supply

Late into 2009 the word was that the reining back of capital at investment banks, but across the sell-side generally, was going to compel an outflow of talent into the hedge fund world. Investment management consultancy Laven Partners have said that they are seeing a trend for traders from banks to launch new businesses, partly reflecting concerns about remuneration levels within banks. They say that many traders working as the number 2 or 3 portfolio manager in a fund feel that now is the time to strike out on their own. In particular this is true in funds that are well below their high water mark. Other service providers confirm the trend - prime brokerage departments were said to be running longer lists of newly formed funds coming to market. For example Morgan Stanley reported a 10% increase in prime brokerage clients in the 4th quarter. So 2010 is expected to build on the recovery in launches of the second half of 2009.

Anecdotal evidence suggests that for Europe at least, the first half of 2010 will be a busier again for new launches. Three quarters of Europe's hedge funds are in the U.K., and in the U.K. the management companies of the investment advisor have to be approved by the F.S.A. Start-up consultancies say that they have a good pipeline of new and completely independent managers, and the workload at the FSA confirms this. In early 2008 I was involved in a fund launch, and the authorisation part of the process took around 4 weeks with the F.S.A. Whilst it is true that the FSA is subjecting applications to greater scrutiny, that firms are being told by the FSA that applications are piling up, and that the average processing time is approaching 12 weeks, reflecting an increasing number of fund management company and fund launches. Rob Mirsky of Laven Partners told me that the FSA is certainly still backed up - even getting a case officer at the FSA at the moment is a struggle, he says.

Demand

So what kind of demand environment are these management companies and new hedge funds going to launch into? Alternative investment data specialist Preqin surveyed investors in hedge funds in the last couple of months to find out about their attitudes to emerging managers. The Preqin survey suggests that only 29% of investors would consider investing in a hedge fund with less than $100m in AUM. Further, they suggest that, in the main, funds of funds are the only investor type to get involved. So a principal difficulty faced by emerging managers is that they are mostly trying to attract capital from a type of investor that remains under commercial pressure itself because of its own investment returns and capital flows. 

Flows at the industry level, having turned positive in April/May of last year, have reversed in the short term. After seven straight eight up months up to November last year, flows turned negative in December 2009, according to HFN. In October investors committed $16bn of new capital to hedge funds, and in November investors subscribed a further $26bn. However, in December investors redeemed $4bn from hedge funds, according to analysis of the HFN database. Given the emerging bear phase in equity markets, it is not expected that capital flows into hedge funds will resume with force until later in 2010.

Industry level flows can be very important to new funds. Funds of funds went through a lot of fire-fighting in the second half of 2008 and the first half of 2009. The senior staff that have the ability to make seeding decisions or can decide to back an early-stage manager were completely occupied with existing investments (and keeping their firms afloat) during that twelve month period, and only emerged with some degrees of freedom in their management choices very recently. When industry flows are consistently positive again funds of funds will be able to get on the front foot in decision-making. In the aggregate, funds of funds have barely had any positive flows yet, even when single managers were gathering assets again in the second half of 2009. So the major source of capital for small and new hedge funds has been, and will continue to be, constrained for capital and senior management time in the first half of 2010, with a few small exceptions.

The small exceptions are funds and funds of funds that seed and invest in new managers on a dedicated basis. Seeders have been making capital commitments, and are well invested - many are looking to raise additional capital before they can back any more new funds. There are some new entrants: United Investment Managers and Aptima Capital Management have both recently announced plans to launch fund of hedge fund vehicles focused on emerging manager hedge funds. They should both have plenty of choice, at least in Europe.


Addendum I: according to magazine AR, the assets garnered by new funds declined 36% to $14.89 billion in 2009 —the worst showing in years. In total, new funds in 2009 that were managing a minimum of $50 million in assets by year-end amassed a mere $14.89 billion, the lowest on record, according to the biannual survey by AR, which has been tracking the biggest new fund launches since 2004. That is 36% less than $23.17 billion in 2008—a figure that was helped by two mega launches from Goldman Sachs that raised a combined $7 billion—and 63% less than in 2004, when assets garnered by the biggest new funds peaked at $40 billion.

While the number of new fund launches in 2009—53 funds met AR's criteria for inclusion—came close to those in 2008, the average assets are lower, and the number of funds managing more than $1 billion has collapsed. Only two funds were able to end 2009 with $1 billion in assets or more, as compared with 2008, which boasted five funds managing that amount. 


Addendum II: Edgar Senior, head of capital services at Credit Suisse in London, commented in February 2010: "It is harder to launch new funds than in the past, so existing hedge funds that have capital to deploy and have built out the institutional infrastructure have the luxury of choice." (source: Financial News)

Tosca Fund and Abaco Financials - Return Outcomes versus Portfolio Construction and Alpha Type

    Preface

The following discussion and analysis looks at two equity hedge funds that specialise in the financial sector. Naturally the sector was stressed as the nexus of the Credit Crunch, and the dislocations within the sector have created gross opportunities which have been taken advantage of by both the funds covered here. The longer-established Tosca Fund has undergone a successful reorganisation in order to align the portfolio processes with investors' requirements. So, to be clear, the portfolio construction elements discussed here relate to the Tosca Fund after the reorganisation of the final quarter of 2008.

One of the tenets of my consultancy business is that the portfolio construction and risk management used by a hedge fund should be consistent with the desired outcomes. The target returns are usually given as a range of absolute return per year, and sometimes come with a volatility of monthly return co-target or secondary target. The ranking of return versus risk assumption, whether it is volatility of return, downside risk, semi-variance, drawdown or worst monthly loss forecast is a primary element in understanding a particular hedge fund. Not just ex-post external measurement of risk versus actual monthly returns, but ex-ante from the perspective of the portfolio manager(s). What are they trying to achieve in terms of secondary risk characteristics other than absolute return, and how important are the higher moments in how they impinge on the investment process?

I have been looking at two hedge funds operating in the same speciality, and looking through their portfolio construction techniques. Both funds are financial sector specialists. Naturally, both the funds have had different portfolio shapes in the last 18 months than in the previous period.

Directional versus Market-Neutral

The Tosca Fund set up by Martin Hughes and now managed by Johnny de la Hay is a long/short global equity fund which is run with fund shape drawn from Hughes' experience at Tiger Management. Tiger cubs tend to have a net long bias, but to always have a significant short book. The shorts are there to make money more than hedge. The net varies between +30 to +50%. The gross used to be typically above a hundred and fifty percent of equity; the gross of Tosca Fund has been closer to 100% of equity this year. Tosca is a net-long bias, directional, and fundamentally-driven hedge fund.

ABACO Financials Fund is self-described by the managers as a market-neutral equity fund. It is of critical importance that that label market-neutral is at the first level of description along with the dedication to financials. For Inigo Lecubarri, Louis Rivera-Camino, and Martin Deurell who run the fund the beta-based market-neutrality encompasses a net between 20% net long and 20% net short. Striving to achieve relative performance within the portfolio, shorts are in place to hedge much more than for profit. A typical gross exposure (not average) has been, say, 190 percent of equity. A year ago the gross was less than 100% of equity, and is now back to the typical levels.

So the ABACO Financials Fund has had a structurally constrained and smaller net exposure to markets than Toscafund, and a slightly larger gross through its life. The gross exposure of the ABACO product is thought to be nearly twice that of Tosca Fund at the moment. The ABACO Financials Fund is a structurally market-neutral, very slightly directional equity hedge fund in which returns come from both fundamental investing and trading. Not that Tosca doesn't trade around positions at all, rather trading has not historically been a major contributor to overall returns.

Mandate Scope and Thematic Similarity

Tosca is not a pure financials fund. The top-down parts of the process includes a macro-economic analysis and micro-level analysis (firm and sector level) which gives an understanding of the growth prospects of various product categories. Whilst the core of this work is about the financial sector, inevitably the prospects of the financial sector as a buyer or seller of products and services becomes evident. So Toscafund invests in service sector stocks which the fundamental research process on the financial sector suggests will have a tailwind (longs) or headwind (shorts). For example, moves to a cashless, lower cheque utilisation banking sector drives demand for other forms of payment processing and transaction methods. The beneficiaries may be software or hardware providers.

ABACO is a pure financials hedge fund, with only a few positions being from outside Europe. The top-down elements of the ABACO investment process, the medium-term idea generation component, are very similar in outcome to those at Tosca. The knowledge base of the ABACO managers allows them to isolate the fundamental drivers for each sector and stock in their universe of more than 250 names. Drivers are of three classifications –a) Operational, b) Sector / Industry, and c) Macro-Economic. Companies financial performance is modelled based on the relevant drivers on the understanding that there is a trade-off between explanatory power and complexity. So for each company followed at Abaco the managers calculate an earnings sensitivity per factor. Earnings under various economic/sector scenarios can then be extrapolated, and then probabilities attached to the scenarios.

So for the top-down (longer time-frame) element both Tosca and ABACO are using a thematic approach. This means that in effect stock positions in the respective portfolios are knowingly related to a degree.

Time-Frames, Stops and Liquidity

The ABACO Financials Fund is managed with multiple time-frames as ABACO always has trading positions as well as core investments. The Tosca Fund is managed with a much greater bias to the medium term, and in hedge fund terms one could even suggest a long-term time frame. The Tosca process derives a target price based on internal analysis extending out two years or more. In the short term the stock market resembles a beauty pageant, and in the long term a weighing machine. The Tosca approach assesses the companies' worth on a rational multi-year basis (weighing machine basis) and looks through the fashionable or commonly held subjective biases.

This can be very powerful in allowing the manager of Tosca to argue with the short term perceptions in the market, and hold onto positions. Historically Tosca would tend not to use stops on positions or the whole portfolio, having taken a fundamental position on a stock.

The Abaco Financials Fund is run by three Portfolio Managers with different type of backgrounds:
from research (Inigo Lecubarri),portfolio management (Rivera-Camino) and from a trading background (Martin Deurell). Capital is allocated as a function of expected risk/return and catalysts, the latter acting as triggers for timing. So the core of the process is a creating an orderly ranking of long/short candidates. Candidates for inclusion are assessed for their marginal contribution to portfolio diversification before they are added. Both Tosca and ABACO use a correlation matrix of names in their universe to understand the relationships between their holdings (and potential holdings) on a historic basis.

Both Funds pay attention to the liquidity of positions – for Tosca Fund it must be feasible to liquidate 90% of the portfolio within three months of normal trading. In practise all but 10% of the current Tosca portfolio could be liquidated in 5 days on 20% of the market volume. For the ABACO fund at least 80% of the portfolio can be liquidated in less than a day's trading, and the balance of the portfolio can be liquidated in 2 to 3 days' trading. There are two factors at play here – size and style.

The Tosca Fund is more than $2.5bn in AUM, up to 20 times the size of the ABACO Financials Fund. As important is that the medium to long term holding period of the Tosca Fund is matched by fund liquidity terms of quarterly redemptions with 3 months notice. The ABACO Financials Fund has monthly dealing and it has a trading component as well as investment time-frame positions. So the liquidity demanded of the underlying positions of the ABACO fund is consistent with the style, just as it is for Tosca Fund.

Martin Deurell of ABACO has commented: "We are much more liquid (than Tosca) which can help us to execute the risk management efficiently. The drawback of this, of course, is that we can't capture certain alpha that Tosca can: they can take bigger positions in less liquid companies."

Some Diversification by Book for ABACO

As mentioned, a differentiator of ABACO versus Tosca is that the former explicitly run trading (short term) positions. Allocations of capital to trading positions vary through time, as does the P&L versus the medium term holdings. So there is an element of diversification by book for the ABACO Fund.

One further difference to emphasise between the two financial specialists is that, consistent with a market-neutral mandate, the ABACO Fund is described by the managers as a relative value fund. The long book is conceptually held versus the short book as it is at Tosca, but at ABACO the long and short books will be more similar. When a long position is put on by ABACO it is likely that a couple of short positions will be put on to minimise country and sector factors for the long. So for the same return target the ABACO fund structure would require a bigger gross.

Having written that however, the Tosca Fund (a global financials fund) is much more diversified by country exposure than the ABACO Financials Fund. Maybe it is appropriate as European financial specialists that ABACO has more concentrated country risk. It is clear too that both fund managers spend a lot of time analysing and ranking country growth and credit worthiness, so the thematic top-down element is at least partly about expressing country biases. It is worth pointing too that Tosca Fund takes an active view on emerging market exposures – over a market cycle this should contribute to both risk and return relative to a fund that only invests in developed markets.

In terms of the activity levels, from all of the above one could infer that the holding period of Tosca Fund is a lot longer than that of the ABACO Financials Fund, and that names turnover a lot quicker at ABACO. It doesn't mean that the research effort is more or less intense at either; it is just applied differently.

So on balance the manager of Tosca Fund is trying to extract alpha over a longer time-frame than the managers of the ABACO Financials Fund, and given the larger bias to fundamentals has been more prepared to argue with the markets. Tosca Fund is net-long biased; ABACO Financials Fund is a market-neutral relative value fund. The target return of Tosca Fund is 15-20% net to investors over a full cycle - something it has achieved historically for most of its existence. I believe it will be achieved in future. The target return for ABACO Financials Fund is 10%, and just about as important to the managers is the lack of correlation to markets.

Outcomes from the Two Styles

Tosca C (since re-organisation) versus a Peer Group of European-Based Equity Hedge Funds

 















The Tosca Fund was up 43% in 2009, the fifth time it has posted annual returns in excess of 20% since its inception in late 2000.

Data Source: Eurohedge

The ABACO Financials Fund has had an annualized return since inception in June 2003 of 8.69% ($ version) achieved with a monthly volatility (annualised) of 5.99%, and is having its best year yet in 2009. However, given the mandate, it is just as significant that the returns of the ABACO Fund have an r² of 0.01 with the S&P500, according to a hedge fund database. Further the return series for ABACO has a negative correlation with other hedge fund equity market neutral funds, at least at the hedge fund index level. The Fund also shows nearly no correlation with the European financial sector time series.

Monthly and Annual Return of ABACO Financials Fund (EUR)

	2003	2004	2005	2006	2007	2008	2009
Jan	--	0.71%	1.92%	1.32%	-1.06%	3.67%	2.89%
Feb	--	2.20%	0.85%	3.64%	1.61%	-0.46%	3.07%
Mar	--	0.84%	0.22%	-0.87%	0.44%	-3.13%	-2.58%
Apr	--	-1.54%	-1.02%	-0.50%	2.49%	4.01%	0.56%
May	--	0.69%	-0.34%	0.20%	2.70%	0.14%	2.75%
Jun	0.49%	2.06%	-0.15%	1.29%	1.19%	1.53%	-0.33%
Jul	0.59%	-2.31%	1.14%	0.18%	-2.63%	0.58%	1.37%
Aug	0.50%	0.45%	-1.07%	2.45%	2.65%	1.58%	4.98%
Sep	0.55%	1.26%	1.58%	1.40%	-0.83%	-5.33%	2.22%
Oct	1.34%	-0.18%	0.93%	0.61%	-0.36%	1.14%	-1.90%
Nov	0.51%	-0.42%	1.51%	2.37%	-1.61%	1.35%	2.29%
Dec	2.58%	0.76%	-0.27%	-0.66%	2.28%	0.36%	0.64%
YTD	6.73%	4.51%	5.37%	11.93%	6.89%	5.19%	16.88%

Source: Hedge fund database
The top down processes and risk measurements used by the managers of the two financial equity hedge funds are similar. The risk management and portfolio construction of the two hedge funds are different, but each consistent with their respective sources of alpha and targets for return, and explicit (ABACO)and implicit (Tosca) higher moments of their return series. Investors in hedge funds should always evaluate the extent that the portfolio construction and particularly the money management element of running a hedge fund is consistent with the form and time-frame of insight into markets utilised by a manager. In these two cases they are.

Returns, Rehypothecation, Banks and Hedge Funds

In a presentation written in May last year Manmohan Singh, a Senior Economist in the Financial Sector Analysis Division of the IMF gathered some interesting data about rehypothecation amongst what he termed "international banks". Rehypothecation is the ability of a prime broker to use client assets posted as collateral to that prime broker for the prime broker's own purposes. That the title of the presentation was "Collateral Pledging Post-Lehman: How Reducing Counterparty Risk Squeezed Liquidity" says where he was going with his work. The work gives some colour and data to the ever slower grinding of the wheels of market liquidity that occurred in the Credit Crunch, and I include consideration of it here because hedge funds were and are part of the Lehman's imbroglio through the role of Lehman's as prime broker to hundreds of major hedge funds. The changes to liquidity planning at banks has also inhibited their ability to engage in prop trading and arbitrage and that impacts the alpha available for hedge funds to exploit.

I would recommend the work for several things: for pointing out the difference between US and UK legal treatment of broker-dealers in the event of administration or bankruptcy; and for referring to a CGFS study on collateral (published by the IMF in 2001) which raise back then a query of how markets could adjust to a relative scarcity of low risk, liquid collateral. The CGFS study expressed concern that changes in collateral usage might alter market dynamics and the risk management demands on financial institutions, particularly in stress periods!



The key table is given below.

Fair value of securities received as collateral, which can be pledged (billions of dollars)

	Nov05	Nov06	Nov07	May08	Aug08	Nov08	Mar09
LEH	528	621	798	518
MS	798	942	948	953	877	294	283
GS	629	746	891	869	832	579	610
MER	538	634	855	865	676	327

Prime brokerage is not only carried out by American entities, rather, it is also significant for the European universal banks too. The data is not disclosed as frequently for the European banks because of the cycle of annual and semi-annual reporting rather than quarterly reporting necessary in the United States. Looking at first Deutsche Bank and then UBS:

The Group (Deutsche Bank), as the secured party, has the right to sell or repledge such collateral, subject to the Group returning equivalent securities upon completion of the transaction. As of December 31, 2008, and 2007, the Group had resold or repledged € 230 billion and € 449 billion, respectively. This was primarily to cover short sales, securities loaned and securities sold under repurchase agreements. (From the Deutsche Bank 2008 20-F, page 300)

Equivalent resold or repledged securities for UBS were CHF 430bn at the end of 2008 and CHF 1,118bn at the end of 2007 (UBS 2008 Form 20-F, Page 350)

The point here is that the ability to receive and then re-sell or re-pledge securities has been a massive part of bank funding for those involved in custodianship (BoNY, State Street, and JPM), and prime brokerage. The Manmohan Singh presentation went as far as to say that "The terminal event for Bear Stearns, Lehman was that they ran out of pledge-able, unencumbered collateral. If the fair value of securities received as collateral coming into a financial institution is decreasing, and at the same time they are being obliged to post more and more to their counterparties..it gets very uncomfortable."

A consequence of the Lehman's crisis is that the liquidity buffers (cash and high-grade, short-duration highly-liquid government bond collateral) of major banks are increasing as a matter of policy. For example the Goldman Sachs' 10-Q for the 1Q 2009, page 135 stated:

Our most important liquidity policy is to pre-fund what we estimate will be our likely cash needs during a liquidity crisis and hold such excess liquidity in the form of unencumbered, highly liquid securities that may be sold or pledged to provide same-day liquidity. The U.S. dollar-denominated excess is comprised of only unencumbered U.S. Government securities, U.S. agency securities and highly liquid U.S. agency mortgage-backed securities, all of which are eligible as collateral in Federal Reserve open market operations, as well as overnight cash deposits. Our non-U.S. dollar-denominated excess is comprised of only unencumbered French, German, United Kingdom and Japanese government bonds and overnight cash deposits in highly liquid currencies.

The liquidity buffers of leading American financial institutions at the time of the presentation is given below:

Liquidity buffers, Q1 2009 (billions of dollars)

UBS	$200
BAC	$170
GS	$164
MS	$145

The total liquidity buffer (that is the very good quality collateral) across the banks with the biggest derivatives books is approaching $1.5 trillion. The significance for hedge fund returns last year and in prospect is that it is $1.5 trillion of risk capital and balance sheet capacity that may have otherwise been applied to proprietary trading, market-making and arbitrage activities. Has the absence of that capital applied to markets left low-hanging fruit for hedge funds to exploit? Recall that last year, across all strategies in aggregate, hedge funds produced their best returns in 10 years. Having built necessary liquidity buffers and repaid TARP money ASAP, will these banks be back to take this year's fruit from the less-well equipped hedge funds?



PS The IMF's Manmohan Singh gave some nice historical perspective for the significance of rehypothecation for broker dealers.

"The exclusive announcement in Sunday's TIMES that the banking and brokerage firm of Greenleaf, Norris Co. had been placed in the hands of Seiah Chamberlain, as Receiver, on the latter's affidavit that the firm had rehypothecated large amounts of securities deposited with them by other persons, as security for the repayment of loans obtained by them in their own name, and, that in this rehypothecation the securities had been mingled together, thus rendering it a very difficult task for the owners of the pledged securities to obtain their own property, created a sensation on the street yesterday." The New York Times, March 5, 1878.