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Hedge Funds: A decade on the learning curve

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Martin Steward spoke to Finnish pension insurance company Varma about its experiences at the cutting edge of absolute returns

Almost 10% of the €33.8bn managed by Varma, Finland's largest pensions insurance company, is in hedge funds. It is therefore particularly good news that it can report excellent performance over the past three years: from January 2009 to October 2011 its portfolio has tidily outperformed standard industry benchmarks such as the HFRX index. Before the slump of Q3 it had kept pace with the S&P500 index; since then, it has kicked it solidly into touch.

"Our hedge fund portfolio is up 2.6% year-to-date to the end of Q3," says Jarkko Matilainen, Varma's director of hedge funds. "And overall, the experience with hedge funds has been positive for Varma. They have yielded the targets set for these investments."

Varma follows a strict policy of not commenting on individual investments, but a quick scan of its reports reveals that it did not emerge unscathed from the quant meltdown of 2007 (it held AQR Absolute Return), the financials rollercoaster of 2008 (Atticus European and Copper River Institutional) or the crisis-period controversy over gates, suspensions and other redemption-policy issues (Varma held NWI Explorer Global until 2010, for example). Overall, though, its record looks impressive - and no one goes nearly 10 years investing in hedge funds without picking up a few bruises along the way.

"The basic philosophy is that we simply don't make compromises. If we see any kind of problem, you can forget about managing any of Varma's capital," says CIO Risto Murto. To stress the ‘no-compromise' policy, he points out the lack of home bias in the hedge fund portfolio. "You'll notice that there isn't a single Nordic name."

That is pretty remarkable, given that Varma oversees almost 80 different funds from its office in Helsinki. It is no surprise that Matilainen was on the road the week before IPE spoke with him and packing his suitcase again a few days later.

"Managing a portfolio of hedge funds is a full-time job," he says. "You need the resources in place. There are challenges: here we are in Finland, and a lot of our managers are in the US. On the other hand, we have long-term relationships with many of our managers and the level of transparency and communication we enjoy is high - so if you are willing to put in the legwork, monitoring your positions is not as difficult as you might think."

That is a useful message for the growing number of pension funds choosing to rely less on their funds of funds and to go it alone in the hedge funds world. This has been Varma's practice for most of its time as a hedge fund investor, which started in 2002 via funds of funds.

As early as 2003, it started making direct allocations and by 2006 there was enough of an overlap between what Varma and its funds of funds were doing that it changed the way it used its intermediaries: while it still has about one-fifth of its hedge fund assets in funds of funds, largely with Blackstone Alternative Asset Management, that relationship is now all about tailor-made portfolios of niche or exotic strategies and advisory services.

This has clearly given Varma the opportunity to make its own decisions on strategy and style allocation. It has been an interesting learning curve - and Varma has made some courageously big calls.

Credit stands out. It was quite a significant theme in Varma's core fixed-income portfolio, and it carried through into the hedge funds. Matilainen says that a significant research programme in distressed funds was under way as early as 2006, as Varma's macro view started to flash warning lights over the straining credit bubble. He started to implement small positions through the latter part of 2007, as the credit crunch began to unfold, before pulling the trigger in earnest after the collapse of Bear Stearns in spring of 2008. A raft of allocations included a number of funds from Golden Tree Asset Management and real estate debt specialist H/2 Capital Partners.

With hindsight, of course, this was the proverbial falling knife. "That was a classic timing mistake, unfortunately," Matilainen concedes. It meant that 2008 was Varma's only calendar-year underperformance against the broader hedge fund industry.

But that should take nothing away from the fact that this was exactly the right strategic call, implemented with impressively gutsy conviction. Moreover, there can be no doubt that the quality of Varma's manager selection should take credit for the porfolio's resilience through 2008, which left it still in the game to benefit from the supercharged performance of these distressed strategies through 2009.

Varma continued to build its positions through 2009 and into 2010, adding funds from Harbinger Capital, Newport Global Advisors, Cognis Capital, Bayview Capital, Element Capital and others. At the same time, similar positions in deep-value special situations and activist or ‘catalyst' strategies were being built up, including well-known names like Carlson Capital's Double Black Diamond and funds from Scout Capital and Ospraie Management.

The broad hedge fund industry enjoyed a banner year in 2009 - but this big call meant that Varma's portfolio still outperformed the HFRX index by a factor of two. Even now, its four biggest non-fund of funds allocations are in these types of strategy.

"We have taken a lot of money out of distressed since 2009 because positive performance has been very impressive," says Matilainen. "But we have also made some rotations within the strategy: the opportunity in large-cap corporate distressed is over, but other pockets still offer good opportunities. There is still a lot of juice there and we are ready to allocate with really good managers."

Indeed, Varma might have had even more in these strategies were it not for constraints on the hedge fund portfolio's illiquidity. Like most Finnish pension insurance companies Varma offers credit lines to its corporate clients, and in the cash crunch of 2008 many took them up aggressively. Varma had to respond by building-up its own liquidity buffer, which in turn meant a decrease in its hedge fund allocation.

"We had to make some redemptions, which meant choosing those funds we would shut down altogether, as well as redeeming small amounts across the board," Matilainen explains. "This was not always about performance or what we thought about the quality of the strategy: because this was about re-building our liquidity, the liquidity on offer from the underlying funds was an important criterion for deciding which relationships we would retain."

Liquidity management came to the fore in other ways during 2008. Varma's losses were not all down to the early call on long-distressed opportunities - it also had its fair share of the leveraged, long-credit, short-volatility strategies that got pummelled that year. That might seem odd, seeing that Varma's decisions in the distressed arena demonstrate that it knew the credit crunch was coming. Just to take one specific example, during 2008 Varma held two mortgage-backed securities strategies from Tequesta Capital Advisors, at the same time as it was betting on ZAIS Group's Scepticus fund, which focused on selling short residential real estate debt.

"Coming into 2008 we knew we wanted to get rid of the highly-leveraged strategies to remove bankruptcy risk from the portfolio," Matilainen recalls. "In the event, things unravelled faster than we anticipated and we hit a couple of air pockets in our attempts to exit from those positions - we were about one-third of the way through the redemptions we wanted to make by Q4, thanks to notice periods and gates.

In addition, while we wanted to remove bankruptcy risk, that did not mean removing drawdown risk - we maintained some long-biased but less-leveraged strategies. The latter half of 2008 turned out to be much worse than we anticipated and this long bias and credit orientation hurt us."

Alongside the ongoing attempt to reduce exposure to illiquid and leveraged strategies, Varma had also been researching long-volatility exposure since 2006. Several allocations were in place by 2008 which took some of the edge off of that year's losses - trend-following managed futures with BlueTrend, for example, or the long-volatility and vol-of-vol options strategy exemplified by the Titan Global Relative Value fund.

These strategies have only really come onto the radar screens of most pension fund investors post-crisis - as their risk management vocabularies have expanded (‘tail risk', ‘black swans', ‘kurtosis') and their fear of the headline volatility of some of these funds has been tempered by better understanding of their diversification benefits.

Matilainen admits that he wishes he had had more of this exposure in the portfolio by Q4 of 2008, but he also continues to see a place for it in the strategic allocation. For example, in 2010 Varma became one of the first investors in an innovative new fund from Capula Investment Management, Capula Tail Risk, which specialises in downside optionality in fixed income.

It is the perfect example of how Varma operates at the cutting edge of the absolute returns world. It will never be right in every detail, and Matilainen must spend a lot of his life on aeroplanes. But this combination of innovation, decisive calls, tight risk management and informed manager selection - which investors simply cannot get from the market in off-the-shelf, diversified funds of funds - must be one model of how a sophisticated pension fund should engage with the hedge fund world.
 

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