La Fayette Investment Management is a $6 billion fund-of-hedge funds with a 15-year track record. Asia is a particular focus for the firm and it has one of the few Asian-focused fund of funds offerings. CIO Andre Visser believes strongly that pension plans in Europe and the US are extremely under-exposed to Asia and thus won’t be able to fully enjoy the upside growth that the region offers. Visser says, “with on average only 2% allocated by European pension funds to a region that represents 13% of global GDP, and growing rapidly, this represents a real disconnect.”
What are the peculiarities of Asia markets and Asia managers that overseas institutions should be aware of?
It is clear that Asian markets rely heavily of foreign fund flows. Without such flows, the Asian markets can be vulnerable given the lack of local investors. Asian managers have relied on such flows and have therefore been long-biased to capture the beta returns. In times of market stress and volatility such managers have performed badly. Note also that the derivatives markets in Asia are developing which will continue to facilitate going short, and the Asian difference, at least from that angle, will gradually disappear.
Besides, one should be aware of the very heterogeneous nature of the opportunity, from one place to another, from one industry to another, at different points of time. Many cultural gaps exist, many different languages are spoken, idiosyncratic political factors are quite significant, all points into the direction of making sure that the managers are equipped to deal with the multifaceted aspects of investing in Asia
And given the local hedge fund industry is still in its very early stages, some other things that we have to be aware of would include significant key man risk, as well as the lack of infrastructure (in terms of compliance, risk control, or simply operational management) associated with small or new boutiques.
What would a typical Asian hedge fund of funds portfolio look like in terms of country exposure and strategies adopted?
To a large extent, investment opportunities are constrained by the relative growth rate, earnings, size and access to investment opportunities one can find across the various Asian economies. At this stage, according to Eurekahedge, about half of the hedge funds in Asia (49%) are equity long short strategies. The second largest category is Multi-Strategy (14%) followed by Event Driven (9%), Arbitrage (5%), Macro (4%), Fixed Income (4%), CTA (4%), Relative Value (3%) and Managed Futures (3%). China and India’s markets are fairly obviously attracting the most attention and are where we see some of the best managers emerging.
“A dynamic allocation would probably push the equity based strategies more towards the 70% in positive macro conditions, whereas more protective strategies around fixed income, convertible bond arbitrage, relative value or other low volatility strategies will be given the bulk of the allocations at time of prolonged poor market conditions
How do institutions go about choosing managers, should they use a consultant or gatekeeper?
Consultants or gatekeepers have the advantage of extensive knowledge of the manager universe, which can serve as an invaluable resource for pension funds lacking the experience, expertise, or resources necessary to successfully search and select the most suitable Asia managers.
On the other hand, the advantage of a multi-manager is that, in addition to also having extensive knowledge of the manager universe, they are able to access and employ multiple managers, serving to effectively diversify manager and style risk. Also, multi-managers can help from a bottom up angle, introducing new managers and implement manager changes in a more timely and efficient manner relative to consultants/gatekeepers. In an emerging market environment, being able to act fast, efficient and flexibly sometimes is quite crucial. A funds of funds can also help a lot from a top down angle, identifying themes in the region, and from a risk management angle, setting overall portfolio volatility at the appropriate level. This, in view of the elements mentioned in answer to the first question, is particularly relevant.
What questions should an investor ask of a prospective manager of managers?
Most particularly when talking about Asia, a long and established track record, in risk adjusted terms, produced by a stable investment team, is very important. This will highlight the performance of the fund of funds through various market cycles. In addition it is very important to ascertain the operational background and the due diligence process that the FOF employs. This check should include on-site due diligence and rigorous references able to ascertain managers’ integrity, alignment of interests and ability to operate in good and in stressed conditions.
Then one has to ask all the typical questions: what quantitative analysis and/or tools have been adopted and how they combine with the more qualitative and forward-looking assessments being made? What is the investment process? Is the fund of funds an asset allocator to equities or bonds or is the role to pick managers/funds only? What is the commitment of the FoF manager to the Asian product? How much resources have been built in order to keep in touch with that set of opportunities? Has the FoF manager invested into the Asian FOF? How do you protect investment during a market downturn? How independent albeit integrated is the risk function?
What should they look for in terms of target returns, due diligence, performance measurement and attribution?
No one can predict the short term returns, but target returns, over time should average around 8-12%. Generally speaking, in the Asia environment, with approximately 2-3% in dividend and another 6-8% growth in earning, this kind of return can be achievable over a complete business cycle. This also makes sense in the overall context of the relatively higher inflation rate environment and higher equity risk premium in emerging markets.
There will be some disparity from one year to another. While a FoF typically thinks in terms of absolute rather than relative value, one can still bring performance relative to an index. From that angle, a FoF should be able to deliver around 50 to 70% of the relevant benchmark index performance in a good year, and to limit the bad years’ performance to a 0 to -10% of absolute negative return.
With regard to due diligence and other measurement, I think investors should look for a clear investment philosophy, a well defined process, strong consistency in applying the same approach over time through thick and thin (i.e. no style drift), stability of team, and last but not least, a strong infrastructure in terms of risk management and compliance.
In terms of performance measurement and attribution, granularity should be expected up to come at least at the strategy and the country levels. Drilling further down than that supposes the willingness of underlying managers to provide additional data. Assuming the data is there, it’s not that difficult to run through the risk models and to come up with the performance measure and attribution, which should reflect managers’ investment strategy.
How do you identify managers that actually hedge?
We have to bear in mind that most investors come to Asia for growth, not for market neutrality. We also have to recognize that the Asian markets, especially on the derivative side, come from not being yet as developed as those of the US and Europe. Shorting is still subject to certain restrictions and, in some cases, not even allowed. So, even the sincere-type of hedge fund managers are in fact, very often, long-biased. One has to be pragmatic with it and accept that there are practical difficulties in the current less-than-perfect market environment. The positive long term trend has so far not made this too much of an issue.
All this being said it is true that some hedge funds have nominal short positions on their books only to justify hedge fund types of fees. And this clearly calls for a careful and systematic examination of the investment process and of the historical track record prior and after investment.
On balance, well established FoFs are in a good position to identify those managers that are sincere in executing hedging, at least to a certain extent, in their portfolios. And also to reach to other managers, typically ex prop-traders or arbitrageurs, who consider the short side as natural as the long side. Such individuals have a good understanding of risk management and consistently work towards the goal of achieving positive returns in all market conditions.
How should investors approach investing in Asia, or increasing their exposure, within the conservative guidelines they often operate under?
There is indeed a compelling argument for investing, or increasing exposure to Asia, and even more so after the recent market correction. Positive macro trends are quite solidly in place, and tremendous value can still be captured within the next few years at least on the back of economic growth, of demographics, rising income level and domestic consumption, of urbanization and deployment of infrastructure, of real estate and asset reflation in general, of rising investments and of more privatisations to come.
By and large, pension funds should approach investing in Asia as they would with any other equity asset class. By conducting extensive due-diligence and research, employing managers that coincide with their overall investment objective, philosophy, and principles whether it is taking large/small active risk, passive management, or a preference for particular investment styles such as value, growth, absolute return etc. But investing in Asia remains quite a challenging exercise, requiring an ability to weather sudden changes in volatility, liquidity and correlation regimes, and an ability to take advantage from the significant diversity in returns from the different segments of opportunities. The best channel to that aim is via a specialist fund of fund.
(a) Protecting against sudden volatility, liquidity and/or correlation regime shifts although real Asian economies stay by and large on a decoupling path from the Western economies, the financial sphere remains global, hence prone to exhibit global peaks in risk aversion causing prices to drop everywhere following phases of brutal divergences.
The first challenge is therefore to understand what drives the correlation regime changes and to correctly assess how much such changes could result in impairing any given investment vehicle. Asia is a mixture of real opportunities and bubbles. Even if the long term picture is relatively simple to predict, short term volatility, sudden reduction in liquidity, and/or sudden jumps in correlation could make poor allocation decisions turn into “value traps” and significant underperformance.
(b) Benefiting, not suffering from diversity
While true, effective and robust diversification remains paramount, it should not be static nor equally weighted. There are large variations among Asian markets and different sectors in Asia which one should also seek to benefit from by insuring that the largest allocations will be made, over time, to the best performing countries and best performing sectors. There has been as much as 70 to 80% disparity in the yearly returns from the different segments of the Asian investment matrix.
So the Asian opportunity exists quite significantly, and even more from this price level. But only experienced managers can take advantage of the volatility and of the diversity in returns of all the various segments, bringing capital protection into the equation. Access to these managers requires having an effective network which can’t be built overnight.