Aquila Capital

Absolute return and real asset strategies from Germany

Originally published in the December 2010 issue

The world of German alternative investment funds is quite circumscribed. German politicians and leaders of the business ‘Mittelstand’ of small and medium-sized companies have demonised hedge and private equity funds. For German investors, it has meant that any access to hedge funds has typically come through Swiss funds of funds and private banks.

Although the country’s hedge fund community is extremely limited Aquila Capital is beginning to change this. Aquila was founded in 2001 on the belief that markets were entering a radically new plane. This analysis led founders Dr Dieter Rentsch, the chief investment officer, and Roman Rosslenbroich, CEO, to develop a funds group to offer investors returns through hedge funds, enhanced equity and bond offerings, and real asset strategies. Nearly a decade on Aquila is managing €2.3 billion spread across a wide variety of funds and investment products.

The spur to forming Aquila came in 2000 when Rentsch, then in the asset management division of insurance giant MunichRe was commissioned to prepare an analysis of future investment trends. He found that returns from equities and bonds would be dramatically different over the following two decades compared with the 1980s and 1990s. The big time frame of the study reflected the fact that a large insurer couldn’t shift its asset allocation style in a short period of time.

Spotting trends
“We saw a strong business case come out of this study to set up Germany’s first alternative investment management company,” says Rosslenbroich, who had worked on the sell-side with Salomon. Aquila, of course, is Latin for eagle; Rosslenbroich says they liked the picture of the eagle spotting prey from a distance and moving fast to snatch it. “It is a picture of us spotting strong trends in financial and other markets, and trying to participate in these trends,” he says. “What we aim for is to identify interesting trends in different markets and set up intelligent products around that.”

Setting up the business to test the thesis about the market’s future helped Aquila get traction during the 2001-2003 bear market. The firm’s hedge and real asset funds grew steadily, but have grown at a heightened pace since 2008 (See Fig.1). The flagship AC Statistical Value Market Neutral Fund (SVMN), managed by Harold Heuschmidt, is the leader in AUM with €750 million in its 7% and 12% volatility sub-classes. But growth of Aquila’s funds quickened after the financial crisis as German investors, like others, faced up to correlation-related losses and gates on their investments.

The difficulties provided an opening to UCITS funds. Their regulated status, daily liquidity and suitability to the German tax regime helped ignite interest. Thus began a step-by-step transformation of Aquila’s product range.

UCITS attractions
“We started out with typical Cayman offshore structures,” says Rosslenbroich. “We found a way to make them tax transparent and transport them into the German settlement system, but it was always difficult to get German investors to invest in those types of products. Therefore early on we understood quite clearly what the UCITS regime offered. We started in 2007-2008 to switch all our funds to UCITS. Since then we haven’t looked back.” Offshore structures are now reserved for special niche strategies such as distressed debt.

The SVMN went into a UCITS wrapper in February 2008 when the AUM was €250 million. The offshore fund was subsequently closed. In the ensuing three years, Aquila saw a wave of allocations, including one €100 million ticket from a German institutional investor. Any concerns about investors’ willingness to embrace the onshore product were quickly dispelled.

“We didn’t have one single investor that wasn’t able to move to the UCITS,” says Rosslenbroich. “But this may have been because we have had dominantly a German-speaking – Germany, Swiss, Austrian – investor base. I have to say we have also got a new base of investors, especially out of Asia. Investors from Singapore, Hong Kong and Taiwan are predominantly investing into UCITS products. It is something we discovered fortuitously after changing our strategy to UCITS.” He concedes that not having a lot of US investors made the transition easier, but notes interest in UCITS stateside is real and increasing.


A historic macro call
When Rentsch undertook the research assignment at MunichRe two mega-trends were shaping markets. Equities were concluding a 20 year bull market fuelled by the combination of a two decade long bond market rally and a price/earnings ratio (PER) expansion from seven in 1982 to 38 in 1999. The inflation of the PER, according to Rentsch, accounted for over 60% of the uplift in stocks during the period.

“From our point of view it was quite easy to make the prediction that this PE expansion couldn’t last any longer,” Rentsch says. “We expected that stocks would have quite a different future from what they’d had over the previous 20 years. The current situation shows that we are still about one standard deviation above the long-term trend and we still have PE ratios of 19-20 whereas at the outset of other bull markets in 1941, 1932 and 1982 we had PERs of upper single digit. So we are still quite far away from the starting point for a new bull market in stocks.”

With fixed income, the bull market has carried on even longer. Aquila’s analysis for the next decade shows bonds returning just 2.8% per annum in a best case scenario reminiscent of recent Japanese experience. Should interest rates revert to the post–WWII average of around 7.2% fixed income investors would lose money after taxes and inflation. Aquila also calculates that financial assets as a ratio to real GDP remain near peak levels after growing for decades.

“In the last 25 years we have experienced a really golden quarter of a century for financial assets but that has come to an end,” says Rentsch. “We believe that this ratio won’t rise for the next 10 to 20 years or probably reduce considerably. This lies behind our main assumptions that the financial area has, at best, come to a halt and that now the real economy will come back.”

Fund creator tool
The SVMN fund invests in several different asset classes, including stocks, fixed income, and commodities. Allocations are steered by the expected volatility of the asset classes rather than by the expected return. It means asset classes with normally low volatility like government bonds get a much higher exposure in the fund than stocks and commodities. The whole process is adjusted on a daily basis using the FundCreator risk management tool developed by Professor Harry Kat. Adjustments to the allocation seek to ensure that the volatility target (7% or 12% depending on the fund sub-class) is met, while also making sure that the correlation to the other asset classes is near zero. Further monitoring is done to keep typical Greeks like kurtosis and skewness distributed evenly around zero.

The performance over seven years (See Fig.3) shows an annualised return of 12.21%. The SVMN portfolio is more or less uncorrelated to a portfolio composed of 40% Eurostoxx shares and 60% European government bonds. Market timing in terms of the allocations between the asset classes is avoided. The most important value driver of the fund is diversification among the different asset classes and the fact they are uncorrelated to each other.


Weighting allocations by volatility rather than expected return means SVMN is heavily overweight bonds and short-term rates and dramatically underweight equities and commodities. The seven vol fund has monthly maximum risk of 400 bps. When the fund starts to fall it protects assets by decreasing exposure and going into cash.

“It explains in 2008 when we had the mother of all crises we had volatility in the fund of 6.99% – just shy of the 7% target,” says Rentsch. “Over the past two years the volatility is near 4% and 8% for the 7% and 12% volatility funds. Even though we had a higher volatility target we achieved a lower outcome while still getting the same return we’d have got with the fullvolatility. So diversification really works. You can eat it.”

Real assets get traction
Since launch, Aquila has positioned itself well to catch the trend of investors looking to invest in real asset markets. It has developed funds to invest in timber, agriculture, renewable energy and climate change. The investment thesis draws on ideas from the ground breaking Limits to Growth published in 1972 by American scientist Dennis Meadows who is on the Aquila board. Famously, Meadows ran over a dozen scenarios that all led to the conclusion that the global economy would experience constraints on growth from pollution and resource shortages between 2010-2050. In updates to the study, Meadows has found that limits on natural resources – potable water, fish stocks or top soil – are becoming apparent more quickly than he expected four decades ago.

“To be honest, we are not hard core believers in the results of the study,” says Rosslenbroich. “We are sort of agnostic about this. We don’t know if it will play out as predicted. But we do know it is much better to prepare for a bad outcome than to be complacent and expect things to work out nicely. One way to profit from this outcome and to work against the depletion of resources is to invest in agriculture. So we are doing this from two points of view: to make money and for environmental/social reasons.”

The investments in real assets are wide ranging with five to 20 year life-spans. Four agriculture funds, for example, invest in dairy farms in New Zealand. The funds own a cluster of farms with a management company handling individual farmers and a single back office providing operational support. Aquila believes that the combination of very low costs to produce milk and the proximity of large export markets like China for powder make New Zealand a compelling investment case for dairy products.

“We think operational cash flows are important given low interest rates,” Rosslenbroich says. “Milk gives you virtually daily cash flows. We think these types of assets are very important. We love real assets that produce regular cash flows.”

Renewable energy funds
In 2006, Aquila set up a closed ended fund to invest in the reduction of green house gases introduced by the Kyoto Protocol. It has also launched a series of climate change funds investing in landfill as well as stocks focused on renewable energy. There is also a German institutional timber fund which is managed by Copenhagen-based International Woodland Co. In 2010, three renewable energy funds began investing in photovoltaic projects in France and Germany.

The internal rate of return of the real asset funds vary as do their value drivers. With the agriculture funds there is inflation protection from owning farmland with an IRR of 8-12% depending on the investing vehicle. On the photovoltaic funds, the IRR is lower, around 6-8%, but there are tax subsidies and the investment is more secure since investors have pre-defined cash flow streams established for up to 20 years. Such funds are ideally suited for investors looking to find a substitute for fixed income allocation.

Lessons of 2008
Post-2008 Aquila has thrived with big gains in AUM. Both real assets and UCITS funds were attuned to investor demand for tangible returns and liquidity. The SVMN Fund with 7% volatility gained about 9% in 2008 (the 12% volatility fund hadn’t yet been established) helped by bonds performing well. But the AC Triple Value Funds fell sharply as volatility and correlation rose hand in hand during the crisis. Rosslenbroich says the business lessons of 2008 were straightforward: have a strong operational base and good communications with clients. “This still applies,” he says. “Investors are much more geared towards transparency and frankness than they were in 2006-7. They want to clearly understand how you make money, what the value drivers are and where the risks are located. They are not content with generalised explanations.”

The financial crisis also sharpened their perception of the attributes of real assets. While correlation and volatility shot up in 2008, real assets recorded only small losses. Notes Rentsch: “We have a saying: ‘Real assets don’t read the Wall Street Journal and don’t get nervous’. With real assets if you’d marked to market you would have had a small loss, but they are still long-term assets generating real cash flows. If there is solid financing in place you can withstand these kinds of crises. Going forward we think it is one thing that makes these kinds of assets attractive to own.”

Sanguine on euro
The day in, day out combinations of speculation and trauma that surround the gyrations of the euro don’t exercise Aquila unduly. Rentsch says the big problems facing Europe and Japan have helped to prop up the dollar despite a rising US deficit and a new round of quantitative easing. “There are some political risks with the euro, especially to some peripheral countries,” he says. “It is hard to predict what will happen over the next 10 to 20 years, but I don’t think the euro will have major problems over the next four to five years.” The matter of a Greek default is judged academic since its sovereign debt – trading around 55 cents on the euro – is already pricing in a haircut. There may be a profitable trade in Greek bonds, but Rentsch doesn’t expect any upside to take prices back to par values.

Advantages in AIFMD
Growing interest from Asian clients is fuelling allocation flows to both UCITS and other strategies in the Aquila stable. Alongside the interest from Asia is the new regulatory regime coming into play through the Alternative Investment Fund Managers Directive. For Aquila and other European alternative investment managers the AIFMD may offer a standard and brand that, like UCITS, will attract overseas investors.

“The AIFM Directive is more or less an advantage for us,” says Rosslenbroich. “We have built our business in a highly regulated market in Germany and Luxembourg in recent years so nearly everything is in place. We think it should help generate new interest on the client side and attract strong interest from Asia.”