Banque Privée Edmond de Rothschild

Rothschild stands on rigour in hedge fund selection

Originally published in the April 2009 issue

It is the most difficult of times for Geneva’s private bankers. There are mounting attacks from without on Switzerland’s banking industry and barely concealed fury from within among Swiss investors who bled billions on investments with Bernard Madoff.

Such difficulties make it a fascinating time to visit the investment managers of Banque Privée Edmond de Rothschild (BPER), the Swiss private bank, located in the city’s financial district just a few hundred meters from where Lake Geneva flows into the Rhône. The Rothschild pedigree is reflected in the dimly lit red walls adorned with fine art and portraiture, which provide an introduction to the heritage that envelops the bank’s headquarters in the Rue de Hesse.

Having set up the first fund of hedge funds in 1969 BPER occupies an important place in the history of alternative investments. The early foray into investing in hedge funds, including one run by George Soros, proved a key turning point in transforming a fledgling investment style into a proper asset class.

Alexandre Col, the head of the bank’s investment fund department in Geneva, clearly enjoys the grand intellectual sweep of hedge fund investing. Surrounded by Bacons and a Warhol autographed dollar bill, Col is emphatic about the advantages – among them, resources and institutional memory – which BPER brings to the task of manager selection. But he is scathing about the speeding up of the due diligence process over the past 15 years as hedge fund investing has ballooned.

“In 1994 all the managers came to Geneva. We would see them, encourage them to come back in six months and due diligence could go on over 12 months,” Col says. By 2008, however, typical due diligence had shrunk to one month. “I don’t know how the small funds of funds could do it,” he says.

“I have a team of 40 people. I am able to say to a few people in my team: you go to New York, you see the manager, you speak to the auditor, you speak to the administrator, you read over the memorandum, you check the monthly reports, you read the investment letters, you make a report, you check references….We can do it in one month. It is not easy and it is not the best way to do it, but large funds are able to have a team to do it. So I was unable to understand how the small funds of funds were able to do it.”

Rothschild’s group manages €8.5 billion (US$11.8 billion) in hedge funds – either through funds of funds or tailor-made portfolios that account for 11% of the firm’s hedge fund assets. Col’s team monitors allocations to over 100 hedge fund managers (down from around 150) and some of its funds were day one investors in John Paulson’s sub-prime shorting Credit Opportunities Fund following a relationship that had seen BPER invest with Paulson since 2003.

As good as that call has proved, an even better one has been avoiding allocations to Madoff for their funds of funds. “It was not obvious that Madoff was a fraud. I don’t agree with the too good to be true story,” Col says. Three of the big four accounting firms had audited different aspects of the operation, it had major custodians, while regulators from half-a-dozen countries had scrutinised different fund registrations. On the other hand, Col says the red flags Madoff raised were based more on qualitative assessment and judgement. What’s more, given the apparent performance of the strategy, Col found it odd that no multi-strategy fund successfully copied it.

Despite getting it right, the manager of LCF Edmond de Rothschild Prifund isn’t gloating. Though Col distinguishes between the sponsors of the Madoff feeder funds and the funds which only subscribed to those feeders, he is adamant that funds of funds should no more be assailed for investing in Madoff than a mutual fund would be for investing in a fraudulent company like Enron. In each case the lesson is simple: just as no fund manager would invest an entire portfolio in one company, neither should a hedge fund portfolio manager allocate to only one fund.

Entrepreneurial roots
Now approaching its 40th anniversary, the creation of the fund of funds model in 1969 is the legacy of Georges Coulon Karlweis who joined Rothschild in the late 1950s. He has recounted that the key to the funds of funds concept was that a great manager could make a 10-fold return for a client over time while a poor manager could only lose the initial stake. Using a vehicle called Leveraged Capital Holdings, Karlweis sought fund managers with strong convictions who had the courage to wager heavily on a good proposition. The corollary to taking risks with investor money was that the managers took the same risk with their own money and were prepared to be rewarded on actual performance. Karlweis believed that an entrepreneurial spirit was a key attribute, since four decades ago leaving an established firm was a big career risk.

Col says entrepreneurial drive, the motivation of the performance fee and the opportunities of manager co-investment are the prime reasons for the brightest long-only managers to move to hedge funds. “We think that hedge funds are interesting because they attract the brightest money managers,” he says. “If you are good you will make more money being the owner of a hedge fund than being on the long-only side most of the time. If you are less good you will make less money and quickly be out of business.”

The primacy of diversification is key to risk managing any portfolio of financial assets. “It doesn’t work all the time, but it does work most of the time,” Col says. “You need to have bonds, equities, hedge funds and cash. You need to be worldwide, diversified and you need to (periodically) change your weightings.”

BPER, which has grown into 6th position in Switzerland in terms of assets in alternative management, is part of the LCF Rothschild Group, which includes the Paris-based La Compagnie Financière, and has a global network of over 30 offices in 17 countries, including a Luxembourg subsidiary which specialises in fund of funds custodian and administration services. Geneva plays the lead role in allocations, while the London subsidiary does listed closed-end funds and also has a team selecting hedge funds. In Paris, the bank is organisationally separate and the team there runs French funds of funds, but the four main European offices interact in managing hedge fund activities.

Cycle of hedge fund investing
One clear change in the past six months is the time fund of funds portfolio managers will stick with an underlying manager when performance goes askew. In a bid to pare risk, BPER’s funds have become more concentrated, a process that still has further to go.

“We have needed to react much quicker,” says Alexandre Pini, a macro and CTA specialist and one of three portfolio managers on Col’s team. “It is normal to give managers six months to make a turnaround but in 2008 even if you had a small doubt you had to redeem.”

The nature of funds of funds investing meant the volatile environment proved especially challenging. Normally such portfolios aim to be positioned for market trends that unfold over 6 or even 12 month timeframes. Both allocations and redemptions take time. “The timing of funds of funds means you need to anticipate a long time in advance,” says Pini. “You need to be able to identify managers to whom you deploy capital. You need to take time.”

Pini manages Prifund Alpha Uncorrelated, a fund that aims for uncorrelated, low volatility, returns of two to three times the risk free rate and Prifund Alpha Diversified which invests across all strategies with dynamically managed weightings. Prifund Alpha Diversified has increased its allocation to globalmacro strategies to 30% while cutting exposure to long/short equity managers. “Macro people did well because they understood the deterioration in financial markets”, Pini says. “And they were in liquid markets so they could trade around their positions.” That liquidity also favoured CTAs as their exposure to equity risk was mainly in high volume index futures contracts. And both macro and CTAs were able to exploit trades based on falling interest rates.

Pini explains the 20% average fall in fund of funds, heavily weighted to long/short equity strategies, on a misjudgement of how volatility would affect market values. “They looked at exposure and risk with the glasses of the low volatility era,” he says. “They thought they were conservatively positioned but they weren’t. This is one of the main reasons why long/short equity is down so much more than 2002. The second reason is the liquidity crisis – we saw it in 1998 for six weeks, but now it has lasted for six months.”

For all of that, Pini says market liquidity should begin to improve. “My opinion is that the worst part is behind us,” he says. “Now, in some markets a bit of liquidity is back,” he adds, citing convertibles and syndicated loans. But on corporate debt, Pini remains bearish, noting that defaults are still below 2002 levels and look to be some time away from peaking.

The quest for low volatility
If there is a ghost in the machine for funds of funds, it is Bernard Madoff. Swiss investors are estimated to have lost US$9 billion, much of it through funds of funds. The faulty due diligence is a key charge. But there is also the question of why Madoff’s funds attracted so much money.

Part of the answer lies in the changed nature of hedge fund investing over the past two decades. During the 1970s and 1980s long/short equity and global macro strategies encapsulated the hedge fund sector, often making striking returns but with gut wrenching volatility. The 1990s saw the rise of the arbitrageurs who developed funds with less impressive performance, but with consistent returns profiles and far less volatility.

“These funds accounted for the huge success of the alternatives industry,” Alexandre Col says. “Most of the money in the early arbitrage funds went to managers providing low volatility, but double digit returns. Investors wanted low volatility returns and wanted an asset class that did not behave like equity or bond allocations.”

It was in this environment during the mid-1990s that Madoff began making inroads. The low volatility and steady returns provided exactly what investors wanted. Providing this ‘ideal’ saw both (honest) arbitrageurs and Madoff attract billions from investors.

“Since we had been involved in hedge funds for 40 years, we never thought that the arbitrageurs were without risk,” Col says. When the financial system unravelled in September and October, and most hedge funds were unable to escape unscathed, many investors felt betrayed. Here Col’s response is simple. “A lot of investors had unrealistic expectations about investing in hedge funds.”

This coincided with other changes that affected the nature of the hedge fund business during the final phase of the boom. A plethora of funds of funds launched with around 40 listed on the London Stock Exchange alone. “It was as if anybody could run a fund of funds,” Col says. “People started to speak of funds of funds as a commodity and some investors began to say that the chief characteristic for them to distinguish between (fund of funds) managers was the fees being charged. The current crisis shows at least that there are huge differences between funds of hedge funds.”

Col says that he and other managers didn’t anticipate the extent of the financial crisis and how it would affect markets. “I underestimated the crisis in 2008, that’s for sure,” he says. “I thought after March that most of the pain was done.” But he points out that hedge funds overall were down 20% versus 40% falls in the broader market indices.

“People should keep in mind that down 20% means a 25% up move is needed to break even,” Col says. “Being down 40% with equities means you need more than a 60% up move.” He adds that this equates to three times more than the market’s recent strong rebound.

“I think hedge funds have been able to protect on the downside the money of their shareholders,” Col says. “Of course today it is easy to say what we should have done better to lose less money. But you could not forecast it at the time.”

Among BPER’s better performers was the low volatility Prifund Alpha Uncorrelated ($), which fell 15.7%. “I think we have managed it correctly given what has happened, but it is not wonderful,” Col says. “We saw the collapse of the entire financial world as defined by the Americans. When investors saw this they panicked and decided to redeem. We have to realise that for the last five years some financial institutions have been managed in a crazy way.”

“The collapse of the financial institutions does explain the collapse of the stock market,” he says. “It’s not the same as the tech bubble. The collapse of the financial companies meant a systemic risk. In that case the entire system is at risk and hedge funds are part of that system.”

As banks collapse, hedge fund clients panicked and redeemed hundreds of billions of dollars. But a further surprise was then sprung. “Soon we realised something that wasn’t so obvious,” Col says. It turned out that many clients invested in hedge funds using leverage. “We knew that some investors were using leverage but not its extent,” he says. “They thought looking at 2001-2002 that 8-10% returns were always assured and if you leverage on that you go to 15% and there is no risk. But there is no investment where you don’t take risk.”

Long-only, hedge funds fused
The two additional portfolio managers in Col’s team in the investment department are Marc Sbeghen and Jaume Sabater. Both managers have responsibilities which include long/short and long-only funds. Sbeghen focuses on Europe, the US and emerging markets funds and Sabater is manager for Asia and real estate funds of funds.

“A key strength of the organisation is to be able to follow long-only managers who then form hedge funds and vice versa,” says Sbeghen. “Other firms have Chinese walls between long-only and hedge funds.”

Some long-short equity funds run by both portfolio managers suffered sharp drawdowns in 2008, exacerbated by their long bias. Now most of the underlying managers in their funds have moved to low gross and low net exposure. The broad thematic view is that market volatility is still extreme and that weakness from the economy will see corporate earnings disappoint. “This time the lead is from emerging markets,” Sabater says. “We would have expected the US to lead but it is too early to speak about decoupling again.”

Typical of BPER’s newer hybrid offerings is Prifund Alpha Property Securities, founded in early 2006. Sabater is the portfolio manager and property services group CB Richard Ellis is the investment advisor. It combines 50% investment in direct property funds with 25% holdings in property equities and the remainder in alternative funds related to real estate including long/short funds and those of Reech Alternative Investment Management, which uses property derivatives.

Easing out of downturn
With the hedge fund industry reeling fromredemptions, the entrepreneurial roots of the industry are more vital than ever. The hedge fund sector is seeing similar erosion to that experienced by the dot.coms in 2002. Few now dispute that the number of hedge funds of all sorts proliferated too rapidly.

Col says the Madoff imbroglio may have a lingering impact into the second quarter redemptions to the end of June, as the impact on funds with quarterly or semi-annual redemptions will take some time to wash through the system. He says now is the right time to reiterate the private bank ethos and reconnect investors with the value proposition and service that BPER offers.

“When people are giving a mandate to a banker to manage their portfolio they should rely on him,” Col says. “I say to our clients and our shareholders you don’t need to understand everything I do and what our managers are doing. You need to trust Rothschild as a fund of funds manager. Look at the returns and our reporting and make a judgement on that basis.”

He also contrasts the huge differences between different funds of funds. “A fund of funds incorporated in Cayman is not the same as one in Luxembourg,” Col says. “Good luck to investors who put their money in a Cayman fund of funds which is not sponsored by a well-established asset management company.” He adds that BPER Geneva has paid all the redemptions on a monthly basis and that none of its funds have invoked gates, side pockets or suspended redemptions.

Col says size and pedigree should be important considerations for investors. He says this applies to both funds of funds providers and the underlying single hedge fund managers.

“There is a huge difference with a fund of funds where the asset manager is a large and established institution and with a fund of funds where the manager is a boutique,” Col says. “If the institution is doing something that is not right or has broken its agreement, you can complain, hire a lawyer and win. I’m not saying it’s easy. Now people are realising that to give money to a hedge fund is like having all your money in the Cayman Islands or British Virgin Islands unless a bank is the manager or the sponsor. Without that you have no power to have your money back.”

On single manager fund allocations, Col says the liquidity squeeze makes the big single fund operators more attractive. “For funds of funds operators it is easier to go to a Moore or a Brevan Howard,” he says. “It is much more difficult for unknown managers in more specific areas.”

Col realises that there is a need to allocate to emerging managers, but comes down right now in favour of the staying power of the big names. “Times are so tough and money is flowing out of businesses,” he says. “The regulatory environment is getting much more complex. It is costly and requires a larger team.”

“All of this makes the small hedge funds risky,” Col says. “I have been in favour of a very diversified portfolio, but today I have a more concentrated portfolio. I think it will be more difficult for the smaller funds and currently I’d rather have money with big hedge funds. Maybe by the year end we will reallocate the portfolio again.” Big firms, he says, have more staying power to negotiate credit lines with prime brokers and are more able to tap into some of the special situations the current investment environment is throwing up. “Geithner needs big players in front of him for his new plan,” Col says, discussing the US Treasury Secretary’s plan to auction toxic loans. “Big funds will be around the table, the small ones will not.”

Col is matter of fact in his pragmatism. “You need to adapt to the environment constantly,” he says. “I have no pre-conceived views.”

Qualitative focus
Another constant in BPER’s approach is the focus on the qualitative aspects of due diligence. Nothing, he says, is more important than understanding your manager. His core team of Pini, Sbeghen and Sabater each have between six and ten years with the firm.

“I think that the portfolio manager has to be able to act as an analyst,” Col says. “The portfolio manager has to see the hedge fund managers with whom he is investing. You can’t assess the risk you are taking if you have not met the manager, if you have not made yourself the due diligence. It is a mistake to separate analyst and portfolio manager. I’ve seen 90-95% of the managers we have in the portfolio. I think it is an important part of my job to see them.”

The liquidity limits squeezing the hedge fund industry mean that seeding – normally 3% of the total allocation across all BPER’s funds of funds – is in abeyance. “Currently it is impossible,” he says. “You need to raise money to seed new managers. I hope in six months we can start again. Right now we are actively making moves to maximise the opportunities we see.”