Diversification took a drubbing in the financial crisis. Risk assets across most markets fell in unison. All but a handful of funds of funds were badly hit with an average drawdown of around 20%. But there is still evidence to support Markowitz’s dictum that diversification offers the only free lunch in financial markets.

At Cube Capital diversification takes several forms. The $1 billion firm manages three platforms, the core fund of hedge funds business, as well as hedge funds and direct real estate. The flagship fund of hedge funds is the Cube Global Multi-Strategy (CGMS) fund of funds (AUM $600 million). It is joined by QBridge, a single manager fund (investing in greater China and Asian distressed debt), and Cube Global Opportunities, a closed discretionary opportunities fund. The Hedge Fund Journal visited Francois Buclez, Cube’s CEO, at its Great Portland Street offices. The discussion ranged from the relationship of diversification and risk management, to manager selection and investment opportunities in Asia. A key theme for Buclez is what funds of funds need to do to rebuild confidence with investors.

“In the fund of funds model operating in 2008 portfolio allocation and risk management were quite static,” he says. “Downside protection was also lacking. Now fund of funds portfolio managers are much clearer on what drives returns in a portfolio of hedge funds. They are also more apt to use overlays to protect a portfolio by using puts on the S&P 500 or on interest rates futures to immunise a fund of funds to a certain set of risks.”

Improving the model
Even pre-crisis Cube sought to actively manage risk and strategy allocation which helped them weather the storm during the 2008 crisis. CGMS was by no means immune from the issues in 2008, but by increasing liquidity and allocations to directional strategies in late 2007/early 2008 limited the downside to 12%. Given the risk management and portfolio actions, Cube re-risked the GMS portfolio to generate returns in 2009. The manager selection of the GMS is structured so that funds can be recovered within its redemption notice period.

A second emphasis is manager selection and transparency on allocations. Here the focus is on tighter risk management and better transparency by investing, with medium sized (around $600 million) managers. These managers are often sector specialist equity long/short funds rather than generalist long/short managers. The aim is to avoid significant overlapping risks/positions across underlying managers. A special emphasis in due diligence even pre-2008 has been to assess counterparty exposures and risks.

Not surprisingly Buclez believes that funds of funds and GMS in particular can be a flexible tool for investors over a cycle if used actively and optimally. The performance of GMS since 2003 (See Fig.1) bears this out. “Most investors won’t have thesize or skill to be able to do a fund of funds on their own,” he says. “With its hedges a fund of funds is a good medium for market exposure. Funds of funds mean that with one allocation an investor can access every region, every strategy and every asset class. I don’t think there is any other investment that can match that reach. It is a very powerful tool to manage money.”

Flexibility in returns
A neat twist in Cube’s fund of funds is its periodic use of direct investments to take advantage of specific market dislocations which offer outsized returns (See Fig.2). For example, in 2008 during the market panic, GMS bought a portfolio of credits including investment grade, high yield and convertible bonds when such assets were hated. Cube’s portfolio managers liked the trade but didn’t want to allocate money to credit hedge funds. For one thing, many credit funds had big legacy problems in their portfolios. For another, the trade was a beta trade and Cube didn’t want to pay 2 & 20 for beta, especially when they had the expertise in-house. What’s more, the instruments used in the trade were likely to be more liquid than an allocation to a hedge fund offering the strategy. Though the fund of funds has an express mandate for such manoeuvres, investors were informed directly when the trade was put through Cube’s trading desks in Hong Kong and London.

Several other strategic allocations also feature occasionally in Cube’s playbook, for example, re-insurance on the US East Coast during hurricane season. These will be structured in specific managed accounts with certain managers to carve out the specific desired risk when returns that can be achieved are far in excess of what is the long-term average. An example of this is after the credit crisis, and Hurricane Ike, premiums paid on certain risks were over 30% as compared to the average of around 15%. These types of allocation are only taken when the returns are extraordinary and the risks are the same.

Returns in difficult markets
Over the past decade equities have been characterised by poor returns and high volatility. Credit has earned better returns on less volatility but on the back of a massive bull market returns don’t look to be sustainable, and yields are minimal. To get returns, institutional investors need to look beyond the traditional approaches to managing money.

Taking a 10 year view, hedge funds have done well, generating 6-10% annualised returns with an average 8% volatility. Moreover, it is not clear what will be the impetus for the re-emergence of a new bull market in a way that saw post-WWII reconstruction and then globalisation and the IT revolution drive bull markets in recent decades.

For Buclez the answer is clear. “Investors should have another look at hedge funds,” he says. “The way funds of funds invested was not optimal before but the new products available now are a lot more robust. From a philosophical point of view, hedge funds make money from process driven strategies independent of beta.” He cites event driven M&A. Investors can’t get exposure to that through index investing. It is the same thing with fixed income arbitrage or volatility arbitrage – strategies that make money on process.

Buclez doesn’t skirt some of the weaknesses inherent in hedge funds. He acknowledges that hedge funds can have difficulties with responding quickly to changed market environments. This can be particularly true for funds of funds. Given their longer investment lead times it can take six months for a fund of funds to adapt and begin making money again.

Indeed, Buclez is critical of how funds of funds operated until comparatively recently. “On portfolio allocation and risk management funds of funds were quite static, operating a concierge model where big fees were paid to intermediate large branded funds, but no real service except access was provided,” he says. “Funds of funds had a passive allocation to a portfolio which often meant high correlation with other asset classes and a lack of downside protection.”

Dynamic hedging
In contrast, Cube has looked to dynamically allocate to different strategies as its reading of markets evolves. The firm divides the hedge fund world into three buckets: defensive, relative value and beta-driven. During 2003-07 the portfolio rode the bull market and thus allocated a lot to beta-driven strategies. Worry set in during 2007 as Chinese growth faltered and structured credit funds began to blow up amid growing realisation about massive leverage in the financial system. This occasioned big portfolio shifts in GMS to defensive allocations as the year wore on. The portfolio was re-risked in 2009, but with a large allocation to relative value on the basis that a lot of the leverage that had hurt the strategy had been forced out, so offering good returns with much lower risk than beta strategies.

“On portfolio construction, our macro view was wrong,” says Buclez matter of factly. “We were coming from a 50% drop in the equities market and thought there would be a dead cat bounce of 10-20% before the market flattened out. We were wrong, but we managed to model the portfolio in such a way that we made good money.” (GMS was up 17.5% in 2009). The message is that even if a fund of funds is wrong on its macro call, portfolio construction can still generate returns. Proof of the Cube multi-manager fund’s quality of returns is shown by beta of 40% in up markets but only 12% in down markets (See Fig 3).

“I think the people who have survived post-2008 have a different model with a lot more dynamic allocation to different hedge funds and different hedge fund strategies,” says Buclez. “Portfolio construction is the key to weather different market environments. You can have a macro view and you build your portfolio in a certain way but if your macro view is wrong you need to be able to build your portfolio so you can still make money or not lose money even if you are wrong on your macro call.”

Targeting dislocations
Right now Buclez is targeting two big dislocations. One is European distressed debt. The other is the effect of the regulatory environment on particular derivatives used to trade volatility and correlation. The attraction of these areas is that the withdrawal of capital improves the corresponding opportunity to generate outsized returns. The markets have been challenging and continue to be challenging. However, Cube is confident that there are enough interesting opportunities out there to generate solid returns.

In terms of investor attitudes, a recent road show in the US leaves Buclez optimistic about the future of hedge fund investing. “In the US, it is not unusual for 30-40% of a pension fund’s total assets to be allocated to hedge funds versus 5-10% in Europe or Asia,” he says. “It comes down to the fact that because the industry started in the US over 30 years ago they are more comfortable and they understand the product better than European or Asian investors. I think that trend will come to Europe and Asia because hedge funds really offer value over a long period of time.”