Dalton Strategic Partnership

Thriving on breadth of thinking

Simon Kerr
Originally published in the August 2005 issue

One of the tenets of the hedge fund business is that investors in hedge funds are prepared to pay high fees to get the best operators in a strategy. The more narrowly the strategy is defined the greater the opportunity to be the best informed source in the area. So Tiger Management Corporation alumnus Bill Hwang ran the Tiger Asia Overseas hedge fund to manage positions in domestically-related Korean stocks, and KiCap Management was set up to run a fund dedicated to global telecommunications shares long and short, etcetera. Patrick Earle and Mark Beder ofKiCap were also employed at Tiger Management. The Tiger-model is still widely deployed in the United States, and has been pursued in the next generation by FrontPoint Management, the hedge fund umbrella-company.

One of the tenets of the hedge fund business is that investors in hedge funds are prepared to pay high fees to get the best operators in a strategy. The more narrowly the strategy is defined the greater the opportunity to be the best informed source in the area. So Tiger Management Corporation alumnus Bill Hwang ran the Tiger Asia Overseas hedge fund to manage positions in domestically-related Korean stocks, and KiCap Management was set up to run a fund dedicated to global telecommunications shares long and short, etcetera. Patrick Earle and Mark Beder of KiCap were also employed at Tiger Management. The Tiger-model is still widely deployed in the United States, and has been pursued in the next generation by FrontPoint Management, the hedge fund umbrella-company.

Dalton Strategic Partnership LLP was founded in 2002 by a group of former colleagues at Merrill Lynch Investment Managers in London. The original partners beside Andrew Dalton himself were global macro manager Bruno Serfaty, COO and head of marketing Magnus Spence, and risk manager Rajiv Sachdeva. Perhaps surprisingly, as Rajiv Sachdeva is the risk manager of DSP, the last named in some ways is the most indicative founding partner. One of the key differences between long only managers and management companies and hedge fund managers and hedge fund management companies is the appreciation of risk. By taking Sachdeva with him to DSP Andrew Dalton indicated that he was taking risk management very seriously from the outset, and making Sachdeva a partner from the early days demonstrated that risk management at DSP is central to the investment process across the range of products.

And indeed, the range of products at DSP has expanded through time on the basis two core rationales. Firstly Andrew Dalton as managing partner has identified areas of expertise/product that he would like to add to the range. For example he says: "At the moment it would be very natural for us to add a specialist UK equity capability to what we already have."

A common culture

The second rationale for expansion is opportunistic. The talent has to be available, and be capable of working within the dominant culture brought over as a consequence of most of the investment staff heralding from the old Mercury Asset Management business. "We wouldn't only take former Merrill Lynch Investment Managers staff, as we did when James Hordern joined us to run European equity funds in 2003," says Dalton. "For example, we have brought in Henrietta Luk to manage Asian Equities for us from a Hong Kong base, and she has never worked for Merrill Lynch/Mercury."

Initially, the commonality of the backgrounds was useful in building a new investment business. Mostly this is because almost all the professional staff had worked for the same company and so had acquired some similar habits in ways to operate. They know how to work together, partly through being acquainted professionally, and at best working along side one another. But that is not all. Beyond that there is some comfort in the sorts of people that were recruited to be the investment professionals of Mercury/Merrill Lynch and that have come together at DSP. Dalton Strategic Partnership has an echo of the former Mercury Asset Management in the somewhat patrician air of the bright investment professionals gathered there. The shared background contributes to the uncommon combination of being fervently open to ideas and coming across as knowing at the same time.

Both the last two attributes are important at DSP, but not at all investment management organisations. All investment managers end up having to live and die by their ability to take effective investment decisions in an informed and appropriately sized way. That is they have to be informed enough about what the markets have discounted and what their view is to generate a "variant perception", to borrow a phrase from hedge fund giant Michael Steinhardt. All investment managers have to be knowledgeable to that extent. The DSP team comes across as being particularly sharp, but that is what one would hope for in an investment manager, if not expect.

A key differentiation of the DSP investing approach is the openness of the investment professionals to new ideas. Andrew Dalton is very keen to draw inspiration from a wide variety of sources, and not all of them are external. "One of the great joys of doing this has been to build up a group of colleagues," he expounds. "As experienced investment professionals they know what is useful information at the margin, and, for me in what I do, looking across the asset classes, they are a great source of information."

40745290table A

Melchior Japan Fund

The most commercially successful of the range of products offered by Dalton Strategic Partnership is the $750m Melchior Japan Fund. DSP is the investment manager of this fund, and the investment advisor is FuNNeX Asset Management of Tokyo. Ken Nishizawa is the principal and CIO of FuNNeX, a firm he founded in 2000. He has worked in financial markets for 30 years for, amongst others, Merrill Lynch/Mercury in Tokyo. Nishizawa launched a long-only mutual fund for the Japanese retail market in 2000, and began managing the hedge fund three years later. The track record of the hedge fund has been very good (see Table A) as is the record of the long-only product. The hedge fund returns compare well with the Eurekahedge Japan-only Long/Short Equities Hedge Fund Index returns in each of the last three years of 16.29%, 8.11% and the year to date index return of 4.79%. The Melchior Japan Fund has achieved a similar Sharpe ratio to the Japan-only hedge fund index ratio (1.41versus a 5-year 1.50 for the index) with about twice the level of volatility of return (a standard deviation of 11.02% versus 5.55% for the index).

A factor that marks out Ken Nishizawa amongst his peers is his restlessness. He is not satisfied to leave his investment process as it is; rather he is constantly driven to improve it. This is illustrated in a couple of areas – idea generation and shorting.

Idea Generation for the Melchior Japan Fund

The portfolio manager has given a great deal of thought to how best to marshal his research resources, and in particular how to generate investment ideas. Like most long/short Japanese equity managers he concentrates on mid-cap names, but "I do not screen my universe of names using sieves, I scan it," he explains. "It's a much more effective way of finding where to concentrate research. I want creativity in my investment team, because out of the intellectual wildness I demand, come our most interesting ideas."

Like DSP, the staff of FuNNeX are expected to be alive to signs of shifts in demand regardless of the source. There is an ideas box in the office to which any visitor can contribute as well as the FuNNeX staff. "Town Wisdom" can be a source of ideas in the answers to questions along the lines of "What do the discussions and activities of children or neighbours tell us about shifting demand patterns?"

In addition to more typical sources of insight (given in the graphic) Ken Nishizawa sparks new trains of thought and connections by hosting what he calls "Visionary Meetings" which feature guest speakers. When one hears that amongst the half-million subscribers to Nikkei Electronics magazine there are 30,000 staff at car manufacturer Toyota, it is understandable why the Chief Editor addressed a FuNNeX Visionary Meeting – the impact of technology on old industries is a staple of the magazine. A more eclectic though no less stimulating speaker was a Japanese poet. Out of such meetings emerged the potential significance of advanced voice recognition technology, and an investment in Advanced Media (3773).

Through time devoted to thinking and discussions within the team, themes are developed which can evolve from high concept (the effects of demographic and social changes) to observation (shifts in female worker participation rates in Japan coupled with increasing divorce) to shifts in demand at the more micro level (for example, dating services). Amongst the areas experiencing expansion in Japan are leisure pursuits in various forms, and outsourcing of domestic activities (classically reflecting an economy moving to its tertiary stage of development, i.e. a shift towards services from manufacturing). These tendencies have highlighted investment opportunities to FuNNeX, like outsourcing cooking and domestic robots, and services for pets (an ageing society may have increased pet ownership).

Finding the instrument to best capture the investment concept Another area which Nishizawa and his team of six analysts are particularly adept at is exploiting is the information edge inherent in the company/security with the most leverage to the idea. The development of the hedge fund has only helped in this regard, because the group have to think about which entities are going to be badly affected by the changes anticipated or under way (short candidates), as well as the beneficiaries of those changes (long candidates). Knowledge up and down the supply chain of a sector is very important to get to the right stock to take a view. For example, the boom in flat screen televisions obviously gave Sharp a fillip, but it was also a big boon to Korean company Samsung. The FuNNeX team connected Samsung with a Japanese-based supplier Nitto Denko (6988) that has continued to thrive even as Samsung Electronics has suffered because of over-capacity.

Such an ability to see beyond the obvious, research in some depth, and make connections between sectors, is a function of the size and quality of the firm's research effort. In this regard having professional staff with an average market experience of 17 years has been a big plus, according to Nishizawa. He also likes to stretch his staff and reinforce its teamwork process. The analysts have various sector and macro-group responsibilities, and Nishizawa has been known to switch them amongst the team just before the end of a reporting period. This forces the analysts to share their specialised knowledge of companies and co-operate to a heightened degree. A fresh eye looking at the sectors also helps the team-view on stocks to move on from favourite or pariah status.

A London-based partner of DSP, Robert White, also contributes to the running of the Melchior Japan Fund. "Robert White's major role is to put the developments in Japan into a global context," says Nishizawa. "The technology industry and, say, the basic materials sectors are better covered in Europe than Tokyo. So we tap into the macro thinking of Dalton Strategic Partnership and in particular get a feel for international investor flows via London. An important factor for our market is to know when global investors are very willing to buy or sell Japan, and we get that through Robert [White]."

"Ken [Nishizawa] is on a journey," proffers marketer Magnus Spence, "and is always looking to change what he has in his process." A recent example of this restlessness that affected the hedge fund was on the short side. The sequence of five losing months in the second half of last year gave the manager pause for thought. Analysis showed that the returns to that point were principally coming from the long book. In a radical step, rather than giving sector responsibility to the individual analyst as had previously been the case, Nishizawa established a sector review team comprising four of the senior analysts, which commonly decides on a weekly basis the sector exposures of the short portfolio whilst leaving stock selection with the individual analyst. As a consequence the holding period for shorts has become a lot longer, and turnover is down significantly, reducing the burn rate through the stock of short ideas. Most significantly of all, the profitability of the short book has become a major component of the out-performance of the fund this year.

Dalton Strategic Partnership's Second Hedge Fund

There is another hedge fund under the umbrella of the Dalton Strategic Partnership LLP. The performance data and analysis for the fund is shown in Table B.

It is quite difficult to divine from these tables what sort of fund this data comes from. The annual returns have been 8.92% for 2003, 8.82% for 2004 and -6.97% for the first half of this year. The fund is the $43m Melchior Global Macro Fund.

The index returns for Global Macro have been 17.99% for 2003, 8.49% for 2004, and 2.97% for the first half of 2005 according to the CSFB Tremont Hedge Index. As global macro has a wide dispersion of returns it is particularly difficult to make valid performance comparisons using index data. The correlation of the global macro index with financial markets, the percentage of profitable months, the average sizes of winning and losing months for the global macro indices, all are simply not useful for benchmarking individual hedge fund performance in the sector. Arguably global macro indices are not at all relevant for the construction of portfolios of hedge funds.

The HedgeFund.net database contains fund rankings within a sector, and there have to be caveats about putting the performance of individual hedge funds into that context. These statistics have been calculated for the data set available for each manager – a manager with an 18 month track record is compared with a manger with a 5 year track record, so taking no account of the different opportunity sets available to each. Usually this counts for a lot in examining track records and making comparisons. For global macro it matters less because the investment methods used vary so much, and essentially investors are buying idiosyncratic directional investing skill. So it is that some say that macro may be the most skill-based of the hedge fund investment strategies. Macro funds can invest anywhere and in anything, so theoretically they always have opportunities for investing since they are not restricted to be long-biased.

Bearing these intellectual risk warnings in mind, how has the Melchior Global Macro Fund done on a comparison basis? The rankings by measure are given in Table C.

To some extent the absolute returns achieved by manager Bruno Serfaty with the Melchior Global Macro Fund tell the story, but as much relevance to the manager has been the volatility of return exhibited. The manager has run the fund positioned so as to achieve 10-12% returns but with low volatility for a macro fund (14% per annum – ex ante). The commercial aim has been to attract investor attention by the control of risk rather than the absolute returns delivered. The combination was intended to give a superior outcome in terms of return per unit of risk for which the Sharpe ratio is a proxy. Serfaty achieved this in the first two years of the fund, but the losses this year have queered the pitch.

The concentration on risk-adjusted return has been a brave commercial decision. It is true that most hedge fund managers try to run funds that are true to their own particular takes on the market. Quants run quant funds, contrarians run contrarian investment styles, conviction investors have large positions, and stock-pickers try to drive returns from the bottom up. Bruno Serfaty takes a rather balanced view of the financial markets and how they inter-relate with macro variables. Whatever a manager's view, and however good he is, any position taken on has a chance of being a winner, of the view being correct – all investing is probabilistic. Most hedge fund managers take outright bets, though some take relative bets (arbitrage strategies and market-neutral equity for example). What is unusual about the Serfaty approach is that he builds portfolios that try to capture more of each side of the probabilities than most other hedge fund managers. This is not outright directional risk assumption, and so sits somewhat uneasily in a style box, in this case global macro, that is typically executed as one-sided trades.

Handling Risk at Dalton Strategic Partnership

Risk manager Rajiv Sachdeva described macro manager Serfaty as good at allocating risk in a disciplined fashion. "We allocate risk here [in London] by VaR. I'd say as a whole the asset allocation process and the macro fund are run by smart economists. The way the macro fund is run by Bruno [Serfaty], the bets are never entirely one way."

The portfolios are constructed to reflect a number of scenarios – for example, the Fed will carry on raising rates at the same frequency as previously, or the Fed will accelerate interest rate increases. The asset mix that benefits under one scenario – say a long equity bias with a long dollar-linked currency bet – will not be the same as the asset mix for scenario two – say a long bond bias (or curve flattening trade) with short positions for the dollar against a basket of currencies. The risk budget is allocated 7030 or 6040 to the preferred scenario, and optionality is used when pricing facilitates it to reduce the overall capital consumption.

The risk measurement and risk management of the macro fund are very well tailored for the individual product, as they are for other products at Dalton Strategic Partnership. They fit with what the manager is trying to achieve. From the perspective of determining and implementing an appropriate risk framework the firm will be well placed to handle other sorts of mandate as they arise.



To complete our hedge fund-biased overview of Dalton Strategic Partnership LLP, the Hedge Fund Journal asked the 56-year-old Managing Partner and Chief Investment Officer Andrew Dalton a few leading questions.

How did the link with mining share specialists Craton Capital come about?

Andrew Dalton: "I have been interested in mining shares for 35 years. In fact I started my career in investment management as a mining analyst. As you probably know Mercury Asset management (as it was then) has long had expertise in the sector. When Julian Baring brought his mining team to Mercury [and with him the top-performing World Mining Fund] it was a very natural fit. Julian had been one of my best brokers when I was a (buy-side) analyst.

"When I was introduced to Markus Bachmann and Joachim Berlenbach it seemed good timing for a commodity play [the Craton Capital Melchior Precious Metal Fund was launched in September 2003]. I was very pleased too to have the input from Markus and Joachim who are talented investment managers. Again it broadens the perspectives of the information flow we receive."

Any views on bonds at the moment?

There is a cycle in bonds just as there is in equities. I take it you are asking me whether there is a cyclical argument for being pro-bonds at the moment? In my view dis-inflation has not gone away; it has been a 15-year phenomenon and it is still with us. A reinforcing argument is that there is taking place a secular shift from equities to bonds amongst insurance companies and pension funds.

Do you see any investment consequences because bond investors clearly have been reaching for yield?

That is one of the great investment questions of the moment. The consequences of that excessive risk taking have not all come out as yet. There could well be afurther round or two of market disturbances resulting from the reaching for yield. For our part we expect to see opportunities created, but they are not there yet.

A yield-related opportunity we do see, and like, is the chance to buy Japanese companies with a utility-like income stream. These are high yielding shares (a 2% equity yield is high for Japan) with a dividend cover of 5 or 6 times. We like Japan Tobacco and Kao Soap on this basis for example.

What ideas are you using in your asset allocation process?

We have three big themes at the moment. The global hunger for yield we have touched on. The second one is global competitiveness: it is getting very rough out there for companies. It used to be, 20 years ago, that the job of an asset allocator was to pick the best markets from across the world. That has changed. The correlation between markets has increased and the correlation within markets has declined [intra-market correlation]. Now even very big companies can be destroyed by global competitiveness; just look at General Motors and Ford and their competition from Toyota.

Our third big theme is the carry trade, encompassing everything from property to high yield bonds, and the use of leverage.

For the US Dollar/Yen, the terms of trade are moving against Japan – the Yen could soften on the back of deteriorating terms of trade and the new price of oil.

40745290table D

In our asset allocation we look for excess liquidity in the world. It may seem as if there isn't as much liquidity as there was, if you look at the US. But it has appeared elsewhere – a great example outside the US is in Korea where the consumer borrowing and banking problems can only be addressed by the central bank pumping away [cutting rates]. So we are not looking solely at US investments, but at where the liquidity is popping up. On that basis we have substantial exposure in emerging markets, particularly in Asia.

How is Dalton Strategic Partnership differentiated from other investment management companies?

We don't seek to differentiate ourselves, that is for others to determine. I would say the fact that we consider global asset allocation to be a very significant factor in returns makes us different. After that it is probably down to the returns themselves – they show whether or not we are fulfilling our investment objectives.

Also, we have a desire to produce absolute returns for clients. We have had this mindset for some time. You may recall that my last position at Merrill Lynch Investment Managers was as Head of the Total Return team, where we ran $6bn for 270-plus clients. It may take a while for others to adopt that thinking. We think, given the environment of inflation that we have, that our clients will be looking for returns of 5 to 10% over short term interest rates depending on risk profile, and we have achieved those objectives [in the mixed asset class products; see Table D]."

What benefits do you see from running long only mandates and hedge funds in the same investment operation?

For my part, running global asset allocation, I think the experience is richer for sitting next to two fund managers. We have an intellectual integration of hedge fund and long-only managers, and that has to be the case. Hedge funds are a significant influence in how markets trade. Hedge funds are not in a separate silo from other forms of investing and the managers are not a different species. They talk – Ken [Nishizawa] and James Hordern, our European equity specialist, are constantly bouncing ideas off one another. The Japan funds have exposure to a company [Access] that we think can be a category killerglobally. We came across the name in Europe through our European team talking about Symbian and Opera to companies in the mobile phone business. That is a working dialogue.

What areas for expansion do you have in mind?

There are a number of areas that I have in mind. I'm quite prepared to shuffle their order as opportunities present themselves. We see scope for developing further our balanced investment product in a variety of ways. We have spent 18 months looking for a UK equity team to join us, but if we succeed first in bringing in an emerging markets capability (which we also see as a useful addition) then so be it. We have a platform in Hong Kong which is for investment management, not just marketing or client support. The office in Hong Kong and links with Tokyo and Johannesburg allow us to work in a number of ways with those that join us.

Whichever area of investment we add to our current range, it will enhance our capabilities overall because it will deepen and broaden our investment debate in the firm. I see that as an important positive factor in our growth.