Eddington Capital Management

A high volatility approach to the fund of funds formula

STUART FIELDHOUSE

Eddington Capital Management is Caledonia’s second venture into the hedge funds sector. The investment trust was seeking to make a further investment in the space following its successful participation in Polar Capital Partners, but with a company that would not compete against Polar. The funds of funds space was viewed as a potentially fruitful area to explore further.

Consequently, Caledonia acquired a 50% stake through its support of the start-up of Eddington, which is led by Glenn Baggley (ex-Attica) and Alex Allen (ex-EFG). Caledonia’s Tim Ingram and Jamie Cayzer-Colvin both sit on the Eddington board, along with Polar Capital’s Charles Hale, a previous Chairman of DLJ International.”We knew what we needed to do to build a successful business, but wanted solid institutional backing,” says Baggley, Eddington’s CEO. “Caledonia provided us with $25m of seed capital and together we contributed the working capital to get the company up and running.

“Eddington spent six months in 2003 seeking out the managers that would comprise the initial portfolio of its flagship “Eddington Triple Alpha Fund”, which was launched in September of that year. Baggley and Allen did not want the firm to be a provider of standard low volatility “mainstream” funds of funds, as they felt the market for these products was already saturated. “Even though that is a very significant growth area, there is also a vast over supply,” Baggley says.

“We pitched to Caledonia that Eddington should be a high return fund of funds specialist, targeting much higher returns than mainstream funds of funds, but without using leverage or any of the other unattractive methods commonly employed to enhance returns.

“Eddington did not want to use strategy timing, or concentrate their investment in a few managers or strategy types, nor did they want excessive exposure to illiquid strategies, emerging markets, managed futures, or any of the other strategies that are habitually used to spice up returns. Instead, Eddington set out to simply find those managers delivering high returns through superior skill and investment insight. This is the sort of innate investment talent that can’t be found in text books, and identifying it requires a great deal of qualitative assessment – spending time with the manager to understand how they think, how they operate, how their risk controls function, etc.

Eddington’s first fund is seeking to generate high absolute returns with a 10-12% maximum volatility, but without using leverage, and employing a diversified portfolio of typically 18-25 managers. It adopts a bottom-up buy-and-hold manager selection policy, and only avoids those strategies which simply cannot provide the returns it is looking for (e.g. short bias or market neutral funds).

Baggley stresses that the volatility of the Eddington Triple Alpha Fund is still modest, with a standard deviation of 8.5% per year since launch, yet with significantly higher returns than most funds of funds. In addition, “We draw a very clear distinction between volatility and risk,” he says. “We accept higher volatility: it is the fuel our managers use to generate their higher returns, but we don’t want to accept higher risk. Volatility is monthly “noise” around a mean return, but risk is the possibility of a loss that could take years to recover. We invest in managers that are very flexible, pursuing directional strategies with a bigger upside than downside, with the skills to get the directional call right, and whose skill is sustainable, because we want to stick with them for three to five years or more.”</ p>

Turnover has been slightly higher than that since launch, as Eddington has been improving what it considers to be the overall quality of the managers in its portfolio, but Baggley expects it to settle down going forwards. Given the opportunistic nature of its managers, Eddington requires a high degree of transparency to properly monitor and control exposures across its portfolio. Many hedge funds are reluctant to disclose the intimate details of their portfolios, but Baggley feels that Eddington’s reputation as an informed long-term buy-and-hold manager helps the firm to get access to the details it requires. “By the time we make an investment, they will have provided us with a vast amount of information,” he says. “We develop a rapport with our managers. If we operated differently, we simply wouldn’t get that degree of transparency. Knowing what their positions are provides invaluable insight into their investment style, allows us to watch for problems, and mitigate risks across our portfolio. But it’s not just about current positions – we spend a lot of time trying to understand how a manager thinks so we have some feel for what he is likely to do in the future.”</ p>

As part of this process, Eddington set up its first managed account in October with a managed futures (or “CTA”) fund. Baggley says CTAs are the exception to the no strategy timing rule. “They are predictable,” he says. “The hard part is knowing when to get back in, but getting out at the top is relatively easy and you can add an enormous amount of value if you get that timing right.”

Eddington is only interested in funds that are capable of returning at least 25% net per annum over a two year plus horizon, but doesn’t invest in start-ups. It particularly likes partners funds (the private investment vehicles some hedge fund managers set up to run some of their own money, but which are generally not marketed externally). Eddington has been able to gain access to quite a few of these ‘best ideas’ vehicles, often as the first external investor.

And going forwards? “We think 2007-08 will be very strong years for us,” Baggley predicts. “This is illustrated by our performance in months where conditions were reasonable, like November 2005 (+5.00%), January 2006 (+7.06%) and April 2006 (+5.27%). These sorts of numbers should not be unusual for us: we should be up over 4% in four or five months of the year.”

Caledonia’s Other Hedge Fund Investments

POLAR CAPITAL

The launch of single manager Polar Capital Partners, and Caledonia’s involvement with this hedge fund, dates back to its founders’ days at Henderson Global Investors.Brian Ashford-Russell and Tim Woolley both worked at the blue-chip UK fund manager, where Ashford-Russell was specialising in the booming technology sector when he was approached by Caledonia in 1999. At the time, Caledonia was interested in increasing its exposure to technology, and Asford-Russell, who was already noted for his out-of-consensus calls on the tech market, advised it against the move, rightly predicting the imminent technology-inspired market crash.Ashford-Russell and Woolley were already hatching plans to start their own asset management business, but like so many other start-ups, were faced with practical issues like office space, and the hiring of a suitable COO they could work with. Caledonia was one of a number of parties the duo entered into discussions with, and had an established reputation has a long-term investor in people that the Polar pair admired.Caledonia funded Polar in exchange for a 24% stake in the business, and brought its expertise and past experience with other asset management firms to the equation. It introduced Polar to its COO, John Mansell, who joined from Lazards, and helped with office space by installing the firm in its headquarters at Cayzer House. Peter Buckley and Jamie Cayzer-Colvin both sat on the board.Mark Kary, the current CEO of Polar, who joined from Morgan Stanley, sees Caledonia’s involvement as instrumental. The fact that it owns a stake in Polar and invests in its funds has played a big role in attracting other investors to the Polar stable. Six years on, Caledonia still owns 20% of the company, and as far as Kary is concerned, “we are still treated as part of the family.

ERMITAGE

The management buy-out of funds of funds specialist Ermitage from the South African Liberty financial services group was one of the big stories in the industry in Q1 this year. Caledonia played a critical role in financing and facilitating the deal, although going back to 2005, Ermitage management had yet to decide whether a trade buyer or private equity fund would best suit their strategic goals.”It takes time for the distribution benefits to come through with a trade acquisition,” says Ian Cadby. “We elected to go down the private equity route in the end.”When Liberty Ermitage began its beauty parade of potential private equity buyers for the business, there were twenty-odd suitors, although Cadby and his colleagues were intensely aware that many of them would be looking to sell the business on within two or three years. They were also conscious that a couple of major investors had said this level of disruption might not be tolerable. It was in this context that Caledonia’s offer started to look more promising, particularly its longer holding period. “They had a very definable track record in asset management,” Cadby explains.It was during these discussions that Ermitage was introduced to Paul Myners, returning from a sabbatical and keen to become involved in the industry again following his days with Gartmore. “It all came together fairly neatly,” Cadby says. “Our investors liked Caledonia, and they liked the Myners effect.”Caledonia now controls 60% of Ermitage, with two seats on the board. Cadby finds its ongoing participation as both shareholder and discrete investor in some of the Ermitage funds as a reassuring factor as the firm starts to consider plans for expansion, including potential acquisitions in North America and the Asia Pacific region.

Biographies

Glenn Baggley began his financial career with Bita Plus Consultants, where he led a team of computer programmers and research professionals in the development of risk control, optimisation and portfolio management software. In 1997 he joined Quaestor Investment Management, a provider of global market-neutral equity hedge funds. In 2000 he moved to Attica Asset Management as Managing Director of the Alternative Products Division, raising $200m of alternative assets. He holds a 1st Class BSc (Honours) in Astrophysics from Newcastle University and a D. Phil in Astrophysics from Oxford University. He has also conducted research in Astrophysics at Durham University and Nuclear Physics at The Daresbury Laboratory.

Alex Allen began his career at Barclays Bank in Paris in 1994. This was followed by an internship program at Morgan Grenfell Asset Management. He joined EFG Asset Management in 1997 as a hedge fund analyst, gaining exposure to all analyst disciplines, including analysis, portfolio construction and fund screening. In 1999 he became fund manager for EFG’s hedge funds range. During his tenure, the fund range increased from 1 to 5, and AUM burgeoned from $13m to in excess of $110m. Allen held a seat on EFG’s Asset Allocation Committee, overseeing tactical and strategic capital allocation. He holds a 2:1 BSc (Joint Honours) in International Management and Modern Languages from the University of Bath.