Emerging Managers: 2005

The seeding of HSBC's global technology hedge fund

Simon Kerr
Originally published in the August 2005 issue

Nascent hedge fund managers Conor O'Mara and Mick Dillon have won the backing of two significant hedge fund industry players at the outset. Their HSBC Global Technology Alpha Fund will launch on September 1st with $50m, half of that to come from HSBC and half from Thames River Capital as a strategic investor. Ken Kinsey-Quick of Thames River says that the combination of his firm and the alternatives unit of the world's third largest bank is a case of two-plus-two-equals-five. "I spoke to Conor and Mick first and, though I liked their approach very much, what they needed from a seeder I thought was better met by HSBC. So I introduced them to Bill (Maldonado of HSBC Halbis)."

HSBC Alternative Investments' Maldonado made introductions of his own: " I had Conor and Mick meet people in all different areas of our business. Every single one of them gave me positive feedback on these two. In particular I can see the technology team getting on very well with our European hedge fund team."

At the St.James's Street offices of HSBC O'Mara and Dillon get access to the deep risk management tools of the HSBC asset management business, marketing support, and an investment culture that suits them.*

From the managers' point of view HSBC makes a great fit. "Obviously HSBC is a great brand name to have, and the bank has such scale in Asia that it is a big plus for us," says O'Mara. "HSBC runs the largest mutual fund in India, and we have already met the manager. Similarly we have met the chief investment officer in Hong Kong. These asset management contacts are a natural feedback loop for our process: we get investment ideas at the company or sector level and can road test them with local market experts. The other thing we get here is a risk management capability that is particularly experienced in emerging markets," he adds.

The strategy

The HSBC technology hedge fund will be long and short equities of technology companies and has an unusual investment bias for that strategy. "We decided to make it an EAFE-focussed fund," says Mick Dillon, "because we think that there are large information inefficiencies to take advantage of in Asia, but also because there is a medium-term shift that we can profit from long and short. We see a structural hollowing out of European technology companies to Asia.

We will also invest in American companies that face similar conditions, but we have an EAFE bias."

The growth potential of Asian technology companies is exemplified in Graphic 1. This shows the different sales growth rates of the Indian and European systems integration companies. But it is not just on the software side that O'Mara and Dillon see opportunities. They see the fact that European technology companies are heavily biased towards hardware as a significant long-term structural negative. They see the value chain in technology being fragmented by Asian component suppliers, as they seek to add more value. "You only have to look at mobile handsets," says O'Mara. "All the handsets with Japanese names on the outside are made elsewhere is Asia, and Asian brand owners are building sales in their own name" (see Graphic 2).

Relevant experience

The backgrounds of the two portfolio managers are very relevant to their new role as money managers. Prior to joining HSBC Halbis Partners the pair worked together at Arete Research LLP, the independent research boutique dedicated to the technology and telecom sectors that was founded by alumni of Goldman Sachs. As Arete research features model short and long portfolios O'Mara and Dillon have a paper trading track record of four years to support their new standing as money managers. In addition Conor O'Mara has a real successful track record in portfolio management from his time running $1bn of assets at Dresdner RCM Global Investors in London.

As analysts of global software and IT services companies (Dillon) and digital consumer and software companies (O'Mara) at Arete they have had a lot of exposure to a serious hedge fund client base. The dialogue with seasoned investors at big hedge fund firms in New York and London has exposed the neophyte hedge fund managers to both trading and investing strategies. O'Mara and Dillon will apply both in the HSBC Global Technology Alpha Fund, as shown in Graphic 3 (page 56).

Australian Mick Dillon's career has also encompassed working in the technology sector as a strategy consultant, and he has been on the other side of such advice when he worked in the corporate strategy department of Logica. This background working at the strategic level in technology comes into play in Dillon's new role. He is able to form the industry intelligence he gleans from the bottom-up at the 10-12 trade shows he attends each year and from working the network of 1500 industry contacts he has, into a big picture view of the dynamics of the industry. The company contacts are not just in the executive suite of technology firms: Dillon and O'Mara both put a lot of store by their relationships with divisional managers. Information flows below the boardroom level can be more timely and more anecdotal. In addition the discussions at divisional level can flow naturally, away from the company PR and investor relations professionals that can restrict them.

Both Dillon and Irishman O'Mara see part of their edge as their ability to interpret the effects of an industry shift up and down the supply chain in a sector, and across borders. There are information disparities between country markets for companies in the same sector which the technology hedge fund will exploit long and short. For example in 2002 Dillon heard about the purchase of a television business by French company Thomson from a competitor of theirs. As there were three or four potential purchasers and the various stockmarkets had assigned varied implicit probabilities of a successful purchase for each company the opportunity was rich to play long and short.

Portfolio shape

The idiosyncratic risk in technology stocks is high. The stocks can be proxies only for themselves and at times can fail to mirror sector or sub-sector performance. This gives tremendous potential to add value from the bottom up, and throw up

Graphic 3: Investment Process Optimise risk and reward in construction tremendous challenges in managing risk. It is expected that within the ranges of fund level exposure given in Table 1, the HSBC Global Technology Alpha Fund will typically be close to market neutral but will have the ability to go long or short. The short side positions will be for profit and for hedging the long book, and there will be sector bets taken (currently the view is to be long DRAMs and short semi-conductor capital equipment). Individual position size varies with capitalisation (and liquidity) – large cap positions can be 2-6% and mid-caps 1-3%. The size of positions will also be a function of the level of agreement on the stock between the two principals.

  • Leverage experience across whole value chain:
    • Conor O'Mara – CE, semis.
    • Mick Dillon – telecom equipment., IT services, software and computer hardware.
  • Stop losses essential given average 10% weekly vol.
    • Tech stocks are volatile due to rapid product obsolescence, shifts in competitive advantage and investment cycles.
    • Stop loss 10% move intra-day relative to tech.
    • Reassess position post-exit.
    • Review if move against us over 3 days.
    • Review trigger 10% below cost.
    • Directional position & liquidity monitored daily.

"I see the way they operate as being something like Voltaire used to do it: balance sheets of 100 versus or 75 versus 75 and decent sized positions that have been thoroughly researched. The positions can then be run with confidence," says Ken Kinsey-Quick.

The inherent volatility in technology stock investing is also addressed in a rigorously applied stop-loss/review framework per position. The levels are:

  • stop loss for a 10% move intra-day relative to tech
  • review after a move against over 3-days
  • review triggered for 10% drop against cost price

The fund has a targeted capacity of $500m in a strategy that has not attracted large inflows from hedge fund investors recently. So why have they been backed to the tune of $50m by experienced hedge fund operators like Thames River and HSBC? For Thames River it is partly a matter of the strategy space. "There is potential for a transformation in tech stock investing," says Ken Kinsey-Quick. "Historically tech hedge funds have been long-biased and managers have been trying to extract alpha from beta. The management teams have acted like stale technology bulls since the tech bubble. Now there is scope to make money from both sides of the balance sheet, and these are the guys to do it. Conor O'Mara and Mick Dillon have passion; they have energy and they have experience, and that's what new hedge fund managers need," he says.

Bill Maldonado concurs: "they have a real love for what they do, and that enthusiasm will take them a long way when they get in front of potential investors."

*The business model employed by HSBC Alternative Investments was featured in some depth in "The Hedge Fund Journal" April 2005 edition.