Growing Assets and Launching New Products

Q&A with Donald Pepper, Old Mutual Global Investors

Originally published in the April 2015 issue

Hamlin Lovell: We are privileged to be talking toOld Mutual Global Investors’ managing director of alternatives, Donald Pepper. Don, thanks very much for agreeing to talk to us today, and telling us more about the spectacular growth of Old Mutual’s alternatives business.

Donald Pepper: Thank you, Hamlin and thanks actually to The Hedge Fund Journal, because you came and saw us two years ago when really we were just getting started on this.

HL: So what has been driving all this asset growth?

DP: It has been a number of factors. I would suggest, firstly, we really do have some first-class managers who have delivered what we’ve set out to deliver. The main objective has been on delivering a diversifying asset, so with a big focus on low or, indeed, uncorrelated returns. The global equity market-neutral strategy, in particular, has achieved this. We have two versions of this strategy, which we can talk a bit more about later: a UCITS version and a Cayman version. Both of them have achieved this virtually uncorrelated return stream and that, along with a number of other changes and enhancements we’ve made, has been one driver of AUM growth.

In addition to that, it’s pleasing to see that we’ve also seen growth from other strategies as well. We have a global statistical arbitrage strategy, for which we’ve raised around $200 million, mainly from pension funds in Europe and North America. We’ve raised money for our UK equity long/ short strategies as well, albeit in smaller amounts than the equity market-neutral strategy, so growth has been reasonably broad. But definitely the big focus has been on the liquid alternatives, UCITS vehicles. That’s where the bulk of the assets come, while a smaller amount has come into the Cayman funds.

HL: With assets now at $3.7 billion as of year end 2014, how fast has the growth been since you came on board?

DP: We’ve gone from $825 million at the end of 2012 to $3.7 billion at the end of 2014. In fact, as we sit here at the beginning of March, AUM in our alternatives is just over $4.1 billion two months after the year end. The UCITS fund when I joined two years ago was $78 million, and that ended last year at $2.8 billion so that, without doubt, is the fund that’s really garnered investors’ enthusiasm the most. But, as I say, we’ve also raised getting on for several hundred million away from that as well.

HL: With assets growing so fast, do you, the staff, still account for one-third of the asset total as they did when The Hedge Fund Journal profiled you a couple of years ago?

DP: I certainly wish we did! There was a time when about a third of the AUM in the UK Mid and Small Cap Equity Long/Short hedge fund was from staff. Now I’m very glad to say we’ve got a lot of money in from third-party investors, so the proportion of assets from staff has really dwindled, but the aggregate dollar amount has increased quite notably from staff. We encourage a culture of the managers, in particular, investing in their own funds, eating their own cooking. A significant proportion of the performance-linked pay that managers receive is deferred over three years and has to be placed into a fund managed by Old Mutual, and the managers, not unsurprisingly, generally will pick their own funds, so it is a growing dollar amount, although I very much hope and expect it will become a smaller and smaller percentage amount as we get more support from external investors.

HL: So is AFMD actually increasing the amount that managers invest in their own funds, or did they always eat a lot of their own cooking anyway?

DP: I think AFMD is having a positive impact on that. I’d expect the proportion that is deferred will increase over time. It’s a significant portion but it’s highly likely that the percentage will increase. I think that’s a good thing for investors. So, yes, I think AIFMD has raised the level of debate, and made hedge funds think about it a bit more and realise it’s a good idea to be more aligned with investors.

HL: In terms of the culture of the firm, how important is it for investors to see that a hedge fund manager is signed up the Hedge Funds Standards Board?

DP: It’s a statement of intent, to my mind. I’m a big believer that it encompasses a lot of very good values. It’s interesting: I’m somewhat surprised that more investors haven’t proactively come to us to require us to be signed up to it. We signed up to the Standards because we think it’s the right thing to do, and it has been a good exercise. We engaged a specialist external consultant, to really help us and go through all the current practices as they were, to see whether we measured up and, in fact, we found that even though we thought we had high standards – which we do – there were certain things that we could improve on. So as an example, previous to this, the hedge fund boards only had meetings three times a year. The HFSB recommendation is for them to be quarterly, so based on that, and to sign up with the Hedge Funds Standards Board, the Boards agreed that they’ll meet four times a year.

There are a number of other small changes like that, with us now agreeing to explicitly provide disclosure of any hard-to-value assets, were we to ever end up holding any of those, although we are not expecting to in our strategies. So there’s a number of incremental improvements for investors. I think the fact that we went through that rigorous process, and we can actually explain why, point by point, we do actually comply, has been a good maintenance task for us and it’s something that investors, I’m hoping, will be pleased we’ve done.

HL: So being part of a larger asset manager certainly brings some advantages in terms of corporate access and research resources, but it can also create potential for conflicts of interest, and we recently saw that. Aviva, the UK’s largest insurance company, has apparently been misallocating trades amongst accounts and allocating more profitable trades to accounts with performance fees and less profitable or loss-making trades to accounts with lower fees or low performance fees. Could this ever happen at Old Mutual, and what safeguards exist to prevent?

DP: I think it just comes down to the culture of the organisation. It somewhat surprises me that these events tend to occur every four or five years, that somehow internal controls at organisations allow this to happen. We’re always looking to dynamically improve, dynamically learn, dynamically make sure that we have best practices and that there isn’t anything we’re missing. So further to that event, our compliance department conducted an analysis of what happened, what went wrong, and made absolutely sure that we would have prevented those transgressions happening. We’re very comfortable that we already had in place the necessary safeguards. What I mean (without going into the details of that case) is there are several very clear things that went wrong that ought to have been prevented at various different stages, and somehow none of the safeguards fell into place, so we double checked that we were very robust on these.

I’m surprised it was at such a big organisation, because I’d have expected that to be less likely at a big organisation. I think often investors take comfort from an institution like Old Mutual Global Investors, which is owned by a FTSE 100 company, that we’re going to absolutely not cut any corners on items like that, and we certainly don’t. But I think it is beholden on all of us to constantly re-evaluate that and make sure that there’s nothing that may have changed that we’re not paying full regard to.

Just to take in the first part of your question though, yes, Ithink being part of a large asset manager can be a definite benefit. We’re finding that, especially in the UK funds, we run a large amount of long-only UK money that allows us tremendous corporate access, and that has definitely helped the discretionary managers there, for whom corporate access is important. There are other economies of scale in terms of the calibre of legal and compliance teams and other group trading resources that the hedge fund and alternative UCITS managers, as well as the long-only managers all benefit from, and therefore their investors benefit too.

HL: We hear that your Head of UK Equities, Richard Buxton, is ramping up the corporate governance drive by more proactively voting on remuneration issues. Does this marker move towards a more aggressive activist stance that could even see Old Mutual launching an activist hedge fund, or is this really restricted to specific issues on remuneration?

DP: Well, it’s a good question. Richard has been known for being willing to be vocal when he really feels that management can do with a bit of advice. He recently hired Paul Emerton to come in as head of UK stewardship and governance, to spend time looking at issues where a company’s share price might be improved by the management paying attention to some deficiencies or areas of potential improvement. Richard’s approach has generally been to try to work with management rather than confronting them, but there are times when he thinks things have be said. In this case, Paul felt this was one where really, it comes down to misalignment of interests. I think Paul’s view was that failure was being rewarded in the longevity of some of the contracts with board members and other executives. So he felt this was something it was worth making a stand on. There’s no plan currently to launch any activist hedge fund strategy – but it clearly is one that investors see value in, and it’s something which, down the road, I wouldn’t rule out if we felt we could do it particularly well. Certainly having that kind of experience, that Paul Emerton brings, could lead us to go in that direction.

HL: Do you think that management fees in the hedge fund industry in general are too high for a world of low inflation and low interest rates and, indeed, sometimes negative interest rates?

DP: I think we’ve been very conservative on our management fees. This is led by talking to investors. Investors are concerned about it; if they’re concerned about it, we’re concerned about it. Investment consultants are concerned about it; so we’re concerned about it. The way a lot of investors and consultants think about it is the share of the alpha that should be retained by the investors. After all, it is their money, and they believe that they should retain at least 70% of the alpha – to pay more than this implies to the alpha generator begins to feel a little toppy to investors.

Therefore, we have deliberately calibrated our fees to have a lower management fee. We have also introduced a cash hurdle rate, so that if and when rates go up, we’re not charging performance fees on the short sale proceeds cash rebate that we receive. So yes, we’re being very understanding of that issue and we’re really trying to make sure that we deliver value for money.

To my mind, it’s not the absolute level of fees, it’s the fees per unit of alpha, and especially fees per unit of uncorrelated or diversifying alpha, that’s the key – to make sure you’ve got value for money in that. Ratcheting down the management fee is one of the ways to help achieve that.

HL: So you introduced hurdle rates for performance fees. Are these rates floored at zero, so that investors would not pay a performance fee on negative performance, even if the relevant currency share class had had a negative rate on that currency?

DP: They’re not, no. I think that’s fair, because effectively what we’re saying is if rates, for argument’s sake, go up to 4% and we made, say, 10% gross of performance fees, we’re not going to charge performance on the first 400 basis points. We’ll just charge a performance fee on the remaining 6%. However, if for argument’s sake, rates went down to -4%, the opportunity cost for your money is -4%, so were we to achieve a -1%, the investor is 3% better off, and therefore it’s only reasonable for that genuine performance to merit performance fees. I don’t expect we’ll be down to those levels, and it’ll hopefully be a moot point.

HL: There is some debate in the hedge fund industry over how important star managers are relative to teams and processes, and recently we have heard that Old Mutual will be losing one of its star managers, Ashton Bradbury. When did you first discover that Ashton Bradbury had plans to retire?

DP: Ashton let us know officially in September of last year. Tim Service had been working as his deputy portfolio manager for over three years up to that point, so it was a relatively easy transition. Ashton agreed that he would work through to the end of the year, so there was another further three-month transition period where Tim became the co-manager with a view to becoming the lead manager, which he now is. We then engaged with all investors. They had plenty of time while Ashton was still there – it was a monthly dealing fund – to take out their money if they wanted to. One investor halved their allocation, but I’m glad to say kept half of the money in the strategy having got comfortable enough with Tim in the role, and most other investors actually kept their money in as well, so I’d feel that was managed reasonably well. Assets are actually up somewhat from a year ago, despite Ashton having left, so I think that’s testimony to the fact the team impact on that was understood by investors.

In other funds, we very much have a team approach. The global equity market-neutral team, run by Ian Heslop, Amadeo Alentorn and Mike Servent, is a clear co-portfolio management team. Interestingly, they have got two analysts who have both been with them for longer than six years. The PMs have been at Old Mutual running this type of strategy for over a decade each, so there is cumulatively well over 45 years of aggregate experience at Old Mutual running the strategy. It really isn’t down to one person. There’s a lot of tenure, a lot of experience in the team there.

Take another hedge fund strategy, the Old Global Statistical Arbitrage Strategy: that’s run by Paul Simpson and John Dow. As a team, they’ve worked together previously at Millennium, and prior to that at places like UBS. They work alongside Leif Cussen, and together the three of them together have over 20 years of experience at Old Mutual, running their Stat Arb strategy. It’s certainly the case that were any of the key members to leave, that would be very important and would require us to have conversations with investors. I think the UK example with Ashton Bradbury and Tim Service gives us hope that we would find investors willing to continue supporting if the bulk of the rest of the team stayed with the fund.

HL: So do you have succession plans in place for all of the key fund managers?

DP: I wouldn’t put it quite like succession plans as such. What we do feel is that if, for argument’s sake, one of the team were to leave and the rest of the team were to stay there, we’d expect there’s enough shared experience that we’d hope that investors would be comfortable that there is sufficient continuity. If you get more than two of the team leaving, that becomes more questionable, frankly, and then you’d really have to engage with investors and see what they thought. But I think the idea is that we’re not reliant on just one star manager, that it is a team approach.

HL: More broadly, how is Old Mutual balanced between quantitative and discretionary fundamental investment processes?

DP: Overall, we’re very much a focused investment boutique. We’re not a massive asset manager. We run about $32 billion in total, and of that, around about $5.5 billion is in quant, so around about a sixth of the assets. In the hedge fund and alternative UCITS side, it’s more concentrated, so in that case probably, around 85% of the assets are driven by quant processes. I feel that’s a really good place to be. I think a quant approach is one that’s very complementary to a discretionary approach, so one can argue if one’s got a number of discretionary managers, actually having a quant manager who looks at the market and looks at stock selection in a very objective way and squeezes out behavioural bias can actually be quite a good diversifier, even in the same investment universe – call it equity long/short, global equity long/short or market-neutral. We’re very happy that we’ve got some of each.

HL: Did the launch of your OM Arbea fund actually have to be a Cayman Fund in order to achieve the higher volatility target which it is designed to do?

DP: That’s a good question. What we did when I first came over here was talk to a number of investors and ask them about the calibration of the UCITS version which has a target volatility 5%-6%, with the intention of seeking at least cash plus 6% annualised returns. It’s been successful achieving that, with annualised volatility of around 5% and returns of cash plus over 7%. But there are a number of investors who have higher return targets. They may be – particularly in North America – pension plans who have then, say, an 8% target – and so cash plus 6% is not going to do it for them. These investors were willing to more volatility, in pursuit of higher return.

We therefore decided to launch a Cayman fund, with a target volatility of 8%-9% and an expected return of cash +9%-10%, for two reasons. Firstly, to have a more appropriate volatility versus return expectation calibration to appeal to those investors with a higher risk tolerance but higher expected return targets, and secondly, North American investors in general can’t buy UCITS, so it really met two criteria. It also allowed us to engage with other investors who may prefer the offshore structure, but to answer your question, we could absolutely have delivered the higher-volatility version, utilising higher gross leverage, within UCITS rules. It’s such a diversified strategy, there’d be no problem hitting the 5/10/40 rule, no problem delivering the liquidity requirement and VaR limits of a sophisticated UCITS fund. GEAR was already a sophisticated UCITS fund. It was more with a view to the North American institutional market that we decided to launch a Cayman fund.

HL: Looking at new launches elsewhere within Old Mutual, a while ago you seeded Simon Murphy for a UK equity hedge fund. How has that been doing?

DP: Simon Murphy and his co-manager, James Bowmaker, have done really well. Simon’s  had a terrific long-only track record in UK larger cap equities for a number of years, and has now been running this long/short UCITS fund for the last three and a quarter years since October 2011. He’s annualising as at the end of the year at around 8.8% with a 4% volatility, so a Sharpe nicely above two, very minimal drawdowns and very variable net. As we sit here today, the fund is -20% in terms of his net beta exposure, so they are willing to be contrarian and willing to move the net around. We hope to see those assets grow. Their track record would lead us to believe that it ought to merit more assets coming into it.

HL: So as well as seeding funds internally, is Old Mutual active in seeding new hedge funds externally?

DP: What we’re trying to do is to set up setting up a first-class institutional quality infrastructure at Old Mutual, so we tend to say to managers, “Why wouldn’t you want to join us and ply your trade here? We’ve got all the compliance, legal infrastructure, support for you. You can ‘plug and play’.” Historically that is the route we’ve gone down. But we’ve been very flexible in that. So, for example, last year, Old Mutual was successful in attracting Russ Oxley and his team who used to run the Ignis Absolute Return Government Bond Fund, and they were running around about $6 billion. They’ve agreed to join Old Mutual Global Investors. Basically, part of the way to attract them was to be flexible on where they want to be situated, so we’ll shortly be opening an Edinburgh office, but they will be employees of Old Mutual Global Investors. Similarly, on the long-only side, we attracted Josh Crabb, who was at BlackRock, had an amazing track record in the Asia equity long-only space, and we’ve therefore already opened an office in Hong Kong for him to run money from. Again, he’s an employee of Old Mutual, but I think it demonstrates we’re willing to be very flexible. I wouldn’t say never on potentially providing seed capital to someone not wholly part of Old Mutual, but it’s not currently in our plans.

HL: And going forward, which asset classes, strategies, or fund structures could Old Mutual be looking to develop? For example, you’ve already launched a Cayman vehicle, partly to appeal to US institutional investors. Would you ever consider launching a ‘40 Act fund to appeal to US retail investors as well?

DP: The ‘40 Act is obviously a very interesting space. A lot of assets are being attracted into it, and I think that’s going to be a secular trend, so it’s certainly something we’re examining. The one worry I have about ‘40 Act is there is this risk of negative selection bias, because, as it’s structured, you can’t really charge a performance fee. The assets that we run in the alternative space absolutely in my view – and, by the way, in the view of investors who have poured a lot of money into these funds – merit the performance fee.

So then we have to say, why would we sell it that cheaply? One can examine, perhaps a version of a strategy that’s still a good version but not the optimal version that facilitates greater capacity in a capacity-constrained strategy, i.e., a slightly watered-down version, which as I stress, would still be a very good risk-adjusted version, but take up less capacity.

I do like the fact that under UCITS rules, you can get the full fat version of many of the more liquid strategies. It means you can still get pretty much all of what you’d expect from a Cayman hedge fund, because you are paying the same type of fees, and therefore you’re attracting the same first-class managers with the same version of the strategy.

HL: Well, Donald Pepper, managing director of alternatives at Old Mutual, thanks very much for your time today, and we at The Hedge Fund Journal very much look forward to watching the continuing growth of Old Mutual’s alternatives franchise.

DP: Great, Hamlin, thank you.