In three and a half years London-based investment operation Julius Baer Investments Limited (JBIL) has grown to the eye-catching level of over $2bn in fixed income hedge funds.
The bedrock of the success of JBIL's hedge fund business is a successful long-only fixed income business. The insights that have made their managers good at managing bond portfolios for institutions have been applied to funds in the hedge fund format. The sources and types of investment ideas are the same, though the views may be expressed in different ways in the two asset-management formats, and the risk framework has to be very different for hedge fund products.
The house style at JBIL is based on fundamental top down macro analysis and understanding. The backgrounds of the senior and longer standing staff members explain a lot. Under Chief Investment Officer Tim Haywood there are experienced practising economists: both Adrian Owens (Senior Portfolio Manager jointly responsible for the JB Global Rates Hedge Fund) and Andrew Snowball (Portfolio Manager on Global Rates Hedge Fund) have worked at HM Treasury as economists. Owens has a Masters degree in Economics from McGill University, Snowball has Masters degree in Economics from Cambridge University. Paul McNamara (Portfolio Manager of the JB Credit and Emerging Markets Hedge Fund along with Darren Reece) worked as a macroeconomist in the UK's Government Economic Service and holds a Master's Degree in Economics from the London School of Economics. Thankfully for investors, academic debates about the application of economic theory to macroeconomic policy are limited at JBIL as the economists working as fund managers are conceptually economists of the one-armed variety. They are able to formulate a view and implement it.
The Diversified Fixed Income Hedge Fund
If the whole business unit is founded on the success of running long only mandates, then the hedge fund business has flourished on the back of excellent returns from the Julius Baer Diversified Fixed Income Hedge Fund (the Diversified Fund). Starting in January 2002, this first fund had a six month 'test phase' with seed capital from the group before external investors were allowed to subscribe. It took a little while to get commercial traction (gather assets) as Graphic 1 below illustrates. The returns of 16.72% in 2002 commanded attention from allocators when others in the same strategy were barely passing muster – the CSFB Tremont HEDG Fixed Income Arbitrage Index was up 6.75% in 2002 (and then 7.97% and 6.86% in the following two years).
For the first year it seemed that all that was happening on the investor front was that the good performance was disseminated in monthly letters and in the commercial databases. Then after a year potential investors in the Diversified Fund went from being interested watchers of the returns to actively carrying out the intensive due diligence that is the hallmark of the industry. For many investors, US$50 million of assets and 12 months of track record were seen as key hurdles. Edward Dove, Chief Executive Officer of JBIL, put it that "traditional funds have to be sold, but it seems that (single manager) hedge funds are bought."
The Diversified Fund is fed by ideas from across the group of investment professionals and is run by Tom O'Shea and Tim Haywood. Although there may be 600 positions in the fund they aggregate into a number of themes (anything from four themes at any one time), and it is a common feature of the JBIL hedge funds that there is a clear framework to control and limit the portfolio shape. In the case of the Diversified Fund leverage is restricted to five times equity (adjusted 10 year Treasury equivalent), and the exposure to securities with less liquidity is limited to 60% of net assets. There is roughly an 8020 split between core interest rate strategies (G13) and emerging market and credit strategies. Total risk assumed is limited to a Value-at-Risk (VaR) of 6% (30 days with 97.5% confidence interval), roughly equivalent to 1.1% on a 1-day basis. FX risk is limited to 33.3% of total VaR.
Within these well-defined boundaries there is a lot of scope for the managers to express their views, and they have been a lot more right in their views than wrong. The net returns of the Diversified Fund have been 12.2% annualised since inception, and with a standard deviation of return of 6.62% over that time, that gives an attention-grabbing Sharpe ratio of 1.62. Along the way capital has been subscribed to the extent that the fund will be hard closed after the 1 July 2005 dealing day. Assets under management in this offshore fund were about $1.62bn at the start of June with about $1.8 billion in the strategy overall.
Sometimes it is chance, sometimes it is by acute design, but one of the key ingredients for a successful hedgefund is to work within a risk management framework that is appropriate for the source of alpha. This seems to be the case for the capital run in hedge funds by Julius Baer Investments Limited.
As a group of managers of a business, as well as managers of assets, JBIL has a very mature take on the nature of risk, so it is quite appropriate, given the reputational risk for the parent organisation, that the risk profiles of the three current fixed income hedge funds are tracked on a weekly basis by risk professionals at the group head offices in Zurich. But at this stage, after two and a half years of successfully staying within the varied hedge fund mandates, one would not anticipate a difficult dialogue on that reporting line. What is more interesting is how JBIL has positioned itself in the area of hedge fund asset management.
The three current funds run by JBIL (and one, Alpha FX, run from Zurich) have been designed and are run with a higher return target and a correspondingly higher level of risk than for funds of hedge funds. The level of risk assumed to generate a target net return of LIBOR + 7-10% is fairly typical for funds run in the hedge fund format within an asset management business. The Morley G7 Fixed Income Fund has settled into a pattern of running with a daily VaR (95% C.I.) averaging 1.1% for the last 18 months. So the level of risk assumed in running the Morley fund recently has been slightly higher than that of the JBIL Diversified Fund (1.1% daily VaR maximum), and the Morley G7 Fund was run with an assumed risk of just under 1.5% daily VaR for the second half of 2003.
The comparison given in Table 1 is in Sterling because that is the longest running class of share for the Morley G7 Fund. One of the clear distinctions in the pattern of returns is that the Morley fund has just experienced its first losing month since inception in February 2003, and the JBIL Diversified Fund has had seven down months over the same period. Given the broadly similar levels of return it is no surprise that a corollary of the differences in winning/losing months is that the JBIL fund has larger winning and losing months. The Morley product has consistently run with a higher measured risk profile, yet has the smoother, more positive return series. Clearly there is more to running a successful hedge fund than measured risk assumption.
Global Rates, the Second Fund
The second fixed income fund launched by JBIL in January last year was the Julius Baer Global Rates Hedge Fund. The concept was initially tested as a discrete fund, as opposed to a component of the Diversified Fund, through a three-month test phase using $20 million in 'proprietary' capital. This global macro fund utilises a different risk footprint to the Diversified Fund: as Graphic 2 shows, the product is expected ultimately to produce higher returns with higher volatility than the core Diversified product. The target average return is LIBOR +15% pa. To a minor degree the differential outcome may be because the expected return of the Diversified Fund is lower at $1.6 billion than it was at less than $1 billion assets under management.
The major driver of a different scale of return is that the Global Rates Fund may have twice the level of risk assumption of the earlier product – a maximum of 12% monthly VaR, of which up to 6% may be in FX risk. Whilst it may seem slightly contradictory for a "higher risk product" that the maximum level of gearing, at 5x fund equity is the same for both the Diversified and Global Rates funds, the leverage is employed differently. The global macro fund has more directionality in the exposures and has a more concentrated portfolio by themes and number of positions. The macro fund may exploit the same themes as Diversified but put the trade on in a different way. What does this deliver to investors?
It was only in May/June this year that the returns showed that the Global Rates Fund was being run in a markedly different way from its' older sibling. The back-to-back largest losing month/winning month for the global macro product showed that indeed more risk was being taken in the fund. This period also amply demonstrated that the managers were mentally strong enough to hold on to positions that were losing in the short term, though some of the winning themes in May were not the losers in April. It remains the case that the Global Rates Fund draws on the same established top-down investment approach as Diversified, so five of the eight losing months for the macro-focused product have occurred in losing months of the Diversified Fund. The correlation between the funds returns has been 0.4.
The largest current themes by notional value in each category show the diversified nature of the potential sources of profit for the Global Rates Fund:
- Fixed Interest
- Short US Treasuries
- Long Mexico
- Short UK Front End
- Short Europe Front End
- Long New Zealand
- European real yield flattener FX
- Short NZD
- Long Mexican peso
- Long Canadian Dollar
- Long Icelandic Krone
- Short USD
- Long JPY
The return of 7.05% in 2004 and 1.89% in the first five months of this year puts the fund about in-line with the global macro indices – the CSFB Tremont HEDG Global Macro Index was up 8.49% last year and was up 2.44% in the year to date to end-May. As the managers increase their confidence to deploy the available risk budget there is great potential for this fund to achieve more. As it is, investor confidence has been sufficient to bring in $155 million in capital to the fund, and managed accounts within the strategy bring the total assets under management to around $270 million.
An Unusual Fixed Income Hedge Fund Launched
The third hedge fund launched by Julius Baer Investments Limited brings together to two different areas of bond management in one fund. The Credit & Emerging Markets Hedge Fund (CrEM) takes advantage of valuation anomalies through arbitrage in corporate credit and sovereign bonds, and undertakes what the managers describe as "controlled currency plays". As before there is a list of maximum exposures by type: the neutral position by gross assets is 70% corporate credits and 30% emerging markets (EM); the neutral position by VaR is 50% corporates and 50% EM including FX exposures.
The credit views tend to be implemented via investment grade debt with linked credit default swaps. Credit strategist Darren Reece says "the approach is more credit relative value focused on the corporates book. It's not so much outright views as more of a bottom-up perspective. Thankfully we're not really involved in the structured credit (the CDO) market." A minority of the corporate exposure may be in convertibles and high yield instruments. The portfolio manager for CrEM is Paul McNamara and it is his expertise in emerging market sovereign credits (and currency markets) that is brought to bear in the Fund.
The JBIL thinking in putting this fund structure together was that the fund is a natural blend of asset sub-classes. It also enables JBIL to play to one of its distinguishing features in bond fund management. JBIL tends to focus on the local currency market for emerging market bonds. This is unusual as the dollar or at least G7-denominated bonds tend to dominate the trading and holdings of international bond management groups. Only three other managers have this expertise, Ashmore, ABN Amro and ING. So unusually in the bond world JBIL has a true edge.
CrEM has a target return of LIBOR +10%, with a measured risk envelope of up to 9% monthly VaR.The maximum permitted FX VaR is 4% on the same basis of 97.5% confidence interval and 30-day forecast horizon. In the seven months of trading the Fund is up 10.97% with only one down month.
External investors have been cool to date in assessing the CrEM Fund. The Fund was launched with $120m in assets transferred from the Diversified Fixed Income Hedge Fund into X Class (no-fee) shares, as the product is a "carve-out" of the credit and emerging markets strategies from that vehicle. The fund opened to direct external investment from January 2005 and currently has $153m under management. Returns for the first seven months are shown in Table 4.
The Next Opportunity
The recent turmoil in the credit markets showed that too much concentration of particular levels and categories of credit risk can be dangerous. JBIL has largely avoided taking views through structured credit instruments. "Partly this is a liquidity issue for us;" says CIO Tim Haywood, " there are only six liquid issues in the mortgage -backed securities area, and even for something like iBoxx. How do these things trade? The other part is we need to see how certain new instruments trade in practice in different market environments." Risk manager Dick Howard concurs: "the liquidity in some territories will naturally limit the size of some funds. The markets for G13 bonds are very efficient as well as being very liquid. It is the markets like Poland and Hungary, where there is not the depth for a $100 million position, it is these markets where we can add a lot of value, that limit the size of the funds overall."
JBIL has become most excited recently about the re-emergence of opportunities in convertibles. "We will be launching a convertibles and high yield fund soon," says Edward Dove, Chief Executive Officer of JBIL.
Greg Hopper will be lead manager on the new fund. Hopper has been providing ideas for the Diversified Fund for well over two years and JBIL has built up the London investment team recently with the transfer of Johannes Wagner from Julius Baer Zurich and Mary Gottshall from the New York office of Julius Baer Group to work under Hopper. "We have been preparing for this internally for some time. We have taken on Henry Hale from JPMorgan to manage the convertibles part of the process, and he will be working with our high yield specialists" says Dove. Up until this point convertibles were managed by Tim Haywood, and the addition of Hale allows Haywood to concentrate on outright convertibles as well as contributing to the G13 core of the Diversified Fund with Tom O'Shea and James McAlevey.
These developments illustrate several points about the approach taken by JBIL. First the company is continually looking for ways to leverage what they already have in terms of resources. Second the senior managers recognise that they have a responsibility to develop the careers and talent of the investment professionals that work at JBIL, and they can achieve this in a way that is mutually beneficial by offering the chance for portfolio managers to run their own funds. The company increases the chances of retaining its staff, and the managers get a chance to step up to the plate in the hedge fund format (and everything that that entails in terms of challenge and potential recognition). Such an arrangement also generates a sense of ownership through appointing named managers to the hedge fund products. Whilst acknowledging the strength of branding in finance, and the importance of process and house style, JBIL is also explicitly acknowledging that the hedge fund business is about talent. The managers' remuneration is tied into the funds very directly, as part of their rewards are channelled into their own funds with a multi-year lock-up.
The third point that these developments illustrate is that Dove and Haywood are prepared to try to grow the business by taking on investment expertise from outside the group. JBIL is growing staff numbers from a strong position – Dove, Howard and Haywood started working together 14 years ago, for example. The addition of expertise from outside may reflect the joint belief in the strength of the process and the effectiveness of the teamwork at JBIL. When Baer enhanced the team's ability to look at credit by bringing in Darren Reece from ING, where he was head of credit default swap trading, a good precedent was set. Not that all the talent that is co-opted is wholly external. In addition to the two high yield specialists moving within the group, Mark Dragten, a foreign-exchange specialist in Julius Baer's Zurich office joined JBIL at the start of this year.
Darren Reece gives some insight into the appeal of JBIL when considering a move within the industry. "I had some choices when I was moving from ING last year," he says, "and I was talking to a couple of hedge funds. For my part I saw that everyone here seemed to be heading in the same direction, unlike in banks which can be quite territorial. Here we all have the same incentives and the same autonomy. I liked the fact that the business is taken very seriously at Julius Baer, and I like working with Tim and the rest of the team. In choosing between different organisations the name itself was an attraction, as it means something within the investment management industry. I think one of the great advantages of working here is that the money is run under your own name. It really works for me – I'm more focussed than any period in my life!"
It is clear from its changing terms of business that JBIL are on a upward path in managing hedge funds. The first product launched, the Diversified Fund, has a fee structure of 1% management fee and 20% performance fee (with a LIBOR hurdle in the currency of the share class). Global Rates was launched in January 2004 with a 1.5% management fee, and the CreM and new Convertible and High Yield products have a 1.75% management charge. All the products have the same performance fee as the Diversified Fund.
Top Ten Factors for a Hedge Fund Business
Whether by design or happy accident Julius Baer Investments Limited has a got a lot right in building a hedge fund business. Here is a Top Ten of those factors:
- Focus. JBIL only runs fixed income funds. There is no conflict between running long only money and long/short money. In fact the information flow from one activity helps inform the other.
- A rich investment culture. There is an open, sharing, communicative investment culture at JBIL. There are structured interactions across teams (daily and weekly meetings) and frequent dialogue between individuals. This constructive atmosphere most readily comes about when most of the portfolio managers have worked together in the same company before, or, as is the case at JBIL, the cadre of most senior managers have been together a long time.
- A balance between ego and humility. This occurs in two senses at JBIL. As investors: portfolios are invested with ego (to take the market on), but good investors know when the markets are telling them they are wrong and they show their humility by cutting losses. As a team: whilst the investment process (and to some extent the reward system) is structured to bring contributions from across a group, the hedge funds are run by one or two named individuals, giving psychological ownership.
- Reward structures. Rewards for managers are at the high-end of the scale according to Edward Dove. They also manage to recreate the classic ingredient of hedge funds, that of significant investment by the managers in their own funds.
- Branding. The Julius Baer name has opened some doors for the fixed income management operation in moving into hedge funds.
- Marketing/Outsourcing. JBIL has co-opted external marketing resources when and where appropriate. JBIL has used Dexion in Europe, QMC in the United States, and has recently concluded a deal with an agent in Japan. The use of seasoned hedge fund marketers shortens the time it takes an organisation to understand the very different demands of hedge fund investors, and extends reach beyond the internal sales, marketing and client service team.
- Source of alpha. The means of sourcing investment ideas must be repeatable, and with a good hit-rate for the style/strategy. In the case of JBIL the team has been expanding to include additional sources of insight or expertise as the AUM and number of funds have grown.
- Scalability. The core strategy must be scalable to commercial size, and not constrained by either market liquidity or the limitations of the source of alpha. JBIL scores well on both counts.
- Risk framework suitable for source of alpha. The shape of the portfolios and the risk limits for them should be a function of desired risk/return profile (outcomes), the opportunity set given by the markets and the edge of the investment professionals. Yes, yes and yes for JBIL.
- Multi-dimensional risk. The risk measurement and the risk management within a hedge fund operation have to be multi-dimensional. JBIL uses stress-testing, simulations (Monte Carlo), and sensitivity analysis. The risk control framework goes beyond the managers' spreadsheets and is externally supported (by Riskmetrics in the case of JBIL, and by an independent risk management function within the company).
- Good Client Servicing. Even if hedge funds are bought rather than sold, good client retention is brought about by bringing investors along with the manager through access and transparency. JBIL provide full portfolio transparency to investors with a five-day lag for its Diversified and Global Rates funds as well as manager letters and dedicated client support staff.
The reasons for success as a hedge fund business can be many and varied. For Julius Baer Investments Limited the nub is a successful investment process that has been developed and refined over a long period of time by a core of managers that have stayed together. The process just happens to have been applied to hedge funds, but the investment smarts applied with an appropriate risk framework would probably work in many strategy/fund combinations at JBIL.
Where do they go next? In the immediate future is the launch of the Julius Baer Convertibles and High Yield Fund. "We have scope to bring in some more talent and go deeper in several areas of fixed income money management," says Tim Haywood. But both he and CEO Dove have begun to think bigger and more long term. "In the course of time I can see us extending into equities," Dove suggests, "and maybe even commodities. But we have quite a few things to do in fixed income first."
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