Indeed it has not been an easy path, and the route has been one that few managers in Europe have been given the opportunity to take: the second chance. Angella was working for Albertini (part of Dresdner Bank) in Milan, and as Head of Investments when he persuaded Swiss wealth management group Getraco to back him in setting up the Prometheus European Fund, a long/short equity fund. The fund started trading in June 2001, a time when markets were still unwinding the excesses of the TMT bubble of just over a year previously. All did not go according to plan for Angella – after only a few months his supporting analyst left, and while still trying to adjust to running a long/short fund along came the real world and market events of 911.
Against this turbulent background the first seven months of trading of the Prometheus Fund gave a return of -2.49% for 2001. At the time the manager was also feeling the burden of the amortized fund set-up costs (amortized over 3 years, but a drag on return of nearly 20 basis points a month for a small fund). Part of the dream of running a hedge fund is to have the constraints of running other forms of mandate removed. The presence of so many degrees of freedom presents a huge opportunity set, and also some dangers. Managers have to be very self-aware of where they are truly adding value and operate in those areas. For Enrico Angella operating on his own, running the fund was not how he had anticipated. "I ended up relying a great deal on externally provided stock ideas – from brokers and analysts at the investment banks. Of course I could do anything in terms of scope within Europe, and with limited analytical resource in-house the fund ended up with too many under-researched ideas. There were over a hundred positions, and yes we were quite well invested in markets but not making money on these externally generated ideas."
The shape of the funds' portfolio through 2002 and into 2003 was to be broadly market-neutral and to go up to 20-30% net short on occasion. This portfolio structure was strategically correct, after all the MSCI Europe was down 30.8% in local currency terms 2002 and was down further to the market lows in March of 2003. However the Prometheus Fund was not prospering – the fund was down 1.53% in 2002 and coming towards the end of 2003 the manager was beginning to take some large directional bets in response to investor pressure for performance. Those bets did not pay off and returns for the full year of 2003 were worse (a loss of 7.34%). While markets were declining the owners of the private wealth that was in the fund were relieved their capital was not deteriorating with markets. However, the bounce in markets in the second half of 2003 brought more pressure on Angella. "It felt like there was always someone leaning over my shoulder," explains the manager, "and it is not easy to take risks with capital (including my own capital which is in the fund) with that going on."
"It was clear to me that I could not carry on with things as they were," states the manger. "I went to the principal of the firm, Mrs Raffaella Pacinotti and told her, that we needed to invest in the fund management company or close down the fund. I felt that there had not been enough resource to do the job properly, and that with some help we could do a lot better. I persuaded him to back me at that point, and won a grace period of six months to show what we could do."
Enrico Angella had formulated a clear action plan. Foremost in it was to find someone to work with that would bring control of idea generation in-house, and to bring some real depth of understanding of the companies where the fund was to be invested.He found the ideal person in Aurelio Matrone, who joined him in the second quarter of 2004. Whilst Angella had a buy-side biased background from working at Mediolanum Gestione Fondi and Robert Fleming prior to Dresdner-Albertini, Matrone's background was as a sell-side analyst with Salomon Smith Barney in London and then with Mediobanca in Milan. Matrone also worked in corporate finance as an M&A executive with Vitale & Associates, specialising in industrials and consumer goods.
The depth of understanding of their investments was to be a cornerstone of the new regime at the newly renamed Kkienn Investment Management Limited. The Managing Director Angella had come to realise that previously he had been reacting to market events as they occurred rather than being ready for them through meticulous preparation. Under the former way of operating the Prometheus Fund was trying to capture many small opportunities that existed in markets for short periods of time. As the Kkienn European Fund they were going to exploit the inefficiencies of the market through greater asymmetry of information over longer timeframes and for a much more limited universe of companies.
The foundation of the new investment process of Kkienn Investment Management is detailed company analysis. Aurelio Matrone's experience in corporate finance makes the discounted cashflow approach to company analysis and valuation a natural starting point.
To ensure the validity of the models and his understanding of the companies and industries Investment Manager Aurelio Matrone takes his lap top to private meetings with senior management of companies. The models and assumptions are passed by the CFO, or COOs of companies to ensure that they are near to capturing the company financial model and operating parameters. This is no trivial matter – the Kkienn due diligence on potential investments includes SWOT and Porter's analysis that establishes through dialogue with management the current and prospective state of the company's markets and the competitive environment for it. Matrone says that he can take 110 pages of reports with him into a meeting with company management. "Now you can understand why our meetings with management can last 5 hours," he earnestly states. The managers also conduct what they term a "consistency analysis" in which they examine competitor companies to make peer comparisons.
This work gives a very through understanding of the company and it's place within it's industry. However in the refined Kkienn approach that fundamental sound basis for investment is not sufficient. Hidden value has to be recognised by markets to give shareholders their return. So if an asymmetry of understanding exists between Kkienn and the stock market Kkienn have to see what triggers are forseeable that will cause the public markets to re-evaluate a situation. In some ways this is a pale reflection of The Children's Investment Fund approach – enormously detailed analysis of companies and industries that discloses significant under-valuation. Then some catalyst to help realise that gap between inherent value and public valuation. The Hohn vehicle has now got into the position where other parties do not have to be involved to create the event. The presence of Chris Hohn's fund on the share register is sufficient to cause a generalised reassessment of a company and sector. Few investors carry the clout of the former Perry star manager, so Matrone and Angella anticipate and rely on corporate events, stock market activity, and earnings releases to be the triggers for price change.
Having established the presence of underlying value in longs and a flawed business model for shorts the Kkienn Investment Management approach does not commit wholesale to an investment even if triggers have been identified and mapped out in a schedule (which is their preference). Rather an entry stake is acquired – of the order of 1% of fund equity. Even if the money managers from Lugano have a refined and accurate take on the sector dynamics and the potential for a company and its stock they prefer to verify that their pre-investment assumptions were accurate through watching the company closely in real time. When company announcements are made and earnings releases come the Kkienn team look for the consistency of message and activity from management and its impact on company financial performance. This may require further discussion with management and assessing management's willingness to engage with shareholders as evidence of sensitivity to shareholder concerns as well as the apochryphal "shareholder value". If and when this real time test of the investment hypothesis is passed then Kkienn will build a further stake.
The stock part of the portfolio therefore consists of a couple of dozen positions that are being built and a handful of core positions that have the potential to really drive returns. These are the high confidence positions that theoretically could be up to 20% of NAV each, though to date no long position has exceeded 10% of NAV. Shorts may be up to 3% of NAV, and they are always in large or mid-caps. Option NV, the Belgian designer, manufacturer and distributer of mobile data equipment, was a 1% position for the Kkienn European Fund. "We had studied Option for two months," says Matrone. "So when the shares fell from €97 to €80 in one day in February we were in a position to act." In a situation like this the Kkienn managers will ring around the market to ascertain whether there is news on the fundamentals of the company that the market knows that they are unaware of. In this case their canvassing revealed nothing new, so the position was taken from 1% to more than 3% of NAV. This is the advantage of having an in-depth appreciation of the company – a larger gap appeared between the fair value of the company (as determined by the Kkienn analysis) and the market value. So the portfolio manager can add to the position with conviction.
There are constraints on the exposures that might be taken to a single industry in the fund. The limit for long industry exposure is 35% of the NAV, and on the short side a single industry cannot amount to more than 15% of fund equity. The fund is run with a policy of being fully invested. Except when a portfolio re-organisation is under way at least 100% of fund value is invested in equity, and the operational limit for leveraged exposure is 150% in equities.
This description is quite specific because the managers of Kkienn European Fund have an unusual structural element to their portfolio. Up to 25% of the fund NAV is in corporate bonds of European companies. This is not some theoretical prospectus investment power: the fund typically has between 15-25% in the bonds of companies where the managers have carried out their detailed cashflow analysis. Enrico Angella explains, "we like to think of this part of our fund as providing a base return for the month. We know that whatever else happens we are generating maybe 10-20 basis points a month of return." The manager continues," yes we are equity managers, but our detailed analysis of company cashflow put us in a position to understand that Fiat was not going to go bust and we could buy their paper on a high yield. Similarly with France Telecom – it was not the 10% yield that was available when we bought it that was the sole consideration. We determined that it was financially viable, and that the yield was well covered."
Risk measurement at Kkienn Investment Management has been enhanced as part of the maturation of the investment process. The managers have developed their own Kkienn Risk Management Model (KRM) that measures the factor bets in the portfolio and stress-tests the current portfolio for changes in those factors. The long/short portfolio of current positions and sizes is measured for correlation with FX rates, gold, broad European equity market indices, American indices, large cap and small cap proxies, growth, value and cyclical factors, the VIX index, Treasuries, and a variety of industry groupings (S&P Europe 350 Energy Index, for example). The beta and t-statistic for each are also calculated to show where there is a statistically significant variable at work in the portfolio. This factor bet should be one that the portfolio manager explicitly wants to take, if not the analysis gives the opportunity to consider a hedge (typically an offsetting short).
The managers also carry out a simulation for the current portfolio to ascertain how it would have performed in the previous six-month period against the market. This analysis gives a mean return and standard deviation for the portfolio and the DJ EurStoxx 50. In particular the managers look to see whether the fund can/will generate a superior risk/return profile. So a higher simulated return is not sufficient, the managers are looking closely at the volatility of the return, hopefully to demonstrate that the risk assumption as measured by standard deviation has had a suitable return pay-off. Another part of this analysis produces distributions of the returns for the market and fund. This shows whether the fund is meeting its investment objectives – in this case the current fund portfolio would have produced a typical equity hedge fund return profile of bettering market returns except for extreme up-moves in markets.
The portfolios, both current portfolio and proposed portfolios, are stress-tested for shifts in factors. Across six factors (DJSTOXX 50, US10 Year Treasury, €/$ exchange rate, MIB Index, Bunds, and the VIX Index) the fund returns are determined for the most extreme market moves over the previous 6-12 months of each factor in isolation. The manager intends this report to reflect the efficiency of portfolio construction.
When it comes to the risk management of individual positions Angella and Matrone use a standard industry method. Positions are reviewed after they have contributed losses equivalent to half a percent of NAV for longs, and quarter of a percent for shorts. On principal the stops for shorts are tighter than the stops for longs.
There are three classes of The Kkienn European Fund, and the one written about here is class A. The other two classes reflect that the fund Investment Advisor, Getraco Asset Management, is a wealth management company. Class B is a bond fund run by Roberto Simone. Class C is a balanced fund with 50% in equities and the rest in bonds and cash, and this class is intended to have an absolute return focus. AUM across the three classes were €104.4m at the start of March.
For the first time Kkienn has some forward momentum – assets are growing well from a small base. "We've recently added a junior analyst to the team, and we'd like to add more resources as assets grow," states Enrico Angella. "Another analyst is probably our next hiring." It is expected that the new hires will have as well-defined roles as the incumbents. Angella himself personifies the interaction of the portfolio with the market, as Matrone concentrates on the fundamentals of the companies. It is very indicative that Matrone does not have a quote machine on his desk, preferring to devote his time to preparing for his three company visits a week and then utilising the insights he gains in updating the company models.
What Angella and Matrone have done is arrive at an investment process that suits them. The stock universe for Kkienn is now a function of that process. The added-value of the managers comes from developing a close enough relationship with the companies in their universe, predominantly Italian companies, that they have transparency of how the companies are operating and a keen sense of how the company or sector dynamics might bring change. "I can experience an incredible sense of satisfaction when we have investments that have paid off for the fund, " says Angella. "Running a hedge fund is not an easy game, but like a Porsche or Ferrari, these are the best vehicles around and now I'm enjoying the ride."
The managers describe their history as a three-year learning curve before the recent blossoming. As such they are very fortunate to have served such an apprenticeship without having the tools and materials taken away from them by the owners of the residual capital they had in 2004. Many funds would have been wound up in similar circumstances. To their credit, part of the capital base at that time was their own money. The managers' edge is now clearer, the risk management processes are refined and a more full and appropriate resource is being brought to bear at Kkienn Investment Management. All money managers make mistakes, even the most monied and feted of managers still make plenty of mistakes. What benefits investors is learning from them and reducing the probabilities of failure in future. That is what Angella and Matrone have done in keeping alive Angella's hedge fund dream.