Lombard Odier Investment Managers

Building hedge funds to create alpha and manage risk

Originally published in the March 2011 issue

When Hubert Keller joined Lombard Odier Darier Hentsch & Cie in 2006 as a Managing Partner the Swiss private bank’s asset management operation ran a traditional long only platform for institutional investors. The focus on running actively managed funds for institutional investors had been the mainstay of the asset management business since it was founded in the 1970s.

Jump forward five years and Lombard Odier’s hedge fund arm runs over $2.7 billion, putting it among the top 30 firms by AUM in Europe. For Keller, this is just the beginning: with the hedge fund platform now firmly bedded in, he is looking to more than double assets under management in the next few years.

When Keller looked at the evolution of asset management in the new millennium he saw two factors driving rapid change. One was the explosion of passive structures, notably exchange traded funds, tracking benchmarks. The second was the poor performance recorded by active managers during the market downturn of the early 2000s. With managers trying (and largely failing) to beat benchmarks – something ETFs did at a much lower cost – the active model looked increasingly unsustainable. Over the past 15 years, events like the Asian currency crisis, the Russian default, the tech bubble and the credit crunch show the failure of traditional asset management. Investors would have done well to preserve capital, let alone make gains.

“We wanted to bring an approach to risk that was much more absolute in nature, moving away from risks relative to an index or a specific risk premium,” says Keller. “Essentially, we wanted to adopt an approach much more akin to how hedge funds look at risk and we wanted this to permeate the whole Lombard Odier Investment Managers (LOIM) division.” But the firm also wanted to retain elements from the traditional asset management industry: particularly, liquidity, transparency and an understanding of the specific market beta to which the risk budget is allocated. The combination of these two approaches is the basis of LOIM’s value proposition to investors.

Separating alpha and beta
“We felt very strongly that the best way to compete in the future was to try and design a model where we would systematically separate beta and alpha,” Keller says. “We also felt it was important to design a model where risk management would be at the cornerstone of any offering. These two principles: separation of alpha and beta, and risk management were hard wired into the DNA of the re-launch of our asset management business.” The new absolute return funds share these characteristics and were christened with 1798 – the founding date of the Lombard Odier private bank partnership.

To usher in the launch of single manager hedge funds, the firm put in place separate teams. One focuses on benchmarks, often looking to build smarter benchmarks (risk weighted versus asset weighted) or seeking to replicate benchmarks on unconventional betas. The other teams are focused purely on alpha which meant scouting the best investment talent on the market – whether it was in equities, fixed income or macro. In this world of unconstrained investing many of the portfolio managers that ultimately joined the firm came from either a traditional portfolio manager background with a hedge fund or a prop trading role at an investment bank.

“I think we have a unique model,” Keller says. “There are a lot of asset managers coming from the traditional world who will build a hedge fund business on the side. You will also see a lot of hedge funds moving into the long only institutional business and that hasn’t completely worked. I think we are one of the very few firms today positioned right at the convergence of the two businesses. What we are trying to do is have the same people running the alpha for traditional long only or hedge fund products and that makes us in a way quite unique. And hopefully creates a model that is flexible, will deliver from a performance standpoint and be scalable.”

Launching in the crisis
With the benefit of hindsight, 2007 may not have been the ideal time to launch a new hedge fund business. But Lombard Odier’s venerable history and independent partnership structure meant it could take the long view and look at what it wanted the new business unit to achieve over decades. That gave the firm an advantage at a time when many hedge funds and investment banks were fighting for survival amid unprecedented operational strains posed by the financial crisis.

“Clearly, 2007 was an interesting time to re-launch and build our model,” says Keller. “It was a difficult time from the point of view of performance generation in 2008 but it was an interesting time in terms of attracting talent. In a way, we benefitted from what happened in 2008, in particular, in our ability to attract a lot of top notch talent very quickly.”

The talent that joined Lombard Odier came from many sources. Aziz Nahas, a former global head of equities at the one-time UBS unit Dillon Read Capital, joined in 2007 as chief investment officer and head of equities. In 2009, Stephane Monier came on board as CIO and head of fixed income and currencies, while in early 2008 Jean Louis Nakamura left a big French pension fund to become the third CIO, heading the asset allocation and quantitative team. Portfolio management talent also flowed in. Gary Lehrman joined from J.P. Morgan in New York to head the US special situations team, while a European credit team was recruited from Cerberus. Other teams came from Millennium, Pequot or Goldman Sachs. In October 2010, Marc Bataillon joined from Selectium Europe to lead the European equities operation from London.

Any doubts over whether a relatively modest-sized Swiss private bank could capture alpha generation talent vanished. During a period fraught with uncertainty Lombard Odier offered stable capital backing for the new portfolio managers when it seeded the 1798 Fundamental Strategies Fund with $300 million in November 2007. This multi-strategy fund enables managers to ramp up a portfolio and begin generating performance. Managers have the opportunity to eventually launch a separate fund, something that happened in May 2010 with Lehrman’s 1798 US Special Situations Fund.

Lombard Odier has also worked hard at retaining and empowering its key personnel. Beyond its support for new funds and a deferred compensation policy, it has created a specific Lombard Odier Investment Managers partnership, led by Keller and Thierry Lombard. Nahas is the first to have joined this partnership for his success in building hedge fund equities products. He is also expected to play an instrumental role in developing the asset management business. “We believe the ability to offer partnership positions in our LOIM business will be a key motivating factor for our most senior professionals and will enable us to compete effectively with most hedge fund models,” says Keller.

Multi-strategy offering
The flagship 1798 Fundamental Strategies Fund or FSF is a market neutral equity-biased multi-strategy fund. It has grown to $1.1 billion in assets in the three years since launch. FSF’s multi-strategy book now has 10 strategies (up from five at inception) with eight equity long/short strategies and two mixed ones targeting US special situations and convertible long/short. Nahas interviewed some 400 potential portfolio managers in building the team. The aim was to find managers who would accept the firm’s newly conceived risk management guidelines andwho were attuned to the demands of operating with full transparency in opening trading positions. For example, any time a portfolio manager wants to initiate a position it is necessary to write an investment thesis. In turn, the thesis is recorded beside the position details so that risk managers and the CIOs have full transparency.

The FSF multi-strategy fund returned 50.3% in the rebound year of 2009 even though gross exposure didn’t increase dramatically over the year as FSF’s long book clocked big gains in several months. All the strategies generated gains, notably the US special situations and convertibles long/short funds. In 2008, the credit books, though balanced, suffered from the combination of a beta mismatch and negative basis trades. This led to portfolio behaviour that mimicked a long only book, but the market’s normalization had a big impact on the profit and loss statement. Now the credit portfolio is much more beta balanced. In 2010, it exhibited very strong and uncorrelated performance.

With FSF, both the long and short books outperformed the market, helping the fund rise 8.7%. “There were some periods of dislocation,” says Jena Pascal Porcherot, head of hedge fund distribution. “What is more important looking at 2010 is that August was one of our best months. We were up 2.54% in what was a very difficult month for the market. On the other hand, if you look at September we were flat whereas that was one of the best months for equities and one of the best months for hedge funds. Similarly in November, which was a difficult month for hedge funds, we were up 1.6%. Our mandate is to generate a return which is not correlated with market returns. In 2010, it showed that we could do that pretty well.”

Even though the returns have been high the risk parameters of FSF are relatively conservative. There is a 20% limit in the overall multi-strategy fund to any one portfolio. Net exposure of the equity books is -15% to +25% with a limit of 200% gross exposure on the equities books and 100% on credit books. The chief risk officer, Stephen Grobman has a direct reporting line to Hubert Keller. In effect, this separates risk management from the CIO’s responsibilities. When a portfolio manager or investment team joins the platform they work with the risk team to make sure it understands the dynamics of the strategy and is able to develop an appropriate risk framework.

Separate risk reporting lines
“Once the framework is in place, approved by both the risk and investment teams, then the risk team monitors the strategy and also works with the investment team on its portfolio to ensure that it remains in the framework at all times,” says Jean-Pascal Porcherot, global head of hedge fund sales. “Our risk management team is very hands on, while having a very separate reporting line. The aim is to create a partnership to best manage each portfolio in that pre-designed risk framework – at the same time when markets get really tough and a strategy goes too close to the boundaries the risk team have full authority to act and that has occurred in some cases.”

Allocating capital
A key feature of the capital allocation process is the weekly best ideas meeting with Nahas, the risk manager and all FSF portfolio managers. In this forum, each portfolio manager is expected to compete for capital. Asked about how this affects relations among portfolio managers, Keller is disarmingly straightforward. “We spend a lot of looking to ensure that portfolio managers will accept to work in the construct,” he says. “We don’t want big egos that dispute allocations.” Even though some books in the multi-strategy fund have had their proportion of capital scaled back, none of the portfolio managers have departed to join a competitor. No doubt the fact that FSF has quickly grown assets is an important factor in keeping portfolio managers happy since their book will be growing in absolute terms even if it is smaller share of the overall portfolio.

All FSF portfolio managers at Lombard Odier are required to do their fundamental research in a transparent manner. At a mouse click, Nahas can tap into a brief overview of the portfolio manager’s investment thesis for each of some 600 positions across the funds. All of the work a portfolio manger might do – talking to consultants, to management, reading external research and building a model – is depicted in detail. This investment process is done to initiate a position and done again when it is reduced or expanded.

With FSF, the eight long/short equities strategies cover about 80% of the S&P exposure by sector. The team is settled and the fund isn’t currently looking to engage new mangers. One sector where FSF is purposefully absent is in having no equity long/short book focusing on energy.

“We believe a market neutral approach in the energy sector is fraught with difficulty,” says Keller. “If you want to extract alpha in the energy sector you need to buy some of the small and mid cap exploration and production companies. But to have a market neutral bias it means you have to short some of the same companies. That would be very dangerous because shorting an E&P company, even if it has bad management, may still get lucky and find oil. It makes running a market neutral strategy in E&P very difficult.”

Instead, a separate energy offering was set up in December 2009 when portfolio managers Michael Hulme and Martin Fisch launched the LO AOG Energy Multistrategy Fund. With a long bias, it invests in energy businesses across their entire capital structure. The fund is the firm’s second biggest hedge fund offering with AUM of nearly $700 million.

Special situations
Lehrman’s 1798 US Special Situations Fund offers a hybrid approach to investors. He will look to run a concentrated portfolio of very asymmetric investments in both credit and equities and adapts his investment approach to the opportunities available over the course of the business cycle.

“Lehrman believes that in order to generate attractive returns across the cycle you need to be able to invest across the capital structure of a company,” Porcherot says. “At one point in the cycle the main opportunity is going to be shorting high yield. At another point it might be owning stressed or distressed debt. And at another point it might be in post-reorganisation equity plays, which is what we are seeing right now. The ability to invest across the capital structure enables you to make attractive returns across market cycles.” Another characteristic of Lehrman’s investment style is that he develops both long and short plays. In January, a short play on US retailer SuperValue led to a 5.2% gain for the fund. Launched in May 2010, the fund generated 22.2% in 2010 with consistent positive performance in both negative months and positive months for the market.

Asset management in a private bank
Within Lombard Odier, the investment managers business and the private bank operations are kept distinct. Most of the asset management clients are external, comprised mainly of institutional investors, funds of funds and third party distributors. Private banking clients only account for a small proportion of assets in the funds.

“Within asset management, we don’t really differentiate in the investment teams between those who manage long/short and those who manage more traditional long only strategies,” says Keller. “We try to run a fully converged model where talent can be articulated or expressed on the hedge fund and traditional side of the business.”

In addition to hedge funds, Lombard Odier tailors its offering to include a full range of Swiss products; niche areas outside Switzerland where niche is defined as asset classes or strategies where there is limited competition from ETFs or the firm has an innovative investment concept and a balanced mandate offering.

Hedge fund AUM is $2.7 billion from nil at launch in 2007 within an asset management operation that has AUM of $36 billion. Since Keller’s arrival, Lombard Odier has prioritised the development of the 1798 range of single manager hedge funds over its fund of hedge funds business, an area where other private banks have traditionally been quite active. Given the difficulties that have dogged funds of funds, particularly in Europe, that omission won’t hinder growth. This is especially true now that institutional investors are increasingly allocating direct to single manager hedge funds, something that Keller says has helped the development of their hedge fund operation.

“The fund of hedge funds model has disappointed a lot of investors,” he says. “There is no doubt that we are seeing from clients who want exposure to those strategies a greater willingness to come to single manager hedge fund strategies. That has been beneficial to us.”

Attracting institutional money
The mix of investors varies for different Lombard Odier funds. The FSF flagship only began marketing to institutional investors in 2010, since when it has raised $150 million. However, LOF 1798 Tactical Alpha, the global macro offering, launched in October 2009 and began to attract institutional money immediately. In just 17 months, over $400 million has flowed into the fund. Keller attributes this to its daily liquidity and UCITS format which offers an investment process designed especially for institutions.

“Obviously a lot of institutional clients need the UCITS stamp to be able to have a sizeable position or be able to go into different categories within their portfolio allocation,” Keller says. “The other very important thing that you get with the UCITS stamp is liquidity. I strongly believe that the liquidity of any vehicle should be aligned to the liquidity of the underlying strategy. If you run equity long/short or market neutral on large cap US stocks there is no reason why it should have monthly or quarterly liquidity. Clients will get more and more concerned with the traditional liquidity of such hedge fund vehicles.”

Surprisingly, perhaps, Keller is sceptical about how applicable the UCITS wrapper may ultimately prove to be to a wide range of hedge fund strategies. In the main, he says that most hedge funds don’t lend themselves naturally to the UCITS format. Instead, Keller sees Luxembourg’s Specialised Investment Funds regime as a natural wrapper for hedge fund strategies.

“My view is that ultimately hedge fund strategies will not fit well in the UCITS world,” he says. “It is trying to put a square peg in a round hole. The regulators are not comfortable with long/short and leverage in the UCITS world. Therefore it will become inappropriate for most hedge fund strategies. Today you can do it. You can structure a fund with contracts for difference and monitor leverage, but I think it is very clear where the regulators are going. Each regulator you speak to does not want to see hedge funds in UCITS.”

No penalties on Swiss firms
Lombard Odier is relaxed about the impact the Alternative Investment Fund Managers Directive will have on Swiss firms. With sizeable teams in London, Switzerland and New York, the asset management business looks well positioned to comply with regulatory developments and be able to organise itself it the most optimal way to suit its business needs and the requirements of investors.

As the oldest of Geneva’s private banks, Lombard Odier is keen to emphasise the city’s attributes and topromote it as an investment centre. Geneva’s standing, of course, has risen several notches with the arrival from London last year of several dozen top portfolio managers from Brevan Howard and BlueCrest Capital Management, respectively Europe’s first and third largest hedge fund groups by AUM.

“To integrate within such a short period of time two large firms – among the biggest in the industry – is a real challenge on infrastructure, schools, real estate and IT operations,” says Keller. “I’m certainly hoping we won’t see dozens of firms joining them every year. For Geneva it is very positive. We want to be able to attract investment talent so the city can strengthen its position as a credible place for managing money and generating performance. The question is how quickly such a small place can absorb these big moves.”

2011: tough to predict
Equities CIO Nahas expects 2011 to be a volatile year in the markets. “Social unrest in some developing countries is fuelled by rising commodity prices, valuations in emerging markets seem to overstate growth, more negative headlines from peripheral Europe and US housing having another leg down,” he says. ”If rates remain low (many economists don’t see the Fed changing its stance until 2013), spread compression will continue, which will negatively impact the expected risk adjusted returns of some strategies, particularly convertible long/short and US events. However, long/short strategies should benefit from the current environment. We have an increasing number of short ideas, which we believe will help drive returns of well balanced portfolios. We also note that the Citigroup Realized Correlation 1 index is at multi-year lows suggesting that dispersion between individual stocks is at the same level as late 2007. In Q1, we expect the long/short strategies to be the main beneficiaries of our capital allocation and in particular, we anticipate growing our European long/short portfolio significantly. In the coming year, we will keep a close eye on housing in the US as a stabilization could help a few out-of-favour sectors; we will focus on some over-valued stocks in emerging markets, and we intend to continue to aggressively buy volatility when it is cheap.”

“We strongly feel we have enough that we just need to get scale on our existing fund range,” adds Keller. “We think we have quite a few blockbusters at hand. FSF has exceeded $1 billion and has a track record. The energy fund is quite unique, while both the macro and special situations funds are getting scale. For 2011, we would like to scale up most of the existing hedge fund products on the platform.” Asked about a timeframe to perhaps double AUM, Keller responds, “We are actually much more ambitious than that over a three year period.”