Never The Twain Shall Meet

Taking risk management seriously at F&C Alternative Investments

Stuart Fieldhouse
Originally published in the August 2005 issue

In January 2003, F&C became the latest established fund management house to enter the hedge funds business. A name with a long history in the global asset management business, F&C has been used to managing a large proportion, if not all, of its clients' assets across a range of asset classes. It is a hallmark of a business that has been investing money for clients for well over a century, but times – and markets – are changing, and older, established firms need to change with them. In F&C's case, it realised that in order to keep assets in-house, it would need to develop a hedge fund capability.

It was a choice that was being faced by many of its competitors: service the demand for hedge funds yourselves, or watch clients re-allocated assets outside the business to other firms that do have the capability.

"We could do one of two things," says Fernando Ribeiro, who heads up the group's hedge funds division, as well as helping to oversee its private equity capabilities. "We could let others cater for this need instead of us, or given our relationships with these investors, we could cater for them ourselves."

Ribeiro, who joined F&C following its merger with AF Investimentos in Portugal and Dutch manager Achmea, accepts the initial move into hedge funds was a defensive play on the part of the group. At the same time, he says, it also has its eyes on the potential of acquiring new clients, like funds of hedge funds, and banks with an appetite for hedge fund risk, clients F&C had traditionally not dealt with before.

Before the launch, F&C spent 10 months investigating the viability of a distinct hedge funds business. At the time, its management decided that from the very beginning, its hedge funds division ought to be totally segregated from the management of its long-only funds, especially given the size and scope of the existing long-only F&C business. "We wanted to prevent a conflict of interest, we wanted to prevent any fund manager from favouring hedge funds at the expense of the long-only book," Ribeiro say. "We totally ring-fenced in a way that hedge fund managers were not allowed to run long-only equity portfolios."

Separate under one roof

After its recent merger with Isis, F&C took the step to physically separate its long-only and hedge fund businesses, to the extent that only personnel, authorised to have access to the alternative investments side of the business can physically enter its offices, even though they are still contained within F&C's Exchange House offices. The business still benefits from the economies of scale that come with being part of a larger house, including support from the audit and compliance departments, and the institutional-grade IT capability. In an era for the hedge funds sector, where increasing emphasis is being placed on operational efficiency, this is a major bonus.

Ribeiro is at pains to point out that a great deal of the business support which F&C devotes to its hedge funds business is dedicated, including risk management and marketing. Although some resources like IT may be shared in-house, others are demonstrably devoted entirely to alternatives.

"The reason why we did this is because we wanted to prevent all possible conflicts of interest," Ribeiro says.

For example, he adds, one of the firm's trio of funds, F&C Citrine, follows a long/short European equity strategy: "What I want to prevent is our long/short fund taking a view on decisions made by our big book of business. For instance, if the fund managers upstairs managing the long-only business on the European desk decide to sell a particular stock, we don't want our long/short fund taking a view on the market, and leveraging that position."

Hedge funds tend to trade more frequently, and even if there was no wrong doing, it could be claimed that just by sitting on the same desk as the long-only team, the hedge fund manager was being advantaged.

Given the fall-out from the market-timing scandal in the US, in which hedge funds were major participants, and the subsequent appreciable damage done to the net assets of some of the biggest fund management names in America, it is no surprise that an established firm like F&C, with a strong book of both retail and institutional business, is very aware of the value of segregation.

At the same time, other big firms with a mix of funds, both long-only and alternative, have favoured seating their fund managers together, and have even allowed managers to run long-only portfolios with their long/short assignments. Whether this will continue, or whether either regulators or the influential institutional community will demand a change to business practises, remains to be seen, but F&C has already taken this decision, and seems happy with it. In Ribeiro's view, there are fewer benefits to be had from the sharing of investment ideas, when weighed against the possible downside of being seen to be exploiting the long -only book in favour of nimbler alternative funds.

"F&C is a company that has existed since 1868," Ribeiro says. "So far it has preserved its reputation by making sure that no line of business is in a position to damage that reputation. Our hedge fund managers would like to be skilful enough to make the right bets and take the right positions, in order to, achieve the returns that clients are expecting. We cannot continue if we endanger the firm's reputation. This does not only help the long-only business, it also helps our hedge fund managers. If they see good opportunities in the market, they want to exploit them – they don't want to be constrained by what the long-only book is doing."

Another example of a potential conflict of interest would be if clients of the firm were involved in major hedging operations in order to cover specific losses.

"If someone does that, either on the equity side or the interest rate side, it affects the stock-market," he explains. "We don't want our hedge fund managers, trading much more frequently by nature, to ride on those very short-term movements.

"Even at executive level there is segregation. Would it be more comfortable for the company to have everything together? Probably. Would it be more comfortable for the fund managers? Probably, though once they start to get their dedicated business support and risk control, they do like their teams to be organised like that. But you have to ask, at who's expense would all this be? At the client's expense."

F&C can use its position as a major investor to acquire access to the management or the CEOs of the listed companies it invests with, and can use this leverage if there is a perceived advantage for its clients, but at the same time, its hedge fund managers are expected to conduct meetings with the management of portfolio companies on their own merit, and without resorting to any other holdings the group might have. If a company comes to visit F&C, its management can meet the investment team together, for the sake of convenience, but that is the fullest extent of the cooperation between the two sides of the business.

Even when the funds are trading, there is a queue system for dealing which is rigorously enforced, and whether a fund is long/short or not, large or small, no priority is allocated.

"We are stricter than the regulator requires," Ribeiro reckons. "We have preferred it to be more strict from the start, and in that sense, we expect that the regulator will gradually come round to our approach as best practise in the industry."


The firm's first launches were F&C Amethyst in January 2003, pursuing an equity volatility trading strategy, and F&C Sapphire, in September of the same year, with a quantitative asset allocation mandate.

F&C has traditionally maintained an important derivatives desk, and was known in the City for its competence in this area. One of its main tasks was to service HVB (Hypovereinsbank), an important relationship for the firm, in the area of structured products and principal protected notes.

In November 2003 HVB decided to launch its own internal derivatives capability in Frankfurt, leaving F&C with two alternatives: downsize the desk, or reengineer the business. The derivatives desk was therefore chosen to be the platform that would allow F&C to meet its client demands for alternatives, it would form the core of what would be a growing hedge funds department within the company.

"That's why our two first launches were derivatives-based hedge funds," explains Ribeiro.

In July 2004 F&C announced it was merging with Isis Asset Management, itself owned by UK insurance provider Friends Provident. The latter now holds 51% of F&C, but the merger has also served to put F&C into the top-five category for UK fund managers, and in the top 10 for managers of European pension assets. As such, it places F&C Alternative Investments in an excellent position to capitalise on increasing institutional interest in hedge funds, particularly within the pension funds sector. From the way Ribeiro and his colleagues are tailoring the business internally, to make it as attractive as possible from a risk management perspective, it is obvious this potential has not been lost on F&C's senior management.

In the UK, it is the pension funds that are more proactive in the hedge fund field, Ribeiro observes. Insurance companies could be more active, but are restricted by regulations and the admissibility of assets. Pension funds have much more flexibility. By contrast, in Europe, pension funds started allocating before insurance companies, but the insurance market is catching up.

"There are limits to what insurance companies can invest in non-harmonised vehicles," Ribeiro says.

Product range: single strategy

F&C Amethyst was the first of the single-strategy funds to be launched by F&C. Its main investment strategies are trading of implied volatility (both relative and absolute levels), and trading of other option pricing variables, including correlation. Its manager is Stephen Dolbear, who originally joined the firm from Swiss Bank Corporation in 1995 with a brief to establish a derivative management and design capability within the firm. Dolbear was credited in the same year as being the first person to trade a volatility swap. He successfully made the transition from working in the capital markets departments of investment banks, to running a unit that has designed, launched, and managed new derivative-based funds for a variety of F&C clients. Amongst other achievements, he developed the F&C High Income Plan (HIP), the prototype of the derivatives overlay used by the Amethyst Fund. It was the success of HIP and other funds like it that created the momentum for the establishment of F&C Alternative Investment in 2002.

In September 2003 F&C launched its second single-strategy fund, F&C Sapphire, following a quantitative approach to asset selection. The process again draws on the experience invested in the derivatives desk, namely analysis of implied return distributions generated via the derivatives market, as well as momentum and range-based indicators and other quantitative indicators that can point to absolute and relative value within equity and debt markets.

The fund is managed by Stephen Crewe, previously the back-up manager on Amethyst, as well as, two UK-focused OEICs. Crewe has also specialised in advising UK insurance firms on their asset liability matching, with a focus on guaranteed annuity options.

Sapphire combines three inputs in its investment process, namely quantitative models, a qualitative macro view, and equity derivative indicators. Its quant models have been developed to analyse trends and price the dynamics of assets. The equity derivative indicators are used as a guide to the risk premium embedded in markets, as well as, being vital in determining the optimal means of implementing trades. The qualitative macro view acts as a screen in bringing together the quantitative output and ensuring it remains within the bounds of reasonable probability.

The output of the process is formed into an absolute market outlook and relative stock, sector, and index views. Implementation is via a combination of derivative instruments and physical assets. The sophisticated use of derivatives allows Crewe to hone in on areas of the return distribution that are forecast to offer the best risk return profile.

The firm's final single strategy product is F&C Citrine, which, unlike the earlier launches, has aimed to a more conventional long/short equity strategy. It follows an active fundamental/bottom-up stock-picking strategy using F&C's own valuation and forecasting models. The investment universe is the European equity market with a focus mainly on companies with a market capitalisation greater than €1 billion.

Citrine is managed by Frederic Desage Bonnet, who has run the fund since it opened in May 2004. He was formerly a vice president of European equities at Credit Suisse Asset Management, before joining F&C as director of European equities.

The future

Like other big fund managers that have ventured into the hedge funds space recently, F&C anticipates that future investment talent, needed to launch the new hedge funds it will require to maintain momentum, will come from a mix of sources. It sensibly recognises that, while it would be tempting to lift managers out of its existing teams, it does not want to be seen to be building its alternative investments business at the expense of its tried-and-tested long-only funds.

"That is simply not the F&C model," Ribeiro argues. "We will not use the long-only department as a fund management incubator for the hedge fund management. That is not to say that some fund managers cannot leave the long-only desk to come and join the hedge fund team, but this is not a free ride, in the sense that they can try to run a long/short, and if it doesn't work, they can go back to what they were doing. The manager of our long/short equity fund came from the front office, yes, but he stopped running long-only funds, and his place was taken by someone else. If, for any reason, he did not succeed, there is no returning. That makes people think twice before deciding if they want to move into the long/short space."

There is, of course, the possibility that the client of an existing long-only F&C product might request that a manager be given the opportunity to run a long/short mandate, possibly under a managed account structure. This has happened before with other firms, and was notably the genesis of the successful AlphaGen business at Gartmore. Ribeiro says no such request has been received by F&C thus far, but cannot rule out that, if the client were important enough, F&C would consider the possibility. F&C's institutional client base is largely divided between pension funds and insurance companies, and he considers it highly unlikely that such clients would want to ask for such a facility. He does not see a competing proposition, rather a complementary one: an investor who wanted a specialist mandate would be welcome to approach thealternatives side of the business, and it would be the alternatives side of the business that would cater to it.

As for expanding F&C's existing range of funds, Ribeiro is aware that recruiting decent managers externally is no cakewalk: "We will be going into the market. It is a different kind of recruiting, as you can imagine. It's not simply going to a head-hunter and saying: 'Look, I've got this position – give me a few names. It's not how it works in the hedge fund market. There are several talented people out there with the right investment experience, but who don't have the right infrastructure, the right market platform, to take advantage of their skills. They are looking to be housed by a firm such as F&C – some of them may have had experience with boutiques, and will be aware of the pros and cons. There are many pros to boutique-sized companies, but there are also quite a few cons."

In terms of strategies, Ribeiro admits that going forwards F&C, "cannot afford to be opportunistic.


"We only have three single strategy funds, and there are at least 10-12 possibly strategies, depending on how you slice the market, and even those can be decomposed if you wish."

The aim is to provide positive absolute returns: provided he finds the right manager, regardless of the strategy, Ribeiro feels confident he can launch one of a broad variety of funds. F&C is only just starting out, he explains. There are a vast amount of different funds it can still contemplate launching.

In terms of momentum, Ribeiro says he is seeing greater net inflows to the single strategy funds than the funds of funds business. At the moment, his efforts are still focused on getting the business up and running properly, and establishing its credentials in the minds of investors. "The industry as a whole has experienced a bad second quarter," he says. "There is a sense that money flows were not as great as people expected. We have not suffered from redemptions, but once hedge funds get into the press on almost a daily basis, the experience is not good. When you see the likes of rising stars like Bailey Coates closing down, people in turn get scared and postpone investment. But I think, like last year, we'll be heading for a quite a decent post-September period."

The increased scrutiny hedge funds are under, as an industry, is something of a two-edge sword, and a phenomena that some senior figures in alternative investment are not comfortable with. Ribeiro is pragmatic about the situation, and realises that the rules of the game are changing: "What makes news? Either extremely positive or extremely negative news. The average situation does not attract attention. There are thousands of hedge funds in the world, and some occasionally go to the wall, or decide to close down. Obviously, when such a situation happens, it stands to contaminate the entire industry. This is far from the scale of Long Term Capital in 1998, but people still get scared remembering that. Google was floated last year – an excellent company in terms of its business – but they could not consider floating in 2002 or 2003 because the scars of the dotcom bubble were still pretty much there."


Ultimately, the advantage that many of the big players in fund management bring to the market is credibility. They have been in the business for a long time. High profile stars who decide to go out on their own are frequently not the kind of person, in Ribeiro's view, who fit well in a large company. Institutional investors, F&C's clients, are after a certain degree of credibility and reliability, he argues, "They don't go with the flavour of the month or the flavour of the year. They invest for the long term."

Large investors will understand if a certain strategy fails and a fund is closed. They will not understand if the firm decided to abandon the entire alternative investments business. They are wary of the fact that some hedge fund boutiques are in and out of the market inside five years, their profits made or lost, depending on how well they managed their businesses and their portfolios. This level of inconsistency is not something institutional investors are happy with.

F&C has realised the speed at which the hedge funds industry is growing. It attracts high multiples, and the firm's end game is to maximise the value of its market share. It wants to make sure that its presence in the business makes a significant contribution to the firm/s bottom line, one that is recognised by its shareholders. Expansion looks like it is on the cards, and the firm is on the hunt for more managers, but at the same time the primary focus is to expand the assets already under management.