Paul Dunning, HSBC Republic Investments

Philip Coggan
Originally published in the May 2005 issue

Does the future of the fund of hedge funds industry belong to the big battalions? Paul Dunning, chief executive officer of HSBC Republic investments, must certainly hope so. Not only is his parent bank one of the biggest in the world, but his outfit is a heavyweight operator in the hedge fund sector. The company now has some $23.4bn of hedge fund assets under management, through a combination of a discretionary service (based in London), an advisoryservice (in Geneva) and in other forms such as custody and execution-only broking. According to Dunning, around $4-5bn is in the discretionary service, $9bn-$12bn in advisory and the rest in custody and execution-only. But Dunning says "most of the assets are booked in the name of the bank. This allows us to have an internal secondary market in positions. No other adviser has this model," he claims.

Dunning believes the HSBC model has distinct advantages. "We can get some capacity from managers that have been closed forever. Over the last 10 years, our funds of funds have picked up around 10% of their portfolios in this way."

HSBC's size means that any hedge fund managers trying to attract clients will find it worth their while to drop by the group's stylish St James' Street offices, once the headquarters of the Conservative party.

"Almost all hedge funds know who we are," says Dunning. This is in part due to the extensive research the company does for its advisory service. "We have a 20 person team doing due diligence on 400 hedge funds, much more than if we were a pure discretionary business. That helps defray the costs over a wider base."

This he believes is an important advantage. "In the fund of funds industry, the barriers to entry are rising. The due diligence component is now very expensive and requires highly qualified people. You can't whip something up overnight," he argues.

Dunning says there is room for consolidation in the funds of funds sector. HSBC would obviously look at any deal that came its way but Dunning seems cautious about anticipating any immediate purchases. "We have looked at buying other firms but it is all about getting the right people," he says. Furthermore, a fund of funds purchase might be small fry for such a global bank.

The business dates back to Republic National Bank of New York, built up by the reclusive Edmond Safra, which HSBC bought for $10bn in 1999. Dunning joined the group in 1995 from Goldman Sachs Asset Management International, where he was chief operating officer. He had previously worked at Chemical Bank and Midland Bank international, having studied economics and economic history at university.

"Almost everybody in the business worked for Republic," he says. "We have a fantastic team of senior people who have been with us around 8-10 years and they can act as mentors if we want to add further staff."

Dunning says the group's assets under management have grown very steadily at 30-40% a year, which he estimates to be about the same pace as the rest of the industry or slightly higher. "I believe it is sustainable. We have a scalable model," he adds. "Whether the industry is scalable is another matter…particularly when it comes to arbitrage-type strategies."

Strategy outlook: getting the balance right

Convertible arbitrage funds have suffered heavily this year, with many investors demanding redemptions after poor results, Such redemptions have added to the pressure on convertible prices, making life even more difficult for managers in the sector: "We have been massively underweight convertible arbitrage funds for around two years" says Dunning. "For the first six months, our relative performance was suffering as a result. But for the last 18 months we have been right and recently we have been spectacularly right."

Dunning says HSBC Republic did not like the convertible arbitrage sector for several reasons. "One was that there was an over-concentration of hedge fund ownership in the sector. (In other words, hedge funds were the only buyers of convertibles.) Secondly, credit spreads were compressing too far. Dunning thinks the group did not know how far compression would go but as it was impossible to shift the portfolio overnight, it was safer to be underweight sooner rather than later.

"Thirdly" says Dunning, "it used to be the case that you could buy a convertible and mark a profit on your books on day one. That was no longer the case. Fourthly, equity market volatility was at multi-year lows." Once Dunning added all those factors up, he says "it seemed to us that the next wobble in the hedge fund sector would be in convertibles."

But as with any other asset class, weakness can provide the far-sighted investor with an opportunity. "Once the wobble is over, then the sector might look interesting again," he says. "Our view on convertible arbitrage has now shifted to neutral; although that doesn't mean we've allocated any cash to it."

While HSBC Republic has avoided convertible funds, Dunning says the group has been positive on equity-based strategies since the fourth quarter of last year. "I suspect our team may not be quite so positive now" he adds. "If you'd asked late last year how long our positive view would last, I'd have said six to nine months."

"We are not great fans of short-sellers" he admits. "Although they do well when equity markets do badly, you lose so much money getting to that point." Dunning's views were forged by experience. "In the late '90's, we took the view that equity markets were looking overvalued. We looked at short-sellers but when markets did correct, we didn't make anything like the returns that we considered were necessary to compensate for the risk. It was rather disappointing" he recalls.

Furthermore, Dunning says HSBC Republic "haven't had mortgage managers in our portfolio for quite a while. Every few years, the mortgage managers run out of leverage and there is dislocation in the market. When we see that dislocation is over, then we may go into the sector." pIn terms of other sectors, Dunning says that "fixed income arbitrage could well become more interesting if it becomes clear we are in a deflation scenario than if we are in a growth scenario."

On commodity trading advisers and macro funds, Dunning says "trendless markets are difficult for them. The signals aren't strong enough and they don't get long enough to sit on a trend. We had a big bull market in equities in the 1990s, then a correction from 2000-2002 and then a bounce in 2003 and 2004. But it is not clear where we are going from here.

"We agree with the sentiment that managed futures and pure macro funds have a high volatility component" he adds. "If you just did an optimisation of the ideal hedge fund portfolio, then they wouldn't pass muster. But they do add diversification. There have been several times in the past few years when equity managers have done poorly and CTAs have performed well. We have a sub-sector of our portfolios which put money into CTAs. We tend to have 3-5% of the fund divided between three to five managers."

Sector and manager selection

Sector selection is one of the ways in which Dunning feels a fund-of-funds manager can add value.

"We try to look forward six months and overlay the portfolio with some kind of strategy," he says. The group's recent enthusiasm for equity long-short funds has proved successful since the sector has produced good relative returns. But picking individual managers is just as important. "Our research team has a lot of experience," he says. "They are extremely good at identifying good managers and avoiding problems. We are looking for a manger who has skill, who can replicate that skill, and who can articulate his policy in a relatively straightforward manner. We are looking for people with passion and vision and we are looking for the level of teamwork behind them. "We find that fund managers who were traders often adapt to the hedge fund climate more easily than long-only fund managers," he adds "but it is not a hard and fast rule."

Dunning says he is willing to invest in start-up funds. "First day investing is less risky than it was 10 years ago. Many fund managers launch these days with seed capital and they won't get that without having the right structure."

One factor that he has noticed is the increased use of lock-up periods, under which investors are restricted from selling their holdings. "We do get concerned about extended lock-up periods," he says. "The latest rules in the US on two year venture capital lock-ups have encouraged hedge funds to aim for a two year lock-up. I can't believe it's a good thing for investors. We try to control the amount of lock-ups in our funds at a set value or percentage consistent with the need to meet redemptions from the portfolio."

Around half of the group's investors are institutions, ranging from endowments through life companies to corporates, financial intermediaries through to discretionary portfolio managers. Thanks to HSBC's brand, the client range has been global.

The group's flagship fund is called HSBC GH; according to Dunning, the initials originally stood for Global Hedge "but one regulator didn't allow us to use the word hedge in its title." GH started in 1996 and had assets of around $740m at the end of April. Since launch, the fund has had an average annual return of 9.4%, with a volatility of 6.8%. The target return is LIBOR plus 4%.

The GH fund currently invests with 61 different fund managers but that, says Dunning, is partly the result of the merger of the fund with another one, acquired when HSBC bought the Bank of Bermuda. "At one stage, the fund had 78 and we have been gradually reducing the total," explains Dunning. "Because of our size we are able to manage the process very efficiently."

HSBC also runs two investment trusts, operating as funds of hedge funds. The duo's names are HSBC Global Absolute and European Absolute. Dunning admits that so far the trusts have very little money invested in them with the Global fund having $81m of assets at the end of March and the European fund around £20m. "It has been more difficult for us to market the funds to a retail base but we have appointed someone to do that and we expect the asset base to grow," he says. He admits that, in contrast, Dexion has done a very good job of marketing trusts in this field.

Nevertheless, Dunning says the HSBC trusts have a "much praised structure" which has allowed them to trade at only a narrow discount to net assets. (Some earlier funds in the sector were dogged by the discount problem). The ability to undertake share buy-backs was built into the structure and the directors also have the discretion to offer to redeem up to 25% of the shares at net asset value.

Since April 2001, the European fund has delivered an annualised return of 7.9% (in sterling terms) with an historic volatility of 6%. The Global Fund has delivered an annualised return of 5.3% with an historic volatility of 2.5%.

Tough climate, tough customers

Selling any kind of hedge fund may be difficult for the moment after a period which, Dunning admits, has seen some disappointing returns. "April to August last year was a very difficult period for hedge funds and it looks as if March-April this year has also been difficult."

The 2004 performance numbers were rescued by the rally that followed President Bush's re-election. But average returns have been coming down for several years. "Remember that Libor dollar rates have come down significantly," says Dunning. "Hedge funds often get lots of standby income from cash. So they have lost 3+% of annual return relative to when short rates were 6.5%."

But he reckons that hedge funds are suitable for a wide range of investors, particularly in the light of the big losses incurred by those who backed long-only managers in 2000-2002. "Regulators may have had difficulty in categorising the risk on the different products. I don't think retail investors ever wanted relative performance in the first place. Single hedge funds will probably not be as volatile as an index fund. Consequently, HSBC's view is that a fund of funds is a very acceptable and risk averse way of accessing the hedge fund world."

As for pension funds, Dunning admits that if you look at hedge funds from a liability-matching perspective, then they are not an obvious fit. "But if you can outpace inflation that's attractive" he argues. "We have pension fund clients for whom we have produced Libor plus 4% over 20 months with very little volatility. Their concern is preserving their capital, outpacing inflation and outpacing interest rates. For them a cautiously managed hedge fund portfolio is a good diversifier."

Memories of past sector problems can be a disincentive. But Dunning believes "hedge funds are different now from the times of Long-Term Capital Management. Many more institutional investors are involved and there are higher levels of controls and procedure. Investment banks are constrained by regulatory requirements to make sure they don't indulge in unconstrained lending to hedge funds."

Some have concerns about the link between banks and hedge funds, with the former providing brokerage research and financing to the latter whilst competing with each other for staff and trading positions. "The relationship may be a little symbiotic. Hedge funds are in it to make money and banks make money out of their trading. It is difficult to see why the relationship wouldn't work; they need each other." He argues that HSBC is different from other banks in that it does not have a pure prime brokerage arm. "We can trade in an unconstrained way with hedge funds on their merits."

The high level of fees can also put some pension funds off. Dunning says that unconstrained benchmark long-only managers are starting to charge 1% annual fees plus 10% for performance. "That may capture some money from institutions that might otherwise have gone to hedge funds," he admits. "But excellent fund managers command high fees." He also admits there are fee pressures in the fund of funds sector but thinks this is nothing unusual. "Large clients want to negotiate fees and that is no different from how things have been historically."

Hedge funds will not be the best investment in all market circumstances, he accepts. "In a raging bull market hedge funds will disappoint. And recently we have seen pretty trendless markets. Until you see some pretty definable trends I don't think you will see hedge funds come into their own again. People have been whipsawed by recent markets."

There clearly is some limit to hedge fund growth. "If every pension fund wanted to put 20% into hedge funds, it is difficult to see how returns could be sustained," Dunning admits. "But we think that markets are a long way from being overwhelmed. Only around 2-3% of the total investment universe is made up by hedge funds."

"I expect that hedge fund returns will self-regulate the sector's growth. There will be a wider distribution of client assets into all sorts of asset classes," he says. "35% annual growth in assets may not be sustainable over the long term but we could get 15% growth going forward."

Most hedge fund managers would settle for that.

Philip Coggan is Investment Editor of the Financial Times.