Permal Group

Creating alpha with multi-manager portfolios

Originally published in the June 2012 issue

Following the advent of the financial crisis in 2008, funds of hedge funds have engaged in a battle for survival. Tough performance conditions, an outflow of investors and a change in the supply-demand balance between investors and hedge funds have all taken a toll on funds of hedge funds. One of the few to come through this foaming cauldron and emerge relatively unscathed is Permal Group. Founded in 1973 and acquired by the US fund giant Legg Mason in 2005, Permal has ridden out the storm and with $20 billion in assets under management including a big portion in global macro (see Fig.1), can still count itself among the biggest funds of funds.

The reasons for the firm’s continued success are straight forward. It has focused closely on optimising portfolio strategies, being innovative with investors and adroitly managing risk. Investment has also occurred in a number of areas, notably the managed account platform which now totals 86 accounts, with approximately $7.5 billion spread over numerous strategies (see Fig.2 and Fig.3).

Relevant proposition
A recent visit to London by Isaac Souede, the chairman, CEO and chief investment strategist of Permal Group presented The Hedge Fund Journal with the opportunity to discuss why the proposition that funds of funds offer is still highly relevant to investors. The London-based president of the group, Omar Kodmani, who manages all day-to-day aspects of the business also joined in.

Souede joined Permal in 1986. His experience spans the emergence and transformation of the hedge fund industry, growing from a few dozen managers to what is now a fully fledged industry, employing tens of thousands and playing a pivotal role in markets across the globe. We began by discussing some of the contrasts between the time when the hedge fund scene was, in effect, a cottage industry and now.

Alpha harder to retain
“Early on the key to it all was finding and accessing managers,” says Souede. “The hype, the excitement, the sexiness was the manager himself. And today it’s changed dramatically. Knowing the manager or having him in a database really doesn’t mean very much. The sexiness is really how you put it together, how do you judge and how do you change managers, because alpha is getting harder and harder to get and even harder to retain.”

Evolution is a word that Souede uses often. Only firms that evolve can achieve longevity in the hedge fund sector. It’s clear this applies as much to funds of funds as single manager funds. But it’s also apparent that a certain dynamism is absolutely crucial, especially with managing portfolios of managers. If anything, the need to be dynamic becomes even more important when economic and market conditions are wracked by major turbulence. Equally key, is giving investors exactly what they require in a way that suits them.

“The evolution of the fund of funds business is toward a lot more customisation,” says Souede. “The key is to be able to create value, both from a real standpoint and from a perception standpoint for clients and to do it very consistently. Inside that customisation often a client wants to be fully engaged with you and needs to be the co-pilot with you being the pilot. You need to unbundle the services that you provide and give the client exactly the services that they want you to provide, whether it’s on the due diligence of managers, product engineering or top-down views.”

Manager turnover at Permal has averaged 10-15% annually. Over the past half-decade it means that around two-thirds of the allocations have changed. In tandem with that has been a sevenfold growth in building separate accounts with managers to improve transparency, liquidity and allow a fund to be custom engineered in a way that is more bespoke than a co-mingled fund. This customisation can also extend to fees and terms.

Souede is matter of fact about what Permal and indeed any investment manager must do to prosper. Generating performance and managing risk may sound simple but the dislocation in markets in recent years makes them anything but.

Superior risk adjusted returns
“In terms of the expectations of our industry, whether you’re a single manager or a fund of funds, the expectation has to be, net of fees, that you can create superior risk-adjusted returns all of the time,” says Souede. “That’s the key task. Many investors use both funds of funds and single manager funds. When they ask my opinion to compare one with the other, I always tell them the same thing: plot it on a risk-reward graph and compare. It comes down to risk-adjusted returns, and do you earn your keep or not, whether you’re a single manager or a fund of fund manager.”

Pension funds have allocated increasing sums to hedge funds, including funds of funds, because of the evidence of 8-10% returns over the past decade. During that time there have been numerous crises – the bust, the sub-prime blow up, a banking crisis, the Japanese tsunami and now the European sovereign debt imbroglio.

“When you look at that, if you generated those 8-10% returns over a decade, whether you’re a single manager or a fund of funds, you’re pretty good,” says Souede. “I think that’s really the distinguishing characteristic of the value added proposition. With institutional investors, it’s also about the relationship, being the lamp lighter for them in this industry and being very respectful of their needs and wishes.”

Institutional investors that have experience of allocating to hedge funds using their own investment research and perhaps augmenting that with advice from consultants often take a relatively static approach. They may tend towards allocating to very large, well-known managers. In contrast, Permal looks to be much more dynamic in portfolio construction and will use managers that are of a relatively small size.

Delivering alpha
“With us, it’s all about the portfolio construction and the delivery of alpha,” says Souede. “In addition, for many of these institutional firms, it’s their first step, and they want to use us as a portion of their portfolio, even if they’re going to go ahead and allocate to single managers. They want our expertise and opinion to help them decide what to do with those allocations. We’ve got a whole spectrum of institutional investors, from those that let us invest on a discretionary basis within a mandate that they describe, to those who want to use us in a much more advisory role.”

Assets in funds of funds have slipped by about 40% to around $600 billion since 2008. Some of the multi-manager firms have seen assets shrink considerably, notably Man Group, Union Bancaire Prive and UBS, but others have proven to be more resilient. The reality is that a large proportion of institutional investors continue to invest through multi-managers. Naturally, there is a bias to funds of funds with stronger records of risk adjusted performance and with greater flexibility in terms of the options they offer to investors.

“With Permal, we’ve been consistent performers for a long time, through many periods of very difficult market conditions,” says Omar Kodmani, the London-based president. “But the managers have not been the same at all.” He cites the Hedge Fund Research database, which shows that less than 30% of hedge funds have a five year track record. “It means that 70% are coming and going within five years. However, in our case, because of the risk adjusted return, we’re still here.”

A valuable service
Risk adjusted performance may be the driver of any hedge fund business, but flexibility in how value is delivered to investors is also necessary. This can be a result of blending discretionary management with advisory work.

“I think there is recognition that discovering, selecting, allocating and changing allocations to managers, is a valuable service,” says Kodmani. “There’s an acceptance that this service is worth something, and it’s a question of how do you perform it. And to the extent, discretionary multi-manager firms like ours have delivered, there is an acceptance that there’s value for money there, and the service is worth paying for.”

As hedge fund investing has expanded in the 21st century, the mix of what a fund of funds can offer investors has grown. Competition with other segments, notably consultants, has also grown. But funds of funds do retain a broader skill base than most consultants, spanning due diligence expertise, portfolio construction skill and a history of discovering and working with managers.

“There’s a whole school of investors who for a variety of reasons – expertise, cost or innate conservatism — don’t want to try and do it themselves, or they’ve tried to build something and it hasn’t worked out,” says Kodmani. “There are many things that Permal brings to the table, and investors are becoming, in some cases, more selective about how they want to use professional allocators like us.”

Consolidation shuffle
After years of talk, funds of funds look to be undergoing a new wave of consolidation. Man Group recently acquired FRM and Arkie Busson’s EIM has held talks about the firm’s future.

Meanwhile, Gottex and Union Bancaire Privee have been acquirers in recent months. Though the deal flow that actually happens may prove to be relatively limited, the pressures pushing consolidation look greater than ever before. Rising operational infrastructure costs, shrinking fees and a squeeze on allocations for the fund of funds sector is pushing up the scale requirements. FRM, for example, was managing $8 billion, but still felt it lacked the necessary size to invest more in, for example, managed account infrastructure.

“My view is that because of the cost of meeting regulatory requirements and to provide all the things a firm needs in the UK, US and across the world, it’s getting difficult to be in our space at under $5 billion,” says Souede. “So, I think the barrier to entry has increased and the ability to remain small and meet all these regulatory requirements makes it very uneconomical, as you get towards a certain scale. Certainly we are going to see more rationalisation of the industry.”

Added pressure comes from the changed nature of hedge fund investing. With most allocations coming from institutions, and large ones at that, increasingly they will only allocate to firms that have an institutional infrastructure. This means providing an array of resources including (but not limited to) managed account facilities, analyst teams, regulatory compliance and high end reporting and risk management systems. It is also clear that the cost of running such a platform will only increase.

Portfolios in a RoRo market
Funds of funds and other investors have struggled to cope in the risk on, risk off (RoRo) markets of the 2010s. Long/short equities managers have had trouble adapting. In portfolios where Permal has full discretion over the construction, it has taken several steps at address the RoRo phenomenon. Aside from maintaining a prudent approach, Permal has put in a greater macro allocation to the firms that have directionality or which include long/short equity investing. With discretionary mandates, this has meant going heavy on macro towards the top end of the 15-25% range. With correlations exceeding 92% in 2011, very few long/short equity portfolios delivered the diversification that investors are generally seeking.

“What you are finding this year aremanagers have taken down their exposure and they’ve done so by reducing both the gross long and the gross short,” says Souede. “The idea last year of stock picking creating the alpha in a market that’s completely correlated proved to be a fallacy. So, from a Permal level: more macro. And from a long-short level, less net exposure.”

Moves in this direction got underway after the financial firestorm of 2008. Since then, interest has continued to be in macro and fixed income strategies over long/short equity strategies. “When you look at the United States over the last three years $1 trillion has gone into fixed income and $400 billion has come out of equities, which is one of the reasons equity markets have been so correlated there,” says Souede.

In 2012, through April, correlations in equities were cut nearly in half and long/short equity managers performed strongly as a group. But May saw correlations race upwards again. “It doesn’t matter, really, where you are in equities,” he adds. “It’s not pleasant and it’s not pretty.”

Paradoxically, perhaps, Souede expects demand for equities to become more normalised. With a less correlated market to pick from, the performance of long/short equity managers should thus improve.

With fixed income, the long-term cyclical uptrend of investment grade and government bonds looks close to ending so alternatives are needed. Lower duration bonds plays are attracting Permal’s interest, including long-short credit, leveraged loans and floating rate instruments. Though the late May ‘risk off’ episode saw safe haven bonds and gilts perform best, Permal doesn’t consider it to be a good long-term proposition.

The scenario for a shift back to equities would be political clarity on US fiscal policy and economic stabilisation. In the event, a bond market sell-off might take the US ten year yield from around 2% currently to about 3%. It would mean that the average US bond fund would drop about 10%.

“If that occurred, I think you’d begin to see the beginning of a migration away from fixed income back to equity,” says Souede. “But as long as fixed income is not losing capital, even if the returns are de minimis, I think most investors will tend to stay there. The very large institutional investors are very, very overweight to fixed income, because of sensitivity to losses, the regulatory advantages of holding fixed income and the lower volatility compared with equities. If there is a seminal change, I think you’ll see them changing their allocation pretty dramatically. But I think it’s going to require the first shock that, yes, I can lose money in fixed income.”

China strategy
The growth in emerging market investing, including fixed income, equities and currencies, has been one bright spot. Permal has combined all three asset classes for a strategy focused on China. Once again, the aim is to provide risk adjusted exposure to growth opportunities in those markets. With the equities allocation, the aim is to outperform the equity market but with half the volatility and beta. Permal is using separate accounts in order to keep control over assets deployed to both managers in Hong Kong and on the mainland. Like other equities strategies, the approach in China mixes sector specialists with more generalist managers spread among trading oriented and more value oriented approaches.

“The number of managers wanting to be hedge fund managers in China, whether Hong Kong or Beijing or Shanghai is booming, but the real incremental growth will be Shanghai-based,” Souede says. “The government is now facilitating in-flows and out-flows of capital more than they ever have and I think that is going to continue.”

Variable liquidity vehicles
Investor demand for liquid products has seen Permal develop across the liquidity spectrum, ranging from daily strategies, to weekly, monthly and bi-annual durations for investors who want to capture illiquidity premiums. One strategy approximates Permal’s established macro strategy but does it with the limitations of daily liquidity. It uses factor analysis from the longer duration macro strategy but replicates this in the daily strategy.

Permal has also developed strategies in UCITS for a handful of clients. It is a small part of what the firm offers but Souede says he never ceases to be surprised by where the investor appetite comes from.

“There are a number of investor groups outside Europe that are very focused on UCITS,” he says. “So, it’s very important if you’re going to cover this universe to have UCITS expertise and to know which managers out there have good compelling UCITS strategies, because we do get involved with advising clients on building portfolios of such managers.”

As part of Legg Mason, Permal has access to the resources of scale that most fund of fund operators can only envy. Whether it is backing for managed account infrastructure, expansion capital or providing US distribution muscle Legg Mason has proven a useful corporate parent.

“Legg Mason is a good parent to have,” says Kodmani. “They give that extra comfort level to large institutions, domestically, in the US and globally, who want to allocate to counterparties who are owned by a large independent asset manager. It makes us a great counterparty.”