Q&A: Philippe Bonnefoy

Director, The Cedar Fund

Stuart Fieldhouse
Originally published in the August 2005 issue

Philippe Bonnefoy is a director of the Cedar Fund, a fund of hedge funds that he founded in 2002. Bonnefoy was first profiled in the launch issue of this magazine in August 2004. Since then, the hedge fund market has been under increased scrutiny in the national press, with plentiful speculation about whether a lack of good returns this spring spelled disaster for the asset class. He met up with The Hedge Fund Journal's Stuart Fieldhouse to address some of the trends he is seeing from a fund of funds' perspective.

Do you think the performance of hedge funds as an asset class this year has damaged their prospects with new investors, particularly institutions?

Returns in all major asset classes have been pretty mediocre this year. Currently, most funds of hedge funds are just either side of break-even for the year. During the same period US equities have performed poorly, and global bond yields have generally produced yields beneath the liability targets for these investors. Unlike other asset classes, fund of hedge fund returns have been positive in every year since indices have been compiled. Actively managed funds of hedge funds can use a top down strategy allocation to adapt to market conditions and be opportunistic with manager and strategy allocations.

Some institutional investors continue to tell me about their fear of making an investment into hedge funds. Yet when I look at their allocations and then I look at hedge fund returns – funds of hedge funds have been accretive every year over the past five years, and over the last 15 years have outperformed both bonds and equities by some margin, and in the case of equities, have had 40% less volatility.

We have recently experienced two of the largest ever bull markets in bonds and equities ever seen – yet over the last 15 1/2 years the returns from traditional assets classes in comparison to hedge funds have been inferior.

Should institutions invest in absolute return strategies at all? The question should probably be, should institutions maintain naked, un-hedged long equity and fixed income exposure? In a recent study, Ryan Labs Asset Management calculated that on June 30th, 2005 defined benefit plans (which capture 95% of US pension plans) had an average funding ratio of 67.3% of liabilities. This had fallen from a 101.2% at December 31, 2000. In a world of low interest rates and low equity market returns, and rising liabilities, it appears that a number of these institutional investors may be heading towards a massive crisis unless they begin to embrace a better asset allocation policy – or better liability hedging.

Another trend that has surprised me greatly is that a number of institutional investors, who are trying to match long-term liabilities, are now looking at almost daily returns provided by hedge fund indices – at the same point they're professing to have a 7-10 year investment view.

Do you think this is the fault of the index providers drawing the attention of investors to monthly returns, particularly newer investors?

Index providers have donea good thing for the market by allowing institutional investors to feel more comfortable with transparency, liquidity, and knowledge, or simply that hedge funds could have a benchmark. Bear in mind however, that one of the reasons investors choose hedge funds is because they're not supposed to be benchmarked. They are supposed to be delivering positive absolute returns.

One of the most frequently discussed reasons as to why long-only investors decide to start long/short hedge funds is because they think that there is just too much risk always being fully invested, long and exposed to the vagaries of the equity market. The ability to remove the tyranny of always being fully invested in the equity markets would have probably resulted in much better investment returns. Remember in the decade of the start of the bull market in 1982, equities went nowhere. Benchmarks work great when markets are going up.

The primary job of a fund of a fund of hedge fund provider is to create a stream of revenue which is uncorrelated to traditional asset classes. A fund of a fund of hedge funds can provide investors the highest source of alpha available in the hedge fund universe at the lowest risk.

Do you think there is a shortage of long/short managers out there who are really worth their salt in this respect – i.e. very little beta and decent alpha?

I think we'll find out in the next downturn – the downturn post-2000 was so dramatic, that the great majority of equity managers, including long/short managers, were too long of the market. I think the industry has qualitatively improved its skill-set and risk management capability. This includes the allocators. Almost all hedge funds are better risk managers now than they were five years ago. The thousands of new funds that have started in the last five years have also been reared in a market that did not go ever upwards, like the late 1990s. As such, these managers are much more focused on alpha, rather than just running a leveraged bet on market beta.

The best long/short managers should thrive: it should be a true stock-pickers' market. A fund with zero beta exposure should do quite well. The question is, how many long/short funds have no net market exposure? How many are truly long/short, not just closet long funds with some shorts thrown in for good measure? If you do have a drawdown in equity markets, which I believe may be beginning as we speak, then we'll see who is really doing the job of creating absolute returns.

In terms of the way the industry has been covered by the broadsheets, there seems to have been a lot of negative publicity about hedge funds, potentially even spooking some potential institutional investment in the asset class. Do you think there is anything either individual firms or the industry as a whole can do to rectify that?

Hedge funds are not traditional advertisers. A newspaper does not need to commit financial resources to cover hedge funds. Only Bloomberg and the Financial Times have dedicated hedge fund reporting. I think the general media wants a story. The reporters are dying to cover another LTCM-type collapse. It's a sexy story. It sells newspapers and it interests the general readership.

The likelihood of another LTCM type scenario is very, very small. The hedge fund industry has matured greatly, and the expectation of hedge funds returns has also matured. Institutions have become much more of a driving force in the hedge fund business and they are not seeking 40% annual returns. Institutions are seeking consistent positive returns with low volatility, risk exposures are being closely monitored by counterparties and prime brokers, and they are working in a more controlled environment. They don't want to be on the other side of a hedge fund blow-up.

The chances are that the story of a hedge fund failure today is much more likely to be a boring tale of multi-month sub-standard returns causing a fundto lose investors, becoming sub-critical in its business scope, and shutting down because they're beneath the high water mark. A story about another private company executing poorly on a bad business model, producing sub-standard returns to shareholders, doesn't sell newspapers.

The other issue is that non-specialist reporters don't understand many of the complex strategies pursued by hedge funds. They don't have the time, and to be frank, they don't have the interest. Hedge funds can rectify this by better communicating with the public in general and the press in particular.

Isn't it the nature of the beast, though, that most hedge funds over a five year period will at some point decide to call it a day, and give the money back to investors, because they don't think they will be able to continue to sustain their returns?

There are many hedge funds that have long, successful track records. It often depends on the individual, the strategy that they are pursuing and the type of firm they have created. The majority of managers love what they do – and they get paid well for it. If they are very successful, they can accumulate a lot of assets, and fees continue to grow. These are usually driven 'type A' personalities – if they go on holiday, they are reading e-mails from their Blackberrys on the beach. They are not focused on retiring – they are focused on winning.

Strategies like long/short or global macro can absorb infinite capital. They're really only constrained by their ability to place capital effectively. You now have a number of firms with assets under management over $5 billion under management, which have better infrastructure and management, than some investment banks. These firms have created institutional franchises. Why would you want to call it a day when you run a successful business and investors are knocking down your door to give you money?

As allocators of capital, we monitor and scrutinise the returns of all of our current and potential hedge fund investments for signs of managers who have become too complacent, lost their edge, or those who are running their funds as a retirement annuity.

Do you think there are too many managers in the market now? Some people are claiming it is harder to make money in this industry now than it was 10 years ago.

What has really happened is that the universe of opportunities has greatly increased. This is both positive and negative. On the one hand, it is much harder to find exceptional managers because the selection universe is much wider and requires greater scrutiny to find the truly superior hedge funds. However, from an investor's perspective, it is an advantage to have a larger universe to choose from in order to sculpt a portfolio which will achieve better risk adjusted returns.

Screening funds is much easier to accomplish when your relationships allow you to call the heads of trading desks around the world to check the provenance of managers and their investment skills, not to mention long relationships with the managers themselves. A great CV does not always make a great manager. We saw one new manager who legitimately claimed he was a senior management executive at a well known fund. What he didn't mention is that by the time he was running his part of the firm, it had given all the money back to its investors, so there hadn't been much managing to do. Intimate long-standing market relationships and the experience of having managed a number of the underlying strategies makes our job a lot easier.

In spite of the proliferation of hedge funds, strong returns are still very achievable. Certain strategies have been more highly impacted than others. Risk arbitrage is a good example, there is a finite number of deals and a lot more money chasing them. This drives returns down to levels that are not particularly compelling on a risk-adjusted basis. Other strategies, like long/short equity and macro investing are relatively un-impacted by more competition. Is that why large funds of funds organisations are building their own dedicated in-house research capabilities?

Yes, it gives them a very good insight into the development of the underlying strategies. As hedge fund strategies develop, they become more sophisticated, more qualitative in many cases. You need people who understand the strategy themselves – it really helps if they have traded them. More importantly, as institutions have become more important as allocators of capital to hedge funds, the intermediating platforms, the funds of hedge funds, have had to come up with more of an institutional approach. You need a number of people doing regular infrastructure reviews, qualitative reviews with the managers, and also being able to turn that interface back to the client, so that the end owner, be it a pension fund in the US or an insurance company in Germany, can understand where their capital is invested, and how that affects their risk profile.

As an institutional investor, presumably it's more important to be in there before the $100m benchmark is passed, rather than afterwards, in order to stay ahead of the 'pack'?

It is important to be involved in a fund early, but you don't have to be invested on the first day. It is a distinct advantage to have spent a lot of time in the business, so that one gets that 'heads up' from former colleagues who are now running funds, banks, and other trading platforms. Those contacts can often point out new hedge fund start-ups to whom you should be paying attention to. With the increasing amount of money seeking alpha-generating hedge fund investments, those relationships are critical in obtaining early information about powerful new talent that you might otherwise miss. This process is often repeated when talented traders approach me for advice about what sort of fund they could set up if they had the opportunity. That's part of the role of the fund of funds investor profile: to help the market with its development. One of its dividends is meeting people at very early stages of their development, and having better access, including access to more capacity as they grow. It is helpful to be geographically located where investors and hedge fund managers are working, be it New York, London, Geneva, Hong Kong or Tokyo. Accessibility to managers is key, so that when a fund reaches that critical closing stage, you've done your homework and can make a final investment decision quickly.

Do you think there are too many funds of funds out there right now?


Do you think there will be less a year from now?

The middle market will suffer most. There will always be a role for niche players, like trust agents and family offices with a couple of key clients. Alternatively, there are the super-platform providers who have achieved institutional scale and are using that scale to obtain $300-400 million allocations from institutional investors. It is the middle market of firms that will be in the most difficult position. They aspire to be institutions, but are faced with the challenge of being innovative at the same time as they are tackling the infrastructure demands that institutions require. In many cases, these middle-market fund of hedge funds have difficulty articulating their value proposition.

Do you think fees are going to be driven down?

For years we have been expecting downward pressure on fees. But in reality fees have, if anything, gone up. People who perform can ask for whatever fee structure they want. Institutions that have been paying these prices have accepted that the demands they're making of funds of funds require a lot of infrastructure, a lot of money. It's not something you can do on the cheap. Of course, there is a business case to make for cutting fees in orderto attract massive asset growth – and then sell your business. This is the asset gatherer approach. As an investor myself, I would rather pay full fees and know my manager lives and breathes his business and shares in my successful investment. I don't want to be the one that makes an asset gathering operation grow larger so that the manager can exit the business. I believe in long-term partnerships.

A lot of people outside of this business criticise funds of funds for their fee structures. The best role for funds of funds is to be aggressive in their search for developing managers, making investment allocation decisions based on their assessment of the underlying market and judgements about the individual investment teams. The analysis has to be proactive. It can't be done by simply reading industry publications and making a couple of trips a year. It's hard to find analysts who are good and experienced investors, and they know what their market value is.

Do you see the so-called wall of new money coming into the market?

At the end of last year, a 'wall of money' would have been a good description. But now, I wouldn't call it so much of a wall, as capital has been coming out as well. In particular, mass-affluent investors have been redeeming as they believed that hedge fund performance would be positive each month – like cash but with more return. However, these investors who react impetuously to short term market performance, and are leaving to invest in rising equity markets, are being replaced with a net increase of new investment from institutions.

A number of institutional investors are on autopilot. CIOs have decided that this is a viable asset class that offers returns that are anomalous to other traditional asset classes. A portfolio allocation to a fund of hedge funds adds alpha, decreases portfolio volatility, and as such they want to have exposure. The difference between high net worth and institutions is that a few basis points up or down each way is not going to make much of a difference to the allocation process, particularly with their longer-term investment horizons.

Institutional portfolio allocation to hedge funds, particularly in Europe, is typically between 1-3%. In contrast, most Swiss private banks and European wealth advisers, have between 15-20%, or in some cases 25-35% of client assets invested in hedge funds. Some are using fund of hedge fund exposure as a bond substitute, some as an equity substitute. In the case of institutions, because it's a new asset class to them, decision makers are cautious and employ a much more procedurally driven process. They will grow their exposure gradually, possibly to as much as 10-15% of their assets. The difference is that an institution with $20 billion that goes from 2% to 5-6%, will be committing an awful lot of new cash to this market. Consequently, redemptions from wealthy investors in amounts of $5-25m coming out of hedge funds are being replaced by new allocations in amounts of $200m or $500m from pension funds, insurance companies, and endowments.

Do you think the industry is becoming too commoditised as a result?

It runs the risk of becoming too commoditised. One of the goals of investors should be recognising that you don't want to be benchmarking this asset class. Over time, the key is to find the best possible managers and strategies to express the view you have. You need a forward-looking investment view. If an investment committee simply selects from strategies that made money in the past, then they are not going to do very well. I like to think that we in the funds of hedge funds business support managers that are searching for, and exploiting new market anomalies, new opportunities, new sector- specific funds, and new quantitative approaches. We support all the efficiencies that hedge funds bring to markets, plus the ability to intermediate the capital that institutions provide.

Quite frankly, hedge funds have been instrumental in the growth of credit, interest rate derivative, mortgage, index and volatility arbitrage markets. The result has been everyone pays a lower cost for market hedging and credit protection. In particular, in the case of interest rates, it has lowered the costs of home mortgage finance. I think that is a good thing, don't you? Many of the market reporters and commentators who are looking for the next hedge fund "blow up" fail to realise the hundreds of billions of dollars have been saved by corporate treasurers, pension fund managers and consumers due to the market efficiency driven by hedge funds finding new anomalies to exploit and new ways to arbitrage markets.

If I were an institution, right now, that had been sold on the merits of the hedge fund as an asset class, what would be the primary piece of advice you would give me?

The market has matured to a level where institutions should be extremely comfortable with hedge funds as an investment. They typically have better controls than those that exist in many securities houses. They employ people who, in many cases, controlled risk and trading departments at the major investment banks.

Investors should have realistic expectations of their investment return target versus their risk tolerance. They should be patient and target the number of years that they want to be invested in, in order to ride through the intermediate cycles that generally affect all markets. As an example, this year has been lousy – low volatility, tight trading ranges, rising short term rates, flattening yield curve – challenging conditions for most investors, particularly for relative value and arbitrage specialists. These conditions aren't permanent. We are invested with some of the smartest investors on the planet. They will make us great risk-adjusted returns – but I need to give them enough time to do that. In any market, you need to give some "room" to your trade. Sometimes in markets you sail into the wind, and sometimes the wind is at your back – and so it goes for investments in hedge funds and fund of hedge funds.

Philippe Bonnefoy began his investment banking career as an analyst in international corporate finance at Kidder, Peabody & Co. in New York in 1983. Subsequently, he transferred to a new London-based team that was to be responsible for the group's international fund management efforts, where he was responsible for international equity portfolio management. In 1988, he left Kidder and joined ex-colleagues in a newly created international risk arbitrage proprietary trading group. Over the next eleven years this private group became one of the world's largest proprietary trading firms. When he retired in 1999, Bonnefoy was a member of the management board and head of trading. Since then he has managed his own investments in hedge funds, private equity and real estate and consulted for financial institutions. In 2001he founded Comas Management Limited which is the independent investment advisor for Alternative Investments to Commerzbank Corporates and Markets and to the Cedar Fund.