The premise for launching the Special Opportunities Fund was primarily to access managers who are very much in control of their own destinies in terms of the positions they take, whether they be fixed income or equity situations. What that really means is activist strategies, distressed or stressed strategies, and a number of focused long/short equity strategies. The fund itself has a 12 month soft lock-up for investors, and during the first year of investment there is a 5% fee to come out, at quarterly notice. The portfolio itself is invested to a greater degree in underlying funds with lock ups.
The groups that are offering these products are for the most part quite familiar groups, in that they have more specialist and esoteric products themselves which are more interesting for this portfolio. The portfolio itself is quite clearly focused – it has 20 names currently and, by our own strategy classifications, is invested around two-thirds in what we call Multi-Strategy/Event Driven, but which you could call event-driven strategies. It has a small allocation to distressed, but that really doesn’t fully encompass distressed, as there is a distressed manager within the Multi-Strategy/Event Driven component as well.
Twenty is about right. The fund takes money in quarterly, and the next opening is for the end of the year. We expect decent inflows to the fund because of the performance. We launched the fund with around $250 million, and we had a take-in in June of another $250 million. Given the summer months, and what happened to hedge fund performance generally in August, at the end of September we took in a much smaller amount of money, hence the difference in the valuation now and the end of June is really one of performance.
I wouldn’t envisage increasing the number of names. If we took in another $250 million at the end of this quarter, we’d add to the existing names, and have maybe one more new name in there. The majority of the names we have here, we can add to.
Much of that is looked after for us because of the higher allocation to the Multi Strategy/Event Driven. When we invest in funds like Fortelus, which we class as Multi Strategy/Event Driven, it really invests across stressed situations in fixed income, across Europe, to a great degree. They are finding lots of interesting new ideas in their space, particularly as a result of what happened in August. Hedge funds are really able now to charge a premium for lending money to mid-sized companies who would otherwise be finding capital sourcing a lot easier from traditional sources of capital such as banks, but the environment has changed now, at least for the next six months or so. Funds like this are in a position to generate superior performance over the next six to twelve months.
We assess the manager and their ability to generate opportunities across different sectors over the different points in the economic cycle. That means we don’t have to jump in and out of funds, as most of these funds are offering fairly poor liquidity terms. We don’t want to have to pay too many redemption penalties for redeeming from a fund after a six month period, hence the nature of the portfolio.
The biggest holding in the fund is the Harbinger Special Situations Fund, a more focused version of the flagship Harbinger. That’s a fund which has generated very strong performance during the course of the year. The main source of its performance has come from the shorting of the US sub-prime position within the fund, but they also have positions in particular equity and fixed income situations where they have significant size and focus on a company’s future. That fund, for example is up 159% this year. Strip out the sub-prime short and it is still up 125%, so it’s not just a one trick pony. That’s been a strong contributor towards the performance of this particular product, and it is now the largest single position in the fund at 9.6%.
We have activist strategies in here which have performed well to date, and activism going forwards will still be an interesting area for the fund. Perhaps the exits for activist managers will come over a longer duration given the new environment, but we still believe in it as a strategy for the portfolio. In terms of increasing areas within the fund, one area which is much talked about is distressed real estate securities, and we’ve seen a few groups launching products in that space. What they’re really telling us is that the opportunity is coming, but it is actually going to take quite some time before you really want to be in a fund which is going to be long these sorts of securities, when they’re still going through the process where the actual valuation of these securities is gradually being realised by the street, and by what’s happening to fundamentals. We may allocate to a name in that space at the end of Q1 2008, but it is a little bit early at the moment.
Again, if we take a more broad brush assessment of distressed generally, especially in the US, I think that’s too early to say: it may come in the second half of 2008. It really depends on what the US economy does, on interest rate cuts, and how it reacts to the housing market. We will wait and see there before adding any dedicated names in that space.
We’ve taken no names out of the portfolio – we’ve still got all the original names in there. Changes come when more cash comes into the fund. We haven’t yet had what we call a diligence event on an individual name which would precipitate a redemption of that fund because of worries at the group, whether people-related or risk management. We’re very happy with all the names in the portfolio, turnover has been low. If you look at our more liquid fund products, such as the GH Fund, turnover has been approximately 15% per annum. In the case of this portfolio it has really been adding one or two new names to the portfolio as we’ve grown it. For example, we added the Lansdowne UK Strategic Investment Fund at the end of June, along with a small holding in Cerberus, and the Stark Global Opportunities Fund.
The fundamental part of the risk management for our process is effective due diligence. We rely on this first and foremost, with teams of analysts in London, New York, and Asia. The analysts are very much a part of the investment process, so when we manage this portfolio – and we do manage it on a monthly basis just like all our other funds, despite the fact that it is less liquid – we use two investment committees. The first committee really enfranchises the analysts who speak up with their ideas for any portfolio, on any new funds they have seen over the course of the previous month, as well as any funds that are on our watch list which we should take out. We then go away for 10 days, and convene a second investment committee towards the end of the month, which decides what we should do with our portfolios.
In the case of this fund the turnover has been very low, with the activity only taking place when we’ve actually had a close, at the end of each quarter. The composition of the investment committee, which manages the portfolio, consists of myself as head of portfolio management, Peter Rigg, who is Head of Global Research and Head of the Advisory Business now based in Geneva, as well as the three regional Heads of Research: Clark Cheng in the US, William Benjamin in Europe, and Stephen Dickinson in Asia. Those are the five voting members, and they have a flat majority vote in terms of names for each of the products.
It’s quite scalable at the moment. We could take it to a billion dollars without really changing the shape of the portfolio or having to add any new names. As you know capacity is a dynamic assessment: if the situation changes, or the opportunity set changes or contracts, that affects the opportunity set of the fund. The current environment for hedge funds and hedge fund strategies is excellent, and we’re seeing that with the performance of the product. At the moment we’re happy to take it to a billion over a short space of time, and then we’ll assess it at that point.
I think it’s a valid strategy, full stop. It clearly doesn’t work under certain physical environments, for instance it works better in northern Europe than in southern Europe. Currently in Japan there are still too many opponents for it to work really well, but I think that will change. Efficient use of capital and the more efficient valuation of assets is something that is good for shareholders and more positive for the overall investment community. As a strategy it does have a strong remit for shareholders. We have the Icahn holding [in the fund] which is probably one of the most prominent of activists, and that holding has done quite well for the portfolio.
I don’t think activism as an opportunity will expand or contract organically, it will more likely remain at current levels. It is pretty much a function of the quality of the individuals who are involved in the process. Sometimes those individuals have such prominence that when they start talking about a company, the story starts unfolding and accruing its own momentum, perhaps wrongly, but it is our job to access the best individuals in that space, and add them to our portfolio.
The individuals get those names because they have been successful in the past. If we believe that they can continue that success, then we will allocate to those strategies.
THFJ: Distressed has been a strategy that seems to be generating increasing interest from investors in the second half of the year, with substantial net flows into specialist distressed funds. Do you see this as a medium to long term trend, or merely a short term reaction to the summer’s credit problems?
To me it is not entirely clear whether there will be a significant opportunity in the near term. I think we can afford to wait. I know other groups are happy taking in capital on the back of this story, because of what’s happened, but the underlying fundamental opportunities for generic distressed still haven’t availed themselves promptly within markets. We have traders who specialise in niche sectors, whether it’s smaller capitalisation sectors or just having superior knowledge in particular areas, rather than seeing greater opportunity across generic distressed.
If you measure the opportunity by default rates, actual default rates rather than what is priced into the credit default swap market, then clearly we’re not there yet. For our portfolios we’re waiting to see: we’re aware of the launches that have taken place, and the capital intakes to some of the big groups that have been initiated. We think in certain sectors this story will become more interesting early next year, for example the asset-backed securities sector is going to be interesting for individuals and groups that really know what they’re doing, rather than just using it as a marketing tool to raise money.
THFJ: Do you see there being more demand for specialist funds of hedge funds like this one going forwards? Is that something you as a house see as a trend?
There’s always going to be an appetite for more esoteric ideas within portfolios as the fund of funds industry becomes much more centralised and mainstream. If you want to differentiate your product away from others’, it becomes more difficult. With the launch of this fund, we saw the opportunity, given the research that had been thrown up by the resources of the group, and put this together. There’s probably an opportunity to do something else next year with longer duration strategies, perhaps frontier markets, perhaps frontier structures within clean energy, and that could be something we might look at. These are just ideas that have not grounded themselves yet. More generally, our mainstream flagship fund of funds has a life of its own because of the flows and because of the performance, and has an 11 year track record now. Going forward, however, we’re going to see more products which offer lower liquidity, as the big launches go to quarterly rather than monthly or 35 days’ notice.
Other long funds which are investing in strategies which are producing performance diversified away from headline indices or equity markets generally have to offer low liquidity. They generally have to be in situations which are perhaps far less liquid, investing in arable land in the Ukraine or getting involved in taking over a company, for example. That really involves locking up liquidity. You could offer a portfolio that is doing that and offering a diversified approach for investors, away from more well known asset classes, but then that is going to require less liquidity. I think we’re going to see a few launches like that.
THFJ: It seems, given the flows you’ve had into this fund, that the investor community is happy with the lower liquidity set up, if they’re told in advance that the strategy requires it.
Investors in the past seem to have been very happy to hand over money to private equity groups, which have very poor liquidity, so to have something which is in between, which is generating very strong returns – and you can see the returns from the underlying holdings and where they’re coming from – then that should be a potential investment for clients.
We see all funds where there’s any risk capital against them, whether it be investments or credit. We see the managers at least once a year on-site, and the analyst speaks to the managers at least once a month to get an update. Before we invest we carry out investment due diligence and a separate operational due diligence.
Within our flagship fund of funds we make use of modest leverage – it’s 10% maximum. We run the fund at 5% leverage on average at the fund of funds level. This product [Special Opportunities] has no leverage, other than the frictional costs of coming out of funds, which we employ for redemption purposes, but not for investment purposes.
Idea generation is very much bottom up. We have all the databases which we use to perform the specific performance metrics comparisons over different time periods. We also get ideas from our client investments, from people moving around the hedge fund industry. Someone might come out of a shop who has very high repute and launches a strategy – that might lead to an investment.
We also get ideas from within the bank. We’re a big bank and we’ve been advising sophisticated hedge fund clients on their investments since the late 1980s, so we get ideas from there. Of course, we also get ideas from external sources like prime brokers or hedge fund sponsors. It comes from different angles.
We don’t seed – we don’t take an economic interest in hedge funds. We do on occasion buy into new managers, but they will tend to be a new manager within an established shop or maybe a new manager who has extensive experience of that field. All of the holdings we have in the current portfolio are with established managers. [The minimum track record] is at least three years, but some have 10 or 15 years. The average duration of the managers [within the portfolio] who have been investing in this style is about 10 years, which is quite established, certainly within the hedge fund sector.
Not for this portfolio. It’s unlikely the fund would be invested solely in Asia, clearly, but it’s not part of the remit.
We do not have a dedicated carbon trader in there, but we do have [carbon trading] within one or two of the holdings already. It’s currently quite small, but like all these things that started off as interesting and became mainstream, the natural returns that are currently there, and the inefficiencies which derive from a lack of understanding of that particular market would probably disappear quite quickly, but that’s the nature of the arbitrage.
As Head of Portfolio Management and a member of the HSBC Alternative Investments investment committee, Gascoigne is responsible for the management of the funds of hedge funds and the alternative discretionary mandates. He joined HAIL in 1996, after spending 3 years as an equity researcher and member of the strategy team with Mercury Asset Management. He is IIMR accredited, and earned the Chartered Financial Analyst designation in 1997. He has an honours degree in monetary economics from the London School of Economics.