The Boston Company is an asset management subsidiary of the Mellon financial services empire. Founded in 1970, it currently reports over $67 billion in terms of assets under management.
This month it launches a new fund, a global equity market neutral hedge fund product with an annualised performance target of 6-9% above a three-month T-bill rate benchmark, and four times leverage (200% long/200% short). The important difference here when compared with previous market neutral offerings from this house is that leveraged element, with an offshore feeder structure for non-US investors (The Boston Company Equity Market Neutral Offshore Portfolio).
The Boston Company is no stranger to market neutral management: it has been running a strategy for 15 years, and it has already compiled a track record of managing a similar market neutral portfolio without the leveraged component.
The key figures involved with the new fund are long-term capital markets veterans who have spent years working within the Mellon organisation, and are very familiar with the US equity market in particular.
The leveraged launch is the brainchild of Sean P. Fitzgibbon, CFA, Senior Vice President at the Boston Company and the lead fund manager. As the manager, he will be tapping what he calls 'alpha sources' generated by over 50 investment professionals at the Boston Company, in order to come up with what is, in essence, a best ideas fund. The fund is setting out to achieve equity-like performance, with bond-like volatility, and low correlation with other asset classes.
Market neutral as a strategy was first launched at the Boston Company by its large cap core team back in 1992. Fitzgibbon, who took over as portfolio manager of the strategy 10 years later, started incorporating other teams, like the small cap growth and small cap value teams, into the investment ideas process. "We incorporated their best ideas by giving them 10% of the portfolio," he says. "We built a system that would allow us to track their performance."
Next up it was the international core team, which ran a paper portfolio for six months before the strategy incorporated ADRs to replicate the performance of foreign stocks. The core research team, which supports the company's other portfolio management teams, started providing its own ideas in 2005. The small and mid-cap opportunistic value team joined the mix last year. Fitzgibbon believes that it is only by including the ideas of 50 plus investment professionals that the fund will be able to realise some serious alpha. "The addition of core research to the mix has been very successful," he says. "We wound up with superior information and higher returns."
"Many of our research professionals are industry experts," says Fitzgibbon. "They also support our large cap value and large cap growth teams. They also help with running sector funds and an analyst portfolio, but they largely focus on supporting large caps."
The large cap core team maintains the overall portfolio, but individual teams can buy and short whatever they want within the allocation they have been given. The only hard and fast rule they have to adhere to is market capitalisation: they cannot buy anything under $300m. "Each team has its own process," says Fitzgibbon. "I cannot veto or override a name. I've talked to them in the past about the appropriateness of names. We will have cases where one team will want to short a stock that someone else has long." He is, however, at pains to point out that there is "virtually no correlation of the alpha" being produced by the various teams (see 'Risk management' below for more on this).
Capital allocation between the individual teams is based on what they feel they can manage at any given time. Much of the internal discussion in this respect is chaired by the firm's CIO, David Cameron, who founded the Boston market neutral strategy in 1992. The discussion can turn to the opportunities the teams are seeing on the long side of the book, but the real limiting factor in terms of the capacity they can manage is how many short opportunities they can find.
The portfolio managers within the various teams work closely with their analysts to see if they can find decent long and short opportunities within their respective universes. The large cap team focuses on Russell 1000 stocks, while the small cap teams research the Russell 2000 universe
The international team covers 1800 securities, including the ADRs, GDRs, and securities that can be converted into foreign stock. The strategy also has scope to invest in currencies, and forward contracts in order to settle trades.
The Boston Company argues that one of the unique features of a market neutral portfolio is that it allows a manager to concentrate in the sectors where their skill set is strongest. Historically, sectors like health care, consumer discretionary, and financials, have generated the highest and most consistent returns. These sectors have had the largest weightings, averaging about 20% of overall capital. By combining the best ideas of its various teams, it is throwing its net wide, across the US equity markets, and some of the best global stocks. It represents a level of coverage which few market neutral funds would be able to match.
The firm's small cap team in particular is good at generating alpha, but unfortunately does not have the capacity to increase the size of its allocation. Dealing as they do with smaller companies, it is also harder for them to obtain good short positions. One of the most interesting contributors at the moment is the mid-cap opportunistic value team. They are expected to produce a negative correlation to the rest of the portfolio as a result of their contrarian style. Their long ideas tend to be companies trading at depressed valuation levels. This brings meaningful style diversification to the fund, and the team has been one of the best performers in 2006. "Managers are honest enough to say they don't have any good ideas," says Fitzgibbon. "They are allowed to reduce their role in the fund." Fitzgibbon doesn't want portfolio managers feeling compelled to come up with investment ideas, and consequently recommending stocks that ultimately won't benefit the fund. "They are judged on the spread between their longs and their shorts," he says.
The attribution report received by CIO Cameron will demonstrate what contribution the respective teams and their personnel have contributed to the overall performance of the fund. They are rewarded for generating alpha, and this forms the basis for the bonuses they get paid. "We wind up being more likely to take capital from the team with weak performance and giving it to one with strong performance," says Fitzgibbon.
The Boston Company can now also draw on its international core team, which started off trading ADRs, and which now trades on non-US markets. The final addition to the formula was the US small and mid-cap opportunistic value team, which started contributing ideas last year. Altogether, this adds up to six sources of alpha which, combined, also helps to reduce the volatility of returns via diversification across both market capitalisation segments, and investment teams with their own ideas generation mechanisms.
The strategy of having six alpha sources means that a capital allocation decision has to be made at the outset. This is carried out by the lead portfolio manager and is evaluated on a quarterly basis. At this allocation meeting, the heads of the various Boston teams attend, along with the CIO. On a quarter-by-quarter basis there is usually call to re-allocate the portfolio to some degree between the teams, based on who thinks they have capacity, and who is obviously generating alpha. The large cap core will tend to remain below 50% of the total portfolio, however, and Fitzgibbon says he would rather launch a dedicated large cap market neutral fund than increase large cap to a dominant position within the Global Equity Market Neutral Fund. Right now, capacity within this fund is being forecast at $3bn, so there is plenty of scope to grow it as the investment comes in. With the actual asset management formula determined, it was time to look at the leverage. "We realised we needed to lever the fund," says Fitzgibbon. "We simulated the performance for a leveraged version: we doubled the alpha and took off 30 basis points in borrowing costs. It took the fund well into double digits in terms of its range of performance. The standard deviation picked up also."
The new Boston fund will be employing standard risk controls for a market neutral vehicle. One of the interesting things Fitzgibbon noticed about the risk exposure was how it began to dwindle as other teams were added to the portfolio mix. "Whenever you do optimisation, you run the risk of taking away alpha," he says. "With this fund there is very little factor risk."
Particular attention is being paid to hedging away sector and industry risk, as the Boston Company is focusing heavily on security selection to add alpha, rather than overall sector or market trends (despite the recognition of how some sectors have historically provided the strategy with returns). The overall portfolio will be hedged on a dollar basis to within a small range. Each portfolio segment, be it large cap core, small cap growth, small cap value, international, mid-cap opportunity, or core research, will be dollar neutral to within a small range as well. The overall portfolio is also going to be monitored for a net long or short position in various market capitalisation ranges.
The Boston Company is bringing a very interesting product to the market here. It represents a proven market neutral strategy with a very long track record, being responsibly managed by a fund manager which itself is part of one of the USA's most established asset management and banking entities, with impeccable blue chip credentials.On top of this, the fund has excellent liquidity and capacity levels, and the fact that so many investment professionals are involved in determining the portfolio removes much of the potential portfolio risk exposure.
In some respects, it looks almost like a fund of US long/short equity funds, with the underlying managers specialising in various segments of the market, but without the extra layer of fees and liquidity issues.