The Quiet Rewire of Portfolio Construction ft. Cian Walsh

[00:00:00] Cian

It’s very much a credit focused investment mindset about not making mistakes, being sufficiently diversified, and putting together a robust portfolio that’s going to generate income over time. So, there is a convergence there which we need to be aware of. I think that’s the right approach. You’re getting an extra element of diversification there as well.

[00:00:34] Intro

Imagine spending an hour with the world’s greatest traders. Imagine learning from their experiences, their successes and their failures. Imagine no more. Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world so you can take your manager due diligence or investment career to the next level.

Before we begin today’s conversation, remember to keep two things in mind. All the discussion we’ll have about investment performance is about the past and past performance does not guarantee or even infer anything about future performance. Also understand that there’s a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions.

Here’s your host, veteran hedge fund manager Niels Kaastrup-Larsen.

[00:01:30] Niels

Welcome and welcome back to another conversation in our series of episodes that focuses on markets and investing from a global macro perspective. This is a series that I not only find incredibly interesting as well as intellectually challenging, but also very important given where we are in the global economy and the geopolitical cycle.

We want to dig deep into the minds of some of the most prominent experts to help us better understand what this new global macro-driven world may look like. We want to explore their perspectives on a host of game changing issues and hopefully dig out nuances in their work through meaningful conversations.

Please enjoy today’s episode hosted by Alan Dunne.

[00:02:14] Alan

Thanks for that introduction, Niels. Today I’m delighted to be joined by Cian Walsh. Cian is Head of Hedge Funds and Private Debt at Formue, in Norway. Formue is one of the largest independent wealth managers in the Nordic region. In his role, Cian leads a team responsible for selecting and allocating the hedge fund and private debt managers. He’s worked in the markets over many years on the sell side and the buy side. Was previously an emerging market debt portfolio manager at BlueBay.

Cian, great to have you with us. How are you doing?

[00:02:43] Cian

Thanks very much Alan. Great to be here.

[00:02:45] Alan

Good stuff. Great to get a Nordic perspective. We haven’t had that before I don’t believe. And you’ve had an interesting route to living in the Nordics. I know you’re a fellow Irishman, but you’ve taken along an interesting route to ending up in Norway. So, tell us a bit about your background.

[00:03:03] Cian

Yeah, it’s, it’s been, it’s been quite a journey. So, as you say, Irish, grew up in Ireland, but only until around 8 years old. Then my family moved to Africa, to Zimbabwe. So, I guess that was my first taste of emerging markets. Spent about six odd years there, then back to Ireland, and then on to Scotland to study.

I studied actuarial maths and statistics and found myself working in London on the sales side, initially. I was hired by a client after about 18 months/two years and then moved on from there to a startup firm called BlueBay Asset Management. So, there was, I guess, my first sort of real money management experience. I started initially on the hedge fund and then found myself starting a new fund on the local currency side.

[00:04:01] Alan

Good stuff. And obviously at some point you made the jump from trading and portfolio management to allocating. Did that coincide with moving to the Nordics?

[00:04:12] Cian

Yeah, it did, actually. So, I spent around 8, 9 years in BlueBay, in London, and moved around 2011 to Norway. I actually ended up working for one of my previous clients that was an investor in my fund. So, taking the step from being a frontline money manager to being an allocator.

[00:04:33] Alan

Good stuff. Give us a sense on Formue and the business there (obviously it’s one of the largest independent wealth managers in the region) in terms of the size, and the types of clients, and the types of portfolios you’re running.

[00:04:47] Cian

Yeah, it’s an interesting setup. It’s certainly different to what I was exposed to in the past, which is mostly an institutional client base. Basically, what we do very well is repackaging or introducing a sort of institutional asset class diversification to private clients. So, that means we do run portfolios that go everything from liquid public assets (both debt and equities), all the way through to vintage structures in private equity and real estate. My area today is responsible, as you said, for the fund of hedge funds portfolio, but also for the private credit area.

[00:05:32] Alan

Very good. And I mean you talk about kind of an institutional approach to asset allocation, etc., I mean, would you see the approach being different to what you get maybe from other management? Is that kind of by-design?

[00:05:48] Cian

Yeah, you know, there are a lot of interesting things happening at the moment in terms of democratization of asset classes, specifically the alternative space. So, it’s not an easy one to find the right solutions either.

You know, there is the colored distributor model which, you know, you basically white label or you find a fund that you can sell to retail and you distribute it accordingly. And then the other approach, which we tend to favor, is by being an institutional investor diversifying a portfolio. So, for example, be it in hedge funds or be it in private credit, putting together four or five top managers and selling the sort of package solution, or distributing the package solution to our private clients.

[00:06:41] Alan

Very good. So obviously you’ve given a sense on the kind of the asset allocation approach. I mean, there’s a lot of talk in the markets about a new regime in markets, a potential regime shift. Obviously, we had a higher inflation environment for a few years there, but that’s come down a little bit.

I mean, from your perspective, do you think the macro backdrop now calls for a different approach to asset allocation?

[00:07:09] Cian

Yeah, certainly from my perspective. I mean, it’s not to say that we’re doing anything right-here, right-now, but it’s under consideration and on the drawing board in terms of what is the actual right framework? You know, I think we have had a sort of classic strategic asset allocation model in the past which, as you well know, and you’ve written about as well, is that it’s quite a siloed approach.

So, you have, you know, private equity is just there. There’s no consideration for the common risk factors that you will find across the equity markets, be it private, be it public; similarly for credit.

So, I think those areas are areas for improvement, areas to explore. You can see, from the likes of Man Group and others, that they’re trying to adopt or are adopting a total portfolio approach which will consider all the risks. Which in a sense should make a portfolio, from an asset allocation perspective, far more flexible than what we’ve used to in the past.

Typically speaking, you’ve had a 30%, 40% allocation of fixed income, similar to equities, and then a bucket of 30%, 40% to alternatives. And that’s the model we’ve run for many years. But therein lies the first problem, right?

If you bucket all the alternatives together, then you’re assuming the liquidity is the same, you’re assuming the risks are the same. They’re clearly not. You can go everything from asset backed investment grade debt to venture capital on the equity side. And you’ve got two very, very different risks and two very, very different liquidity profiles. So, in that sense it doesn’t really make a lot of sense to bucket them together.

[00:08:51] Alan

That’s kind of a change that you’ve gone through in recent times, is that fair to say?

[00:08:55] Cian

I would say we’re in the midst of it and figuring out the right way to do this. You know, if we had a client of one, it will be a fairly simple and straightforward discussion. We don’t. We have five, six, seven thousand different clients with each with their own risk profile, all looking to express their own preferences both for liquidity and for risk and return.

[00:09:22] Alan

And obviously, you know, you’ve mentioned a large number of clients, do you have model portfolios presumably, and categorize clients that way, or try and customize as much as possible?

[00:09:34] Cian

Yeah, I think the market has moved in a direction of, call it, mass customization. Which basically means that in order to succeed, from the commercial aspect, you need to have that menu approach where people have the full suites at their disposal. At the same time that can end up with a very complex portfolio building exercise.

Very often that’s beyond the expertise of the clients in question. They might want a simpler approach. And you can certainly see that out there in the sort of larger private banks, be it a JP Morgan or Morgan Stanley. That’s the approach they tend to go down, after a while, where you have the menu option for anyone that wants to choose that route and you have the kind of one stop portfolio solutions or model portfolios as you’d point towards.

[00:10:27] Alan

Interesting. And I mean you outline, at a high level, the asset allocation with still a decent allocation say to fixed income, 30%, 40%. And obviously a lot’s been written about the 60/40 portfolio. It was the standard for a long time. And obviously, 2022 was particularly challenging for that kind of approach.

Obviously yields are higher around the world now, so there’s certainly an attraction for fixed income. But at the same time there are questions around the kind of the role of duration in portfolios. So, what’s your thoughts on all of that?

[00:11:00] Cian

Yeah, I think, you know, you touched on it earlier, we believe we’re in a different macro environment, a sort of new economic era, which probably requires a different set of assumptions than what we’ve been used to. You know, what we’ve been used to, there, I’m referring really from the ‘90s all the way through to 2020 when you’ve had effectively declining yields, and you’ve had that diversification benefit from bonds and equities. That’s really where the 60/40 portfolio was born. And so, post that, now we’re in a period where we have inflation slightly higher than, I guess, comfort zones (for want of a better word), a bit more volatile and less clear.

If you look through financial markets, and the history there, what you find is bonds and equities (specifically duration within bonds) tend to correlate quite highly in those periods when you’ve got more and more uncertain path than inflation. So, what that does say is that you need to really think about your diversification. The reason bonds are in that 60/40 portfolio, specifically duration, is really to do that diversification job. And if that’s not doing that job that well, then you need to find other things that are going to do that job a bit better.

Another thing can be a fund of hedge funds portfolios, for example. You can also look towards, you know, higher yielding credit – floating rate credit, which will generate that income or that yield without the risks of having that underlying duration component.

So, in terms of the asset allocation model, I think if you start thinking about a total portfolio approach, essentially, you’ve got your equity on one side, you got your debt or credit on the other side, and in between you have these, what I term as diversifiers. And diversifiers can be that fund of hedge fund strategies. It can also be duration. It can be things like gold or things that really don’t correlate with either debt or equities.

But I like to separate both the credit and the equity side of things simply because the investment approach for each one of those is inherently different. Credit is all about avoiding losses and generating income. With equities, you’re looking for growth, you’re looking for compounding returns, you’re looking for the upside.

[00:13:28] Alan

Yeah, interesting. And, I mean obviously, you kind of make the case for a total portfolio approach and it is something that we’re hearing a lot more about lately from institutions. I mean, practically it sounds like common sense, and I think it is. But I think the challenge with executing total portfolio is just maybe more organizational in terms of often you have more siloed approaches.

So, a firm like Formue, is that a challenge to kind of be nimble enough to execute that total portfolio where you’re kind of literally deciding between, say, private equity and something very different, such as a hedge fund strategy?

[00:14:07] Cian

Yeah, I think it is difficult. It’s not easy and I think it’s difficult for everyone. You have some investment communities where the board is setting their investment lineup or strategic asset allocation. And in that sense, you really don’t have that ability to look towards a total portfolio approach.

But I think when you distill it down and separate out the risks into that (as I touched on) sort of three asset class, be it bonds, equities and then diversifiers (and that encompasses both public and private in each section), then I think you’re some ways along the road. Maybe the event eventual optimal solution is a hybrid somewhere between the two, where you have the rigid framework of the SAA which anchors your portfolios, if you will. But at the same time, you’re acknowledging that the market environment has changed, and you need to really tilt or alter your exposures to reflect that.

[00:15:12] Alan

And obviously, alternatives are a key part of the portfolio, as you mentioned, and that’s everything from kind of privates to public markets. I mean, I guess dealing with high network clients and private clients, there are different degrees of sophistication. So, is there a big education challenge in executing that side of the portfolio for clients?

[00:15:34] Cian

Yeah, there is. I mean there is, call it, a knowledge gap. And you have this competing product as well. You know, you give them menu approach to private clients. Initially they’re going to be comparing you against everyone. And very often you end up comparing apples and oranges or apples and bananas, for want of a better expression.

So, it’s not as simple as, you know, going to, call it, an institutional level investor and basically distilling all the numbers into risk and return and presenting them accordingly. Here you’re more about, okay, what is the function of this in the portfolio? What is it going to do for you? And focus on that side of the equation.

So, there is storytelling involved, there is educational involved, but it’s more about customizing that portfolio and that risk profile for each individual client so that they understand the risks and the type of volatility they should expect around the portfolio.

[00:16:35] Alan

And I mean, fair to say, then, the clients wouldn’t necessarily understand or have a strong appreciation for all of the various strategies that you allocate to, but it’s more understanding where they fit from a role perspective. Is that it?

[00:16:49] Cian

Correct, yeah, it’s a function. So, I like to use the expression, you know, if you think of your hedge fund portfolio, to use that as an example, that’s the forest. You don’t start talking about the trees. That’s the individual components of that portfolio. But more the forest is there to do this for your portfolio. And I think once you start focusing a lot on that, then I think the sort of educational aspect becomes inherently easier.

[00:17:18] Alan

How about when strategies become more challenged, or maybe are not fulfilling the role that you were hoping for them to play in the portfolio? Does that create challenges from that perspective?

[00:17:31] Cian

For sure. I mean this is up your back alley now, in terms of trend and systematic. You know, that’s probably the most challenging strategy to explain. It is a black box for most people. And, you know, questions will always be raised when it underperforms as it has done since 2022, in fact. And our results have been okay. We’ve had solid results in productive capital in ’22, and generated decent returns in ’23, ‘24.

So, the vast majority of our clients weren’t really aware of the drag that we’ve had from, call it, the systematic exposure, which we believe is one of the few areas which can really benefit from, call it, a higher inflationary backdrop. But we have to be patient, as you well know. I mean the odds are you will throw in the towel and then suddenly it starts to work. And that’s absolutely the thing you cannot do in this role.

[00:18:37] Alan

And obviously, as you say, it’s been challenging since ‘22. 2022 was a good year, obviously, for trend following and many strategies like that, and even 2021 as well. Is it easier if clients have been through that journey for a number of years, and then is it more difficult if it’s people have just come into allocating to a strategy that they haven’t seen work? Is that part of the challenge?

[00:18:58] Cian

Yeah, that is definitely part of it. So, the way we tend to look at our hedge fund portfolio is we’ll focus always on the sort of mid-cycle horizon. And that, for us, is a sort of 3 to 5 year rolling period of returns.

And if we run the numbers on that and show the history, I mean we’ve been running the portfolio, I guess it’s coming up on 20 years in the next couple of years. So, it’s got a fairly long-term track. And what you see very clearly is that the sort of 5 year rolling returns, annualized rolling returns, sits pretty stable over time. The 12 month rolling returns can be anything from a -4, -5 up to a +25. And then 3 year is somewhere in between.

There are very, very few periods where we’ve had a sort of negative 3 year rolling return period. We’re actually in one of those right now. And there the question is, should you exit a manager, should you double down on a manager? There’s a whole lot of, they call it, asset allocation or manager selection discussions that go around in that type of period.

[00:20:10] Alan

Yeah. And is it fair to say that, at a high level, you’re trying to achieve an all-weather type exposure? I mean it’s an expression that gets bandied about a lot and maybe is not exactly how portfolios are designed because obviously some portfolios are inherently more growth oriented. So, would you say it’s more growth or more all-weather in nature?

[00:20:35] Cian

Yeah, I would say it’s more all-weather. We have elements of everything in there. So, the way the portfolio has been set up and run, the last, call it, the last decade, since I’ve been here, has been it’s there to be both a complement to a traditional 60/40 public bonds and equities portfolio and a substitute.

There are a couple of ways you can think about that. So, one is the complement. You can add it on in a sort of, 20% of the hedge funds funding, equally from a 60/40 portfolio. So, funding both from your bonds and your equity side of things. And you improve the risk/reward in your overall book. And that’s one way of doing it.

Another way of thinking about it, which I prefer to think about it, is let’s just start with your bonds or your equities. And if you start building out your exposure in bonds and equities, you start with your passive index exposure, typically, in order to control your cost levels. You move into your long-only active both on the bonds and equities.

And then there’s a step three there, which I believe is where hedge funds can really come into their own (specifically looking forward rather than looking back), and that is utilizing hedge funds as your active public market exposure. So, what that would mean is replacing your long-only active equity manager with a long/short 130/30 type set up within equities.

That, in itself, for me, if you look at it in terms of potential alpha, it’s about five, six times what you would expect from a low money manager. And the same is true on the bond side.

So, if you start thinking (and this is again back to the sort of a total portfolio approach), about, in that sense, an allocation to hedge funds, for me, (specifically hedge funds that are operating within credit or within equities, which are more kind of risk taking type of hedge funds or growth focus or higher return focused), that’s an allocation to active management. That’s it. It’s not a specific allocation to hedge funds.

And then the rest of the hedge fund portfolio can be geared more towards qualitative, discretionary, macro or systematic macro side of things, which can really give you that diversification benefit when you want it. So, I think the issue with blending in both the equity risks and the credit risks comes down to that.

So, your systematic portfolio, your macro portfolio starts to work really well, for example in ‘22. But your return profile is going to be dampened by the fact that you still have some credit hedge funds or still have some equity hedge funds in that mix. So again, separating out those risks into the different components aids portfolio construction. It doesn’t hinder it.

[00:23:32] Alan

Yeah, and obviously you’re an advocate and a believer in the likes of trend following, macro, quant, macro. I mean, do you think the fact that you come from a trading background, you’ve been on the sell side where you’ve seen those kinds of trading strategies work, is that part of the belief?

I asked that question because, obviously, not everybody embraces these types of strategies and often there’s some skepticism about the durability of the returns. But I mean, is that part of it or is it just the kind of empirical evidence supporting them?

[00:24:04] Cian

I think the empirical evidence is one thing. I don’t think you can argue with that. I think the other part, I mean, the questions will always come up: Are there too many people doing it? Is the alpha being taken away? I mean the evolution of signals, the evolution of trading models, it continues. The research continues.

So, I think anyone who wants to really think about how things evolve, about how markets and how durable some strategies are, and how not. I mean, I think the book from Jim Simons, or by, was it Gregory Zuckerman that wrote it, The Man Who Solved the Market, that illustrates actually the history pretty well. And that history is still what’s happening today.

So, a model that delivered alpha, it might have a half-life of 6 months and then a new model comes in and replaces that. So, there’s a continual evolution.

And then when it comes to systematic and trend, I mean, it’s an unemotional strategy. There are no emotions involved. So, the data is what it is. There are always trends. There are always things happening. There are always price signals. They’re not going to go away.

So, I think when you distill it down to the sort of basic facts, all that happens in a drawdown like this is that the risk levels drop until the models get a more sort of conference signal and a clearer way forward. And I think they’re better. And I go back to, to ‘22 as another example. Systematic and models, if you get a drawdown, or even in 2020 during Covid, if you got hit on that, in those type of sort of systemic shocks, the recovery from your systematic fund versus a discretionary macro fund, the recovery from the systematic tends to be quicker than what you’d see from a macro fund that has suffered a similar drawdown. Obviously, there’s psychological impact as well. So, that’s a very interesting way to sort of think about these things.

So obviously, discretionary macro has done better the last two years or so, significantly better. So, they’re on the front foot, so to speak, whereas the models are on the back foot. But the models can tolerate that. They’re not going to be hindered psychologically, if you will, in terms of the opportunity set going forward.

[00:26:30] Alan

Yeah, but it sounds like you’re a believer in having both types of approaches in the portfolio.

[00:26:35] Cian

Correct, yeah. Our macro book is pretty much evenly split between discretionary and systematic today.

[00:26:42] Alan

Yeah, interesting. And I mean playing devil’s advocate, I mean people say to me, oh, maybe trend following won’t work in this environment. Look, we’ve got on/off on tariffs, we’ve got tweet risk, we’ve got policies that last for a day or two and then are reversed, you’ve got geopolitical risk spikes and a reverse. And obviously, we’ve seen that challenging trend following and people say, oh, maybe that’s the reason not to allocate to it. But I mean obviously, that’s not your view but how do you kind of park that risk or park that scenario and retain your conviction in these strategies?

[00:27:21] Cian

Yeah, I think it comes down to sizing. You need to have the sizing of your trend exposure can’t be too big for the portfolio, can’t be too big (the risks or the way you put together a portfolio) for individual clients. And as long as you can control that side of things you can tolerate most… You know, it’s not an easy question to answer. There is no really right or wrong answer either. I do think it’s something that can work. I think you need to be extremely patient.

We saw trend following, in particular, it took a while to work in Covid as well. It didn’t work instantly. It took a long time to work during the financial crisis, in addition. So, I think if you look back at the data, I think trend following, if you look at the SocGen index or something like that, it was down 15% to 20% in 2007, and up 20% or 25% in 2008 when equities were down 50%. And in the same fashion, in this question remark, or risk taking or proprietary trading that went on in those times.

I know several people who were out of a job in 2007 by being short the market. So, you know, you have to respect the market and the price action. I think trends and models do that better than most. And you can’t be pigheaded about it either. You need to be humble and maintain that sort of sensible, balanced risk approach.

[00:28:52] Alan

Yeah, and it sounds like, on this side of the book, it’s all about finding diversifiers, like as you say, discretionary quant macro CTAs. I mean, do you hold any kind of long vol strategies or protection strategies or. again, is that a challenge, having a bleed when you present that to clients?

[00:29:10] Cian

Yeah, that is a bigger challenge. I think when you start pairing them with their underlying exposures, then you can start talking a little bit more, or being a little bit more sophisticated in how you do that sort of thing.

So, examples like I touched on earlier, if you have an equity allocation and you want an active equity allocation, you could actually overlay a trend or CTA with your equity exposure. So, whether you want to term that as portable alpha or whether you want to term that as return stacking, I think you can call it one or the other. But for me it’s just straightforward capital efficiency.

Obviously, that’s not going to be for everyone. That’s for, call it, the more sophisticated level of investors, both on the private and on the institutional side.

[00:30:05] Alan

I mean, obviously you’re very active in terms of the hedge fund side selecting managers. I mean, give us a sense on the process for manager selection. How do you kind of survey the universe and then go from having a broad universe of potential managers then to bringing those through to actual allocation?

[00:30:29] Cian

Yeah, I think it’s the biggest challenge. And I describe this as the hedge fund manager S curve. So, this is like your standard product development S curve.

So, you see the initial idea or initial product start to be developed. The biggest risks you have are in the first sort of 12 to 18 months. And you know, a hedge fund at that point is literally like a small business. So, 9 out of 10 small businesses go out business and hedge funds are no different.

So, you need to have all the operational investments, compliance, regulatory, all those need to be in place. So, that requires a decent size to begin, to start with. And then, you know, assuming all those are done, you have the sort of, call it, what we call the growth period. So, the next three to five years are crucial. Obviously, your investment returns have to be delivered. Very often you can get some very sizable risk adjusted returns in that period. And then, what happens after that?

There are two routes to go. Either you successfully recruit, and develop, and diversify your business into different areas or (and this is kind of looking back the last 10, 20 years) you assume that you are the best at everything, and you take on more and more risks without delegating those risks. And there are a number of high-profile names that have struggled on that basis.

So, there are very, very few firms that have managed to grow from the, call it, single strategy into a multi strategy and continually push and continually develop their internal personnel in order to manage money successfully in the future as well as how they started. So, it’s very much a sort of a psychological evaluation as well.

So, a hedge fund manager that starts out often isn’t that wealthy. They have some money and, by all comparisons, are very wealthy compared to the average citizen. But in hedge fund terms, he’s pretty poor. After three to five years of success, he can be pretty wealthy. And that, itself, results in a changed risk profile for most people. They’re no longer looking to shoot the lights out. They’re suddenly looking to just conserve and preserve capital. And you see that very, very often as well.

So, there are a lot of factors there. I think that, to sum up, hedge fund exposure to a particular hedge fund is not for life. It is something that has a half-life. And that half-life is somewhere between three and five years, which, again, means in a portfolio that we tend to run a fairly concentrated portfolio which is around 10 to 12 names that will take up 80% of the capital. And then we have a turnover of maybe one to two names per year, which, again, ties back to that sort of lifespan or half-life of a hedge fund manager.

[00:33:34] Alan

And for those one to two per year, I mean, does it tend to be top down or bottom up or a bit of the both? Or do you go out and say, okay, you know, we could do it adding a new global macro manager, or we could do it a bit more on the quant directional side, or is it more good managers present themselves to you?

[00:33:55] Cian

It’s a bit of both. I’ve seen a typical situation when we might exit a manager or consider exiting a manager is if they’ve deviated from their strategy, that’s like, that’s a no-go for us. Then it’s a straightforward exit. But if they’ve continued doing their strategy and just caught offside by the markets. This happened in Covid with one of our discretionary macro managers. They got it wrong. They were very upfront, “We got it wrong guys. We didn’t think it would be as big as a deal as it is.” They cleaned out their portfolio the next day.

We had a long conversation with them. We believed in their process, the area they were focusing on was emerging markets, but they had built out a very nice portfolio of pretty safe investments, in our view, which were heavily discounted after Covid. So, what we ended up doing in that situation was doubling down on our capital whilst respecting the high watermark that we had in place before.

So, that’s the type of decision we have to take in a sense. Do we exit that manager and pick a new guy at the bottom of the market and pay full performance fees or do we double down on the manager we believe is being a bit humbled, is still a good manager (that doesn’t change), and come in on a very low sort of fee deal, if you will.

We’re in the same situation now on the systematic side. So, we have a number of systematic managers which are doing various different forms of systematic trend across a multitude of markets. And then the question for us would be, well, this guy has done much better, their trend performance is much better. Should we just replace one for the other?

But then it becomes more a question of well, these guys are 20% under their high watermark. I’m going to come in and pay a new guy 20% or 25% of their performance fees from day one. And then once you start backing out and working out the math and the fees, you kind of figure out, well, I don’t really want to do that, at least not here or not now. But are there parts of this strategy that have worked particularly well, of this new manager we’re considering?

In fact, there is. There is an equity piece, an equity market neutral piece that works extremely well in this environment and it’s a type of exposure we don’t have. So, maybe the right decision for us is to just focus on that part of the portfolio right here and now whilst keeping the rest of our systematic trend, which effectively has no performance fees until they regain the highwater marks.

So, I think those, the sort of capital efficiency, the fees, fee net things, being conscious of when you exit, why you exit, and what are the alternatives. Is it better to stay or is it better to be quit and we want to move on to newer pastures?

So those are all very valid questions and, as everybody knows, I think costs can really eat your returns very, very quickly if you’re not careful.

[00:36:57] Alan

But it does sound like, I mean it’s absolutely valid, that fee sensitivity, but maybe does that keep you allocated or at least it’s an incentive to stick with a manager. If you didn’t have that performance fee element it might change numbers, but it is still valid, obviously, because if you need to find somebody else, they have to be that much better on a forward basis, isn’t that right?

[00:37:23] Cian

That’s correct, yeah. So, suddenly they need to be 20% better than what you have. That just matches your returns.

[00:37:31] Alan

Exactly, yeah.

[00:37:34] Cian

So, there is a very strong argument for sticking with a manager. I mean, you invested with them in the first place, so there must have been something good about them. Has anything changed? And that’s where I go back to the earlier comment. If their strategy has changed, if they’ve deviated, if they’ve gone a little bit off piste, then that’s more of an argument for exiting than actually poor performance.

Poor performance should be expected from everyone from time to time. Otherwise you’re running a bit of a Madoff, or a Ponzi type scheme. So, we don’t need to go into those.

But I think you should expect, on a portfolio of 10 managers, I fully expect two or three of those managers every year to be having a poor year and that poor year means like way below their expected return profiles.

[00:38:23] Alan

And I mean, obviously, fee sensitivity is important. We’ve seen the growth of the multi strat pod shops, multi manager pod shops in recent times, which are obviously unapologetically expensive, I guess it’s fair to say. I mean, is that an impediment allocating to those fees?

[00:38:42] Cian

Yeah, I would say, actually, it’s not an impediment because it’s the net of fee return stream that you’re really looking for. But what is an impediment to the pod shops or the multi PMs for us is the liquidity profile.

So, the fees are one and paying away half your fees. Nobody really likes to do that. But if you’re getting a very stable return stream of 10% to 12% to 13% every year, you’re not really going to complain too hard about it.

But when you’re running a portfolio of relatively liquids hedge funds, and by relatively liquid, I mean we run a fund that has monthly subscriptions and quarterly redemptions. We can’t do that with an allegation to the multi PM pod shops. Their liquidity profile is annual, even less than that for a number of the bigger ones.

So that’s a bigger impediment to us than the actual fees. But fees are sensitive as well. I mean, we’re fully transparent with our end clients. And again, if we start reporting a big chunk of our portfolio as 40%, 50% of your total returns are going away in fees, you’re not going to get a lot of takers on that type of argument either.

[00:39:53] Alan

Yeah, and I mean, you mentioned the S curve for, you know, the hedge funds, their growth from early stage to more established and more diversified managers. I mean, at what stage are you happy to allocate? I mean there’s obviously pros and cons at each stage. But are you happy to underwrite kind of early stage risk with emerging managers?

[00:40:15] Cian

Yeah, we have done so and we, in fact, run a sort of an early stage seeding program. That program we’re running via an investment in Blackstone today. And Blackstone has a seeding vehicle for new starts.

We don’t have the manpower, the capacity to do all of that ourselves, but, back to the S curve, that sort of early stage return stream is particularly attractive. So, there are a number of things there to unpick, but you do need the capacity and network to do that job successfully.

But, early-stage managers, we have invested off our own hands. Very often it’s been sort of a very good team that we’ve known very well spinning out and looking to form their own fund, you know, managers. So, we have had some early-stage and successful spin outs from larger enterprises.

[00:41:18] Alan

Interesting. And I mean, you mentioned the experience with the Blackrock industry. Are there managers that have kind of graduated from being in kind of an early-stage allocation into being more of, you know, a full allocation in the portfolio?

[00:41:34] Cian

Yeah, we tier them, so we have a sort of entry level for us is a 2%, 3% sort of, call it, a stakeholder position, if you will. And then we move up into, call it, a tier 2, and that’s somewhere between a 4% to 7% allocation. And lastly, we have our tier ones, and they’re up to sort of 7% to 10% type allocation. Some of them do go up to 11%, 12% depending on performance etc., but those three tiers tend to be how we run things.

[00:42:05] Alan

I mean, the process of selecting managers is, you know, subject to a lot of different behavioral biases. To my mind it’s quite a different skill to asset allocation or trading but curious to get your perspective on that.

[00:42:20] Cian

Yeah, it definitely is. There are a lot of things to cover there. The due diligence, operational due diligence can be quite intensive. We do use Auburn and their data and analytics. If we feel the need to run an operational due diligence in conjunction with them, that’s something we happily pay for. So, it is a different skill set. It requires a little bit more time.

I think the way we like to approach it is, you know, let’s just take equity long/short to start somewhere. So, the equity long/short universe, you know, we have tended to go away from the global long/short managers and focus much more on sector specific where we believe there is a greater alpha potential.

And within the sector specific we’ve looked at the likes of energy transition, health care, you know, basically subsectors of the equity market where we see mega trends in place or structural trends in place. Then it’s about finding the right manager. They probably are running a low net beta which we’re happy to take, in that scenario, because it sort of aligns with our sort of macro, or backdrop, or other longer term structural trends in the market.

[00:43:43] Alan

And, I mean, it sounds quite intuitive and compelling. You know, you have these structural trends at play which should throw out better opportunities. I mean, do you think your experience supports that?

[00:43:58] Cian

Yeah, certainly the last decade or so it’s paid a dividend. You know, we have had investments since 2013, ‘14 in a manager running a sort of 40% net in long/short tech. We’ve had a similar experience within healthcare. And latterly, since around 2018, ‘19 we’ve had a manager focused on (a little bit more market neutral) the energy transition. And all of those have been very profitable investments for us.

[00:44:33] Alan

Okay, interesting. I mean in terms of, I suppose, the main challenges, we did touch on some of the behavioral biases briefly. You mentioned some of the decisions to exit, style drift, etc. I guess there’s always the obvious ones like changes of PMs. But I mean, it’s one thing saying you should expect a drawdown, you know, and, but presumably when it’s in it, managers in the drawdown, it can be challenging. I mean how do you reconcile that kind of qualitative perspective with the quantitative? Do you have hard stop loss limits, that kind of thing for managers?

[00:45:11] Cian

We don’t run hard stop loss limits, but, typically speaking, reviews would occur when we see a manager running, you know, one to two standard deviations away from our expected returns. And you know, just to clarify how we would view our expected returns, we tend to run it on a risk basis.

You know, this sort of hurdle to come into the portfolio for us is a Sharpe or a risk/reward of 1. So, your returns are going to match your risk on a one-for-one basis.

And so, that kind of gives us an oversight as to what we should expect and then, you know, 1 to 2 standard deviation from then, depending on the market, is it a sort of systematic shock or system wide shock or is it something a bit more manager specific or market specific?

And they tend to create reviews first, conversations around that, why it’s happened, what the approach is from the manager, what they’re looking to know do, does that view from that manager align with our view on our interpretation of the market environment? We will always cross check, find out more.

I mean, if it’s an event driven European manager involved in a few sort of mid cap situations, we have a number of others we can call to fact check, to clarify, to verify is this the right approach or not and is this an investment still suitable for us or not?

So, all those conversations take place around, you know, specific drawdowns and that’s in addition to the sort of monthly quarterly catch-up with managers that we tend to run regularly.

[00:46:56] Alan

Okay, maybe just switching gears a little bit. I mean obviously you have responsibility for hedge fund allocations and private debt, private credit, which I mean are quite different from trading strategies. Does that require a different mindset, a different perspective when you’re looking at that universe than when you’re looking at trading strategies?

[00:47:18] Cian

Yeah, it does. And it’s a continually evolving space on the private credit side of things. So, on the trading side it’s a bit more, sort of, you’re looking more on the risk – how do they manage risk on the portfolio level? How do they control in terms of drawdowns?

On the private credit side, that has to be done at the investment level. You obviously don’t have the liquidity to manage around any specific events. So, it’s very much a credit focused investment mindset about not making mistakes, being sufficiently diversified and putting together a robust portfolio that’s going to generate income over time.

And therein is a little bit of the problem set with competing products from be it high yields which offer daily liquidity. Even though I think most people in markets realize that that daily liquidity is a little bit of an illusion at times.

And now we have the likes of Apollo and the likes of a number of other bigger firms, on the private side, claiming that the liquidity on the private side for size is coming close to matching that on the public size. So, there is a convergence there which we need to be aware of.

And there is also, you know, as I said, the competing products between public versus private, which is the right one? Should you have a combination of both? I think that’s the right approach. You’re getting an extra element of diversification there as well.

[00:48:47] Alan

And obviously you’ve got responsibility for the private debt, private credit side of the portfolio as well as the public market hedge funds. Does that require a different approach, a different mindset when you’re thinking about allocating on that side?

[00:49:00] Cian

Yeah, it does. I think, just to summarize that very quickly, on the hedge fund side you’re typically going to be looking for or evaluating the sort of ability to manage risk. Whereas, on the private credit side I think it’s more of the ability to manage the sort of the business, if you will.

So, you need to ensure that you have the loan demand on one side or the ability to originate all your loans. And that’s really where the alpha component is. So, what I would say on the private credit side, the key difference is that there’s less of a quantitative approach. There’s far more of a qualitative assessment and, obviously, the usual sort of bells and whistles in terms alignment of incentives from the managers, analysts, all the way through to the whole organization. So, it is a different ball game when it comes to that.

You know, the other, I guess, key aspect is, once you’re in a private credit fund, particularly a drawdown, you are there for a considerable period of time. So, your time horizon is not as flexible as it is on the hedge fund side where you might have a turnover every few years.

On the private credit side, it’s a much longer-term business building aspect. So, you’ll typically be around for, or have that relationship, or increase the value of that relationship over the better part of a decade.

[00:50:22] Alan

So, as you say, it’s not something you can exit very quickly in some situations. So, it’s much more of a long-term relationship, I guess. Does that make you a little bit more cautious when it comes to manager selection, would you say?

[00:50:36] Cian

Yeah, I think that’s correct. You know, a hedge fund investment for me would be more, if you think of your classic sort of equity analysis, equity investments, whereas on the private credit side you’re going to be looking more as a credit investment. And in credit investments you want to avoid losses at all costs. So, you want to ensure you’ve got enough structural protection to manage the downside, the ability of the organization to run workouts when there’s a need to run workouts and avoiding the simple mistakes.

I’m not going to say we’re perfect. We have made mistakes in the past. We’ve learned from them. The private credit markets are evolving, have been evolving for the better part of the last 10 years. I mean, they basically didn’t really exist pre the financial crisis. It was essentially a financial crisis, baby, if you want to put it in those terms, for outside allocators.

And obviously, the evolution of the market structures, I mean, they’ve started with the sort of vintage closed end structure. And even back in 2017, when we first began dipping our toes in private credit, we were pushing pretty hard because we saw no reason why there shouldn’t be an evergreen solution to private credit.

When you add up all the costs of due diligence processes, and to re-up into the next vintage, and then the sort of frequency that those come around, and they’re much higher frequency than you’d see from a private equity player. So, in that sense, there’s a huge sort of business burden in terms of costs of doing that type of approach from a vintage structure which is basically, you know, removed from the liability side of the equation for people looking at more semi-liquid structures or evergreen instructions for private credit.

And obviously, you know, the key thing there is you’re avoiding your J curve. You’re coming into either a relatively new portfolio or a portfolio that’s already ramped up pretty well. So, you know what you’re getting at the outset.

[00:52:47] Alan

Yeah, and I mean the term evergreen obviously reflects the fact that there is liquidity in these structures. I mean, is there a question about what is the, I suppose, validity of the valuations that you’re getting out at when it comes to getting out, or how do you think about that risk and what’s been your experience in that respect?

[00:53:06] Cian

Yeah, I mean they’re pretty new. So, the semi liquid structures have been around the better part of three years. So, we are evolving our business, as well, in terms of how we do that and how we construct a diversified portfolio of that type of asset. I think the simplest way is where you start balancing the liquidity that is automatically generated from a portfolio of private debt.

So, that means the coupon income, the amortizations, when they’re in place. And if you can match that with your gates, investor level gates of 5% are pretty common on a sort of quarterly basis. So, you know, you can do the math. You’re investing for the better part of 5 years from start to finish.

And if you think of the average life of a private credit loan, it’s going to be around 3.5, 4, 4.5 years. So, in that sense, when you put together a portfolio then you can see that the cash generation in the portfolio will allow for that type of liquidity.

Now where you have to be cautious, obviously, is if you don’t have investor level gates and you have fund level gates, then you can be sitting with investors or a particularly large investor that might take up the full 5% on one gate or one quarter and then you don’t have that liquidity.

So, I think it’s a very important part of the due diligence process in order to ensure that you’re not sitting short on liquidity when you don’t want to be in that position ever. Whether it’s private credit or whether it’s rich hedge funds.

[00:54:50] Alan

Yeah, you mentioned that it is still a relatively new asset class in the grand scheme of things. It has kind of been around since the financial crisis. So, with any asset class that, I guess, emerges and is new, on the one side people are pointing to great opportunities and other people a bit more skeptical pointing to potential risks.

I mean, from your perspective, are there any obvious areas of concern or, as we went into a tightening cycle, were you worried about default risks escalating or anything inherently part of the private credit structure and that side of industry that you think needs to be looked at or would be a concern?

[00:55:28] Cian

Yeah, I think it’s, you know, with any sort of new asset class you’re always going to have that risk that there’s too much money that comes in too quickly. And, you know, that is certainly a risk for some parts, maybe the sort of investment grade direct lending areas or the areas of the market which are relatively commoditized. And there are some, that’s for sure.

But I think if you’re smart about it, you know, there is a clear benefit to private credit versus public credit, both from the borrower’s perspective and from the lender’s perspective. And I don’t think that’s going away. That’s a structural shift, a structural change. The banks are not going to be the main provider of these types of loans anymore. It is going to be private credit funds. And I think that’s fairly obvious.

It doesn’t really matter which material you read, you’re going to end up with that similar type of conclusion. And similarly, you have the size, the absolute size of the asset class.

You know, there are a lot of people looking at the… I think the latest numbers I saw were, were 2.5 to 3 trillion in size, which is vastly bigger than what you can find in the real estate market today. Therein lies the sort of conundrum for us and for many other asset allocators out there.

I think if you look through most asset allocation models today, you’re going to find a far higher weighting to real estate than you will to private credit. And already, based on just market size, you should have the opposite. You should have private credit as a bigger component.

But again, lack of history, lack of track record, lack of going through different cycles. And how robust is the private credit model? How robust are the individual managers that are out there today? And can they survive a credit shock or a systemic shock of the magnitude we’ve seen in the past?

So, I think those are all valid concerns, but I think once you address all of those and do your homework you come out with a similar conclusion to what we have, which is that it is a valuable component. It’s a yield component for your portfolios. It is a fairly effective yield replacement for public fixed income.

And I think the last point, which is probably very relevant for a number of people, it really does depend on your jurisdiction and how credit or debt investments are treated from a tax perspective. But more often than not the sort of private credit due to the liquidity is treated more as an equity investment from tax reasons. So, you don’t have the coupon income that you get charged tax on or income tax on. So, I think that’s also a valid point and an extra, almost a hidden benefit in a way or a less known benefit for many investors.

[00:58:19] Alan

Interesting. Credit as an asset class, public or private, it can behave like equity some times in more risk-off periods. And equally, I guess, there can be periods where equity markets might be flatlining and, obviously, in the credit markets you’re picking up the coupon, the income. So, it could be advantageous from that perspective.

Do you look at the two asset classes from that perspective in terms of the relative attractiveness of equities versus credit, you know, maybe on a multi year basis? And until the allocations, are they pretty stable allocations?

[00:58:52] Cian

Yeah, I mean, I think that certainly we in the investment team look at it in that way. You know, I think maybe the future state for putting together asset allocation portfolios are, I wouldn’t term it as sort of tactical asset allocation, which I think is much more short-term. I think that’s best left to hedge funds and the other more short-term risk managers out there, but more of a dynamic asset allocation approach.

So, I mean if you think about the world or the market cycles in sort of four simple cycles, inflationary boom, disinflationary boom, stagflation, and deflationary bust. Most portfolios, the 60/40 model in particular, have grown within the disinflationary boom from the ‘80s through to 2020, call it. And post there we’re going through a period of, call it, very unstable growth. It’s quite volatile post Covid. You have inflation issues, and you have deglobalization issues. So, whether we end up in more of a stagflation or a continuation of what we’ve seen, or an inflationary boom, that remains to be seen. Nobody knows, nobody can predict that.

But obviously there are certain investments which will prove to be more immune to those type of environments than what we’ve had in the past. For want of a better way of saying it, my sense would be that credit markets, particularly well managed credits with a focus on the downside risks are likely to produce similar if not better return or quality of returns than you’re going to see from broad equity markets.

[01:00:29] Alan

Okay, interesting. Well, we’re coming up in time and we do always like to get some perspective from our guests, towards the end of the conversation, on I guess maybe advice for people coming into the industry or even, I suppose, things you’ve done or read through your career that have been influential. So, if you were to give advice to somebody who wanted to develop a career in hedge fund or private credit allocation, what would you say?

[01:00:56] Cian

Yeah, you know I think read. Consume as much data as you want. I think today, certainly in the post Covid world, there are a lot of very good sort of publicly available information be it in the form of webinars or annual investor meetings. I think in our own country, Norges fund, Nikolai Tangen, who runs the MBIM fund today, has a podcast which I think is fantastic and gives you great insights into how they think and how the best CEOs in the world think.

At the same time, they have an annual meeting with, and they invite people like Howard Marks and other sort of well-known top investors out there. And read. You know, some of the best books out there are… I think one of the ones that I mentioned already was that with Jim Simons The Man Who Solved the Market is a fantastic read for anyone looking to get into hedge funds.

I’m not saying it’s repeatable today, but there are techniques and things in there which give you a hint as to how these programmers or how systematic trend can work in in the various different markets today.

And the other one then, when it comes to sort of asset allocation, is, I guess, the fear and greed or I think the book from Howard Marks, Mastering the Market Cycle is a fantastic read as well. It goes through the different market cycles. You know that’s not really what will generate you the alpha. It’s more the identification of what the market perception is at that time within that market cycle.

So, whether they’re over optimistic or over pessimistic those are the key sort of areas in terms of market pricing that you can generate some extra alpha. And that, again, sort of you know leads back to what I talked about earlier in terms of a more dynamic and less static asset allocation over time, focusing more on the kind of 3, 5, 7 year type cycles. And really, I think the whole asset allocation game is really about stacking the odds in your favor. If you manage to do that, manager selection is a distant second.

[01:03:06] Alan

Okay, interesting. Well, yeah, that’s maybe a follow up topic for another day. But Cian, thanks very much for coming on today. It’s been great to get your perspective and hear about your thoughts about allocating to hedge funds and doing asset allocation.

As I guess our guests will infer from the conversation, it’s a world in the midst of a potential regime shift. We don’t know exactly what it’s going to look like, but it certainly is changing and having good thoughts on asset allocation is certainly critical for navigating the current environment. So, from all of us here on Top Traders Unplugged, thanks for tuning in. We’ll be back again soon with more content.

[01:03:49] Ending

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