Why Hedge Funds Still Matter ft. Alexander de Bruin

[00:00:00] Alexander

As a backgammon player or a poker player. That’s the mentality you have. You’re playing the odds and what you’re trying to do is put the odds in your in your favor on every move or every time you’re playing. And that’s exactly what we look for from hedge fund managers.

We’re not looking for guys who can hit the ball out of the, you know, the ballpark every time, but we’re looking for guys who just, incrementally, have some kind of edge and applying that on a systematic or on a continuous basis and trying to pick up those pennies without taking a massive risk.

[00:00:48] Intro

Imagine spending an hour with the world’s greatest traders. Imagine learning from their experiences, their successes and their failures, imagine 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 risk from the investment manager about their product before you make investment decisions. Here’s your host, veteran hedge fund manager Niels Kaastrup-Larsen.

[00:01:38] 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.

[00:02:22] Alan

Thanks for that introduction, Niels. Today I’m delighted to be joined by Alexander de Bruin. Alexander is head of Fund Research at Edmond de Rothschild Group.

Alexander has been in the financial markets for decades, a number of decades, as a trader and now as an allocator and fund researcher in a variety of different roles. Alexander, great to have you with us. How are you doing?

[00:02:46] Alexander

I’m doing fine. Thank you very much, Alan, for inviting me to your podcast. It’s a pleasure.

[00:02:52] Alan

Great to have you on. Well, I gave a very brief intro there and I know you’ve got an interesting background. You’ve worked in the markets for a number of years as a trader and as an allocator. How did you get involved in markets in the first place? And maybe could you tell us a little bit about your route to now being heading up fund research at Edmond de Rothschild?

[00:03:12] Alexander

Okay, thank you very much. It’s somewhat of a long, windy path to where I am today. I’ve straddled both sides of the Atlantic in my past, being in the US and Europe. How did I get into the markets originally? I was offered a job as an options trader on the floor. A guy called Eddie Manfield who only hired games players. So, an interesting background. He mainly had bridge players. He was a world class bridge player and a world champion bridge player. And he only hired bridge players or games players, should I say, to his floor option trader operation in Philadelphia.

So the logic behind that was he wanted people who were quick with numbers, could figure out, you know, not highly complicated math obviously, but could be quick on their feet with numbers, figuring out odds and percentages and also had an ability to manage money. You know, games players especially, maybe not so much bridge players, but poker players, and I was a token backgammon player, have a background in working statistics. And it becomes second nature if you’ve been doing it your whole life.

And my parents were very active backgammon players, and I was involved in a lot of backgammon tournaments when I was much younger, following my parents around. So, from a very young age I was brought up with this kind of odds and probability and statistical background which I think is very applicable to the markets. Which is obviously why this Eddie Manfield gentleman hired games players.

Because that’s the mentality that people want, that they want to have in the markets. To the extent that there’s a luck element when you’re playing card games, when you’re playing backgammon. And just like in markets, you have a luck element, right? You can make the right trades or have good trades on, but they don’t always go your way because it’s not 100% hit rate, right? We all wish there was, but there’s not. And when your trades go against you or when you’re playing a game, you can play the odds, but you don’t always win. You have to know how to manage those situations. And I think that was the thinking that this Eddie Manfield gentleman had in hiring people.

And that’s where I got my start on the trading floor in Philadelphia, which was a great place to start. I had one of those red jackets, a red and black jacket. And there was a rough and tumble kind of world with the writing the tickets initially, and then we moved over to handhelds. And there was a lot of edge. Right? And that’s what’s important. We want to be involved in markets where there’s edge.

And at that time there was a lot of edge on the floor. It slowly disappeared because the markets went to multi listing. Originally, options for single stocks were not multi listed on different exchanges.

There were three different exchanges and then four different exchanges, but those four change exchanges moved to five exchanges when they had the electronic exchange. So, there was quite a lot of edge. And then we went to decimalization and that reduced a lot of the edge. And then unfortunately, Eddie Manfield died and I took that opportunity to move to, what they say called, upstairs.

And I was hired by somebody who was launching or relaunching a convertible arbitrage fund and therefore started with that team upstairs as a trader, and then I became head trader, and then I was made a partner in the hedge fund in January 2008.

And they say timing is everything, and the timing was not fantastic, but that’s how I started off in trading.

[00:07:08] Alan

Then obviously you, at some point, made the jump from trading to allocating. So how did that work?

[00:07:13] Alexander

Right, well, I mean, first of all, trading converts is a great way to go into business in trading as well, right? I mean, as an options trader, so that was just one area. But trading converts gives you a broad universe of instruments, because when you trade converts, you trade the convertible bonds, you trade the equities against them, you trade the options, you can trade CDS and credit hedges, high yield bonds, you trade interest rate swaps and Treasuries to hedge the interest rate exposure. So, you get a really good experience trading a lot of different instruments and perhaps a lot of the reason why a lot of the multi strats, Ken Griffin being a specific example, started off trading converts and expanded into other areas.

So how did I make the switch? Well, as we pointed out, 2008 came along, which was not the best time for convertible arbitrage. And things didn’t go so well for most convert arb traders, including ourselves. And we had two large investors. We got up to like $550, $560 million. Our two largest investors wanted to redeem and therefore we had to close down the fund. I was Based in the United States, in Philadelphia at the time. And it gave me an opportunity to return to Europe where I was born and brought up. So, that gave me the opportunity to come back.

I got a job with a hedge fund advisory firm called Darius Capital, in Paris, which mainly worked with institutional clients and helping them build hedge fund portfolios. That was bought by Metixis and then it was merged with New Alpha, which is part of La Francaise.

But that I did that for basically just over 10 years helping institutionals, mainly French institutions, but also some US institutions build hedge fund portfolios.

[00:09:03] Alan

Yeah, good stuff.

And then at some point made the move into Edmond de Rothschild Group, where I understand you’re dealing with both, I mean, private clients and institutions. People would naturally think of it as a private bank, I guess.

So tell us about the kinds of portfolios you run and the kind of breadth of your coverage there.

[00:09:25] Alexander

Yeah, sure. So Edmund, I started Edmund Rush out three years ago. There was a little bit of a reshuffling and relatively quickly I was promoted to head of research. So as a classic Swiss bank, a lot of the client base is obviously private banking clients.

But the somewhat unique item at Edmund Rothchild, within the team, is that we also run a, a number of institutional client portfolios and an extremely large client portfolio for a Japanese client which is just in total under 20 billion USD. But we run 10 different portfolios of which one of them is a hedge fund portfolio which is just under $2 billion USD.

At Edmund Rothchild, we have one of the largest, I think, fund selection teams. And that is because we benefit from this institutional client base that we work with as well as a private banking client, which are important as well. But the team can be much larger because we have these very large institutional clients that we help build portfolios for.

[00:10:35] Alan

You’re doing fund research or manager research across traditional and alternative assets and strategies, is that right?

[00:10:43] Alexander

Correct, right.

So, in total, our team oversees roughly $25 billion, but that’s across long only and alternatives, of which roughly three and a half billion is in alternatives and the rest is long only.

[00:10:56] Alan

Okay, very good.

And in that world, obviously, is it a singular approach, I guess, or do you notice differences in terms of the kind of the institutional mandates you run versus building portfolios for more wealthy individuals?

[00:11:11] Alexander

It’s very different. Yeah, yeah, absolutely right. We have basically three different areas or client bases that we respond to. One is the institutional clients. Two is the high net worth individuals from the private banking. And then also we build our own fund of funds as well, which are offered out to certain clients.

So those are three very different kind of client bases and different types of portfolios we build for clients. You know, I think what’s maybe your next question might be, you know, what’s the difference between them?

So, institutions are much clearer about their objectives.

[00:11:54] Alan

Okay.

[00:11:54] Alexander

Yeah, you know, they want to come and they normally they’re looking for some kind of diversification away from their risky assets. So, they tend to.. And this is the case as well when I was building portfolios in Paris for large institutions. They typically want a real diversifier. They don’t want the beta to the market within their alternative allocation or at least the client and institutional clients that we have dealt with.

Whereas high net worth individuals would be a little bit more into the story and more instinctive about the portfolio. They might prefer to cherry pick hedge fund managers.

I mean, some clients who are maybe less sophisticated might say, okay, I want to have some allocation, therefore they might go straight to a fund of fund that we’ve built. But then there’s a lot of high net worth clients who will want to hear a story and want to be involved or like the story.

Obviously high net worth individuals have done extremely well for themselves, so they probably have a very good instinct, but they want to hear the story without just being say, oh, we want some kind of boring allocation. Whereas an institutional, like I said, clients tend to be much clearer about their objectives and how it fits into their portfolio.

So, we cater to all three, obviously.

[00:13:19] Alan

Yeah. You know, we’ve kind of seen a shift in the macro environment in the last number of years. Obviously the 2010s were quite unique – low interest rates, low volatility, relatively tough for some alternative asset classes like hedge funds who generally struggled. And now we’ve kind of moved into this decade. We’ve seen higher inflation, more volatility. A lot of people argue and saying in favor of more alternatives. The 60/40 needs to be revamped. Is that something, is that a view you share? Would you say that kind of thinking is reflecting in the portfolios you run?

[00:13:54] Alexander

Absolutely, but I am a little biased because my DNA is the hedge fund background and it’s a little bit like Waiting for Godot, is that we always think now is the time for alternatives and hedge funds. But the last couple of years have proved us wrong as the stock markets have just gone straight up for the most part.

But that being said, I think the higher rate environment is positive for alternatives and we saw strong returns from alternatives last year. In the higher rate environment, obviously those were overshadowed massively by the stock market rally, especially in the US.

But I think we’re heading to an environment with relatively high valuations. I think there should be a lot higher dispersion of asset returns. There should be higher dispersion of returns across sectors. There should be higher levels of equity volatility, higher levels of FX volatility, higher levels of credit spread volatility, and capital structure decompression. All these items are significant drivers of returns for a lot of hedge fund strategies.

So today, where equity markets are and where credit markets are, credit equity markets at high valuations are specifically in the US and credit spreads very tight, with a possibility of significant dispersion across different areas that I just mentioned, should be a very propice environment for hedge funds.

[00:15:41] Alan

And obviously we are hearing a lot now of the move away from 60/40 to say 40/30/30 or 50/30/20, whatever it is. And obviously you should be investing 20% or 30% in alternatives. But obviously there’s a wide gamut of alternatives, both liquid and illiquid in hedge funds and private equity. So how do you think about that? Do you start by positioning alternatives or is your conversation with clients more about private markets versus public markets, or how do you approach bringing these kind of new strategies and new opportunities into portfolios?

[00:16:16] Alexander

The multi level question. I am somebody, once again, somewhat biased, but I continue to try and convince clients that there is an appropriate amount of alternatives that they should have in their portfolio. So, depending on the clients and the type of clients, sometimes they can be zero. So ,there you say they should open the door to alternatives. Some clients have 5% allocations and we think they should have 10% allocations. But the allocation to alternatives, and you mentioned hedge funds but also alternatives should definitely not be zero in today’s environment.

Depending on the client, whether it should be 5 to 20 or 30, that you mentioned, it should be somewhere in that bracket. But then once again it depends on all clients.

I also come from a little bit of a background, once again, and I’ve repeated this a number of times, I apologize, but I am biased towards hedge funds. Sometimes I don’t understand why people are just long the market. Right?

I can obviously say I’m wrong in that view because the markets have gone up significantly. So, I’ve been proven wrong. But the vagaries and the volatility that one can suffer in markets can be quite brutal sometimes.

If you can have allocations to strategies and, depending on your goals, make yourself anywhere 7% to 15% with a lot less volatility, it certainly makes sense to have those types of strategies in your portfolios today, I believe.

[00:18:00] Alan

And even so, granted a bias towards kind of hedge funds and trading strategies, but even within that space there’s a lot of choice. Obviously, different strategies set out with different objectives, trading different markets from kind of more market neutral type strategies. And now we’ve seen the growth of the multi strats and then we’ve got kind of traditional macro and then you’ve got quant, CTAs, et cetera.

Is it a case of diversifying across a number of these strategies, or do you tilt more heavily to the kind of pure diversifiers, or does it depend a little bit, as you were saying at the outset, kind of depending on which type of clients you’re building a portfolio for?

[00:18:44] Alexander

Well, it does depend, but I mean, the main focus is on pure diversifiers. We typically do not focus on the long bias strategies. Right. We’re looking to access strategies that create a diversifier for our clients, risky portfolios. Therefore, we’re looking to remove the beta from the hedge fund allocation.

Because when those risky portfolios are not performing, the idea is that the alternatives portfolio continues to perform and creates that diversification for them. We look across the strategies that you indicated, whether they may be multi strat or quant managers. We’re looking for a diversification of return streams. We like to decompose managers into the different alpha streams and then see how they complement either our hedge fund portfolio itself, but also the hedge fund portfolio should be a complement and a diversifier for the client’s risky portfolio.

[00:19:42] Alan

Yeah, you started off with convertible arb trading and you had the experience of the global financial crisis. And obviously, anybody who’s kind of worked or been in markets through that period, it’s been, I suppose, an informative period.

We definitely saw the phenomenon of correlations going to 1 in that period, I mean, does that kind of experience inform a lot of your judgment still? I mean, you know, in terms of something like convertible arbitrage strategies, where would that sit in the portfolio?

Is that seen as kind of an income generator or kind of a steady type of portfolio as opposed to a pure diversifier, like maybe macro, or is that how you kind of think about building them?

[00:20:28] Alexander

So, you’re 100% right. Living through the great financial crisis, as a trader in a hedge fund, was extremely informative and also made its mark. So, you’re always extremely paranoid about what can go wrong.

I like convertible arbitrage as a strategy, you know, but we all know it’s often sold as a long vol strategy, but it’s long localized volatility or localized gamma. It’s short, out of the money kind of volatility and gamma as we experienced. I mean there were a number of other things, but that’s probably for another whole podcast to go into what actually happened on convertible bonds in 2008.

But yes, it certainly feeds into what we do today and the way we look at managers, and we look at the opportunity sets, and the way we build our portfolios because we want to make sure that, we’re capturing alpha opportunities and we will be tactical and invest in converts.

When converts had a significant sell off a few years ago, it was an opportunity to get kind of the beta of the convertible arbitrage asset class. But it’s not a strategy that we are in all the time.

We look for, once again, different return streams and different alpha streams to build our portfolios. And some of those have to be defensive strategies as well, which are either, you know, trend following, long volatility strategies that are going to perform well because a lot of the strategies, they may appear to be diversifying but, as you pointed out, in a really stressful scenario correlations increase quickly to 1. So, you need to make sure that you have strategies in your portfolios that will provide the protection that you’re looking for.

[00:22:27] Alan

Yeah, I mean one of the things we’ve seen in the hedge fund space has been the growth of the multi manager multi strats. I mean it’s probably the dominant theme of the last five years. And you’re building portfolios, you’re already building multi manager, multi strap portfolios. So, is there a place for those kinds of strategies or do you feel like you’re doing that job already?

[00:22:49] Alexander

Well, to be absolutely honest, I think the growth in fund of funds and then the decrease in their AUM has been somewhat replaced by the multi manager funds. Right. And why is that?

Because these guys, they get access to the managers, more managers and they also can reallocate on a much quicker time basis. And they can also put their stop losses in for certain strategies or managers which is much more effective than your classic old school fund of funds were.

And therefore, I think that is one of the reasons you’ve seen a significant decrease in fund of funds and the massive increase in the multi manager funds. They’ve done extremely well. Hats off to them. They have kind of competed out a part of the market. But it makes sense, right?

One has to realize that these are a better opportunity or a better way to allocate to certain types of managers or to get the access. So, we have included multi managers in our portfolios.

They can be seen sometimes as a kind of a core allocation because they’re already diversified themselves. The one issue I do have with a number of them is the liquidity that they now allow investors to access. Which, you know, because of their success, they have tightened the liquidity constraints for redemptions significantly and pushed out a lot of people that might want to invest in those strategies.

At the same time, we’re seeing a lot more kind of quant multi manager strategies pop up which are quite interesting as well. They’re not exactly the same as the Citadels and the Millenniums, so they can’t be compared one for one to those. But they are still multi manager or multi strategy approaches which remain somewhat liquid for the moment, and are quite interesting ways to access the market if you don’t want to go into a five year lockup.

I mean, hats off to the Millenniums and Citadels that can do that. But I don’t think it’s in the interest of investors. It’s in the interests of the multi strats to do it, but not in the interest of the investors.

[00:25:10] Alan

And with, I mean the multi strats, as you say, very phenomenally successful. The returns are there for people to see. I mean the strongest of the asset growth has been in the last few years. So, in a sense it’s kind of unchartered territory. I mean, do you see any risks there? We talked about the global financial crisis. No two crises are never really the same. But, I mean, we saw back in Covid stresses with the basis trades and things like that. Would that be on your mind as a risk factor or do you think the risk management approaches are very, you know, that’s a key part of their selling point. So that helps mitigate those kind of tail risks?

[00:25:50] Alexander

Yeah, I think their risk processes, in general, do help mitigate those types of risks, but they also transmit a lot of those risks and those risk management processes transmit a lot of the risks to the market. So, when there is a stress event and these multi management shops are pulling the plug on certain strategies that can create a lot of turbulence in the markets which smaller managers can suffer from. So, you have to be cognizant of the crowding effect and the unwinding effect that these large multi manager shops can bring to the markets.

I’m not that worried, to be honest, about them in the multi manager shops themselves. But the turbulence they create, it’s like flying behind a jet. Right. And the turbulence from that wind can be massive and especially in a risk-off environment.

[00:26:52] Alan

Yeah, I mean I was reading a research report, I think it was from AQR, there recently about you know, how a lot of investors, their portfolios don’t kind of, they deviate from what might be the optimal portfolio because of various constraints, and complexity might be one of the constraints. And obviously once you get into kind of alternatives and hedge funds, that’s definitely something to keep in mind. I mean, is that something you find?

Do wealthy investors, are they happy to kind of delegate that selection to your team or do they feel less comfortable investing in hedge funds because of that complexity, and it might be something that they don’t fully understand themselves?

[00:27:38] Alexander

So, the first part of your question, do the constraints create issues building portfolios?

Absolutely, unfortunately it’s very hard, and I think it’s only happened once in my life where I’ve been able to build an unfettered, unconstrained hedge fund portfolio. Right. The constraints from institutional clients, often on either liquidity, or on the types of strategies, or some other constraints do put a lot of boundaries on what you can put in portfolios. So, you’re never building your pure portfolio that you would might want to – your ideal portfolio.

But once again, life is not ideal and it’s not perfect. So, you kind of have to live with that every day in everything we do anyhow. But yes, those constraints definitely, you know, the less degrees of freedom you have, for a manager or anything, I believe that will constrain your ability to generate better returns. But it’s something we have to live with. It’s normal that institutions or even clients have these constraints.

Once again, I think on the high net worth individuals, they’re a little bit more open because they might have less constraints, especially the super high net worth individuals and they might just want to buy into an approach or a story or like I said, they have very strong instincts and therefore they might have more degrees of freedom on what’s included in that portfolio.

[00:29:21] Alan

We’ve talked about kind of the big trends in the last few years. Multi strats being one. The other one that’s obvious is the growth of private markets which has occurred, obviously, due to various regulatory changes. And I guess, obviously, capital has flown in in response to strong returns in some sectors. Again, there are, in some quarters, concerns with how is this going to play out? Is there too much money in the space? So how do you balance kind of, what’s your perspective on the opportunity in the private markets versus the risks?

[00:29:56] Alexander

I love the opportunity. It’s been growing and the opportunity to access private markets has increased, which is great. There are two ways to kind of attack it.

One is the absolute growth has been growing but that’s because the banks are being disintermediated and there are more opportunities, which is good, right? Because it gives you access to these strategies which before might have been the sole domain or majority domain of banks.

And there’s another area as well which is the democratization of these strategies to be able to have access to them at the same time. Before, they were solely available to large institutions who could lock up their money for 5, 10, 12 years or 15 years depending on the asset classes in the private markets. It’s very hard for somebody with 5 million to invest in something that where the money is going to be locked up for 10 or 12 years.

So today you have what we call and it’s marketed or marketed as a kind of democratization of private markets to high net worth individuals. Specifically with these evergreen vehicles which, once again, I think are extremely good. There are lots of caveats to them, right? There has to be a clear understanding of what you’re getting into, and you have to, you know, make… It’s very important, on the selection bias, to select the good managers in this in these areas.

But there are a lot of evergreen structures which I think are very interesting opportunities to access strategies that have, up to now, been difficult to access for high net worth individuals with very interesting return streams. So, we have onboarded a number of these strategies for our client base to access. Once again, it’s important to make sure that when the clients do invest that they understand, you know, that there’s not a miss-selling of them.

These are semi liquid vehicles. They’re not liquid, even though they might look like they’re liquid because they provide, you know, monthly or quarterly liquidity. But normally those are with gating functions of 2% or 5%, 2% per month or 5% per quarter.

So, it’s a great way to have access to these strategies. The return profiles are extremely interesting. They’re very steady. There are accusations, as you pointed out. There are some caveats. You know, a lot of people call it volatility laundering because they’re not mark to market. They’re not publicly traded, and that can create issues.

So once again, the due diligence, the operational due diligence to make sure you’re picking the right managers who have very solid valuation methodologies that you can double check is important.

[00:33:02] Alan

And what about the accusation? Or maybe that’s a bit strong, but I mean, there’s almost been a sense that these are different asset classes. But ultimately, like, private credit is still credit, but it’s in the private markets. Is it just that you’re getting unique opportunities at a higher yield? Is that the kind of opportunity set that’s compelling?

[00:33:26] Alexander

Absolutely. I mean, yes, you’re absolutely right. There’s still credit. Right. And so why is private debt credit different from high yield?

Well, maybe high yield is better and it’s liquid, but at the moment you can pick up a couple of hundred basis points and extra return. Right. The mark to market is not there, as we were talking about. So, the volatility is a lot lower.

For example, taking the Japanese market in August, when it went down nearly 20% and then a week later it went up 20%. Do you really want to live with that volatility when you don’t have to? So, what was the right market?

It wasn’t valued, really, 20% less and then 20% more like a week later. There was just a technical market event which pushed down prices and then pushed prices right back up. Right.

So, you’re avoiding those types of situations, but you do have to make sure that your marking is correct in these evergreen structures. I have a, you know, preference for the specialty finance and private debt area.

I’m a little bit more skeptical about having private equity in evergreen structures because the duration in those investments are much longer, where in private debt, the average duration is three years. In these evergreen structures, there’s a liquid bucket of roughly 20%, or 15% to 30%, depending on the fund. So, there is a liquidity component to it.

And then specialty finance strategies. There can be some very interesting strategies across working capital, consumer… There are a whole bunch of different strategies that can be extremely attractive that, once again, clients historically haven’t had access to. So, these private markets are opening up, growing.

There is an illiquidity premium, a complexity premium, and so you can pick up a couple hundred basis points over more classical investments and without taking on additional risk.

[00:35:33] Alan

Yeah. And for strategies like that, where the attraction is that higher yield, are they displacing fixed income in portfolios, or equities, or both? Or where might that allocation previously have gone that’s now, say, going to private credit?

[00:35:51] Alexander

There’s definitely some of it coming out of the old school hedge fund allocations. And then private credit can also be a complement to fixed income. I don’t say it completely replaces it. In 2022, fixed income, which is normally a stable investment, was heavily impacted by duration. A lot of these private credits have floating rates.

There are a lot of strategies that have floating rates which take out the duration that one can be exposed to in your classical fixed income portfolio. So, they can be seen as a complementary to your fixed income portfolio or they can just be seen as a hedge fund allocation. And I think they take a little bit out of both. Right?

[00:36:37] Alan

Yeah, okay. And you mentioned it’s kind of more challenging for private equity in evergreen structures, but do you still find that segment attractive?

You know, there’s a lot being written and debated for private equity. You know, IRRs, when you’re comparing IRRs versus more traditional rates of return, (not overstating the attraction) how attractive do you see the asset class?

[00:37:06] Alexander

To be honest, I don’t look at the private equity that closely. Private equity is run by a different team at Edmond de Rothschild. They do a very good job with that. So, we do not look at the private equity as a part of our alternative universe from our side, on our team. It’s done by a completely different team.

[00:37:25] Alan

Okay, fair enough.

So maybe moving on to, in terms of thinking about particular types of managers you like, in that kind of manager selection process and challenge, as you say, everybody’s got constraints. Are there constraints, or biases, or preferences from that perspective in terms of size of managers, length of track record, etc. How do you think about what’s your preference for managers?

[00:37:55] Alexander

My personal bias is for mid-sized managers because I believe that one needs to stay nimble. So, I’m always a little cautious about the sizes of managers. Mentally, I normally put a capacity limit on my managers.

If they get above a limit, then I tend to have a preference to maybe exit those managers. Obviously, there are some really big shops that do really good jobs, so we’re not blind to those. But we’re talking about, you know, we have individual preferences and biases which we try not to let influence our decisions. And that’s why we make decisions by teams and not by one single individual.

We have an investment committee, we have a whole, you know, a large team that we work with. So, hopefully my biases don’t over influence.

But on a personal level I prefer mid-sized managers who have demonstrated the ability to generate alpha consistently and are small enough and nimble enough to be able to take advantage of those opportunities.

[00:39:02] Alan

Okay, so there’s kind of an inherent kind of tension or conflict between obviously smaller managers are more nimble. Bigger managers have bigger teams, more research budgets. So, it’s kind of trying to find a balance between the two, I guess. Is that it?

[00:39:14] Alexander

Absolutely, right, and you’re absolutely correct, Alan. And we do have large managers in our portfolios. We have mid-sized managers. In my current role we have less emerging managers just because we’re more conservative. We have a more conservative approach being a Swiss private bank. So, we do less or nearly no emerging managers.

But in my previous shop we did seed lots of emerging managers, which can be very interesting.

[00:39:45] Alan

Yeah. And obviously you were a trader at a convertible arb. So, you were a trader then and part of a fund. So, you’re kind of familiar being on the hedge fund side. And presumably, I don’t know if you had exposure to allocators coming in, asking questions, at that point in your career, but I mean, has that helped inform you to kind of be aware of the kinds of things that managers are not telling allocators, or the questions that they don’t want to ask?

[00:40:11] Alexander

Absolutely, absolutely. As an allocator, our role, it’s kind of like you go in, it’s this iceberg analogy, right. The hedge funds show you what they want to show you, right. Which is the above the water and the glossy parts and everything else. Having been on the other side, I know, exactly. Not that we ever hid anything in the drawer, but there are sometimes things that you don’t always want to show or talk about.

So as an allocator, when I go and meet with managers, I don’t like just to be shoved into the conference room and have the managers and traders or you know, our analysts walk in one by one and then describe their strategy to me.

I’m always like, I want to come and sit down on your desk, I want to see your systems, I want to see how you’re trading, I want to see how you look at your portfolio and really get into it with them and point out questions and say, you know, what’s this doing there? What does this number mean? What if.

And you can be significantly surprised. One, sometimes by how basic some hedge fund manager’s systems are, which is absolutely shocking because we had extremely good systems. Now this was nearly, this is more than 20 years ago when I was a hedge fund manager, hedge fund trader, and we had very sophisticated systems.

So, it’s shocking today to see some managers with systems that are relatively basic. It’s sometimes shocking to see how managers don’t understand their risk or don’t have a good way to look at their risk live, in real time. And that’s what you learn, or at least that’s what I learn when I go in and visit managers.

I sometimes also have done surprise visits to managers. That way I can try and avoid the marketer and say, oh, the marketer’s is not in, good. That’s exactly what I wanted. I wanted to sit down and speak not with the first PM or the second PM, but the third PM. Right. Because the other guys might not be there.

And that’s a very interesting opportunity as well, where you can learn a lot about the managers because often you’re just shown the marketing, the business development people, the main founder or the main PM. But talking to the second or third person down the line can be very interesting as well.

And seeing the systems for me, having worked with them, traded with them, sat in front of Bloomberg’s for hours every day for over seven years. It’s very informative. Correct. And I actually enjoy it.

[00:42:47] Alan

Yeah. I mean do you find hedge funds open to providing that access or is there pushback? I mean obviously you’re a big allocator, Edmond de Rothschild, not everybody will be offered that kind of access, but generally do you think that level of access is more forthcoming these days?

[00:43:01] Alexander

Yes and no. It tends to be sometimes the largest shops, maybe they use a compliance excuse. And once again, maybe one of the reasons I don’t always feel as comfortable with the larger shops, because they say, oh, so we can’t do that. The mid-sized guys, once again, are normally quite open because they’re looking to get capital and grow. So, they typically say, oh, okay.

And I try not to tell them beforehand always because I don’t want them to prepare me a set thing. I want them to be unprepared when we go to the desk and sit down with the desk. Right. And see what their desk looks like, see what everybody’s doing around them as well. So, I prefer to try and surprise them. It’s going to be less of a surprise perhaps after this, but I prefer to ask the managers once I’m there so it’s not prepared. I’m trying to get the managers in the most natural environment and be able to see what they’re doing and have them explain it to us.

And, you know, we’ve picked up on things where we have not invested in managers following those.

[00:44:05] Alan

And is that in terms of kind of risk processes or just the people?

[00:44:09] Alexander

A combination of misinformation sometimes. Right. Because you can’t hide something and say, all right, we’re running 500 million. Well, why does it only say 200 million over there on your system? And not understanding, you ask them about the different risk exposures and they can’t explain them clearly to you.

That can be all warning signs, from a number of signs that you can identify when you’re there, and you get the feeling of how the team is. So, no, no, it can be very informative and it’s very interesting.

[00:44:46] Alan

Yeah. I mean, at the start, you talked about your very early experiences playing black backgammon and luck, and scale, and odds, and probabilities, which are, obviously, all inherent in the job of managing a portfolio. Now when it moves into the job of selecting a manager, I mean, they still apply, but obviously there’s a big qualitative element as well. I mean, how do you think about that challenge of disentangling luck and skill when it comes to the job of manager selection?

[00:45:18] Alexander

I came across a quote on that the other day. I think it was from Robert Heinlein, who’s some kind of writer, and it says, There’s no such thing as luck. There is only adequate or inadequate preparation to cope with a statistical universe.” And as a backgammon player or a poker player, that’s the mentality you have.

You’re playing the odds and what you’re trying to do is put the odds in your favor on every move or every time you’re playing. Right. You’re not looking for the big win. Right. I mean, it’s nice to have a big win, but the idea is you’re playing an odds and statistical game, right. Where you are trying to put the odds in your favor.

Sometimes the luck does not go in your favor, but then you defend as well as possible. And sometimes the odds and, well, most of the time (hopefully) the odds and percentages work in your favor. Right. And therefore, you’re going to make the money or you’re going to make the trade that you expected to make on it.

And that’s exactly what we look for from hedge fund managers.

We’re not looking for guys who can hit the ball out of the ballpark every time, but we’re looking for guys who just incrementally have some kind of edge, and are applying that on a systematic or on a continuous basis, and trying to pick up those pennies without taking a massive risk. It’s not picking up the pennies in front of a steamroller, which is the classic example, but who have an edge in doing something, which they’ve done for a long time, that’s repeatable processes that they’ve put in place where they can continue with that edge. What happens often in a lot of hedge fund strategies is that people do have edge, but then that edge can be slowly whittled away.

And this was exactly what happened when I was an options trader. There was a lot of edge. You didn’t have to be super smart. I mean sometimes they called people down on the floor monkeys because they would just raise a tick and get in on every trade and they just have to hedge themselves out and they will lock in a certain edge. Right.

And then the markets got more complicated, as I mentioned. We got multi listings, so there was more competition, and we got decimalization, which reduced the edge. So, a lot of strategies, the edge over time will reduce.

And our job is one, to identify when the strategies have less opportunities and two, to help to identify new strategies that are coming online in new areas, new markets, where we can move our clients’ money to consistently generate the alpha that they’re looking for, that we’re looking for.

[00:47:50] Alan

And do you think you can do that? I mean like tactically (maybe it’s not very tactical), but I mean at least opportunistically respond to where the opportunity set is growing. Sometimes people say, oh, the opportunities, that doesn’t look great for macro, or it does, but it always seems to look like a fairly volatile environment and reasonably good.

So, I mean, is that something you think you can actually do, opportunistically shift around the portfolio?

[00:48:17] Alexander

Well, the question originally kind of comes from to move to managers where there’s more edge, which is more fundamental than tactical.

So, I would say that we try to identify areas where there’s a lot of alpha in the market still or where there should be a greater opportunity to generate alpha. On a tactical basis, it’s a very good question.

And this is where I guess multi manager shops perform extremely well because they can see the opportunities, the information flow is very quick, it’s not instantaneous, on a daily or weekly basis. And then they can reallocate to where the opportunity set is.

Our information flow is a lot slower often, even though it’s been getting better and better. And so, we will and can take tactical views, but not at the same speed that maybe the managers that are… for sure not the same speed that the managers that are in the markets all the time are.

But we would make tech when we see an opportunity because some asset class has maybe been blowing out or some strategy style has been blown out for some reason, which sometimes clears everything out. The strategy underperforms massively, but then that often creates a good environment going forward.

So, we are sometimes a little bit contrarian in our approach to strategies and we monitor it very closely. We’re in contact with hedge fund managers on a daily basis across different strategies and therefore we look to take advantage of those opportunities when we can. They’re not that frequent, but we will try to.

[00:50:00] Alan

Yeah, I mean my impression is with a lot of investors that they haven’t necessarily had the greatest experience with hedge funds. I mean certainly allocations to hedge funds in sub segments like family offices do not seem to be that high. A lot more to private markets.

I mean, why do you think there has been, for some, that disappointment with hedge fund allocations? And maybe linked to that, what do you think the typical mistakes have been in approaching the hedge fund space?

[00:50:28] Alexander

Like I said, I worked for just over 10 years in France, and for the most part that most institutions hate hedge funds. And when we tried to talk to institutions, we would often not talk about hedge funds, but absolute return strategies.

That being said, I think the issue came because a lot of people invested in hedge funds precisely at the wrong time, just before 2008. So, a lot of European institutions were hurt by hedge fund strategies in 2008, therefore they didn’t get the whole write up before, right?

So, they had this large drawdown. And then following 2008, specifically in Europe, you’ve had the explosion of alternative UCITS. And while this was a liquid way to access some hedge fund strategies, the problem was that a lot of UCITS strategies were geared to a very low volatility target because European clients tend to be, in general, more risk adverse than maybe in America.

And therefore, when you have hedge fund strategies for UCITS, alternative USITS which are targeting 4 to 6 volatility, but then interest rates go to zero and they end up generating basically 3% to 5% volatility. And then you try and create a hedge fund or fund of fund portfolio of UCITS, then you end up with about a 2.6 volatility fund.

And then one of those low vol funds always messes up and loses 10%. But the other strategies are not making 10% or 15% because they’re not geared to that. So, it’s very hard to recuperate.

You don’t have 100% hit rate so there’s always one fund that messes up and you don’t have enough juice in your portfolio to make up for that fund that performed poorly. And therefore, the absolute return on like the fund of fund UCITS ends up being 0% to 2% or 3%. I mean I’m talking in general.

Therefore, today with interest rates having moved up to 5%, you’ve seen a significant amount of money come out of alternative UCITS. I think there was a Kepler report indicating 25% to 30% of AUM has come out of alternative UCITS.

And the fund of fund industry has been decimated in part because of the multi manager that we were talking about, but also in part because they haven’t provided the types of returns that clients have expected.

So, one has to adapt to the environment one is in and be able to move on and provide clients products that are more adapted to their needs, that might have some private markets in them. Because you know, our job is to deliver the returns to the clients in a risk adjusted way.

[00:53:32] Alan

My sense is that there’s maybe been a little bit of shift in the UCITS space towards now offering higher octane, higher volatility products in response to that. Is that something you’re seeing? I mean in terms of volatility profile, you’re open to that kind of strategy presumably?

[00:53:52] Alexander

Absolutely.

We’re seeing more today and recently in the last, you know, maybe six, eight months, we’ve seen more of the UCITS that are coming to markets at higher volatility target levels. You know, ideally, we would want to build a portfolio of high vol decorrelated strategies. Right. Because that’s the best way we can generate returns for our client. Not negatively correlated, but decorrelated strategies.

And then the volatility, to a certain extent, takes care of itself because strategies are decorrelated. The problem is often a lot of strategies are more correlated than one thinks, especially on the downside, as you were mentioning before, when correlations spike up to 1. So that’s when you build a portfolio you have to be extremely attentive to that.

[00:54:43] Alan

Yeah, and we talked about manager selection, strategy selection. I mean when you have managers in the portfolio, anything obvious? I mean I’m sure there’s a range of reasons that can prompt you to deselect remove a manager but what are the typical reasons for that (outside of performance is the obvious one I guess)?

[00:55:04] Alexander

Right. Performance obviously can be one of them. Obviously, a manager PM or a co-PM leaves, immediately we will either divest or… I mean if it’s a co-PM structure we would definitely have a look. There can be operational issues that are highlighted.

I’m just thinking of one recent manager that we divested from which was a relatively levered strategy. They’ve had a 10-year track with no down years but the performance in the last two years has just been on the low end.

It wasn’t a very high capacity strategy but because of that they started getting some redemptions and so when the AUM drops for strategies that use leverage it might trigger ISDAs. Their ISDA triggers and therefore we might feel uncomfortable. So, on the operational side that can be a reason to divest from a manager.

We can divest from manager just in case we find a better manager as well. If we find a manager that we feel like is doing better or we feel like the returns, you know, the alpha generation is being squeezed for some reason, we might look to get into a strategy where we feel there’s more alpha opportunities as well. So, there are a number of reasons from operational, to performance, to better opportunities that we may divest from a manager.

[00:56:37] Alan

Good. So, conscious of time, great to get your perspective on all of those in relation to the portfolio.

We always do like to wrap up by asking our guest, you know, for some thoughts or advice for people who are maybe earlier in their careers looking to build a career in manager selection or fund research. Any thoughts or advice or things that have been helpful for you in your career?

[00:56:59] Alexander

I think getting practical experience is very important for a manager selector. Right. I mean our team, we have a lot of people who have been trading the markets because that’s the best way you can understand really what managers are. If you don’t understand the instruments or even how the instruments are traded, I think you’re at a disadvantage.

So, you might not want to be a trader, but getting spending some time on the floor, even on the operational side or even technical side, but trying to have that experience, even if it’s only for a year or two, I think is crucial because if you don’t understand the underlying instruments, it’s hard to understand the actual strategies of the managers. So, that’s probably the first and most important thing.

And then obviously, you have to be passionate about the markets. Right. When you’re a hedge fund selector, you get to talk to some of the smartest people in the world on a daily basis who are probably much smarter than you. So, you have to have a relative amount of confidence talking to them and confronting them, because you need to confront them from time to time.

And you also have to be extremely interested just what’s happening in the markets. I mean, I was reading Economist magazine since I was a young kid. Somebody introduced it to me, which I think is also a, you know, it’s a great perspective. It gives you a wide global view of what’s happening in the world.

It talks about markets, it talks about economies, you know, and not to mention, it espouses some, you know, very good classical liberal values of free trade and open markets and individual freedoms, which are all items I adhere to. But that would be some advice from me.

[00:58:36] Alan

Good stuff. I think that’s good advice and certainly valuable to have experience in the markets, I think. I absolutely agree with that. And Economist is a good publication, too, so very good.

[00:58:48] Alexander

The articles are short. They’re humorous sometimes, so it’s not like these long reads. Right. Each article is relatively short. So, I agree with you.

[00:58:59] Alan

Yeah. Well, Alexander, thanks very much for coming on. It’s been great to get your perspective and get some insight to how you run the portfolios and select managers at Edmond de Rothschild. So very much appreciate it.

From all of us here at Top Traders Unplugged, stay tuned. We’ll be back soon with more content, so stay tuned.

[00:59:20] Ending

Thanks for listening to Top Traders Unplugged. If you feel you learned something of value from today’s episode, the best way to stay updated is to go on over to iTunes and subscribe to the show so that you’ll be sure to get all the new episodes as they’re released. We have some amazing guests lined up for you. And to ensure our show continues to grow, please leave us an honest rating and review in iTunes. It only takes a minute and it’s the best way to show us you love the podcast. We’ll see you next time on Top Traders Unplugged.