Alex Wise

Following the launch of global fund manager brands such as ChinaAMC and Neuberger Berman ARMS into Australia, OneVue group has announced a significant increase in the number of investment managers using its responsible entity (RE) services.

“Momentum has been strong for us in the RE space in 2015. OneVue RE Services has launched or transitioned seven new funds including Clime International, Sanlam and REITWAY funds with more to come before Christmas and a significant pipeline into the New Year” said OneVue’s Head of Investment Management, Alex Wise.

“More funds are coming to market outside the traditional sphere and we are seeing more demand for International strategies and also alternative investments” Wise continued. “We believe this demand for alternative products is firmly linked to market volatility and investors seeking lower risk, alpha style opportunities, whilst investing outside of Australia has been driven by attractive opportunities and valuations in certain markets”.

OneVue had recently launched the NWQ Fiduciary Fund as a retail scheme and also YBR Protected Equities with a similar approach to investing.

”NWQ Capital Management is moving quickly to respond to the increasing demand from high net worth retail investors for risk-managed solutions given the challenges which traditional asset classes currently face. OneVue has been a logical partner in this process as we transitioned our business to PDS disclosure and the regulatory scrutiny which accompanies it,” said Stuart McClure, Managing Director of NWQ Capital Management.

“Following the recent stream of successful launches have clearly demonstrated how our service appeals to high quality boutiques as NWQ as well as known global brands such as China AMC” continued Wise.

Additionally Wise noted that OneVue has seen further activity in the Significant Investor Visa (SIV) sector. “We are known in the market for dealing only with high quality SIV Funds and we have added further Funds to the 188 Universal Platform we administer.

OneVue has added the following Funds in 2015 using responsible entity and trustee services:

• Clime International Fund
• Sanlam REITWAY Global Fund
• ChinaAMC China Opportunities
• 188 Universal– Bond Fund
• NWQ Fiduciary Fund
• YBR Protected Equities Fund
• Tyche Growth Fund

Wise concluded by divulging that “OneVue will be launching a number of new funds over the next quarter with a continued focus on International Assets and alternative strategies”.

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Alex Wise

Two leading Research Houses, Lonsec and Zenith, have maintained their “Recommended” and “Approved” ratings (respectively) for the Neuberger Berman Absolute Return Multi Strategy (ARMS) Trust.

The Neuberger Berman ARMS Trust is administered in the Australian market by the OneVue Group.

Lonsec says the Trust is managed by stable team of experienced investors, who Lonsec believes have a strong alignment of interest with (ARMS) investors.

“Relative to Lonsec rated peers in the Fund of Hedge Funds sub-sector, the Trust offers investors a greater level of liquidity (daily) and transparency at the lowest total fee load.

“While the Trust has only been recently established, the underlying ARMS Fund has a longer track record,” the Lonsec review notes.

The Zenith review says that it Zenith is supportive of Neuberger Berman’s blended quantitative and qualitative approach to make manager selection decisions.

“The portfolio construction process is an output of Neuberger Berman’s top-down analysis and determines the optimal weights to each strategy and the underlying manager combination.

“Neuberger Berman adopts a dynamic and iterative process to manager selection, screening its universe of 3,500 managers sourced from NB’s industry network.

“This enables the team to focus their due diligence efforts on a reduced set of hedge funds that have outperformed their benchmarks,” the Zenith review says.

The ARMS Trust is a diversified alternatives, multi strategy option, that seeks absolute returns through an active allocation to a select group of best of breed alternative investment managers, diversified across strategy types and geographies.

Its investment strategy was first launched by Neuberger Berman in the United States in May 2012 and then in Europe in October 2013. Globally it has US$2.2 billion funds under management at 31 July 2015. ARMS is managed by Neuberger Berman’s Hedge Fund Solutions team, comprising over 60 individuals based in New York and London who have been managing hedge fund solutions since 2002.

OneVue Head of Investment Management, Alex Wise said “Neuberger Berman are market leaders in liquid alternatives investments, and we are delighted that the Neuberger Berman ARMS Trust has maintained these ratings. OneVue continues to achieve success in the responsible entity market and as a wider fund services provider and we are proud to work with Neuberger Berman in this regard.”

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Alex Wise

Select Fund Services (Select) has made Neuberger Berman’s Absolute Return Multi Strategy (ARMS) investment capability available to Australian investors, including the retail and self-managed superannuation fund market (SMSF), with the launch of the Neuberger Berman ARMS Trust.

“ARMS is a liquid alternatives, multi strategy option that seeks absolute returns through an active allocation to a select group of established hedge fund managers, diversified across strategy types and geographies,” says Neuberger Berman Australia managing director Lucas Rooney.

“The Neuberger Berman ARMS Trust accesses the investment expertise of Neuberger Berman’s existing ARMS investment strategy which has proved popular in the US and Europe, raising over $1.6 billion in funds under management in the past two years. We believe that these hedge fund strategies can play an important diversification role in investment portfolios.”

Head of Fund Services at Select, Alex Wise, commented: “As responsible entity for the ARMS Trust, we are proud to be working with Neuberger Berman on the launch of this exciting new investment solution into the Australian market. We have been working with Neuberger Berman for over a year and have absolute confidence in them as market leaders in liquid alternative investments.

“The recent period of low volatility has reinforced a foreboding for many investors familiar with the inherent cyclicality of investment markets. Investors are increasingly searching for lower volatility investments that offer portfolio diversification with low correlations to equities and bonds, and ARMS has delivered on these objectives,” Mr Rooney says.

The ARMS investment strategy was first launched by Neuberger Berman in the United States in May 2012 and then in Europe in October 2013. ARMS is managed by Neuberger Berman’s experienced Hedge Fund Solutions team, comprising 40 individuals based in New York and London and which has been managing hedge fund solutions since 2002.

“Unlike traditional hedge fund investments, the Neuberger Berman ARMS Trust offers daily liquidity, with daily pricing, along with improved portfolio transparency, right down to the stock level. It also offers lower investment minimums than typical hedge funds,” Mr Rooney says.

“Because we invest ARMS’ assets in each underlying investment strategy via managed accounts, we have visibility on all underlying positions, which helps us to manage and control the risk as well as allowing us to share this high level of transparency with our clients.

“Importantly, our ARMS investment capability provides investors with access to ‘real’ hedge fund strategies, which we believe are run by quality active hedge fund managers, and not the ‘hedge-fund-lite’ replication versions, used by some liquid alternatives funds.

“With historically lower levels of volatility than equity markets, and a low beta to equities and bonds, the ARMS investment strategy provides investors with access to high quality hedge fund managers at lower fees than typical hedge fund investments (and with no performance fees at any level), by virtue of our almost unique combination of extensive hedge funds research and large mutual funds presence,” Mr Rooney says.

“We expect the Neuberger Berman ARMS Trust to be sought after as a differentiated source of risk management and return for Australian investors’ portfolios,” Mr Wise concludes.

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The search for the ultimate ‘system’ of efficient portfolio construction and ongoing management has led to some interesting innovations. Here, Select Asset Management’s Alex Wise looks at the evolution of the underlying product structure with an eye to the top-line investor benefit.

Efficiencies in portfolio management have long been a goal of savvy investors and their financial adviser. But today we are shackled with the onerous task of reporting compliance, Dreaded paperwork. The process of completing a Statement of Advice (SoA) for material changes or a Record of Advice (RoA) for minor changes each time a change in investment is required is a tedious and intensive process for all concerned.  Moreover, client investments may be put at risk when markets begin to gyrate. Advisers may not produce timely, written advice to be acted upon quickly enough in order to protect clients. Similarly, clients are often unable to take advantage of short-term mispricing opportunities.

Solution? Two investment structure approaches have evolved to provide a more responsive investment solution for clients. They are, firstly, the use of a multi-asset unit trust as a core portfolio tool and, secondly, the use of managed discretionary accounts (MDAs), while an increasing number of advisers are considering a hybrid solution as the best of both worlds.

Managed Discretionary Accounts

MDAs are provided by a financial planning, fund management or brokerage house – each working as an MDA operator (“Operator”).  Typically an Operator manages a portfolio of equities for a client on an individual or model basis, although solutions exist encompassing other non-equity assets.  A client gives the Operator discretionary authority to make and implement investment decisions on his or her behalf. Importantly, client approval is not required for each investment decision.  This also means that reporting requirements to clients can be simplified and the Financial Planner is not required to  to engage the client in advance each time an investment decision is made.

Certain MDAs can be tailored specifically to the requirements of each individual client. Bespoke MDAs, called individually managed accounts (IMA), require higher minimum investment amounts in order to be practical. More commonly the MDA operator will apply the same investment decisions to multiple client accounts according to a model portfolio i.e. a separately managed account (SMA). Importantly, from a legal perspective, the client holds a direct legal or beneficial interest in the underlying assets within the MDA. This is distinct from managed investment schemes where the underlying assets are held by a unit trust, and the client has a direct interest (a unit) in that trust.

For clients with larger balances, the MDA offers increased control, however, the expense associated with operating an MDA have made it impractical and commercially challenging for small to mid-size clients to get the benefits of a tailored MDA.  Clients with larger sums to invest are able to take more or less risk depending on their appetite or investment preferences – for example, financial securities could be excluded from a bespoke MDA account; perhaps not a bad thing given current valuations!

Some MDAs can offer portfolio protection via derivatives or options strategies.  However, these protections are not available to all clients as they depend on the Operator’s regulatory status and whether they can transact derivatives on behalf of their clients.  Many fund managers and financial planners acting as MDA operators don’t have the necessary licence to use derivatives or options.  This can leave clients exposed without portfolio protection in times of market volatility.  However, for those clients that benefit from an Operator with derivatives experience, market protection strategies can insulate portfolio returns from severe downturns in market values. All with the attendant risks, of course!

Importantly, the tax impacts of investment decisions remain specific to each client.  This means that the Operator ensures that the client’s tax consequences are insulated against the impact of other investors.  Unit trusts offer a similar outcome for all clients.

It is worth noting that many Operators have a lack of experience outside of equity securities.  This can leave clients facing low or non existent access to  bond and other markets (as well as derivatives outlined above).

One further criticism of MDAs is that they usually do not allow access to global investment markets and outcomes.  Whilst many investors are satisfied having 100% of their investment outcome linked to the ASX, many others are now seeking exposure to fixed income or Term Deposits. Global equity markets – including established markets like the US – or more exotic emerging market locations may be in favour.

Additionally, incentives for MDA operators have also been called into question by some observers.  The use of brokerage commission as a remuneration tool has been linked with an incentive to churn the portfolio, meaning that clients will participate in more trades to generate higher commission for the Operator or their affiliate.

Detractors of the MDA model also point to the lack of accessible performance data.  Unlike unit trusts which have audited track records, the performance of MDA operators on a risk-adjusted basis is less clear.

The universe of fund managers operating MDAs is relatively small except in the case of Australian Equity managers.

Many skilled fund managers generating market outperformance or alpha can be difficult or impossible to access via an MDA, particularly the universe of high quality offshore managers. As such, MDAs can also offer access into unit trusts to access these high quality managers. However, even access to these managers via a unit trust can be fraught with difficulty as many highly skilled managers have high entry levels precluding MDAs from rebalancing into these managers.

For the Financial Planning business considering operating an MDA the costs can be high. Australia’s regulatory authority, ASIC, is considering implementing higher minimum capital requirements for MDA operators which may deter many prospective Operators from offering MDA solutions.  Many Operators also suffer from internal costs associated with reporting. Clients who require customised portfolio reporting creates a business drag on the desired scale efficiencies in reporting, including performance and portfolio reporting. 

Multi-Asset Unit Trust

Many financial planners are also utilising or considering the use of a multi-asset unit trust to act as a core portfolio.  Like an MDA, the discretion to make investments is vested with an investment manager which can be the financial planning group or a third party manager.  This obviates the need to make ROAs and SOAs every time a change in investment is required.

The unit trust would then make investments into third party fund managers or direct assets that can be based in Australia or offshore. Groups that utilise the unit trust solution enjoy the ability to access any investment fund anywhere in the world.

Whilst this approach requires research, many unit trust sponsors will utilise an asset consultant or third party manager to implement research on these funds.

Endowment ‘likes’

Access to the global talent pool is important for investors who seek to diversify their returns from solely Australian equities or fixed income.  Many sophisticated investors are now looking for “endowment like” portfolios that deliver long term returns. These investors view the ASX as being increasingly volatile and the access to unique investment strategies offshore can reduce overall portfolio volatility over time.

Access to market protection is also a key selling point of a unit trust with a unit trust operator being able to hedge foreign exchange, interest rate and market exposure.  These traits are important for those seeking endowment like characteristics.

Responsible entities of unit trusts are subject to rigorous supervision from the ASIC.  Supervision visits and high regulatory capital requirements mean that responsible entities operating a unit trust are subject to higher regulatory standards than MDA operators.

Unit trust structures do come at a price however, and the fixed costs of operating a unit trust can preclude access from smaller groups with small amounts of funds under management.  Whilst providers such as Custodians and Auditors offer protection to investors, they charge additional costs which are typically recharged to unit holders.  Moreover, any third party responsible entities or asset consultants will need to receive fees for their services.

Additionally, ownership of the underlying assets is co-mingled and clients hold units in a trust rather than the underlying investments.  As such investors are subject to the redemption rules of the unit trust rather than having the ability to sell investments directly into the market.

Summary

Whilst MDAs and Unit Trusts deliver significant efficiencies to clients and advisers, both also bring  pros and cons which should be understood prior to embarking on either strategy.  The ability to access a global investment talent pool through a unit trust is tempered by the lack of direct ownership of investments and additional costs.

The MDA often lacks ability to enact portfolio protection from violent swings in foreign exchange rate, interest rate or market movements.  Additionally, the limited pool for accessing investment ideas through an MDA can be off-putting for some clients.  Many financial planning groups are proposing solutions that include a unit trust for a core portfolio but on an MDA platform for satellite investments so that benefits of both can be realised.

Note: The accreditation for this CPD article is no longer current. Please visit our CPD section for current CPD quizzes. 

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Alex writes his perspective from the position of a multi-asset investment firm that has incorporated some hedge funds and other alternative investments into its diversified portfolio construction since inception in 2002.

——————

There have been attempts over many years to classify alternative investments and hedge funds into defensive and growth categories. Why? Expediency is one reason – the primary purpose was to mirror existing industry terminology used to classify mainstream asset classes like shares and fixed interest.

Additionally some allocators placed hedge fund strategies into specific asset classes based on their return characteristics.  Low risk (or more accurately “standard deviation”) funds were included as “fixed income” and higher standard deviation managers as “equity” irrespective of whether they invested in those asset classes!  This made portfolio construction easier but failed to analyse the true characteristics of these investments – allowing the crazy situation of derivatives funds classified as fixed income.  The problem was that these low or higher standard deviation hedge funds did not exhibit the same characteristics as equity or fixed income in many other ways and they shouldn’t have been sold (or bought) on that basis. It is not unreasonable however, where the advisor is more sophisticated, that long/short equity funds that are exposed to the market can be included in equity allocations as they exhibit the same characteristics based on many measures.

Unsurprisingly confusion remains. Which is why many expert investors and their consultants deal with the categorisation issue through the creation of a separate ‘alternatives’ allocation within a diversified portfolio – mostly made up of hedge funds. The existing asset classes within the portfolio are then proportionately reduced to take into account the inclusion of alternatives.

As discussed in previous articles, accessing alternatives requires specialist expertise. The skills required to realise the full benefits of alternative investments should always include:

• The ability to assess which opportunities are worth exploring further;
• The ability to perform the required due diligence;
• Experience and industry networks;
• The ability to discern which investments are appropriate for clients;
• The ability to access certain structures and offshore domiciled funds.

Alternative investments increase portfolio diversification.  A diversified portfolio which includes assets with different risk and return profiles is difficult to build.  A diversified portfolio helps reduce overall risk without necessarily impacting expected returns. A single manager fund exposes an investor to idiosyncratic risks associated with a single manager, for example key man risk of investing with a ‘name’ portfolio manager.

Alternative investments provide access to specialist investment opportunities.  Some of the best opportunities are normally only available to sophisticated investors including large pension schemes or endowment managers. In turn most of these single managers are only available to wholesale investors.  A diversified portfolio can provide access to these “best of generation” investment managers with high alpha potential.

Using a diversified portfolio materially reduces single manager investment risk. This is essential given the complexities that are involved in understanding and accessing some alternative investments.

Provided an adviser and the client have agreed on the diversification benefits of utilising alternatives, the most important question is sizing; how much should be allocated to alternatives?

Investment views on allocation weightings vary. Typically, a diversified portfolio can hold between 10 per cent and 35 per cent in alternative investments at any one time of which the largest part is likely to be hedge funds.

Hedge Fund Behaviour

Equity Funds

The term “hedge funds” comprises many different types of investment styles.  As hedge funds invest differently (for example some invest in equities others in options) it’s not easy to group their returns as one.   There is significant risk in looking backwards at how alternatives have performed in the past.  Having said that, it is worth noting that during the GFC many hedge funds dropped in value as they were positioned to capture market upside or they were “net long the market”, however prior to the GFC these funds had performed very well.

Many lessons have been learnt from the GFC, in particular improvements in transparency and liquidity – meaning investors can “see through” into certain investments to ensure an understanding of the market risk or “beta” that they are exposed to.  Additionally, the evolution of liquidity means many high quality equity hedge funds can be accessed on a daily basis – particularly those that are regulated in the US or Europe.

As stated above many investors classify long/short equity funds as “equity”, which really means “market risk” or beta.  This allows investors to seek out outperforming funds “alpha” and the pay the premium for this skill.  These are often mult-strategy funds that can invest across the spectrum.

The primary driver of these improvements is founded on allowing investors a clean exit in the event that the underlying investments fail to perform.  For our firm, this means access to these strategies with the additional benefit of low fees.  If equity markets perform poorly and these funds are net long these funds are likely to underperform historic NAV highs – but potentially outperform the index.  In such an instance the enhanced structural aspects mean investors can go to cash quickly.

Market Neutral

Strategies such as market neutral (where the manager is long and short often in equal measures) should also outperform equities. These funds take advantage of small mispricing between similar or related securities and tend to use leverage to exploit small pricing inefficiencies.

Systematic Funds/ CTAs

Other hedge fund strategies such as systematic funds performed well in 2008; during this time our firm had exposure to systematic funds or “CTAs” that performed well.  Many believe these strategies responded well to the volatility in the market.  Evidence this year indicates that CTAs fail to perform in periods where equity markets are range bound and bonds underperform.  Many had not expected that both bonds and equities would underperform at the same time and as such both CTAs and equities tended to underperform.

This adds complexity in considering the role of CTAs in a portfolio with many international investors remaining cautious that CTAs can provide portfolio protection in all circumstances where equity markets are flat or even falling.

Tail Risk Funds

Tail risk is the risk of outsized losses outside of the normal distribution of returns, some funds are structured to take profits from these outsize events (“tail risk funds”).  During the GFC some strategies performed extremely well, for example tail risk funds which profited from volatility in markets.  However, these funds tend to perform relatively poorly in a rising market; one of the tail risk funds held by our firm in 2008 made a triple digit return whilst equity markets collapsed.  Many of these funds are also described as long volatility.  Generally in a falling equities market, long volatility and tail risk strategies perform well.

Diversified Alternatives

As discussed above a diversified portfolio of alternatives reduces reliance on one particular asset class.  It is rare to find an asset that outperforms in any scenario! Some managers can exhibit these characteristics and charge high fees to compensate for this rare skill.  By investing in a diversified portfolio – in theory the fund should perform well versus a cash benchmark (or absolute return investing) – as opposed to benchmarking against the market. The range of hedge fund strategies is balanced with the objective of providing “all-weather” protection for investors.  The allocations can also be rebalanced during the cycle to adjust the allocations to alpha and beta.

There is no guarantee cast iron or otherwise that investments will perform as expected.  We all know that that past performance is not indicative of future returns.  The alternative to looking backwards is looking forwards. Performance based on an expected set of worked events can of course be modelled although this is more of an art than a science as prescience has not been a widely bestowed gift since the days of the Hebrew prophets.

Summary

On the whole alternative investments can bring lower correlation with traditional asset classes. This means that when blended with mainstream investments they can help to smooth out an investor’s portfolio returns over time (particularly taking into account times of market dislocation).

Investing in a single hedge fund requires deep analysis on the investment strategy and how it can perform across a range of market scenarios. Where advisors choose one or two hedge funds there is a risk that those strategies can respond poorly at times when protection is needed. It’s also a big mistake to classify funds as equity or fixed income solely based on their standard deviation as an indicator of risk.  A CTA for example has a considerable departure form traditional asset class thinking and is a million miles from fixed income in many respects.

Many institutional investors deal with this problem by building a diversified portfolio of alternatives assets with a target weighting often in excess of 10 per cent.  They also use specialists to help build the portfolio.

Building a portfolio of alternative investment requires expertise in understanding complex investment strategies and the ability to undertake due diligence including business risk due diligence.

Select Alternatives Portfolio

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Looking beyond the Hedge.

Advisers and their retail clients cast a wary eye whenever the expression ‘hedge fund’ is raised.

Why so? Institutional investors have embraced alternative investing with great vigour, while the regulator, ASIC, has recently allayed fears concerning the underlying liquidity and gearing levels of Australian hedge funds. Alex Wise gives an insider’s view on the journey for hedging from lowbrow blunt instrument to today’s legitimate tool in the investor portfolio kit bag.

The alternative investment industry has grown substantially in size since the lows of the GFC (from a low of around USD 1 trillion to over USD 2.3 trillion today[1]).  Institutional investors particularly endowment funds, pensions, sovereign wealth funds (e.g. the Future Fund) have markedly increased their use of alternatives in their portfolios. Alternative strategies (such as hedge funds and managed futures) and alternative assets (such as commodities, private equity, infrastructure and gold/precious metals) have formed an important part of that strategy.

Yet for retail investors the hedge fund has struggled to overcome negative perceptions – understandable given that hedge funds often take conflicting positions to other investors by going short on equity that they believed to be over-valued. Closer to home, a recent ASIC report[2] notes that Australian hedge funds do not pose a systemic risk to the financial system, because they have low levels of gearing and adequate liquidity.

At Select we have been investing in alternative managers since 2002 and in 2004 we launched a fund tailored to alternative investments. During this time we have learnt a lot about the asset class.

What are alternatives and what are hedge funds?

In summary, both terms are somewhat ambiguous. Alternative investments In Regulatory Guide RG240 ASIC sought to define a hedge fund but ended up categorising a large proportion of the investment industry as hedge funds!

We define a hedge fund or an alternative fund by its investment strategy – therefore avoiding broad “catch all” definitions. Typically hedge funds exhibit an alternative investment strategy. This means the main portfolio objective is to do something other than purchasing (long) equities or bonds (traditional investing).  Some examples of what we consider hedge funds are set out below.  Often the descriptions of strategies can be quite technical, so I have sought to apply how Select defines some of those strategies below.

Portfolio Construction: What are the key trends in alternatives investing?

It is now a widely held belief that investors should have some alternatives exposure either directly into a portfolio of funds or into a diversified alternatives portfolio (also known as a fund of funds).   In a recent survey McKinsey noted the growth in alternatives particularly amongst retail investors in the United States:

What should I consider before investing in alternatives?

First of all – we all know that past performance is not indicative of future returns so after a cursory glance at long term and recent performance be prepared to consider a wide range of additional due diligence issues. Advisers should consider capacity, transparency and liquidity when evaluating the appropriateness of a particular alternative strategy/asset for a client.

Capacity

Capacity is important to ensure that the manager can deliver its strategy as its assets grow.  Many strategies are niche and too many assets may indicate a successful marketing machine but not necessarily a good long term performance engine.

LESSON #1 – Objective due diligence

Previously investors has sought to chase returns or chase perceived quality.  Following the herd into an investment has proven ill-advised on many occasions.   Just because a fund is large or “exclusive”, that doesn’t make it a good investment.  Wealthy Swiss investors found this out the hard way with Bernie Madoff!

KEY CHECKS – how much have fund assets grown?  Track performance over the same period along with performance of an appropriate index… Note significant asset raising versus average performance relative to the index.

Transparency

Avoiding funds that are not open about their investment strategy is vitally important.  Many funds harbour secretive strategies behind such terms as “proprietary trading systems”. These funds are unlikely to be engaged in nefarious activity however investors should place high value on clarity of what the fund invests into. This is one easy way investors could have avoided Bernie Madoff’s fund, the biggest managed fund fraud in history, exposed in 2008.   An increasing number of fund of funds are able to look through into the holdings of the underlying managers ensuring that the additional layers do not obscure the ultimate underlying investment.

LESSON # 2 – Transparency

When I first joined the hedge fund industry in 2002 the London based firm I was working for had an investment with a US fund called Beacon Hill.  Whilst our investment team liked the principals and felt the strategy was solid, transparency within the portfolio and governance process was questionable.  We learned the hard way when the fund lost 50% of its value by doubling down losing bets and conjuring up a false unit price.  After this we invested a lot in transparency and operational due diligence to check the portfolio and the unit pricing process.

KEY CHECKS – what reports are available to an investor?  Do you get a breakdown of the entire underlying portfolio? Also ask for the Fund’s audit report.  Does the report show the underlying assets – if not ask why!

Liquidity

Despite the rapid recovery of the industry, the growth of alternatives has actually been held back by many funds lacking the ability to provide desired investor liquidity.  In a recent report “Rise of Liquid Alternatives Survey” Citigroup sees global demand for liquid alternatives from the retail audience reaching $US939Bllion by 2017 and $US1.3Trillion including institutions seeking greater liquidity. They note that this would make the liquid alternatives market nearly as big as the entire hedge fund industry at the end of 2008.

LESSON # 3 – Underlying Liquidity

Many hedge funds began investing in private equity assets in 2006 and 2007.  When liquidity dried up in the markets (there were no buyers), these assets became impossible to sell.  Some pension funds still have these assets on their books.

KEY CHECKS – Does a multi-manager have significant look through to the underlying assets? What liquidity does the fund offer?  Can an independent risk manager prevent the sale of illiquid assets?

What about Fees?

Trends from the United States indicate that fee levels in alternative strategies are reducing – or improving for investors. However investors should carefully review all fees – particularly performance fee structures – that may contain surprises for the unwary. However it is our experience that many hedge funds targeted at US retail investors are now offering structures with no performance fees at all.

For retail investors, unless they are investing through a fund of funds, the choice of alternatives will be limited to those that can offer their products in Australia. This limits the investment universe for retail investors, with many preferring the fund of funds route to gain access to institutional quality managers offshore. The Australian alternatives markets can limit the strategies available particularly in an increasingly global world.

KEY CHECKS – how does the performance fee work? Does it apply to unit holders as a whole or each individual investor?  If the fees seem low – ask why.  Are they being hidden by a swap or similar arrangement?

Summary

The alternative investment industry has evolved substantially since the lows of the GFC and many believe they offer substantial benefits to a diversified portfolio.  The industry must however be able to deliver capacity, transparency and liquidity along with cheaper fees to match the goals of retail investors in Australia.  At Select we believe that change is happening.  Global investors (including the bellwether of US retail investors) are steadily increasing the use of alternatives in their portfolios, as they also believe better conditions prevail to ensure lessons have been learnt since 2008.

Note: The accreditation for this CPD article is no longer current. Please visit our CPD section for current CPD quizzes. 

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It begs the question: in today’s highly regulated world post FoFA, how well do you really know your fund manager? Do you fully understand risk as it pertains to doing business with any particular funds management outfit? Should you even care?

Alex Wise from specialist fund manager Select Asset Management continues his second of a four part CPD mini-series with an insider’s account to better understand what goes on to determine the key (non-investment) risks in funds management. (Click here to read the first article in this CPD series).

Business Risk Due Diligence is an important part of any allocation decision.  The main drivers are always likely to be forward looking views of strategy and manager performance, however since a number of high profile investor frauds such as Trio in Australia and the Bernie Madoff affair in the United States, greater scrutiny has been placed on operational and business due diligence globally. It should be made clear that whilst thorough Business Risk Due Diligence should assist in uncovering concerns and inconsistencies, it is not a fool proof method of uncovering any highly sophisticated fraud.   However, several ‘red flags’ – common to the Trio case and the Madoff fraud should have put investors on notice.

A thorough Business Risk Due Diligence review will consider the risk of a catastrophic event or, in crude terms a “blow up”. Effective due diligence provides a much broader insight into the overall quality of each manager’s business, including the firm’s culture and operational philosophy. Indeed, “business risk” due diligence is probably a more helpful description than a more limited “operational” due diligence framework.

It is important to consider both Business Risk Due Diligence and investment research, when making an investment.  Whilst it is important to differentiate between these disciplines there are clearly multiple points of overlap that exist.

The Manager

Many investors believe that larger managers rank lower on the operational risk scale and are thus relative ‘safe havens’.  Whilst it widely believed that smaller boutique managers tend to be exposed to greater operational risk it is also true that larger managers often have complicated business models and may exhibit significant operational risks.  Larger investors may have “deep pockets” and resources but many investors believe the outperformance or ‘alpha’ is higher in smaller, more nimble managers.  Operational processes do vary within the asset management industry and investors need to do their homework on a particular manager and fund before investing.

Investors should consider whether there has been appropriate investment in people, systems and other infrastructure. After analysis, investors have a good indicator of whether the manager is investing in infrastructure for the long haul or treating the management vehicle as a “cash cow”.

Business Risk Due Diligence should include a review of the manager’s personnel.  The manager’s team of people is important not only in implementing investment strategy but also in supporting that implementation through operations.  Some fundamental questions that should be asked include:

• are the managers significantly experienced to run the strategy?
•  are business support staff appropriately qualified in accounting or law?  (A good test is to review the qualifications of the key staff and where possible take references.  I have seen some underwhelming qualified people acting as “Chief Compliance Officers” and even an electrician sitting on an offshore fund board!

Segregation of duties is important and high level Business Risk Due Diligence should uncover the roles of the portfolio manager and the COO or back office manager.

Technology is increasingly available and affordable, and as such any review should include some review of the manager’s technology platform.  In my experience technology and business continuity plans of fund managers in Australia often exhibit weaknesses for example in appropriate server security or untested business continuity plans.

We have noted far deeper adaptation of cloud based technologies in overseas fund managers and expect this trend to continue into Australia.  Users of the cloud should have significant redundancy in internet connectivity in place with multiple ultra-fast internet connections.

The back office functions are clearly important in any fund manager but often overlooked or treated as mundane.  Trade reconciliation, settlement monitoring and valuation are hugely important areas.  Failed trades represent a risk not only to the manager but also to the fund and its investors.  Furthermore valuation errors can have a significant impact on net asset values or “NAV”s.

In respect of compliance, investors are looking for a compliance culture.  This doesn’t mean a business has to be bogged down in red tape: in fact an easily applicable set of rules is more appropriate for a smaller manager than a 200 page document that nobody reads.  In terms of personnel a seasoned compliance officer and an experienced, independent compliance committee provide a solid base from which a compliance culture can grow.

The Fund

Most investments are carried out through fund structures.  In Australia these are unit trusts and elsewhere these are typically companies or partnerships.  No matter what the structure funds are legal entities and governed by a set of constitutional rules and offering documents.  Whilst these documents contain powers, discretions and authorities they are low on practical content.  A Product Disclosure Statement for example contains limited practical information other than perhaps the fees (unless they are hidden through swaps) or timeframes for redemptions and subscriptions.

A PDS does not typically include some important information, for example who calculates the fund’s unit price or the identity of the custodian and auditor..  These are material issues and investors should ask questions to ensure sufficiently qualified and rated counterparties are involved. I have seen examples where affiliates of the manager are used in various roles without adequate disclosure. Additionally we would prefer accounting firms with dedicated financial services practises to be carrying out the audit.   There are still many managers who prefer to hire lesser known auditors effectively “doing things on the cheap”.

Practical investment terms of redemption and subscription should be carefully reviewed.  It is also important to match the redemption terms of the fund with the liquidity of the underlying investments.  For example, if a fund holding illiquid credit or property offers daily liquidity investors should consider what will happen if unitholders stampede for the door in significant numbers?    Investors should understand the ‘gating’ powers.   During the GFC investors were left holding illiquid investments for significant periods of time – often with managers and “responsible” entities charging substantial fees during those periods.

The fund structure offers significant opportunity for managers to align their interest with investors.  Investors should want to know the answer to one simple question “how much money does the portfolio manager have invested in the fund?” Few diners eat at a restaurant where the chef refuses to eat his own cooking.  In our experience this is a question that largely goes unasked and unanswered by many investors and researchers.  We have also seen many examples (particularly in Australia) of high earning portfolio managers with insignificant amounts invested in the fund.  Investors can make up their own mind as to whether they think the manager has sufficient alignment with investors.

Another area for alignment is performance fees.  In essence if the manager performs he gets paid.  However it is not quite as simple as that and investors should look at high watermarks, benchmarks and equalisation. Some performance fees allow a manager to collect performance fees even where the fund’s performance is down for the year, investors can make their own judgements on whether that is fair.  Equalisation is uncommon in Australia but it effectively means an investor pays an individual performance fee from the time they invest.  Due to the fact that few fund administrators in Australia have purchased systems that allow equalisation; investors can lose out in paying performance fees when the fund performance is below the level at which they invested.

To recap

Many investors and advisers are constrained by their resources but governed by a best interest duty.  Investing with a poorly organised manager with inequitable fund terms, liquidity mismatch and a weak auditor are unlikely to be in the client’s best interest.  Investors should also have some method of concentrating resources only on the highest risk managers.

Business Risk Due Diligence should capture the operational and wider business risks; in particular what can go wrong.  Experienced investors weigh the risks of what can go wrong against the ability of the manager to make money.  Only in doing this can investors truly satisfy the best interest test.

Note: The accreditation for this CPD article is no longer current. Please visit our CPD section for current CPD quizzes. 

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Alex Wise from specialist fund manager Select Asset Management begins this first of a three part CPD mini-series with an insider’s account of making the most of your BDM visit.

Manager meetings can be daunting.  The range of subject matter can be complex, and quantitative statistics difficult to, well, quantify.  Many advisers are also meeting with business development managers (BDMs) who have no involvement in the portfolio management of the fund in question.  The key for meeting preparation is the right mindset: “How am I going to get the best out of this meeting”.

Firstly, what’s going on at such meetings? From the point of view of the BDM entering the meeting there are competing objectives of education and sales.  The BDM is looking to educate the audience about the fund manager and fund in question with an eye to making a sale (whether it is a new investment, increase to existing positions or persuading you to keep your position in a certain fund).  Your job as the interviewer is to carry out or add to your existing knowledge of the fund manager; in essence carrying out due diligence.

The result of the due diligence effectively means an adviser makes a decision whether to allow the fund manager the privilege of managing his or her client’s money.

In order to make that important decision the adviser should be looking at some very simple but vital considerations:

• Can I make a judgement regarding the manager’s honesty?
• Do I think the Fund Manager’s organisation is competent?
• Does the investment strategy have the potential to make money going forward?

Preparation

Prior to the meeting an adviser should receive information regarding the fund.  This could include the latest monthly report, possibly a presentation, an FSC or AIMA Due Diligence Questionnaire (DDQ)  and the Product Disclosure Statement (PDS).  Take more than a cursory glance at these ahead of the meeting, as they represent a wealth of information about the fund manager in question.

The PDS carries (or should carry) functional information such as “when can I subscribe or redeem” and “what are the fees”.  The rest of the PDS is largely boiler plate language and it is difficult to learn about the Fund’s investment strategy from this document alone.   Typically you might also expect wide-ranging language regarding the risks of the fund.  This language is not really for education purposes more to protect the fund manager and issuer should things go wrong!

Fund performance in focus

In relation to the monthly report take a look at past performance.  Are there any periods where the fund has performed well or poorly?  If the fund has performed well in difficult market environments then the adviser should prepare questions on these areas.  Conversely if the fund has underperformed in bull markets this should be analysed too.

The Due Diligence Questionnaire is a very important document.  When reading the PDS an adviser should note down any questions – particularly in areas that are not easily understandable.

It’s also worth making time to carry out some basic desk research via the web.  The internet is a wealth of information and as a first port of call can often uncover some hidden gems of information.

Take the time to call industry peers to take an informal reference on a new manager, particularly if you can find someone who has invested with the manager previously.  Find out what their experience as an investor was like, aside from whether the manager made or lost them money.

Once your preparation is done review your questions and notes with a colleague – perhaps they might have met the manager previously and may have some insights too.

The Meeting

A trait of human nature is the suppression of natural inquisitiveness primarily because we don’t want to appear ill-informed.  The research meeting is not the time to worry about asking the ‘dumb’ questions!  In fact, often what may seem to be a ‘dumb’ question is the best one to ask – and the hardest to answer.  Even seasoned advisers start with entry level questions and many rely on instinct as a guide throughout the process.

A good starting point is to ask the BDM to explain the investment strategy.  If you are confounded by buzz words and fund manager-speak don’t be afraid to ask “What does that really mean?”  There are some cases where the BDM doesn’t really understand what they are selling, particularly if it’s a complex strategy, for example a Cumulative Translation Adjustment (CTA).  If a BDM cannot explain a strategy to you with sufficient clarity then you are perfectly at liberty to ask for someone else who can explain the strategy.   Most institutional investors will meet directly with the portfolio manager (PM) with sufficient frequency.  Ask for a follow up meeting or call with the PM so that they can explain the strategy directly.

Ask about the manager’s investment philosophy and then ask about the investment approach.  Note details on the various stages of the investment process to assist future readers.  Ask for details on portfolio construction and risk management.  This process can be quite complex so the BDM will have to explain it with sufficient clarity.

It also helps to ask for examples, particularly if you are in deep technical conversation regarding, say, the risk management focus on the fund’s ‘sell’ criteria.  It is also very helpful to ask about the fund’s expected behaviour; this can of course be monitored.  When looking at risk management be sure to ask about whether this is independent from portfolio management.  The segregation of these duties is fundamental in any funds management business.

As you work through the list of questions prepared ahead of the meeting make additional notes about follow-up points.  Recap these at the end of the meeting to ensure the BDM knows exactly what your requirements are to move forward to the next stage.

It’s good to note why the fund was set up as this usually leads to a discussion about what ‘edge’ the fund brings and how the manager thinks about the market.

The Meeting Note

The meeting note is a crucial document for your risk management.  The note should be comprehensive enough to show the key points of the meeting yet succinct enough to be read by future users.  The Meeting Note should distil the meeting discussion right down to the key points of the discussion.  The Meeting Note is also a good forum to include text about why (or why not) this particular investment is in the best interest of clients.

The Meeting Note should also summarise the key facts from the meeting.  What is the Managers Funds under Management? How long has it managed money? Who are the PM’s for the fund?

The Meeting note should be differentiated from the Due Diligence Report which should include a call to action “Buy/Sell/Watch” and conclusions on why this investment is in the best interest of the client.

The meeting note should not allow the writer to sit on the fence – it should include information on what the author really thinks!

Once the meeting note is complete it can form part of your due diligence pack on a particular investment.

The Due Diligence Pack

The Due Diligence (DD) Report or Pack should include all information provided by the manager as well as the notes from any meetings held.  These packs are often presented to investment committees.

If you are writing a report about a fund in a relatively new or complex area you may like to insert a section describing the market/strategy so that the reader has enough background knowledge to properly consider the rest of the report.  Try to keep it as concise as possible. Try to not just cut-and-paste from a DDQ as manager prose can often be generic and unlikely to satisfy the best interest test.

Reflect on your notes on the investment process then focus on your opinion of the investment process.  Note what you think are the strengths and weaknesses?  Does it reflect the investment philosophy?  Does it exploit the manager’s edge?  Do you think it leads to any bias?

The DD Report should recap on the meeting notes (there may be multiple).  Some key areas to cover are performance, risk management, liquidity and structure.

Meeting with managers and conducting due diligence requires a significant investment of resources – particularly in a capacity constrained business. Many advisers use a consultant to assist them wade through the tasks.

Above all, however, an adviser should be confident the investment is in the best interest of her of his investors: do not be afraid to walk away from a manager on nothing other than gut feel.

Note: The accreditation for this CPD article is no longer current. Please visit our CPD section for current CPD quizzes. 

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Alex Wise

With the Future of Financial Advice (FoFA) kick-off date of 1 July looming, specialist investment management group Select Asset Management Limited (Select) has urged Australian financial advice firms to have a hard look at underlying investment structures used to manage client portfolios.

“A prevailing sentiment is that FoFA has been a hard slog, with little business upside for planners beyond the implementation date,” said Select Fund Services Head Alex Wise.

“But our experience with a number of financial advice firms is that FoFA has provided a catalyst for positive benefits, beginning with managing the key issues of business risk,” he said.

Mr Wise said that while many financial advice firms are still wrestling with conflicted remuneration and the best interest tests introduced by FoFA, others are seeing operational efficiencies and investment benefits deriving from their solutions.

“Financial advice firms that have found solutions to their FoFA compliance issues are also discovering significant efficiencies and FoFA compliance benefits in operating multi-asset portfolios through regulated unit trust schemes,” he said.

“On the investment side, customised portfolios in a fund structure provide unlimited access to diverse Australian and global investment managers and can invest globally incorporating risk reduction techniques such as foreign currency hedging very efficiently. These unique portfolio construction characteristics have proven beneficial in current markets.”

“Additionally, structuring customised portfolios in this manner has increasing relevance in meeting the best interest test and avoiding the conflicted remuneration obligations under FoFA.”

Recent examples include portfolios operated by Select Fund Services investing in offshore structures that effectively provide insurance in the event of market volatility.

“Select has provided funds with tail-risk hedging that is not easily available through wrap or MDA accounts. One example would be a Japanese focused fund that has provided significant out-performance as Japanese government bond yields have spiked.” said Mr Wise.

Mr Wise said the use of such an approach builds a robust underpinning in the core operational areas of risk, secure custodial arrangements and professionally managed portfolio construction services.

Select Fund Services provides responsible entity (RE) services to numerous dealer group clients. This service enables licensees to focus on investment management and advice – giving Select Fund Services the job of compliance, governance and fund administration.

“Select Fund Services operates 20 funds as RE and trustee for multiple clients. Our systems and processes are tailored to provide fiduciary oversight to multi-asset portfolios.”

In addition to pure governance and compliance functions, Select Fund Services also delivers services to multi-asset unit trust structures. “Select has significant experience in drafting product disclosure statements for these types of portfolios and can also provide expertise to assist with important marketing documents.” said Mr Wise.

Multi-asset managers using a unitised registered scheme also gain the benefit of investor protection mechanisms such as an independent custodian and auditor. “Select has hand-picked tier 1 providers such as Ernst & Young for audit, Baker McKenzie for legal advice and BNP Paribas for the custodial function. This completes a fully institutional offering for our customised portfolio clients”.

Additionally, non-aligned dealer groups and planners have also found a significant operational burden in rebalancing fund investments ‘off-wrap’. This particular challenge has been met by Select Fund Services to engineer an easy outcome.

ASIC’s recent consultation paper on risk management CP204 indicates higher regulatory oversight for the way RE’s address business risk. Coupled with increased scrutiny of MDA operators and their capital adequacy, this has made it difficult for some firms to establish schemes internally.

“From a compliance perspective we also run significant risk management overlays, this clearly being the way ASIC would like RE’s to go and we are ahead of the curve on this,” Mr Wise said.

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