Finding the best opportunities in liquid alternatives requires 3D thinking, a skill Robert Christian has been honing for more than 25 years. He tells us why equity long/short has been their biggest success story of the past 12 months.
The potential for uncorrelated returns is undoubtedly attractive, but if you’re venturing into the complex world of hedge funds, you probably want someone like Robert Christian and his team at K2 Advisors in your corner.
Christian is one of three Citywire AA-rated fund managers on the Franklin Templeton-owned group’s $2.9 billion strategy, Franklin K2 Alternative Strategies. The multi-strategy fund of hedge funds launched in 2014, and has proved to be a hit among US offshore and Latin American investors.
Christian manages the fund alongside the group’s CEO, David Saunders, and head of risk portfolio construction, John ‘Brooks’ Ritchey. Over the past 12 months, the fund has experienced something of a growth spurt – its Ucits version has risen by over 70%, from $1.05 billion to just under $1.8 billion as at the end of December 2017.
Steeped in the world of alternative investments since the early 1990s, Christian has spent his entire career in hedge funds and says that to pick the winners in this arena you need a different set of lenses than those used for the ‘one-dimensional’ traditional sectors.
‘You are either long, underweight or flat your index, or the opportunity set and [the long-only funds] tend to not run with leverage. On the hedge fund side it’s rather more three-dimensional. You can be long, short and use leverage.
‘It’s more multi-dimensional, so I think it’s more challenging to do the research on the hedge fund side,’ says Christian, who is also the firm’s head of research.
Christian and his two colleagues are backed up by a team of 25 analysts, which goes through a universe of more than 10,000 hedge funds and carries out more than 1,500 manager meetings every year. This is all part of the firm’s effort to find the best combination of equity long/short, global macro, event-driven and relative-value vehicles to meet its return target and to limit downside risk.
Each of the managers brings his own skills, perspectives and experiences to the selection process. Christian is a specialist in futures and macro, and his team focuses on the underlying hedge fund manager. Meanwhile, Ritchey runs the portfolio construction side.
‘We purposely make it so his team does not meet fund managers,’ Christian says. ‘They are very top-down focused, so they are looking at all types of possible tail risks and quantitative measures. Brooks (Ritchey) also has a very deep global macro background, particularly in emerging markets.’
Saunders, on the other hand, comes from an equity long/short background. Earlier in his career he was head trader at Tiger Management, the firm of renowned hedge fund manager Julian Robertson.
Their manager selection process relies on finding fund managers that have the ability to generate uncorrelated returns, manage any potential downside risk and possess a sound business ethic.
The fund manager’s team infrastructure, cyber security protocols, team culture and the scalability of their business also form part of their criteria.
‘We obviously focus on risk-adjusted returns but we also spend just as much time and emphasis on the operational side of their business, where they are taking things on a go forward basis,’ says Christian.
Throughout 2017, Christian and his team gradually increased their positions in equity long/short and event-driven managers at the expense of global macro and relative value. One theme in particular proved to be 2017’s biggest success story.
‘Clearly the outstanding group of managers [in 2017] was the equity long/short sector,’ Christian says.
‘Our approach is to have specialists: Portland Hill is focused on Europe, Jennison is in healthcare, Impala is focused on industrials and cyclicals, Wellington is in tech and Chilton focuses on growth at a reasonable price.
‘The correlation between those managers is very low,’ he adds. ‘The highlight for the year wasn’t that equity long/short did well – we would’ve expected that – but how we got there. They did very well compared with the risk they were taking, and it was very diversified in different sectors, security selection, sector selection and country selection.’
Among the sectors that performed well in the managers’ long book were software companies and US financials – both small-, mid- and large-cap banks. Industrial plays, homebuilders and materials also proved to be good bets in 2017.
In the short book, he says the managers bet against some European indices, but most of their shorts have been focused on the US market, which is also the fund’s largest overall regional allocation. ‘Generally, it’s always hard for managers to make money on shorts and last year was even more difficult than normal because you had quite a bit of dispersion and stocks were not very correlated.
‘There was a lot of the pairwise correlation, which is something we watch, but stocks were acting very independent of each other, which in general creates a difficult shorting market. Our managers adapted by moving more toward sector shorts, indices shorts and market shorts instead of outright pairwise shorts.’
Their managers favor shorting sector ETFs for these types of calls, Christian says, as they are low-cost, liquid vehicles whose flows can offer selling opportunities if timed correctly.
There were a few pleasant surprises in 2017, with managers’ plays really starting to pay off in the fourth quarter of last year, Christian says.
‘One of our managers is focused on cyclicals and pays a lot of attention to industrial metals, China, high frequency types of data, railroad orders, that kind of thing. It’s easy now to be bullish when everyone is bullish, but this manager got very bullish in the fourth quarter of 2016. Back then no one was screaming “Be bullish” but this manager was and they played it very well in 2017.’
Christian’s healthcare and technology specialists also held their nerve.
‘What I liked about them was they were able to generate upside returns. There were a couple of swoons in both, but they were able to navigate the downdraughts very well. They participated in the upside and they had a couple of sector calls they were right on.’ Tellingly, while Christian and his team tend to swap out one or two funds every year, in 2017 they kept exactly the same manager line-up.
Last year, investors were rushing to capture the growth of the FANG stocks – Facebook, Amazon, Netflix and Google – with an ETF even being launched to meet the rising investor demand. However, Christian’s chosen hedge fund managers took a different approach.
‘We had minimum exposure to the FANGs and there are numerous sell-side indices that track crowding. We were happy about two things: first that we had minimum exposure to the FANG trade and second that we had limited exposure to popular hedge fund names. So we differentiated on how we made our money,’ Christian says.
But considering these stocks went up by between 30% and 50% in 2017, doesn’t he feel they missed out on some major upside?
‘If investors just want exposure to the FANGs, then they can go out and buy the four stocks and there are some indices you can buy. It’s a diversified factor set that our fund offers,’ he explains.
‘The hedge fund managers are doing what we thought they’d do. All our equity long/short managers are bottom-up focused: They are looking at earnings, businesses and forward pipeline. They were doing their work and not just being lazy and buying the four big stocks and crowded names. It’s not that we didn’t have exposure at certain times of the year, but it didn’t drive our returns.’
You didn’t need to look hard at the S&P 500 index to see that stock correlation was dropping in 2017, Christian says, and this is set to be a rich environment for active managers.
‘We think that will continue. It’s probably linked closely to the interest rate cycle, with central banks starting to pull liquidity back and finally taking the punch bowl away after 2008.’
He is confident on the outlook for this year but is wary of all the positivity among market players.
‘2018 will be a continuation of the fourth quarter [of 2017], but on steroids. The market has obviously gotten off to a good start but we still see a lot of dispersion. Correlations are low and going forward the earnings look good. Everything looks rosy.
‘Almost every Wall Street analyst is predicting a positive year. There are a few outliers that aren’t, but sentiment is running very high. So we are a little concerned that markets might be going too fast, too quickly and pricing in all the good news down the road.’
He believes that the event-driven space may offer some protection in this environment, which is why he has increased this allocation among his current manager picks. ‘It’s a little bit protective as well if you were to get some sell-off,’ he explains.
He expects these managers to start adopting a more defensive approach at some point this year, but he remains constructive on the markets.
‘We think that last year we turned the corner and this year we will continue on and it will be a very rich opportunity set for active investing.’
Head of investment research, Citywire
When the $1.8 billion K2 Alternative Strategies Ucits fund is viewed against the rest of the Liquid Alternative Ucits – Fund of Funds peer group, it is easy to draw the conclusion that it is on the risker end of the spectrum. However, the investment objective of the portfolio is much more akin to those found in the multi-strategy peer group. In that light, the fund’s 3.3% annualized volatility over the past three years would put the risk investors are exposed to just outside the top decile.
The returns have been steady, if a little unspectacular, but arguably that is what investors want from a liquid alternative Ucits fund – a safe haven from the noise and some uncorrelated returns. This return pattern has meant that the management team has been consistently Citywire rated since becoming eligible four months ago for their risk-adjusted returns over the past three years.
Fund manager allocation (Dec. 17)
Event driven 17.42%
- P. Schoenfeld Asset Management 10.16%
- Halcyon Capital Management 7.26%
Global macro 13.65%
- Emso Asset Management 7.89%
- Graham Capital Management 5.76%
Long/short equity 33.15%
- Chilton Investment Company 7.97%
- Impala Asset Management 7.75%
- Portland Hill Asset Management 6.86%
- Jennison Associates 6.14%
- Wellington Management Company 4.43%
Relative value 35.78%
- Chatham Asset Management 11.47%
- Loomis Sayles & Company 9.05%
- Basso Capital Management 8.21%
- Lazard Asset Management 7.05%
This article was originally published in the February 2018 edition of Citywire Americas magazine.