launched in october 2001, the absolute fund is a market neutral fund of hedge funds dedicated to low risk and capital preservation
The Absolute fund is a fund of hedge funds that invests in portfolios with long/short strategies.
The portfolio is market neutral and its main source of return comes from mis-pricings and other anomalies that exist within the bond and stock markets, rather than from trying to predict market trends.
Managed by Charles Hovenden, chief investment officer, and Christopher Aldous, chief executive, the fund launched in October 2001.
The strategy used for the fund was developed following the Long Term Capital Management (LTCM) disaster in 1998. Hovenden and Aldous wanted a investment process that was low risk and would resist any type of external shock to the economy.
Since 1999 the two have been building portfolios that concentrate on long/short strategies as both see this as a way of reducing risk in all economic conditions.
Although the portfolio was only launched in October 2001, Hovenden and Aldous have been running these sorts of strategies for four years. The fund initially started with $20m and was made up of their existing clients. It has now grown to $60m.
The shorting protects the fund when it is economically volatile, while the long positions should give the portfolio extra returns when there are good conditions.
Previously, Hovenden and Aldous only had arbitrage funds in the portfolio. The pair learnt it was necessary to combine arbitrage and shorting strategies.
When the market goes up the fund only loses money on shorts, but when markets go down the shorting positions preserve the capital.
Hovenden says: 'Before the LTCM debacle a lot of hedge fund selection was based on quantitative analysis. This type of analysis examines the correlation of matrices between different types of funds. It works on the philosophy that you should have a series of funds producing good returns with low correlation to each other, therefore reducing the risk level.
'However, when the LTCM crash happened the quantitative analysis showed hedge funds were highly correlated to each other. Funds were performing in the same manner and all did badly together. This was disastrous for managers who used this as a selection process.'
According to Hovenden, a fund of hedge funds portfolio cannot be built on quants alone, but it should start there.
The Absolute fund starts using a top-down macro overview where quantitative analysis is used. Quantitative analysis for the Absolute fund is only used for primary screenings due to the unreliability of past performance.
A shortlist is formed of managers. Each potential manager that could be selected for the fund is met. Hovenden and Aldous look for managers that have consistent results.
Hovenden says: 'Managers must also be able to demonstrate risk management. A fund will be reviewed and replaced if it is down 6% in one month or if it breaches, the stop-loss limits of 12% peak to trough.'
As there is no comprehensive global database for hedge funds, the best way to find managers is from personal recommendation through people they trust. Hovenden and Aldous never give money to managers unless the pair have met them.
Potential managers are questioned about every single aspect of how the fund and business is run. In the meeting the two address the whole nature of the business from the administrator to the auditor, whether the company has a chief executive, whether a second pair of eyes looks over everything, and whether a fund has a lot of liquidity.
They make five or six research trips a year to the US to meet with managers.
Initially the turnover rate of funds for the portfolio was high because the two wanted to increase the number of funds in the portfolio.
The portfolio initially started with 25 funds in it and this has now risen to 40. Each fund is equally weighted and there is an absolute maximum of 5% in any one fund. This is to keep the portfolio diversified and reduce risk.
At the moment turnover is low and it will hopefully remain so as the managers look for long-term performers, irrespective of their strategy. The portfolio may shift between net-long and net-short, large-cap and across sectors.
As the Absolute fund is dedicated to low risk strategies and to preserve capital in falling markets it avoids certain strategies. This includes macro CTA-type funds due to unpredictability of returns, black box or excessively complex strategies, strategies based on illiquid securities, most start-ups, and for the most part funds with lengthy lock-ups or restricted liquidity.
Hovenden and Aldous presently favour the Japanese market. There are lots of anomalies in the Japanese economy. Companies in this market are selling at a significant discount to cash in on balance sheets and the rewards are greater.
Distressed is another strategy the pair favours.
At the moment the fund is 7.5% multi-strategy; 7.5% event driven; 10% convertible bond arbitrage; 5% fixed income arbitrage; 15% distressed securities arbitrage; and 2.5% option volatility arbitrage.
Although the fund suffered last year because it did not include a macro approach, Hovenden and Aldous do not wish to change its strategy, preferring to try to safeguard it from potential blow-ups such as the LTCM disaster.
Hovenden and Aldous think the outlook for the fund in 2003 will depend on its exposure to equity long/short funds and US equity long/short funds as this dragged down performance for much of last year.
They do not believe that pure arbitrage strategies in general are capable of delivering the returns the fund seeks without the use of uncomfortably high levels of leverage.
Hovenden says: 'In contrast, the magnitude of anomalies that the funds equity long/short managers are trying to exploit tend to be much greater and leverage is not required to boost returns. The correction of those anomalies and hence capture of, does, however, depend on fundamental factors being dominant in determining share price movements.
'If stock-market volatility declines to nearer its historic average, 2003 should be a great year for stock pickers. If not, it might be better to reduce exposure to equity long/ short strategies or at least to make some changes to our underlying funds.'
The fund is listed in Dublin and domiciled in the Cayman Islands. Assets are held by ING Group NV. Minimum investment is $100,000 and it is also available in euro and sterling.
The management fee is 1% per annum and performance fee is 15% of gains between 6% and 24% only in any year. There is a high water mark.
The fund aims to achieve a return of between 10%-15% pa. No leverage is used for the fund and liquidity is monthly with 35 days' notice for redemptions.
About the manager: Christopher Aldous
Christopher Aldous, chief executive, has had a successful career in investment banking. He joined Absolute Fund Management from Robertson Stephens, a US investment bank where he was a managing director. Prior to that he was an executive director at UBS and a director of Barclays de Zoete Wedd.
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