Interview with Philippe Dubois, Vice-President, Investments at Hedged Return Strategies
Founded in 1993, Hedged Return Strategies (HRS) is a leading Canadian investment manager specialised in alternative investment strategies. The firm manages core global multi-strategy funds of funds as well as niche Canadian funds of funds. The firm also manages customised hedge fund portfolios for large investors. HRS' investors include leading pension plans, endowment funds and family offices
Could you describe your investment philosophy? What kind of portfolio management practices are in place to ensure superior alpha returns and to manage risks?
We subscribe to the philosophy that identifying and investing in hedge funds that offer sustainable alpha is best achieved through fundamental bottom-up sourcing, research and thorough due diligence. Underlying hedge fund managers must demonstrate a proven sustainable competitive edge in their sphere of influence that translates into delivering on market opportunities that exceed their risk and cost of capital.
We adhere to the belief that a sound qualitative understanding of hedge fund strategies is far superior in future risk identification and return estimation than quantitative analysis of past returns alone. Quantitative analysis serves to underpin conclusions reached from the qualitative analysis of hedge fund managers.
What is the typical holding period of your funds’ investments?
We prefer to identify hedge fund managers that demonstrate a long-term competitive advantage versus their peers and develop lasting relationships with such managers. The nature of the fundamental analysis we perform on managers means that our target holding period is typically more than 2-3 years. We are very comfortable holding managers for more than five years if it is warranted. However, things can change relatively quickly in the hedge fund business and we are also ready to terminate a manager’s mandate more quickly should key elements start deteriorating.
Funds of funds have traditionally underperformed their hedge fund peers investing in similar strategies. What can investors look forward to in a fund of funds such as yours versus a multi-strategy, Canada-centric hedge fund?
Academic studies have tried to show that an efficient way of accessing some of the more cyclical strategies is through multi-strategy managers. While we believe this is appropriate for a small sub-set of hedge fund strategies (and we do allocate a small portion of our portfolios to such multi-strategy managers), we also believe that the best multi-strategy firms are generally institutional-type hedge fund managers with a large asset base, significant infrastructure and a clear separation of (and often entirely distinct teams devoted to) investments, risk management and compliance. This type of established, multi-strategy hedge fund is not yet present in Canada as the industry is still in its growth phase, though we expect that there will be a small number of hedge fund managers who fit this profile in the medium term.
Given the current stage of the Canadian hedge fund industry, focused, niche Canadian hedge funds represent the best risk-return profile for investors. There are obviously challenges for most Canadian and non-Canadian investors in directly accessing these managers. A local, established fund of funds, such as ours, is often the best entry point into such a market.
With the significant increase in the number of hedge funds based in Canada in recent years, how do you see that impacting local financial market inefficiencies?
Although there has been an impressive number of new hedge fund launches in Canada in recent years, the industry is relatively small both in terms of number of hedge fund managers and assets under management versus other markets. Some market inefficiencies – those which are the result of more significant price discovery or search costs at the security valuation level – may disappear over time as the number of sophisticated investors, namely hedge funds, rises. Others, which result from more structural factors, such as the disproportionate number and size of institutional allocators in comparison to the size of Canadian securities markets, should be much more long-lasting. More importantly, given the Canadian market’s early stage of development, new, more “niche” strategies will emerge. We can see this, for example, in the recent growth of arbitrage focused sub-strategies that focus on non-equity asset classes such as fixed income products, mortgage-backed securities and options. Our objective is to access those niche strategies that result from a more enduring set of market inefficiencies.
Eurekahedge has close to 100 hedge funds and 20 funds of funds in Canada listed in our databases to date. How is your portfolio different from those of your competitors’?
Several Canadian-based hedge fund managers as well as funds of funds implement or access hedge fund strategies focusing on a US or global content. While we also manage a globally focused fund of hedge funds, our niche Canadian fund of funds focuses exclusively on hedge fund managers who, in turn, invest a majority of their assets in Canadian financial instruments.
How do you allocate capital between the various strategies you invest in? How dynamic are these allocations?
We define Canadian-focused hedge fund strategies under three main categories: security selection, event driven and relative value arbitrage. Although the allocation to these strategies can change over time, they each generally represent a third of the fund’s capital. The fund’s investment policy dictates the target allocations and boundaries for each strategy. The allocation process between strategies is dynamic and can vary significantly from the policy allocation. The decisions to overweight or underweight a strategy in order to add value to the portfolio are based on a medium- to long-term outlook and the opportunities of a given strategy. Factors which influence the asset mix decisions include the firm’s appraisal of the various elements that can materially affect a strategy’s risk/return profile but also, and just as importantly, the views of all the managers we monitor on an ongoing basis. Asset mix shifts are also executed with a shorter time horizon when risk management systems warrant them.
Could you tell us more about income trusts and how they have shaped the Canadian hedge fund landscape?
Income trusts as an alternative to a traditional corporate structure allow the pass-through of pre-tax income to end trust unit investors. In addition to the direct benefit of tax expense savings at the business level, the trust structure is seen as a potentially shareholder value enhancing structure as they prohibit profligate spending by corporate management at companies where, it is argued, the most optimal use of capital is to return it to investors.
We have seen many conversions to an income trust structure by Canadian corporations in recent years. Several hedge fund managers looked to such events as performance drivers while retail investors enjoyed the high yields associated with investment in many of these trusts. However, on 31 October 2006, the Canadian Federal government proposed a change to its taxation policy which would effectively eliminate the tax advantage of trusts versus their corporate peers. Anticipated trust conversions quickly stopped dead in their tracks.
We expect to see greater return dispersion between income trusts going forward as their once largely retail, yield-craving investor base rotates away from this sector of the Canadian equity market. This should allow for unit prices to more accurately reflect underlying business model fundamentals rather than mere distribution yield considerations. As a result, the sudden dearth of income trust conversions has shifted the focus on income trusts away from the event-driven strategy towards the relative value arbitrage and fundamental long-short strategies. Over time, however, it is widely expected that certain trusts will become the targets of acquisitions by financial and strategic buyers as a result of depreciated valuations while others will seek to convert back to a corporate structure, adding to the set of corporate reorganizations. Both trends should be beneficial for the event driven strategy. From our perspective, this shift in public policy is merely another example of a uniquely Canadian inefficiency that has created new opportunities for local hedge fund managers.
Could you describe your research process and the kind of resources you use in picking your managers? What methodologies do you apply in evaluating the limit in the number of managers and the maximum allocation per manager for your portfolio?
Leveraging local market knowledge and our established network of contacts in Canada, we endeavour to uncover what we believe to be the best Canadian-focused hedge fund managers. From this initial universe of candidates, we initiate qualitative analysis of the manager’s business case, the team he or she has put in place and their value-add to the business. We generally prefer firms with an entrepreneurial mindset, where the investment team is aligned with the interests of investors through economic interest, and a focus on a single fund or a relatively small stable of products and where the key people have their skins in the game (ownership of the business, significant investment in the fund).
The number of managers in our portfolio is mostly driven by practical considerations rather than academic optimisation models. Our global programme currently has approximately 35 managers while the Canadian programme has approximately 15. The most important determinant of the optimal number of individual managers in the latter is the availability of complimentary investment strategies within the Canadian hedge fund landscape. As new strategies emerge, we expect the number of managers in the portfolio to increase to potentially 20-25.
Individual hedge fund managers within the fund are typically weighted by their expected risk level with the constraint that the overall fund will nonetheless achieve its stated return objective. All other things being equal, a hedge fund that exhibits greater volatility/business risk/strategy illiquidity will be allocated a smaller portion of capital.
Canadian exports to the US represent close to 30% of Canadian real GDP. With the expected slowdown of the US economy, how do you foresee the Canadian economy performing in 2007 and what will that hold in store for Canadian hedge funds?
A potential slowdown of the Canadian economy is always taken into consideration and has influenced our asset allocation over the last 12 months. We have actively positioned the portfolio towards more defensive or market neutral strategies and away from long-biased equity strategies. As such, the portfolio is positioned to perform well during prolonged periods of equity market weakness.
With emerging markets continuing to surge ahead in the global economy, in your opinion, do you expect a shift of focus in investors in developed economies? What do you expect to see in the long run for North American investments?
What we believe and what numerous investors are confirming is that Canada is a developed country that is to some extent levered to the economic growth in emerging markets, especially those of Asia, as a net exporter to such countries of important input commodities. A distinction should therefore be made between US and Canadian investments within a North American context. As a result, although investors may shift focus from US investments towards those in emerging markets, Canada should be relatively sheltered from such capital reallocations. Additionally, hedge fund investors looking to diversify their portfolios will continue to look for Canadian hedge fund strategies as they are still absent or under-represented in global hedge fund portfolios.
We expect that opportunities for Canadian hedge fund managers will continue to grow and believe sophisticated investors will want to profit from them.