London-based KBC alpha Asset management is the specialist
Japan and Asia regional focused fund of funds division of
KBC Alternative Investment Management, an arm of KBC Bank
& Insurance Holding NV, one of Belgium's leading financial
institutions. Neale Safaty, KBC alpha's CIO, has over
twenty years experience in the Japanese and Asian capital
It is only quite recently that it was possible to construct
a diversified portfolio of hedge funds that generate absolute
returns predominantly from Japan. In fact, approximately 80%
of the universe of Japan-focused hedge funds has emerged only
in the last four years. Whilst a few Japan-only, equity long/short
funds did exist several years ago, the bulk of hedge fund
exposure to Japan was traditionally found in the Japanese
allocations of global CB arbitrage funds and in the Japan
portfolios of global macro funds. Index and warrant arbitrage
strategies (which were prevalent in the late 1980's and early
1990's, when an "arbitrage" still existed) were
employed primarily by the proprietary desks of investment
banks and when run by hedge fund managers, were not offered
as stand-alone products.
As of March 2004, we have identified 203 funds that are Japan-only
or have a significant exposure to Japan in Pan Asian funds.
This universe includes strategies from across the hedge fund
risk/reward spectrum: opportunistic, event-driven and relative
value. However, the lion's share of the investible universe
is comprised of equity long/short and our Japan portfolio
The remit of this column is to explain our investment criteria.
Fund selection is a function of our overall portfolio objectives
and risk management guidelines as well as the underlying individual
fund appeal, although there are other factors that may be
taken into consideration. At the macro level, the mandate
of our fund allows us to invest across strategies. Let us
consider some of the key ones.
As stated, the universe of Japan-focused hedge funds is dominated
by equity long/short and to a great extent this will inevitably
heavily influence the weightings of a portfolio, unless an
allocator feels very strongly that Japan long/short cannot
generate good risk-adjusted returns.
We would argue that this is unlikely for several reasons.
Firstly, the size, depth, breadth and maturity of Japan's
capital markets and derivatives capability means that it is
cheap and easy to trade from both a long and a short perspective.
Secondly, despite the improvement in the economy, the corporate
profit recovery that is underway and the favourable policy
initiatives that have been introduced by the authorities,
the market can trade on factors that are not wholly fundamental.
This disparity can offer tremendous opportunities that smart
long/short managers can exploit.
Thirdly, the acceleration in corporate restructuring, including
mergers and bankruptcies provide additional sources of alpha
for long/short funds. Fourthly, despite the rapid growth in
recent years of long/short funds, they do not represent a
significant proportion of stock market activity and are still
tiny, relative to the long-only equity universe, in terms
of both assets under management and number of funds. Long/short
is essentially operating in a hedge fund environment that
is not crowded and managers tend not to 'chase' the same trades.
Finally, the huge surge in stock market volume that has been
fuelled by foreigners purchasing equities as they discount
improving fundamentals and a more favourable demand/supply
outlook is a positive factor for long/short. For example,
managers that discover opportunities in smaller cap stocks
can be more aggressive when liquidity is so good and furthermore,
execution impact is negligible when volumes are so high.
As managers with long-standing professional experience of
Japan's convertible bond markets and with expertise in convertible
bond arbitrage, we do not feel that it is appropriate, at
present, to invest in convertible bond arbitrage for a number
Firstly, the Japanese CB universe has contracted, as new
financings have not kept pace with bonds have matured. Secondly,
by historic standards, Japanese CBs are relative expensive.
Thirdly, the overwhelming majority of convertibles are held
by CB arbitrage funds. Whilst long/short funds do invest in
CBs when appropriate, equity funds' ability to employ them
as stock substitutes is limited as the vast majority are deep-out-of-the
money. Furthermore, at new issue, the pricing of CB's does
not attract equity-substitute interest. We regard an environment
in which an asset class is predominantly held by one investor-type
as an unhealthy one. Should any of these factors change, we
would incorporate CB arbitrage.
Equity statistical arbitrage is a strategy that conceptually
interests us and we have one manager operating in this space.
However, we believe that in today's environment, our portfolio
is better positioned with a heavy bias towards long/short.
Event-driven strategies have relatively low representation
in the Japanese hedge fund universe. We have taken a strategic
view to exclude real estate/distressed securities funds from
our portfolio at present . As the underlying assets are illiquid,
the funds may require long work-out periods to generate decent
returns and thus tending to have lock-up clauses.
However, as far as the risk arbitrage/corporate activity
space is concerned, we are keen to increase our allocation.
Two of our more recent investments have been in variants of
this strategy. We believe that changes to the legal, regulatory
and cultural framework will lead to significant and increased
corporate activity in Japan. We have already witnessed diverse
examples of this is recent years, such as, less emphasis placed
on protecting corporate stakeholders, share buy-backs, consolidated
accounting, corporate restructuring (like equity for debt
swaps), easier merger procedures and spin-offs and the absorption
of affiliates, to name but a few.
We are interested in Japan dedicated macro as a strategy
diversifier although this is very limited at present. In the
global hedge fund context, macro represents approximately
8% of the universe. However, as specialist regional macro
is far more limited in scope, we would expect this to remain
a small minority, but increasing, strategy.
From a portfolio perspective, the addition of a new underlying
fund has to be consistent with the risk/return objectives
of our fund and risk management guidelines. We are looking
to generate, annualised returns in the region of 10-12% with
a low volatility, around 3-5%. This is on the basis that the
fund is not leveraged. We recognise that in certain periods
it may be possible to generate much higher returns and of
course, in difficult years, grinding out single-digit returns
may, in fact, be a "good" performance.
We believe that a portfolio of between 12 and 20 funds is
appropriately diversified for risk control, yet sufficiently
concentrated to produce target returns. We currently own 16
funds. We are keen to ensure that our portfolio consists of
funds that have relatively low correlation to each other although
we are less concerned if funds have a degree of correlation
to bull phases as long as they exhibit low correlation to
the downside. A potential new fund is regarded as either a
diversifier or as a substitute and a correlation overlay will
be undertaken when determining a funds possible status. A
new fund will also be labelled as a low-, medium- or a high-risk
fund, based on a combination of the investment strategy and
the entity risk. Our portfolio consists of funds across the
risk spectrum, but is consistent with our overall target return
and risk objectives.
Of those funds that are included on our short-list, we categorise
them by our likelihood to invest. Tier one funds are those
we are very keen on. Funds in tier two are those we are interested
in but where we have issues or where we have not completed
due diligence. In tier three are funds that we continue to
monitor but at present are impressed with.
We impose limits to single positions, on top-five fund concentration
and on redemption liquidity. We are not averse to investing
in funds with lock-up periods or low liquidity, especially
as it is sensible in certain strategies to impose these restrictions,
although we tend to favour underlying funds that have monthly
liquidity. We also prefer to invest with managers that conduct
currency hedging at the fund level, as we are currency neutral.
We will hedge ourselves, however, if they do not.
We are flexible on a number of issues. Whilst we have not
seeded new managers, we are willing to invest on day one if
the key return generators are previously or currently known
to us in professional capacity. A specific fund track record
is not a prerequisite for investment.
Our portfolio consists of institutional, boutique and quasi-institutional
entities (managers that have significant assets, extensive
infrastructure and possibly several funds in the stable but
are not regarded as institutions per se). We recognise that
there are advantages and disadvantages of both institutions
and boutiques, although the inclusion of institutions reduces
individual entity risk and therefore, the overall risk of
We are also pragmatic on the location of where a fund is
managed and by whom. Our fund is comprised of Gaijin and Japanese
managers and by entities operating in Japan and outside of
Japan. We have analysed the performance of managers throughout
our universe and there is no statistically significant evidence
that risk-adjusted returns from funds based in Japan are superior
to those funds operating elsewhere in the world, despite advantages
that local presence and intuitiveness may bring.
We are open-minded on asset size. If we are analysing a boutique,
we will consider the breakeven amount of assets and invariably
do not invest until this point is reached. It may transpire
that we will invest in a fund that has a relatively low asset
base. It is also possible that we may commit to a fund that
is small and in which we are initially a significant or relatively
large investor. This has been the case where a boutique has
a significant amount of assets that include Japan exposure,
but where there is a small dedicated Japan-only product or
when the entity is an institution but the fund is either young
or lacking assets because of, say, low-profile marketing.
The universe of Japan hedge funds is dynamic. Our Japan fund
was launched in January 2002 and since inception, the number
of funds has expanded quite rapidly, as we envisaged. In fact,
it is very encouraging that there are an increasing number
of very talented managers emerging from long-only institutions
and investment banks.
Originally, we clipped the wings of the universe that we
identified by excluding funds where assets were unjustifiably
low relative to the age of the fund, where performance was
poor or where key managers were personally known to us and
we felt that they were not strong enough. Investing in hedge
funds is a people business; we do not trade them like stocks
and thus the integrity of managers is very important.
Notwithstanding, there are now funds brought into the fold
that we had initially excluded from our monitor list because
circumstances changed. It is also a matter of procedure to
meet all start-ups unless we know the managers and it is highly
unlikely that we will not invest. We insist upon at least
one site visit before committing to a fund and we will conduct
more extensive due diligence on boutique managers.
It is not uncommon for fund of funds to monitor investment
candidates for a specific period. We do not set a minimum
time-frame, evident by the fact that we have, on occasion,
invested on day one. However, it is not unprecedented for
us to follow a manager or a fund for in excess of twelve months
before pulling the trigger.
Ideally, once committed, we like to make investments with
an eighteen-month time-horizon in mind. We believe that over
the course of about eighteen months, it is likely that there
will be at least one period when the environment is benign
for a particular strategy/style and there will probably be
at least one period where conditions will be difficult. Furthermore,
we ought to be able to assess whether our manager is achieving
risk-adjusted returns that are within or above our expectations.
This time-frame should be a sufficiently long enough period
to confirm whether our manager can make decent returns while
the "sun is shining" and to determine whether investors
capital can be preserved when the going is tough, i.e. to
get a sense of whether they are good hedge fund managers or
not. Of course, it is not given that we will be invested for
a minimum of eighteen months. Our post-investment review criteria
includes, amongst other things, peer group analysis, possible
strategy or style drift, infrastructure or personnel changes,
asset contraction or rapid growth and events that may specifically
impact expected strategy/style returns, such as short-selling
restriction or lack of corporate activity.
So, what do we consider when we analyse a specific manager?
In our preliminary meeting or meetings with prospective candidates,
we will focus on the fund's historic returns, the investment
process, risk management, the key portfolio managers and/or
analysts and an overview of the organisational infrastructure
and fund structure. We give priority to qualitative research
rather than quantitative research.
There are several aspects to our qualitative research. Fundamental
to assessing any fund is to understand and to evaluate fully
the investment process and approach. Our strength is that
the key members of our team have extensive experience in the
Japanese capital markets and are able to discuss managers'
investment approach to Japan against a back-drop of our deep
personal knowledge of the securities, companies and market
place. We are also able to review performance in different
market conditions with the advantage that we know when an
environment enables managers to just "pick up dollars
lying on the floor" or whether they really had to earn
Risk management is very important to us, we like to discuss
with managers how they would expect to cope under different
types of conditions so that, should we invest, we minimise
negative surprises. Furthermore, we like to discuss the rationale
for their specific risk management policy and their enforcement
procedures. We regard changes in risk management practice
positively as we believe that it is likely to evolve. Even
so, we do not necessarily take issue if risk management policy
is the same as it was on day one. It is interesting to note
that we have invested in funds that had poor first years but
have demonstrated to us, that risk management has been enhanced.
We are fortunate that we have an extensive personal knowledge
of many of the Japan-focused hedge fund players and, therefore,
we like to understand why they have chosen this path and why
and how they developed their specific business models. We
believe that we can determine their competitive advantages
and areas of weakness and we will examine potential issues
that may impact their strategy and their ability to generate
absolute returns. If they are boutiques, we like to identify
growth plans for the management company and clarify their
remuneration culture and ownership structure. We will also
assess the possible capacity to us as potential investors
as we would like our investment to grow as our business expands.
Whilst we emphasis qualitative research, we naturally conduct
quantitative research. We review risk, return and correlation
data, and we make peer group comparisons. We believe that
there are limitations in this analysis and quite often dismiss
results that may, on the face of it, be regarded as negative
or even positive, where we feel the data is not statistically
We tend to focus on cross-correlation analysis with qualitative
overrides. For example, if existing Fund A appears to be highly
correlated with a potential fund, Fund Y, if the strategy,
style or investment approach differs significantly, we would
not be too concerned. If, however, we are analysing two long-short
funds that have operated over a similar statistically significant
period with, say, a large cap top 400 stock mandate and where
the managers have emerged from the same stable, the high correlation
would have more emphasis in our selection process.
Once we are comfortable that we like the process, risk management
and people and that we sense a manager may be either a diversifier
or a replacement fund for us, we will conduct our operational
due diligence, legal review and reference checking. In our
operational due diligence, we review, for example, systems,
trading platforms, disaster recovery plans, choice of service
providers, compliance procedures and the fund valuation process
and degree of transparency, to name but just a few. The legal
review will primarily focus on the fund's prospectus although,
as and when appropriate, we consider other documentation.
One of our advantages in assessing the character, integrity
and strengths of managers is that we are able to draw upon
our decades of experience and professional network. If we
have not had personal dealings with key principals in the
past, we are able to solicit opinion from our colleagues within
the KBC Group and we also are able to leverage the network
of our professional acquaintances on both the buy and sell
side of the business.
To conclude this column, it is worth making some general
comments on management selection issues that have arisen during
the course of researching the universe and since the fund's
We tend to prefer investing in funds where the managers have
worked together in some capacity at other organisations. We
are not generally keen on hedge funds that are managed by
ex-brokers or a team that may lack balance, i.e. where the
key return drivers are analysts and portfolio managers that
have no obvious trading acumen. Conversely, with respect to
non-relative value strategies, we are not enthusiastic about
funds run by ex proprietary traders. We also prefer the key
functions, trading, research/portfolio construction, operations
and compliance to be separated, if possible. Nevertheless,
we strive to be pragmatic and open-minded. An experienced
and talented equity long-only manager from an institutional
background may not be a good equity long-short manager, whereas
a bank's proprietary CB trader may be in fact, an excellent
equity long-short manager.
Running a successful fund of funds portfolio is about finding
the right people and putting them together in the right shapes
and sizes. It is, certainly, more art than science.