The Billion Dollar Interview with Henry P. Davis, Managing Director at Arden Asset Management
Arden Asset Management was established in 1993 and is an independent privately held firm that is 100% employee-owned/controlled. Headquartered in New York, the company consists of 62 employees in New York and London, including 24 investment professionals that are involved in top-down market analysis and bottom-up manager investment research. Arden Asset Management is registered as an investment adviser with the US Securities Exchange Commission and as a Commodity Pool Operator and Commodity Trading Advisor with the Commodity Futures Trading Commission1. The UK office is also authorised and regulated by the UK Financial Conduct Authority. With current AUM at approximately US$6 billion, Arden Asset Management focuses solely on creating and managing portfolios of hedge funds. Institutional investors comprise 85% of the AUM and the remainder are from high net worth as well as retail investors.
The company has a diversified global client base including large US, Japanese, and European pension funds. Its flagship fund is a multi-strategy fund of hedge funds with fund size estimated at US$1 billion. Arden Asset Management also has a ‘40-Act mutual fund called the Arden Alternative Strategies Fund (AASF) (ticker: ARDNX) which stands at approximately US$1.1 billion.
Eurekahedge: What is a liquid alternative mutual fund?
Well, although there are many different definitions, we define it as a registered mutual fund, be it a ‘40-Act fund in the US or a UCITS fund in Europe, which is invested in hedge fund strategies with daily liquidity. It is available not only to institutional investors but also to retail investors.
EH: Before we delve further into the Arden Alternative Strategies Fund, could you tell us a little bit about your flagship product?
Sure. Our flagship fund is a diversified, multi-strategy investment program that seeks to achieve capital appreciation with relatively low correlation to major equity and fixed income markets. This flagship fund makes allocations to funds managed by relative value and event driven managers that are identified through our disciplined, research-driven investment process. We have been managing this fund since 2004 and its predecessor vehicles since 1993. Currently its AUM stands at approximately US$1 billion.
EH: How does the Arden Alternative Strategies Fund (liquid alternative mutual fund) differ from your flagship fund?
The largest difference is in the terms of liquidity. The Arden Alternative Strategies Fund (AASF) is a daily liquidity fund where investors can redeem and subscribe on a daily basis. On the other hand, our flagship fund is a traditional fund of hedge funds where investors can redeem on a quarterly basis with 65-day notice. This means that AASF investors can access a daily NAV, where our flagship fund investors receive a monthly NAV.
EH: Manager selection may be a key determinant of the performance of your fund. In that context, what are the eligibility criteria that make a hedge fund or manager suitable for consideration to be in your fund’s portfolios? Could you describe your manager selection process?
Arden sources information on hedge funds through a number of private and public channels. Certain sources are traditional in nature, such as capital introduction desks and third party marketing firms, while others are more proprietary in nature and include our current roster of managers, our current investors and our collective network.
Our criteria for filtering managers rely on eligibility factors as well as qualitative and quantitative analysis. Eligibility factors essentially serve as the minimum qualifications that are required before further progressing in our vetting process. The following are more specific steps:
Minimum qualifications for investing in underlying funds or hiring a manager include maintenance of best business and operational practices, favourable background checks of the manager we consider investing in.
Also, key qualitative factors include a sustainable and repeatable investment process, a demonstrated record of success, a culture of excellence and competitiveness in its people.
Key quantitative factors entail quality of returns, with a focus on the level of risk a manager needs to assume to generate the returns, correlation and beta to the strategy index, market index, competitors, leverage and exposure analysis, and liquidity of the underlying hedge fund assets.
EH:How flexible is your investment mandate? What is the smallest fund you will invest in? Do you look at single country funds or funds based in Asia, Emerging Markets, Latin America etc.?
We require that managers have a minimum of US$50 million of AUM in order to be considered for inclusion in our portfolios. We also typically like to see 24 to 36 months of performance history for a prospective manager; however, we recognise that this is not always possible and make determinations about minimum manager tenure on a case-by-case basis.
We tend not to look at single country funds or those based on regions, but we do invest in funds with managers who are based in Asia and Latin America from time to time, in addition to managers based in cities where there are a lot of hedge fund managers like New York, London and others.
EH: How can the AASF provide daily liquidity? Do you need to hold X% in cash in order to meet redemption requests?
AASF’s daily liquidity feature is predicated upon the liquidity of the portfolio managed by the underlying hedge fund managers. Industry regulations require the fund to maintain a very high percentage of the portfolio in liquid investments, and we exceed that as a matter of course. Most hedge funds don’t offer that type of liquidity, but we will discuss potential managers whose strategies can be managed with a high degree of liquidity even if their private fund vehicles don’t offer it, or whose strategies can be adapted to be liquid. These managers are then added to our managed account platform, and if ever needed, they can provide the liquidity necessary to be in the mutual fund structure. We have been analysing hedge fund investment strategies for a long time now, and we draw on this experience to identify those managers, and then we work with them to refine the investment mandates. I suppose this is where we add value to form a liquid alternative fund.
Regarding the level of AASF’s cash position, we are currently keeping it between 4 to 5% of the portfolio. The nature of the product’s liquidity requirements are such that portfolio positions are more than sufficiently liquid to meet redemptions in the normal course.
EH: If there are 8000 hedge funds globally, how many do you consider ‘investible’ for your flagship fund? Out of those, how many will offer you managed accounts with daily liquidity for the retail fund?
We invest with approximately 100 hedge fund managers and another 100 we monitor closely. With regard to the daily liquidity portfolios, we currently have identified more than 30 investable managers. This universe is increasing as time goes on and more and more managers choose to participate in the liquid alternative space.
EH: What other features of the AASF are attractive to investors?
Firstly, in addition to daily liquidity, the fund has no lock-ups, no notice period, no side pockets or gating. Many investors experienced the less liquid nature of hedge fund investments during the 2008 financial market meltdown. Most investors would not wish to repeat that experience, which stemmed from the less liquid nature of many traditional hedge fund investments.
Secondly, the AASF fund is designed to achieve a relatively low correlation and beta to the major equity and fixed income markets. The fund seeks to preserve capital as a high priority as well, which appeals to many investors.
Finally, the regulated nature of the fund gives many investors the comfort that risks will be controlled by the fund’s manager and service providers, through the application of mandatory investment guidelines and the application of strict compliance program rules.
EH: The European UCITS industry has grown from virtually nothing pre-financial crisis to 950 funds with US$200 billion. Every major alternative asset management house has a UCITS version of their flagship fund. This demonstrates the global desire for increased transparency and liquidity from institutions investors. Are we going to see the same kind of explosive growth in the US Alternative Mutual Fund space? And will we see this growth globally?
Most definitely. As you mentioned, there is a strong and universal desire on the part of investors to have more transparency and liquidity. This is one of the consequences of the 2008 market meltdown experience. We believe a large source of investor capital that will be interested in alternative mutual funds will be defined contribution pension funds and annuity funds, individual retirement accounts and other similar vehicles.
Today, demand for fixed income remains robust while yields hover at record lows due to a number of economic factors. Moreover, an unexpected rise in rates can easily strain retirement portfolios which are overweight fixed income assets. Alternative strategies are one potential solution. For years, the addition of an alternative asset allocation has been utilised in an attempt to increase the risk-adjusted returns of endowments, pensions, and other institutional portfolios. Simply put, there has been no reason why this complementary asset class could not become an option for defined contribution plans and IRA accounts but for a mechanism to deliver it. The recent launch of open-end mutual funds of hedge funds provide one solution that can be attractive to both defined contribution providers and financial intermediaries and their clients who seek enhanced risk adjusted returns and diversification alternative strategies offer.
At the same time, US industry regulators such as the SEC and CFTC are requiring many hedge fund managers to be registered and the funds they manage are subject to increased reporting and disclosure. Trading methods and markets are becoming subject to more and more regulation. Take the changes taking place in the OTC derivatives markets as one example. The regulators believe hedge fund managers should have consistent and documented compliance programs designed with the goal of protecting investors and the integrity of the markets in which the funds trade. This increase in regulation of the traditional alternative investment business makes it easier for managers to get comfortable with other regulatory structures, and consequently we have been seeing a rapid growth in managers willing to participate and the launch of ‘40-Act funds that invest in alternative strategies, to provide the supply that we believe investors will demand.
Although it has started in the United States, we believe it will catch on in other advanced economies like Canada, United Kingdom, and Japan. The speed and magnitude of such growth varies from one market to another; however, the underlying trend will be there. In particular, we believe Japan is a promising market for this as investors are looking at an investment portfolio that seeks to preserve capital and has low correlation to traditional asset classes.
EH: Why do you feel that this is of particular interest to the Japanese market?
We have been managing assets for Japanese clients for 13 years. In fact, we manage roughly US$1 billion for Japanese investors today, which accounts for nearly 15% of our firm’s AUM. We interact with our clients in Japan on a daily basis and visit Japan every quarter. We are fully aware they are the most ‘risk-adverse’ investors. Their first priority is the protection of capital and looking for a product that has low correlation to the Nikkei, S & P, or MSCI World indices. Additionally, their return requirements are not outsized. These requirements fit the risk/return characteristics of our liquid alterative portfolio. They can always redeem such a vehicle on a daily basis, which is an attractive feature as well.
EH: What are the main differences in redemption requests from the retail versus institutional industries post-liquidity crunches circa 2008 financial crisis?
In general, the average retail investor has a shorter investment horizon than an institutional one such as a pension fund. Moreover, they tend to redeem faster than their institutional counterparts during a major crisis like the 2008 financial crisis. In fact, a great percentage of redemption from the hedge fund industry came from individual investors in 2008 and these characteristics still persist. In this sense, liquid alternative products have a wider appeal to retail investors.
Having said that, the segment of retail market for our AASF is different from the average retail market. The end investor is invested in a discretionarily managed risk-based asset allocation program sponsored by a large mutual fund company. The asset allocation program makes the investment in AASF on behalf of its clients. As this program is professionally managed by portfolio managers, we do not expect the fund flows to have the characteristics of typical retail investors. We believe it represents ‘stickier’ money.
EH: We understand that liquid alternative mutual funds charge higher fees. How do you justify higher fees to the retail market?
Up until recently, liquid alternative mutual funds were not available to retail investors. Moreover, alternative investment funds tend to have lower correlation to traditional asset classes such as ours. In times of crisis, many investors tend to behave in the same way - cutting positions and exposures and buying Treasury bill or raising cash so liquidity is a premium in a time of crisis. Less-liquid hedge funds are more vulnerable while the more liquid ones can better withstand the crisis. In this sense, higher fees are justifiable.
EH: When the next liquidity squeeze comes, the Fed really only has two choices: to allow deflation and the likely collapse of some financial institutions or with ‘shock and awe’ amounts of quantitative easing. Do you agree and if so how are you preparing for both scenarios?
What you indicated could be the approaches the Fed may take for the next liquidity squeeze. Frankly we do not know. What I learned from the last crisis in 2008 is that avoiding large drawdowns is most important. Highly liquid underlying assets enable me to mitigate such drawdowns. The impact of such an extreme market on the liquid alternative asset class is less severe than that of the traditional asset class.
EH: Do you have any new funds in the pipeline?
Yes, we plan on launching a UCITS fund domiciled in Dublin, Ireland in early December. It will be an umbrella fund where we will have different sub-managers with their respective strategies including global macro, long/short equity, and fixed income relative value. Additionally, it will have multiple share classes with different currencies such as USD, GBP, Euro, or JPY.
In the United States we have already registered another ’40-Act fund called Arden Alternative Strategies II. This fund caters not only to retail investors but also defined contribution plans.
EH: And for our readers that would like to meet up do you have any overseas trips planned on the horizon?
Yes, our investment professionals; including myself, or business people visit Asia on a quarterly basis. In fact, we plan on visiting there during the first quarter of 2014. We would be delighted to meet with your readers that are interested in liquid alternatives.
1 References to Arden’s registration status do not imply a certain level of skill or training. SEC registration does not reflect approval or disapproval by the SEC.