By Claire Makin
Post-crisis, a new breed of asset managers has sprung up, with new ideas and ways of implementing them. One of these is London-based Falcon Money Management, which has a clear sense of its own identity and where it fits into the evolving fund of hedge fund space.
Michael Perotti, Falcon’s founder and chief investment officer, says that much of the funds of funds industry became the victim of its own success, commoditised and beta-dependent, and on those grounds recent criticism of the industry is warranted.
But Falcon has moved beyond this business model to view hedge fund strategies as a way of delivering defined return streams in a mixed-asset portfolio – no magic and no mystique. “It starts with our not being a hedge fund shop. We start off being an asset manager trying to achieve certain objectives,” Perotti points out.
Falcon applies these views to $4.2 billion in portfolios that it manages across a range of asset classes, including a $475 million hedge fund allocation currently outsourced to about 25 managers. All of these are alpha-seeking funds that are largely uncorrelated with each other and with mainstream assets; and many are small, early-stage managers employing complex strategies.
“I think there is an important role for people like us to play, particularly in niche strategies where you want to go off the beaten track to find funds doing different things to your mainstream managers,” Perotti says.
Conspicuously absent in the uncorrelated alpha strategies approach that Falcon is looking to offer to other investors are many core hedge fund strategies: no long/short equity, and very little credit, distressed, event-driven or anything with a long bias. Instead, Falcon prefers relative value and market-neutral-type strategies that are also highly liquid.
This is because Falcon has followed a distinct low-volatility approach since it was founded in January 2009. Until recently, Falcon managed assets exclusively for Beazley, a major Lloyd’s of London insurer that has a 25% ownership interest in the firm. The risks inherent in Beazley’s insurance business required its assets to be run with a high degree of liquidity and minimum volatility – in other words, to avoid draw-downs, particularly year on year.
Falcon’s low-volatility strategy has so far done just that, with positive returns in each year since January 2010, and in 80% of months including May 2011, which was a catastrophic month for many hedge funds. The strategy’s maximum drawdown was -0.78% in July 2010.
The agreement was for Falcon to manage money exclusively for its strategic partner for three years, to focus on performance. Now, with a three-year track record behind it, Falcon is actively courting additional clients, and Perotti and his team are working on new products for institutions with different risk and return requirements.
Before founding Falcon, Perotti spent 11 years with Swiss asset manager Union Bancaire Privée, becoming CIO for UBP’s London operation where he oversaw a 40-strong team that he had helped build. He resigned in 2007. “I wanted to build up something from scratch, something entrepreneurial that would meet the demands of an institutional client base,” he says.
At the same time, Beazley was looking to boost its internal asset management capabilities, conscious that attracting talented people for an in-house team is much easier than retaining them. The solution was Falcon Money Management, which is located in Beazley’s headquarters near the Tower of London.
Thanks in part to Beazley, the operational and risk infrastructure that Falcon has in place, as well as its 18-person team, are more suited to a large public organisation than a niche asset manager. “We had to make sure our standards were up to theirs from day one,” Perotti notes.
Besides Perotti, senior members of the alternatives team include Ermenegildo Schettino, who is head of external manager allocations including hedge fund strategies, and responsible for Falcon’s alternative investments in foreign exchange and fixed income, commodities and volatility, as well as other relative value strategies. Schettino was previously head of European hedge fund strategy research at UBP, and before this, worked at Tarchon Capital Management for seven years.
Edoardo Rulli, formerly with UBS Alternative Investment Solutions, oversees Falcon’s alternative investments in equities and credit, while Antonello Russo, Falcon’s head of risk management, joined after an 11-year career at Deutsche Bank, where he worked mainly on hedge fund prime brokerage and risk monitoring and reporting.
Anchored in fixed income
Falcon’s investment strategy has so far been shaped by an ultra-conservative approach that mixes traditional asset classes with hedge fund type strategies. The ‘anchor’ for its main port-folio is fixed income, which has a relatively short duration of around two years and is close to the duration of liabilities.
Half of the portfolio is managed directly by Falcon’s team, and about a third is invested in non triple-A fixed income, outsourced to traditional fixed-income managers. A further 12% to 15% is allocated to capital growth strategies with a higher target return, including uncorrelated alpha strategies.
This allocation targets a return of T-bills plus 400 basis points with a tight risk budget, and is invested in liquid strategies with a low beta element, meaning that they are largely not exposed to equity market or interest rate risk, or dependent on economic growth scenarios.
However, this does not restrict Falcon from investing across the whole spectrum of strategies, including commodities, credit, equities, forex and fixed income and volatility. Typically, the focus falls on relative value and arbitrage strategies with a non-cyclical bias that are uncorrelated to major asset class indices.
“One of the main principles I believe in, particularly for this portfolio, is to have different drivers of return,” Perotti says. In fact, diversification is the key differentiator in Falcon’s investment approach, he notes.
Proof that the strategy works is its -0.12 correlation with the MSCI World index. Managers also have a low correlation with each other. Over time, only two pairs of managers have a higher than 0.6 correlation and most have correlations ranging from -1 to 0.3.
By diversification, Perotti says he means not just three to four drivers of return but more than 15 different drivers in a portfolio. He and his team achieve this by looking for managers with original strategies but “that’s not to say we won’t end up with one or two global macro managers” for protection, he adds.
Commodity trading advisers perform a similar function, although Falcon chooses specialists and not the large, traditional managers whose strategies held up well in 2008. “You have to be pretty granular in what you expect from different strategies, and indeed, from different hedge fund managers within those strategies,” Perotti points out.
In general, Falcon looks for strategies where there are high barriers to new entrants for various reasons. They may require long experience in a particular region, a high degree of technical or legal expertise, as in commodity arbitrage, or a large capital investment, such as high frequency trading.
Such strategies may have limited scalability, so Falcon often invests with small or early-stage managers. Investing early also brings the benefits of added transparency and better access to key people. There is no size limit and Falcon has even seeded one manager. “What’s important for us is a robust infrastructure, also that the strategy is liquid and there is no asset liability mismatch,” Perotti says.
Around half of Falcon’s managers are located in New York or London, with the rest in various locations around the world. About 20% of the hedge fund allocation is invested with Asia-based managers, who have outperformed the rest of the portfolio, according to Perotti.
“Traditionally, allocating to Asia was very much an equity-based hold-onto-your-seat type of investment. We are now seeing relative value and market-neutral strategies appear to take advantage of inefficiencies in newer markets,” he says. Obviously this comes with extra risks, he adds. One is that liquidity in Asia is lower, so managers have to be sized accordingly.
Looking for alpha in complex strategies requires constant vigilance, and not only in Asia. “We embrace complexity as a way of adding return. However, you do have to be very careful about the risks involved in these strategies,” Perotti says.
To monitor and manage risk, Falcon employs all the usual metrics, as well as some unusual ones. More importantly, the team relies on its own judgement and experience to understand how a strategy will behave in different market conditions. “Our main defence is knowing the strategies and the risks involved very well,” Perotti says.
Falcon has two lines of defence. First, its front-line investment professionals are very experienced in recognising the risks and warning signs in the strategies they oversee. The second line of defence is Falcon’s independent risk management team, headed by former Deutsche prime broker Russo.
Perotti says that when he built his team, one of his priorities was to hire a head of risk who was familiar with prime brokerage agreements and the counterparty risks involved in complex hedge fund strategies. “That’s not to say we are immune to risks. You can do all the due diligence you want, and at the end of the day you will always be exposed to risks,” he notes.
Perotti’s greatest concern is a liquidity-driven crisis when normal market relationships tend not to work. “The key is to limit volatility, to make sure managers are not taken out by volatility, or by investors or counterparties who call in their lines,” he says.
As for attracting new clients, Falcon is ideally looking to develop new relationships with sophisticated global institutions, “including those who are curious to expand beyond the realms of the usual”. Prime candidates are investors in the UK, Nordic markets and the Far East, in particular Japan, where Falcon has a Tokyo office.
Falcon is conscious that capacity in its uncorrelated alpha strategy is not limitless, and so has set no targets for asset growth. However, growth will be capped before it requires any change in the underlying strategy, Perotti says.
Falcon also sees itself as a solutions-based provider and is developing other strategies with different return streams in response to client requests. One is an equity-based approach that aims to deliver some of the upside of global equity performance while limiting downside losses. Another is a higher return-seeking, higher risk allocation that aims to profit from the illiquidity premium in strategies such as distressed and direct lending.
Perotti acknowledges that the strategies Falcon has followed so far are sophisticated and costly to implement, but says there is no question about the value added.
“I would say it is absolutely worth it. If you can generate a 5% return in this interest rate environment with low correlation to major asset classes, those returns will be worth their weight in gold,” he notes.