Art of FoHF management: interview with Peter Rigg, head of alternative investments group, HSBC Private Bank

The alternative asset group of HSBC Private Bank has an impressive track record, built mainly on the strength of its research and commitment to a thorough due diligence process. Hedge Funds Review talks to the head of alternative investments about the model used and views of the future.

Peter Rigg admits that despite analysis, due diligence and use of sophisticated modelling techniques, the choice to invest in a hedge fund is more art than science. As head of the alternative investments group at HSBC,Private Bank, Rigg should know.

Based in Geneva, the group has 140 employees around the globe including New York, London, Hong Kong, Geneva, Paris and Sydney with distribution in Singapore and Tokyo. For Rigg it is important to be where hedge fund managers are. The group offers fund of hedge fund (FoHF) products as well as advisory and discretionary services for tailored hedge fund portfolios for specific clients.

Being part of the HSBC banking network is another advantage, according to Rigg. He believes the bank’s worldwide connections give the team a deep understanding of local markets and help to open doors to investment opportunities.

The combination of a strong research team with access to a wide universe of funds coupled with the knowledge gained from the managers as well as clients of the group gives HSBC a tangible edge over other FoHFs, Rigg believes.

HSBC Alternative Investments is one of the top five hedge fund investors worldwide, managing $30.6 billion (at December 30, 2009) of assets invested in hedge funds, real estate and private equity. The majority of the money, confirms Rigg, is in hedge funds.

Despite a to-be-expected dip in returns in 2008, investors seem to be happy with Rigg and his team. He believes this confidence is to a large part based on the very thorough due diligence process the group goes through before putting a fund on its ‘approved list’, which at the moment contains around 260 single-manager hedge funds.

“The universe contracted in 2008 but it has expanded again,” says Rigg. The selection process begins with the research team. A committee approach is taken to a large extent, although a specific team of analysts will do the onsite visits. Senior management may also take part in this and once on the list, there are regular onsite visits.

There are two parts to the process. First is operational due diligence. Funds are rated from one to five; only those who manage a rating of three or above are considered for the next step. Rigg is keen to ensure analysts do not cover too many funds on a regular basis as he believes they need to keep on top of monitoring and interaction with the managers.

When assessing a fund for investment, HSBC “determines this on an individual basis. There are hundreds of funds that our FoHFs and our clients can invest in.” However, HSBC “needs to put limits on concentration, particularly when we are adding a large amount of investment into a fund. Ideally, we take up to a maximum 20% stake in any one fund,” he says. “Once a fund makes it on to the approved list, we can then invest in it.”

In general Rigg says his team is looking to find the best managers in a wide range of strategies, wherever they may be located. This is where he thinks the spread of their own presence coupled with that of HSBC in general gives the group an advantage. “We’re well placed to do that because we have a big and experienced due diligence team around the world.”

Rigg continues: “We tend to invest in a full range of strategies and look to combine them sensibly within a portfolio context. The research is really the first line of defence and it is probably more a case of what things we don’t invest in.”

Managers need to be able to give some level of transparency and there needs to be a match between what liquidity the fund is offering and its investment strategy. “We look to see why a fund does well; what it is about the way it executes its strategy that makes a difference,” he notes.

This means funds are constantly monitored to ensure there is no style drift. “But how much scrutiny do you need? We can’t follow him [the fund manager] around all day. At some point we have to make a judgement,” Rigg states. “We join the dots. We try to triangulate truth.”

Although he believes transparency levels have improved, “the fact is that traditional hedge funds are not the most transparent and open. You take on a risk as an investor. We have seen transparency improve in 2009 but it is still sometimes basic. We don’t want to restrict our universe of investment. It is a balance. We have a minimum standard below which we will not consider a fund,” he explains.

With such a wide universe of funds to monitor, the group is able to compare and contrast the performance of funds within the same strategy. There will be an “expectation of return” and “acceptance of volatility to get that return” he notes. So if a manager starts performing very differently compared to its peer group, a red flag will be raised. The manager needs to explain why he is out of step with the rest of the strategy group. This could be because of style drift or it could be because he spots an opportunity that others may have missed.

He is cautious, too, about pushing managers into straitjackets. This is one of the reasons HSBC does not run any managed accounts on its FoHF platform.

Rigg also takes a pragmatic approach to what fund managers did to manage the extreme market conditions in 2008. Sometimes negotiations may result in a new share class more tailored to the needs of HSBC or one of its clients. But “we don’t want to change the way the manager trades. We don’t want to kill the magic. If the manager can make money from the market, we’re not going to force him to run an equity market-neutral strategy. We don’t want to constrain the investment process. The strategy may look attractive, but constraints may dilute it,” says Rigg.

This in part helps explain Rigg’s attitude towards how he views fund managers who imposed gates or had to use side pockets for illiquid assets.

“There was a whole range of the ways funds reacted to the events of 2008: side pockets, gates. If we could look back and say the manager was right to do this or that, then it is a fund that could be retained. But not all of them pass this test. So it’s not a blanket ban on all funds that imposed gates. We distinguish between them. It [2008] was an extreme environment. We need to look at how the manager solved the problem,” says Rigg.

Like many FoHF investors, Rigg has embraced Ucits hedge funds. HSBC was among the first to launch a Ucits FoHF, the AdvantEdge Fund. It and all the underlying fund investments are Ucits compliant.

“Certainly with Ucits hedge funds you get liquidity. You get more information on counterparty exposures. If it makes sense on the performance side, we will look at it,” Rigg says. He is careful to add that there is the same level of research and analysis into Ucits funds before an investment is made.

Rigg says the Black-Litterman model is used to construct the FoHF portfolios. This is a mathematical model used for portfolio allocation developed in 1990 at Goldman Sachs by Fisher Black and Robert Litterman. The idea behind the model is to overcome problems institutional investors encounter in applying modern portfolio theory in practice.

The Black-Litterman model is used to estimate inputs for portfolio optimisation. It mixes different types of estimates, some based on historical data, others based on equilibrium conditions, to arrive at updated estimates.

“We tilt the portfolio one way or another to achieve different neutral portfolios. We take a view and add our conviction into the model. It is quite complex and technical,” he says.

Looking forward
In a glimpse of how the group will manage portfolios in 2010, he reveals that the team has a positive view on quite a few strategies. Strategy ratings represent the group’s views on the different hedge fund strategies relative to each other. So, for example, a neutral rating means the outlook for performance over the next three to six months is broadly in line with the longer-term expectations of return for the strategy.

For 2010, positive ratings have been assigned to interest rate levels, fixed-income volatility, merger opportunities, distressed opportunities, macro and distressed, while event driven/multi strategy, merger arbitrage and statistical arbitrage have achieved a neutral/positive rating. Overall HSBC is neutral on global liquidity, credit spreads, equity market level, equity market volatility, convertible bond issuance, trending markets, equity long/short, equity market neutral, convertible arbitrage, fixed-income arbitrage, managed futures and high yield.

Turning to the thorny question of fees, Rigg has strong opinions. “If we can trim fees, we do and we pay it back to our investors.” He would prefer to pay lower, rather than higher, fees but admits “the more successful funds can charge higher fees”.

Looking at how his own FoHFs earn their fees he says quite simply that it comes down to performance. “If you perform well, then you should get paid. It is the same for a hedge fund manager and should be for FoHFs.”

Rigg adds: “Over the 15 years we’ve been running we’ve beaten equities, we’ve beaten bonds, we’ve beaten peer groups. So I think over the long term, that is what you should look at.”

Rigg is also bullish on the future for FoHFs. He refutes any claims that the model is broken. “We have been in business for over 15 years. I think there is a difference between FoHFs, the same as with single-manager funds. Some had problems and had to suspend or impose gates. Some had problems with performance.

“We had redemptions at the end of 2008 and early 2009 but we paid out 100 cents on the dollar. We kept our performance strong. I think there will be a distinction between different types of FoHFs. So the model certainly isn’t broken,” he declares.

The proof of this is in the fact that Rigg says his FoHFs are gaining back assets. “Our growth target went out the window in 2008/09,” he admits, “but we expect to grow in line with the industry this year. Our goal is to produce the best research, to provide the best hedge funds to our clients, and to perform well. If we do this, assets will come.”

In general Rigg says there has been a “nice pick-up” in assets, reflecting the industry as a whole. He believes there are still a lot of opportunities for businesses like HSBC to pick up on.

“The opportunity is still good. We don’t see any particular problems at the moment. Obviously, we have business targets. But it is strong performance that will attract new assets,” he concludes.

He admits that during the crisis “we had to do a lot of reassuring. We had a disappointing performance in 2008 but we did relatively well, down 16.6% compared with the average FoHF that was down 20%.” Rigg and his team spent time speaking with clients and explaining the situation and then deciding what action to take. “This put a strain on the team, but we did it. They are professionals. We had to convey difficult, complex situations to our clients and this was appreciated. Our assets increased by over 20% during the second half of 2009. We were rewarded for doing a good job,” he declares.

“We will continue to grow assets and come to the market with the right products,” he adds.