The weight of true institutional firepower...applied with a deft touch

Russell Investment Group runs more than $5bn in its funds of hedge funds, making it quite a hefty hitter in the FoHF universe, writes Solomon Teague. However, as Alex Trichot explains, size has not stopped the group from diverging from its peers on some important points

Russell Investment Group runs approximately $5.3bn in funds of hedge funds, all with the same non-directional investment philosophy. Its flagship, the Alternative Strategies Fund (ASF), was launched in June 2001, soft closing at $3bn. It has since delivered annualised returns of 9% with a volatility of 2.1%.

"You see a lot of conservative funds that claim to be non-directional but have equity or credit beta. This one is truly non-directional. Since inception, we have equity and credit betas between 0.1 and 0.2," says Alex Trichot, senior product specialist, alternative investments at Russell.

In October 2004, Russell Investment Group launched ASFII, to compensate for the soft close of its predecessor, which has raised $1.5bn in assets.

Additionally it runs Erisa, a fund for US tax-exempt citizens, offering quarterly liquidity, with $600m-$700m in assets, and a $250m mandate for an unnamed Japanese institutional client.

stand out from the pack

Russell has a distinct philosophy with some investment attitudes unlike many funds of hedge fund groups of a similar size.

Most obviously, the strategies of the funds Russell's products invest in must be niche hedge fund strategies, with few enough players in the area to allow it to extract significant alpha. For example, while it invests in equity long/short managers, the group concentrates on smaller-cap players playing specific sectors, such as small-cap US healthcare or European consumer discretionary.

It avoids the crowded arbitrage strategies altogether. However, Trichot was reluctant to disclose many of the specific strategies in which Russel Investment Group does invest in, although he notes that mortgage-backed securities (MBS) and asset-backed lending are two areas to which it has "quite heavy exposure."

Trichot elaborates: "In the US, they have a real shortage of financing, so we see a lot of opportunities over the next few years. It is a long-term view.

"We have some very esoteric strategies," he says.

"We have some strong strategists and are able to dig quite deep into the more esoteric strategies, where our competitors might not bother."

Russell Investment Group wants to invest in highly specialised managers with high barriers to entry.

"Many investors will only invest in what they can easily understand. That is a good approach, but today the universe is quite crowded and there is not a lot of added value to get from these areas," he says.

under the hood

"We prefer to dig into new areas and understand how they work." In this way, Russell Investment Group avoids the most-crowded strategies where returns are being squeezed.

Trichot believes the majority of its underlying hedge funds would be unknown to most other fund of hedge funds groups.

For this reason, there is seldom a significant overlap between the funds in Russell's funds of hedge funds and those of other large fund of hedge funds groups, Trichot says. This is especially attractive for investors with more than one FoHF in their portfolios.

when small is beautiful

Despite the size of its funds, especially ASF, it prefers to invest in relatively small funds. Because Russell will not increase the number of funds held in its portfolio - ASF has barely changed since inception, declares Trichot, with 35 underlying funds - it has many investments constituting substantial proportions of the hedge fund's overall assets.

The average size of an allocation is approximately $60m-$90m. This defies the conventional wisdom prevailing throughout much of the industry that to constitute more than 10% an underlying fund's assets carries an unacceptable risk.

"On the one hand, you could have an investor with 10% of a fund's assets, and on the other, one with 60%. I prefer to be 60%, because the manager will be more concerned about your happiness," Trichot says.

Trichot believes having a majority share in a fund's assets brings several distinct advantages. It encourages higher levels of transparency, he notes. With a medium to long-term approach to investing, Russell Investment Group is able to build up strong relationships with its underlying managers, Trichot says, and, in some instances, gain more influence over them than is typical for a fund of hedge funds.

ok chaps, now focus...

It is unwilling to further diversify the portfolio beyond the 35 funds it invests in because, as Trichot says, further diversification would make his fund of hedge funds little more than an index.

Russell Investment Group's preference for smaller funds and niche strategies leads it to investments in relatively new funds without the track records, a prerequisite for so many of its peers.

Russell Investment Group believes it can leverage the depth of experience and coverage of its long-only business; when managers leave large asset-management organisations to set up on their own it already has an established relationship with them and is therefore prepared to consider an investment from the outset.

Alex Trichot accepts that other firms see this approach as a risk.

Conventional wisdom holds, for example, that among even the best long-only managers, many will never make good short-sellers. Trichot agrees with this thesis too.

However, in the instance of a long-only manager setting up a long/short fund, Russell considers the manager's process.

from long to short

"A long-only manager setting up a long/short fund is unlikely to have an issue managing the long side. But the short side is a completely different issue," says Trichot.

"There are a lot of issues. If you know the manager has a quantitative background, that makes it easier. If he can model on the long side, the chances are he can also model on the short side."

Trichot believes the long-only team at Russell is able to make an informed decision as to how likely a manager leaving that business to set up a hedge fund is to succeed.

For example, it invested in one market-neutral fund whose manager had left a large quantitative house. The long-only side of the Russell business had known about him for 10 years, and they believed the process the manager employed would work on the short side as well. Therefore, it became one of the fund's first investees.

However, Trichot insists, "we are not adventurous. In some instances, we can move quickly because we have known most of the market for such a long time."


In all strategies, understanding the process is more important than any performance data the manager might provide.

"We have a very qualitative approach," he says. "I am not going to buy a track record. I want to buy an investment process."

Track records are a less-reliable guide to the future than understanding the dynamics of the strategy, Trichot explains.

"If you try to have a strong understanding and deep transparency at the investment-process level, you will be able to see if what they have achieved in the past will be replicable in the future," he says.

"A manager might have delivered 20% over two years simply because the markets rallied and the fund was leveraged. There is no skill in that. It is good timing, but it is not added value."

Russell Investment Group is not an enthusiastic believer in leveraged funds, although it is prepared to consider it in some circumstances, Trichot says.

"You have to take risk in order to generate returns," he says.

However, a fund that operates a strategy that relies entirely on leverage is not attractive. "Leverage is good as long as you are right, but it significantly increases your tail risk.

"You increase your upside but you significantly increase your downside." He says too many people don't realise this point.

"It is exactly what happened in May and June to many CTAs. They were leveraged and doing well while the market was trending. As soon as there was a correction, everybody got caught in a very nasty way." Trichot has earned the right to make such statements given that his fund avoided any losses in May and June.

This, he says, is why it insists on its "truly non-directional" approach.

Russell does not typically try and second-guess the market and adjust allocations to reflect macro views.

On one level, lock-ups in hedge funds make this very difficult to achieve successfully for any FoHF: by the time it has extracted its money from one fund to allocate it elsewhere, it is unlikely to capture a significant proportion of the upside it was chasing.

It expressly states it does not try to time the market.

More importantly, and specifically to Russell, it is a reflection of the company's aversion to crowded areas of the hedge fund universe.

"Recently, an investor noted how much M&A activity was going on and asked if we had exposure to an M&A arbitrage manager. I said no, because that is a short-term view. We don't know how long it is going to last, and there is too much money chasing those M&A opportunities," says Trichot.

He notes the number of deals has not been increasing in this area, just the size of the deals.

macro conviction

There are instances in which the fund will adjust its holdings according to macro views, when these reflect its views on risk.

Since mid-2005, Russell has been monitoring credit spreads. "We believe there is a very significant risk there," Trichot says. If its underlying funds are long here, then it will monitor this situation very closely, he says, because it would be very nasty if credit spreads blew up. "We rely on the ability of our underlying hedge funds to move according to the market environment," he says.

"Our market-neutral and long/short funds did extremely well during the second quarter, despite conditions being tough. The Vix index went from 12 to 24 in June, doubling in a few days. At the short end of the market, there was a lot of tension. A good long/short guy will react by reducing his net and growth exposures."

That is what happened with its underlying equity managers, in response inflation and to geopolitical issues.

diligence where it's due

As well as having the analysts covering Russell Investment Group's investment decisions, there is a risk and operational due diligence team, whose job it is to thoroughly examine any potential investment's operational procedures.

This team has a veto over any investment, no matter how compelling, if processes are not deemed to be of an acceptable standard, Trichot says.

"Most of the blow-ups come from this area. Bayou and Wood River, they were both valuation issues. There is a significant risk there, and that is nothing new."

He notes Russell Investment Group's funds of hedge funds have never had an investment with a hedge fund that has blown up, although he concedes you can never protect yourself entirely against this eventuality, and there has to be an element of luck as well as good due diligence.

"We minimise the different risks, especially operational risk. You can never say there is no risk, as there obviously is."

Here, again, Russell Investment Group's size and its relationship with relatively small managers gives it certain advantages, according to Trichot.


"As well as being a significant investor, we try to be a partner," he says. The underlying fund managers often value the experience and advice of Russell.

Whether they moderate their organisational structures to ensure they receive the investments that will constitute a significant proportion of their overall assets, or are acknowledging the superior experience and expertise of Russell's due-diligence team, they often defer.

For example, in one instance Trichot cites, a fund operated with the portfolio manager operating in a dual role as the chief financial officer. Effectively, he was therefore charged with overseeing his own investment activities, and of valuing his own positions, presenting an unacceptable conflict of interest. "You need a clean separation of duties," he notes.

The manager in this case responded by hiring an external chief financial officer within two weeks. "It shows we have to learn from the hedge fund managers but that sometimes they have to learn from us. Running a business is different from running a portfolio, and often, they are happy to get your feedback."


Once an investment has been made, Russell will redeem for a number of reasons, mostly ones typical to most reputable FoHFs.

Managers that grow beyond their stated capacities, jeopardising the profitability of their funds, might find themselves losing a sizeable investor. Style drift, another scourge of FoHF managers everywhere, is a red flag.

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