Stenham Advisors, Kevin Arenson - Dec 2005

Risk, not returns, governs the way Stenham Advisors look atmanaging money. And after a century in the business, who‘s to say they’re wrong.

When you have been in the financial markets for more than 100 years, you learn a thing or two. And when you have been in absolute return for 18 years, you learn a thing or two more.

So it is with Stenham, whose heritage stretching back to 1901 has not stopped the London-headquartered firm making large and important business and investment decisions at key moments – and not living to regret the decision once made.

Harry Wulfsohn, director at Stenham Advisors, the research division of the group, whose hedge fund holdings have just breached the $1bn mark, says Stenham has been moving into multi-manager, single strategy products in recent years, diversifying beyond the firm’s broadly diversified, multi-strategy flagships, Universal and Universal II, and this strategy comes with the launch of a fund of global macro hedge funds.

EXTENSIVE EXPERIENCE
But Stenham hedge fund investments began well before that, in 1988, when it ran discretionary portfolios including hedge funds, which later became the Stenham Universal portfolio, from June 1992. (About 65% of the firm’s assets are run on a Stenham Universal portfolio-type mandate, either through Universal I or II, or through discretionary mandates. Stenham Universal now holds about $270m of the firm’s $1.1bn, with Universal II, launched in 2002, holding $310m.)

“We were driven by a client base in those days which was very risk-averse: successful entrepreneurs who had made their wealth in their businesses, and wanted their investment manager to look after that money for them,” Wulfsohn says.

“In our view, if you’re going to create wealth, you have to take on risk – something a lot of investment bankers are not very good at,” he adds. “They end up taking on too much risk and destroying the capital. We see the entrepreneur’s role as the risk-taker to create wealth, and our role as to preserve and enhance that wealth.”

The philosophy of wealth preservation led to some momentous changes at Stenham.

THE MOVE TO LONG/SHORT
After the markets crashed in 1987, Stenham stopped investing in long-only portfolios.

“Our clients said they didn’t care we had beaten our benchmark, they said instead, ‘You’ve eroded my capital. You should have got out of the markets and been in cash.’ We realised then that you can’t deliver this absolute return kind of mandate using long-only equities,” Wulfsohn says, “as it is very difficult to get the market timing right. We have therefore not bought a long-only equity for our clients since 1987.”

Since then, Stenham has focused on hedge funds and commercial property, targeting absolute returns.

Stenham as a firm has come to focus as much on risk as on returns, Wulsfohn adds. While $400m of its AUM it describes as coming from institutional investors, with much of this amount actually being family offices and private banks that are like institutions, Stenham’s risk-awareness puts paid to any simplistic notion that providers of product to non-institutional investors focus on returns, while institutionally focused providers focus more on risk.

“Through the experience of the last 18 years, our whole investment process has evolved to be as much about managing risk as delivering returns,” Wulfsohn says. “We focus on the volatility and downside risk with the whole investment process and how we structure the fund is driven by this philosophy.”

MANAGING RISK
‘Risk management’ for Stenham encompasses operational and investment due diligence – with far greater emphasis on qualitative assessment than was historically the case – and includes annual full operational risk reviews of every investee fund.

“We also ensure that we understand both the quantitative and qualitative interaction of strategies before combining them. To that extent we look at the underlying level of directionality with a particular focus on short volatility strategies versus long volatility strategies that we regard as portfolio insurances.” Asset-allocation reviews are conducted quarterly.

“With underlying managers, we focus on their added value and the sustainability of that added value,” Wulfsohn says, “and the resources they have to deliver that. How they manage risk is also important, we focus on risk controls, and whether they understand the risk in their strategies.”

And if one loses sight of risk control?

“If you target returns, you’re going to take on too much risk and deliver volatility. We believe that if you manage the risk, the returns will look after themselves. The important thing is to preserve capital, make a small positive return every month, and with the power of compounding you end up making a healthy risk-adjusted return over five years.”

Universal has done just that, producing 128% (USD) for its investors, or an average five year annualised return of 8%, on volatility of 2%. Its worst month in the five years was -0.5%, with a  trend of 83.3% of its months producing gains for the portfolio.

Universal I and II are opened and closed from time to time so that one is usually open for investments, and Universal II has mirrored the steady performance of its older namesake, producing 23% (7% annualised) on volatility of 2% and a worst month of -0.66% between its inception in April 2002 and September 2005.

Wulfsohn sees the arrival of Kevin Arenson in 1997 as managing and investment director, as a key moment in the company’s development. Arenson brought 15 years of investment management experience. He rang the changes soon after arriving, and they were weighty decisions indeed.

A total exit from fixed income in 1997 – “far too leveraged” – helped Stenham’s funds weather 1998’s volatility well.

Then, at the end of 2001, Stenham exited from convertible bond arbitrage, seeing it as over-leveraged in an instrument market held largely by hedge funds. It was a decision it has clearly not regretted over the past 12 months.

“For six months after we redeemed from convertible bond arbitrage, the strategy continued to have a very good run and we kept asking ourselves whether we had made the right decision,” Wulfsohn says. “We have not gone back into convertible bonds at all since, and fixed income was also a good decision.”

The Universal fund is now invested in global macro, equity long/short, event-driven and distressed-debt managers.

“When we got out of convertible bonds, the distressed-debt cycle was taking off, so we went to an 18% weighting in distressed and the cycle ran its course. Towards the beginning of 2004, we reduced distressed to 7%-8% and moved the money into multi-strategy event-driven managers. Now the arbitrage portion of our portfolio is split about evenly between distressed and event-driven and there’s a feeling that distressed debt may have another big cycle in a few years’ time,” Arenson says.

Equity long/short
The other major element of the portfolio – equity long/short – has remained steady at about 45%-55% since 1998, moving between heavier weightings toward short-term momentum, trend-following managers in the late 1990s, to “deep-value” managers now, fundamental stock-pickers taking a hands-on, private equity-type role in their stocks.

The equity long/short part of the portfolio in aggregate is marginally net long, with the heaviest directionality being around 30%.

“Debt has gone through a very good cycle over the past few years,” Arenson says, “but it’s harder now to achieve returns. This isn’t a function of the money flowing into those sectors, but rather a function of points in the economic cycle when distressed is attractive. The whole economy and companies get restructured and the opportunities go away, but there may be another good distressed-debt cycle that comes again in a few years. Next time it is likely to be consumer rather than corporate debt.”

DYNAMIC MARKET
Kevin Arenson has also overseen a diversification away from around 80% reliance on United States-based portfolio managers, to embrace Europe and, in the past five years, Asia as well.

The largest change Arenson mentions seeing in his time investing in hedge funds, however, has been the institutionalisation of the industry, from “visiting boutiques in Manhattan with one man, a computer and some support staff 10 years ago,” to more professional operations with more complex risk management today.

“The whole industry becoming more institutionalised means the risks from a due diligence point of view can be mitigated. It’s easier to do 90% of the due diligence today than it was then, although there’s always a risk going into hedge funds,” he says.

“In 1992, the whole hedge fund industry was very different to how it is now, most of the funds were global macro-type funds and they weren’t the institutional type of hedge funds you get these days.

“The types of managers you could invest in were probably not the type you would invest in these days because they didn’t have the kind of risk controls and infrastructure we were looking for,” Arenson says.

These days, Stenham’s underlying managers must be able to demonstrate track records of managing money for at least five years, and a two-year record as a hedge fund manager for stand-alone, non-institutional funds.

The negative side of institutionalisation of the industry, Kevin Arenson notes, “is that enormous flows into hedge funds have had such an impact, particularly in certain sectors and certain arbitrage strategies, that they are no longer arbitrage strategies and their returns seem to depend more on leverage going forward than they have historically.”

IDEAL SIZE
At $1.1bn in assets under management, Arenson says Stenham sits in a sweet spot, of between $1bn and $2bn, where “the firm can still put money with smaller funds – a typical investment would be between $20m-$50m – so we can still invest in the smaller funds where we think those have the greatest opportunity in returns, but we are not too big to want to dominate the investor base of the individual hedge fund.”

(As risk control on this front, any position Stenham Universal holds in an underlying portfolio cannot be more than 10% of the target fund’s assets, nor of the Stenham fund’s assets, and there are ceilings on allocations to specific strategies. However, Wulfsohn notes, “we rarely reach these limits.”

Arenson insists that, although the $1bn AUM was a landmark Stenham celebrated reaching, the company’s focus is very much on measured growth: “The last 18 months is the first time we have really seen institutional-type business coming in and because of the size of those mandates it can dwarf the individuals. I would like to keep the balance.”

“We are trying to control our growth, focusing more on preserving our track record than asset gathering. We do not want to be under pressure to make investments we are not completely comfortable with,” Wulfsohn says.

While Stenham’s asset growth has been impressive – from $122m at the end of 1998 to $1.1bn today – the rate is far less than that of many other funds of hedge funds. Stenham is targeting, Wulfsohn says, clients  who themselves understand the added value “someone of our size with our track record can bring.”

BEYOND UNIVERSAL
To better cater for sophisticated clients, Stenham embarked on launching single-strategy funds of hedge funds in 1993, with Stenham Growth (equity long/short) and Stenham Trading and Quadrant (trading/global macro) being complemented by Stenham Asia and Stenham Select (special opportunities) and Stenham Gold (bullion and gold managers).

Each has 12 managers or fewer – “if you have 100-plus managers in a portfolio, the good ones can’t have an impact and you have to question whether they can all be high quality managers” – and each FoHF, by being single strategy, allows a more targeted exposure.

“We will still do multi-strategy portfolios for people who want that type of exposure, for example clients who may not be as sophisticated in hedge fund investment,” Wulfsohn says, “but a lot of the family offices and private banks, for example, already have a fund like Universal in their portfolios.”

Stenham’s fund of specific strategy funds gives investors a more targeted exposure and access to closed funds.

Stenham’s latest addition is Stenham Global Macro, (see story on page 1), with capacity of $50m-$60m spread across seven underlying hedge funds.

“In the next 12-18 months, we believe, global macro will do well, as there are a lot of global imbalances that could play out in 2006. There is a bond bubble, commodities are volatile and...fundamentally the dollar is weak. There’s a lot of risk in the marketplace and global macro managers are best placed to benefit from that, trading very liquid assets and they can reposition themselves very quickly.”