Dalton Strategic Partnership: A cautious but effective approach to investment and risk management

Buy-Side Features
10 Mar, 2011

“The hedge fund industry did not cover itself in glory in 2008,” rues Magnus Spence (pictured), chief operating officer at the London-based investment management firm Dalton Strategic Partnership (DSP). “It was the one year when we had to demonstrate to investors that we could preserve capital and by and large, the industry failed. Hedge funds didn’t preserve capital and we prevented investors from redeeming their assets because managers had illiquid positions and side pockets,” he adds bluntly.

DSP, which has $2.25 billion in assets under management, invests predominantly in equities. Over the last nine years, the firm has grown exponentially and has seen offices open also in Hong Kong and Mumbai. As well as its two hedge funds, DSP manages several long-only funds and Ucits products. The firm prides itself on its ability to make consistent, absolute returns irrespective of the market conditions. It adopts a somewhat conservative attitude to investing favouring solid if unspectacular returns in bull markets – but simultaneously ensuring its investors make reasonable returns during bear markets like in the recent past. It is one of very few asset managers out there that considered 2008 to be a pretty decent year – its European long/short equity fund gained 6.26% during the crisis - a rare achievement to say the least given the equity market volatility. The firm’s macro hedge fund, however, made marginal losses of 8% - despite this, Spence says investors did not redeem assets en masse. “We had a manager who was particularly good at protecting capital in weakened markets. We had low net exposure and relative gross exposure and a particular skill in alpha generation from the short portfolio – 2008 was our kind of market,” he acknowledges.

However, Spence says that renewed investor risk appetite, especially during rosy markets, does put DSP at a slight disadvantage. “In 2009, our European long/short equity fund made 4.29% and some potential investors said these were dull returns – however, these were the same people that lost significant amounts of cash in 2008,” he highlights. As memories of 2008 wane, investors have rediscovered risk appetite and are more willing to put cash into hedge funds that could potentially end up giving them correlated returns. This frustrates Spence immensely.

“During the third quarter of 2008, investors wanted lower risk and uncorrelated returns irrespective of market conditions. When the markets recovered, investor appetite recovered and these same people started putting money into beta-driven, high volatility, high correlation hedge funds invested in equity markets. Investors haven’t learned their lessons. It is frustrating and it could lead to problems. I stick to the view that hedge funds must deliver absolute returns irrespective of market conditions and produce uncorrelated returns. It is not good enough for a fund manager to turn around to an investor and announce ‘we are down 14% when the index was down 24%.’ Hedge fund investors get excited about making 15 to 20% returns when equity markets are up – but it works both ways too,” he highlights.

Spence has made no secret of his disapproval towards the industry’s conduct in 2008. However, he has another fear that the Ucits brand could be irreparably damaged, much like the alternative space was two years ago, by irresponsible managers wrapping illiquid products into Ucits wrappers. Given the ever-increasing popularity of Ucits – particularly among European and Asian investors, this is not an unreasonable suggestion to make. In February 2010, DSP launched a Luxembourg SICAV version of its Melchior European long/short equity hedge fund – it is managed by Leonard Charlton, a former GLG portfolio manager and Goldman Sachs trader. Entering into Ucits was a somewhat predictable development for DSP given its background in managing long-only funds. Ucits, says Spence is a privilege for fund managers that he fears, however, will be abused.

“There could be Ucits-III compliant hedge fund managers out there seeking to generate alpha in less liquid spaces such as small-cap stocks in Eastern Europe. I could envisage an event whereby liquidity dries up and investors attempt to exercise their right to get their money out but the manager prevents this from happening. We have been given a phenomenal opportunity to ply our trade in a Ucits format, which is great for investors and it is a lifeline for our industry. Unfortunately, someone out there will take illiquid positions and abuse this opportunity. Investors must not think a Ucits-compliant strategy is copper-bottomed. Some investors at the end of the day may not get what they thought they were buying into,” he warns.

Given this conservatism and inherent caution, it is inevitable that risk management, be it market risk, counterparty risk, operational risk and business risk, feature highly on DSP’s and Spence’s agenda. Counterparty risk is something Spence feels very strongly about – it is often easy to forget how close the financial system came to a complete meltdown during the darkest days of September 2008. It is clearly an experience that impacted Spence and his approach to risk.

While the company has always opted for multiple counterparties, there were times during that long September where anything - no matter how remote - seemed possible. “The industry crisis did not pass us by without incident. We were worried about counterparty risk but we did a lot of things to protect our clients’ assets. We ring-fenced assets and made sure we understood what rehypothecation was. We did have Lehman as a broker but in the weeks running up to its bankruptcy, we took it off our recommended broker list. Our head of trading kept an ear close to the market and we therefore knew there were problems at Lehman,” says Spence.

“We looked at every conceivable position of a prime broker going bust and we opted in for client money and used CFDs to reduce the counterparty risk. Since then, we have been more alert to understanding the issues that the banking system faces at any points in time. We watch credit spreads very carefully now. We also do a lot more due diligence on our counterparties. We meet them regularly and ask more questions – we don’t just accept their answers at face value but probe them harder. The industry has undergone a complete change in this respect. While we have always been reasonably conservative, we are asking about counterparty risk a lot more,” adds Spence.

DSP may adopt a cautious approach to investment. However, it prides its risk management highly particularly in regards to counterparty risk. Nevertheless, its warnings about the corruption of Ucits by risk-taking managers should be heeded. Hedge funds are only starting to regain investor trust following the events of 2008. Let’s hope Ucits products do not experience a similar blow up when the liquidity dries up and Spence’s prophecy does not come true.

Magnus Spence is one of the founding members of Dalton Strategic Partnership (DSP), which was established in October 2002. He is responsible for business development, sales, marketing and operations. Prior to this, he trained as a chartered accountant with KPMG in London and joined Mercury Asset Management (now Merrill Lynch Investment Management) in 1995 as group financial controller. In 1998, he joined forces with Andrew Dalton (now CIO and managing partner at DSP) where he was responsible for business development and client relationships at the firm’s global asset allocation service. In 2001, Spence became head of the ultra high net worth team and was involved in developing the company’s presence in this segment in Europe, the Middle East and Asia.