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Seeking out hedge fund alpha is goal of JP Morgans FoHF unit


Creative minds Author: Kris Devasabai Source: Hedge Funds Review | 03 Apr 2012 JP Morgan Alternative Asset Managements conservative reputation masks a passion for unearthing untapped sources of hedge fund alpha. It readily embraces niches ignored by most hedge fund investors.

Paul Zummo (pictured), co-head and chief investment officer of JP Morgan Alternative Asset Management (JPMAAM), will always be a little skittish about hedge funds. He readily admits to being deeply sceptical of managers that promise attractive returns with little or no risk and encourages analysts at JPMAAM to take a glass half-empty approach to evaluating hedge funds. We are a very risk-focused group, he says. We always start by looking at everything that can go wrong with a manager and their strategy. Only then do we turn to the return side of the equation to see if we are getting compensated for those risks. But Zummos cautious and conservative exterior masks a real passion for unearthing untapped sources of hedge fund alpha. A quick look at JPMAAMs strategy preferences for 2012 reveals a willingness to embrace niches that are overlooked by most hedge fund investors. JPMAAMs current top strategy pick is reinsurance. The investment team identified dislocations in the reinsurance market in early 2011 following a spate of earthquakes, hurricanes and other natural disasters, which caused losses estimated at more than $100 billion for insurers. Hedge funds have stepped in to replace some of this lost capital, attracted by the higher premium levels. According to JPMAAM, reinsurance strategies are more attractive now than they have been in a number of years, with current premium levels implying a 75% chance that returns will be 17% or more. The bet on reinsurance is not unusual for JPMAAM. Zummo believes hedge fund investors have to be prepared to venture off the beaten path to find the best returns. As more money has come into hedge funds, a lot of the traditional strategies are no longer as attractive as they once were, he notes. To compensate for this, the group has researched a whole host of unusual strategies, from life settlements to music royalties and reinsurance. Weve passed on a lot of it, but we will look at everything, says Zummo. JPMAAM is equally open-minded about the types of managers in which it will invest. Zummo certainly does not believe size and a long track record equate to safety. In fact he prefers to invest in smaller managers that are nimble and flexible. The average size of managers when they enter JPMAAMs portfolio is $250 million to $750 million, although many are even smaller. Investing early also means the group is able to build close ties with managers, which has its own benefits. In 2007 JPMAAM created a separate portfolio to co-invest in the best ideas of its underlying managers. If the manager has a high conviction idea, we may ask them to structure that trade for the co-investment portfolio, Zummo says. We can often accept the incremental risk of having more exposure to a trade [than the underlying manager] because of the number of managers and aggregate risks at the fund of funds level. The group is currently very bullish on the return potential of its co-investments, which include several Asian special situations trades, an

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investment in a Chinese financial services company and arbitrage trades that seek to capture mispricings between American depository receipts (ADRs) and local shares. The combined positions represent less than 10% of JPMAAMs fund of hedge funds (FoHF) portfolios but they are expected to be a significant contributor to returns. This combination of caution and creativity is a hallmark of JPMAAMs approach to investing in hedge funds. The FoHF group effectively operates as a boutique within JP Morgan, with its own investment, operations, risk and client service teams and a dedicated technology platform. The business is jointly led by Zummo and Corey Case, JPMAAMs chief operating officer (pictured).

Founded in 1995 with just $7 million in assets, JPMAAM now manages around $9 billion and employs 66 people in teams in New York, London, Geneva and Singapore. The group runs a series of multi-strategy and specialist FoHFs with around $3.5 billion in combined assets and oversees a further $5.5 billion in discretionary customised accounts and advisory mandates. Close shave The 18-strong investment team is led by Zummo, a founder of the business. He started his career in the pension fund consulting group at Chase Manhattan in 1990. After a couple of years advising clients on manager selection and asset-liability modelling, he joined the Interpublic Group to manage its retirement plan assets. At the time, the Interpublic Group was in the process of overhauling its pension portfolio and had started allocating to alternative investment strategies, including hedge funds. However, Zummos early taste of hedge funds left him with a healthy dose of scepticism about the industry. One of the first hedge fund managers Zummo met at Interpublic Group was David Askin, whose supposedly low-risk mortgage funds blew up in 1994. A respected mortgage analyst, Askin got into the hedge fund business in the early 1990s and quickly raised more than $600 million from sophisticated investors, including pension plans, banks and insurance companies. Zummo met Askin on multiple occasions but eventually decided not to invest in his funds, which traded opaque instruments with leverage. This experience has set the tone for JPMAAMs risk-first approach to investing in hedge funds, which places a strong emphasis on manager research and due diligence. Zummo takes real pride in the fact the group has never invested in a fraud or blow-up since launching its first FoHF 17 years ago. This is not simply a case of good fortune. The group has looked at most of the hedge fund frauds and blow-ups of recent years and passed on all of them. A couple of important factors have contributed to JPMAAMs unblemished record. First, the investment team consists of strategy specialists with real expertise in their fields. Second, the group actively manages its analyst-to-manager ratio to ensure the team is not spread too thin. There are 18 people on the investment team, including Zummo, overseeing roughly 80 to 90 managers in which the group invests. The aim, Zummo says, is to have an average of five or fewer managers per analyst. Due diligence As might be expected the groups due diligence is rigorous and intensive. Last year the investment team screened and rated 800 new funds and performed deep dives on 450 of them. Of these, only 20 were added to JPMAAMs portfolios. The selection process consists of multiple interviews with portfolio managers, key analysts and risk and operations teams. From start to finish at least 10 people from JPMAAM will have looked at a prospective manager and analysed them in some dimension before a final decision is made. In evaluating a manager, the investment team looks at their investment process, skillset and experience as well as other intangibles like the managers character and personality traits and the culture of the organisation. What we are looking for in a hedge fund manager is someone with an innate need to win, balanced with the humility to admit mistakes and learn from them, Zummo says.

There are lots of people with a need to win but all too often it leads them to run off a cliff. It is the combination of the two, knowing when to step on the gas and when to hit the brakes, that separates the top 1% of managers from the rest. It is not an easy combination to find. There are lots of people with a need to win but all too often it leads them to run off a cliff. It is the combination of the two, knowing when to step on the gas and when to hit the brakes, that separates the top 1% of managers from the rest.

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JPMAAMs investment process combines bottom-up manager research with a scientific approach to strategy selection. The group divides the hedge fund universe into six main strategies (long/short equity, credit, relative value, event driven, opportunistic macro and portfolio hedge) and 32 sub-strategies. The investment team assesses the relative attractiveness of each sub-strategy by modelling the specific return and risk factors associated with them and then adjusting for macro conditions. The models forecast the forward 12-month returns and the level of dislocation or inefficiency at the strategy and sub-strategy levels. Risk is measured in relation to the liquidity/crowdedness and volatility/tail risk of each strategy. The risk and return factors are then weighted based on the teams assessment of macro conditions, which takes into account factors such as the interest rate environment and risk premiums in credit and equity markets and external forces such as the eurozone sovereign debt crisis. The results ultimately feed into a heat map that ranks the outlook for each of the 32 strategies. The modelling is unique to each strategy and reflects the typical exposures, return drivers and liquidity profiles of managers employing those strategies. For example, the formula for analysing convertible arbitrage focuses on the cheapness of the equity option embedded in the bonds and the financing environment for the strategy. The models ranked convertible arbitrage in the top quartile of the heat map in 2009 as the theoretical discount rate widened to unprecedented levels. However, the mispricing was quickly arbitraged away and convertible arbitrage has been in the bottom quartile of its rankings ever since. JPMAAMs portfolios are rebalanced monthly to maximise allocations to sub-strategies with the best near-term return prospects. Zummo says around 25% of the groups value add comes from top-down strategy selection and rebalancing, which are largely driven by the results of the heat map analysis. The investment teams most recent analysis suggests a moderately attractive return environment for hedge funds in 2012 tempered by stillelevated risks. In this scenario the group prefers uncorrelated strategies that are liquid and flexible, resulting in a focus on macro and relative managers. Currently, the top five strategies in JPMAAMs heat map are reinsurance, statistical arbitrage, co-investments, relative value commodities and volatility arbitrage. Finding cohesion Bringing these disparate strategy elements together in a cohesive portfolio is no easy task. The group uses what Zummo calls a bullet and barbell approach to portfolio construction. The bullet represents 75% of the portfolio and consists of managers with a risk/return profile that is in line with the overall objectives of the fund or customised account. For a moderate risk/return portfolio, this will include a lot of relative value and low net exposure long/short strategies. The barbell consists of portfolio hedges at one end and return enhancers at the other. The hedge portfolio is designed to protect the bullet in periods of market stress when many of the embedded arbitrage relationships that hedge fund strategies exploit tend to come unglued. JPMAAM will also layer in some extra protection in the hedge portfolio so it can take more aggressive risk with return enhancers at the top of the barbell. The group has been committed to building portfolios with a hedge almost from the start. However, its approach to tail risk has grown more sophisticated in recent years. Until 2007 the group relied primarily on equity short-sellers for protection in market downturns. More recently it has added volatility arbitrage and short credit strategies to the hedge portfolio. The portfolio hedge we now have in place is more complex and has more moving parts but it offers much better protection in market declines, Zummo says. Improving the quality of the tail risk protection has also allowed the team to be more aggressive and creative with return enhancers. The top of the barbell includes more volatile macro and commodity long/short funds, opportunistic strategies and managers that carry more beta risk, such as activists. We will tolerate a higher degree of volatility and directionality at the individual manager level than many of our peers if they bring other benefits to the portfolio in terms of correlation and return, says Zummo. There are some strategies that may appear risky on a standalone basis but, in the context of a well-structured portfolio, they make a lot of sense. The portfolio construction model affords JPMAAM considerable flexibility in structuring customised solutions for clients. The bullet and both ends of the barbell can be calibrated to meet specific risk, return, exposure and liquidity objectives and can be offered on a standalone basis or as a complete package. For instance, in early 2008 the group was approached by a pension plan to build a customised tail hedge for its portfolio. The client was a direct investor in hedge funds and had already allocated to a long volatility strategy. JPMAAM was tasked with crafting a more comprehensive tail hedge around this existing position and performing risk aggregation and reporting across this portion of the portfolio.

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These types of bespoke solutions are the fastest-growing area of JPMAAMs business and have helped it win clients that are moving away from traditional FoHFs products. Of the $9 billion in hedge fund investments overseen by the group, around $5.5 billion is in customised portfolios, including $1.7 billion in pure advisory mandates. Almost every corporate and public pension we are talking to is moving away from comingled FoHFs and towards more direct investments with the help of an adviser, says Case. This is exactly the type of client we want. The shift to direct investments and customised accounts really plays to our strengths. There arent many FoHFs that can compete for these mandates. As Case explains, the demand for customised portfolios and advisory services stems from investors moving to a risk factor-based approach to investing in hedge funds. Rather than treating hedge funds as a separate asset class that deserves a 5% or 10% allocation, JPMAAMs clients are disaggregating the risk factors embedded in hedge fund strategies and incorporating them within traditional asset allocation categories such as equities, fixed income and commodities. This can make a lot of sense for pension plans eager to reduce volatility without necessarily lowering their return targets. By including hedge funds in their allocations to equities or fixed income, they can expand their sources of alpha while reducing market beta and diversifying the risk factors in their portfolios. A typical pension client may index a portion of their equity allocation and split the rest between active long only and hedge fund strategies, Case says. As this happens investors are exiting traditional FoHFs that provide exposure to hedge fund beta and moving to direct investments and customised portfolios that are more closely aligned with their specific investment goals and objectives. JPMAAM is benefiting from these trends. The group won its first advisory mandate in 2003 and has been building customised portfolios for clients since the 1990s. The demand for bespoke solutions has grown significantly since the financial crisis. For instance, in 2009, JPMAAM was hired by a pension plan to build a dedicated portfolio of hedge funds to capitalise on the dislocations in the credit markets. More recently, it was asked by the same client to create a separate hedge fund portfolio that will be funded through its risk budget for equities. Were having many more conversations with pension funds that want to include hedge funds in their overall asset allocation to equities, fixed income and commodities, says Zummo. IT factors JPMAAMs technology platform has been an important factor in winning these types of mandates. The group made a significant investment in developing a proprietary portfolio management and risk system in 2002, which is now starting to pay real dividends. The technology was originally intended for internal use but has recently been made available to clients over the web. An often overlooked element of the shift to direct investments and risk factor-based allocations is the need for more robust risk aggregation and analytics on hedge funds. Investors may have the internal expertise to select managers but they often lack the technology to deconstruct their returns and aggregate the underlying risk factors so they can analysed in the context of the overall portfolio. JPMAAMs technology is able to do exactly this. We can pull all the exposure and risk information from a clients direct investments, separate accounts and FoHF exposures and provide this back to them on their desktops, says Case. Some FoHFs have been reluctant to provide this type of reporting to investors for fear that it will hurt their core business. Others simply lack the technology and expertise to do so. Far from bemoaning the added complexity that comes with customisation, JPMAAM has embraced the opportunities it affords. While the group continues to offer a range of FoHF products, the goal is not to push these on clients. Instead, the focus is on providing a wide spectrum of customisable services that enable investors to combine effectively hedge funds with their overall asset allocations. We no longer think of ourselves as a FoHF in the traditional sense. Were a provider of alternative alpha, says Zummo. The relationship we have with clients has clearly changed. We are no longer providing a standard product and asking people to accept it. Were working with clients to understand their unique needs, issues and preferences and structuring solutions for them.

JP Morgan Alternative Asset Management: fast facts


Established: April 1995 Assets under management: $9 billion, including approximately $1.7 billion in assets under advisory Offices: New York (headquarters), London, Geneva, Singapore Professionals: 66, including 18 in the investment team Key executives: Paul Zummo, co-head and chief investment officer; Corey Case, co-head and chief operating officer Products: multi-strategy fund of hedge funds, specialised single-strategy vehicles in event driven, merger arbitrage and credit/distressed strategies, customised separate accounts and advisory services Print | Close

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Incisive Media Investments Limited 2010, Published by Incisive Financial Publishing Limited, Haymarket House, 28-29 Haymarket, London SW1Y 4RX, are companies registered in England and Wales with company registration numbers 04252091 & 04252093.

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