Interview with Andrew McCaffery, Aberdeen Asset Management

As winner of the 2012 best overall group award, McCaffery explains how he believes the fund of hedge funds industry will evolve and develop, increasingly reacting to institutional investor demands.

European funds of hedge funds (FoHFs) could be forgiven for feeling besieged. As 2012 draws to a close, performance is still rather lacklustre, sales of off-the-shelf products are under threat and continuing pressures on fees coupled with industry contraction and consolidation are reducing numbers.

Then there is the international investment management group, Aberdeen Asset Management, a relative newcomer to the FoHF scene. Some may consider it bad timing that after acquiring the UK and US institutional businesses of Deutsche Asset Management in 2005 and 2007, its FoHF business began to take off just as the crisis hit. Nevertheless, for Andrew McCaffery, global head of hedge funds at Aberdeen Solutions, a specialist part of the group, the future looks bright. “I have a sizeable business and it’s a key part of our solutions division, which is about delivering both bespoke ideas and customised portfolios to clients. We see hedge funds as a key part of this,” states a confident McCaffery.

With a deep and abiding interest in the FoHF world, McCaffery (pictured) was appointed head of institutional hedge funds at Aberdeen in April 2011, coming from BlueCrest where he was a founder member of Alignment Investors, a separately branded division of the management company. He joined BlueCrest in 2008 after two years as head of absolute return strategies at Aberdeen, having previously been CEO of Attica Alternative Investments, a FoHF business. Before that he was a managing director at UBS in London, overseeing global coverage of hedge fund investors and an architect of the bank’s hedge fund business planning.

His return to Aberdeen may not have been seen by some as the best time to head a FoHF business but McCaffery relishes the challenge. The FoHF business is evolving and the industry is focusing much more now on what investors need and want, rather than simply peddling products. While realistic, he does believe that over time the FoHF business will become a larger part of Aberdeen. “Certainly Aberdeen sees it as a key part [of the group] building not only the diversification of what we do but more importantly of what we can offer to investors,” he says. “We need different ideas for the future.”

Small proportion
At present the FoHF element of Aberdeen’s business is small. Total client assets under management and advice at the group totalled $292.7 billion at the end of August 2012. The FoHF business accounted for only $4.5 billion of this. But McCaffery believes he can build a significant business leveraging off Aberdeen’s considerable global presence with close to 2,000 staff in 23 countries.

Aberdeen Solutions, the multi-asset investment options part of the group, provides investors with a range of FoHF and multi-manager investment solutions. This includes active management of diversified multi-asset portfolios, multi-manager funds and FoHFs. Original research is a cornerstone of the investment process together with a team-based approach working across the London, Edinburgh, Paris and Philadelphia offices, according to Aberdeen.

While the European FoHF industry witnessed the creation of another member of the $20 billion club in 2012 with Man Group’s acquisition of FRM, McCaffery is cautious about predicting any further acquisitions by Aberdeen. Its own expansion was fuelled by the purchase of the UK and US institutional businesses of Deutsche Asset Management in 2005 with additional purchases from the German bank in 2007. In 2009 Aberdeen acquired the bulk of Credit Suisse’s asset management business and in 2010 bought assets and contracts from RBS Asset Management and RBS Asset Management Holdings.

“We will consider ideas if they are the right ones. We looked at some of the offerings out there but [any acquisitions] will be very selective. There is nothing on the agenda today,” he admits.

Looking at the future he says retaining and accessing more investors will be a “key part of the bigger business”.

“Obviously we would like to look at ideas to help us do that but I am really looking at organically developing our business in the next few months and few years.”

That goal should keep McCaffery busy. He admits he expects a continuously evolving industry for the foreseeable future. FoHFs still need to recover from the “self-inflicted wounds” of 2008. The influx of institutional money into the industry since then has had a “massive impact in what you need to be as a provider”.

“When you look into the future, it’s now much more about hedge fund strategies incorporated into a broader portfolio rather than as an add-on allocation.” A part of his team’s job continues to be educating investors about hedge funds and their strategies. However, he believes many investors are beginning “to incorporate hedge fund strategies into their portfolio and, therefore, fund of funds providers are a far more effective way [of achieving this], which will mean the future is pretty bright”.

Coupled with education is a growing emphasis on discussions with investors about what exactly they are trying to achieve by allocating to hedge fund strategies. “When you look at the context of a portfolio, what is it that the hedge fund strategies bring and the way you can combine them? It can either be a risk mitigant or it can be as a yield enhancer. Now it’s about how you go about that,” says McCaffery.

Some investors are dynamically using hedge fund strategies, mainly as a reaction to a low return environment where “seeking out the alpha that’s available” becomes “very important”.

A lower return profile is also pushing investors to look at hedge funds. For McCaffery and his team it is about “making sure that the risk-adjusted return profile for the investor is something that can be valuable for them. We need to make sure that when we are having a dialogue [with them] that we really understand what they want to achieve, that they give us the insight into what they need, their greatest concerns.” He believes Aberdeen needs to be “almost ruthless in focusing on what are the key factors that we need to incorporate into a hedge fund recommendation”.

Coping with investor expectations is another important element. He admits the industry is still coping with a “level of disappointment”. Despite signs that investors should and are moving into alternatives, allocations remain small rather than becoming an “embedded part of their portfolio”, according to McCaffery.

Some of the more sophisticated and larger European investors are still actively using FoHFs and hedge fund strategies as they have seen what they can do for their overall portfolio, he says. But trying to boost asset flows will remain difficult. He sees more movement in the retail and high net worth markets. In particular, McCaffery believes Ucits wrappers around hedge fund strategies will continue to attract interest from investors.

However, as investors continue to face a challenging investment environment, what hedge fund strategies can bring into a portfolio will become an important consideration. “Whether it will be over time, in terms of access in different asset classes like volatility or relative value-style returns, to try and move away from the beta profile, there are going to be many different ways in which [hedge fund strategies] will be used. I think for the European investor this will take time and rebuilding but I think that [investors] will have to look more extensively at that in the course of the next few years,” he says.

Regulation impact
Contending with this aspect of asset management may, however, be a bit easier for McCaffery’s team than coping with the amount of regulation hitting the industry, particularly in Europe where the EU’s alternative investment fund managers (AIFM) directive is scheduled to be implemented in July 2013. “It’s hard to see [regulation] as anything but a challenge,” he admits.

However, he doubts it will “end up being something that really stops the evolution of the industry”. Never­theless he does think it will “create a stumbling block and increase barriers to entry in certain product types and for certain managers that need to access certain types of investors. That’s disappointing, but it’s just a reality. We have to live with the way that politics have evolved in Europe.”

He expects new pockets of demand to be created by the AIFM directive, particularly an onshore market that needs to become more efficient and effective than just the Ucits products. “We can get some of the better strategies and managers into areas where investors can access them,” he says. Just keeping on top of the regulation, including the still-to-be revealed implementation measures known as level 2, will cause further headaches. Trying to understand and cope with the amount of detail required under the directive will be a major task in 2013.

Another piece of legislation that will up-end the European scene will be Solvency II. Although the rules have been delayed and no one is really clear what will happen and when, many regulators are already contemplating new capital requirement rule for European insurers, including the UK’s Financial Services Authority. With a capital charge of 49% attached to hedge funds, however, the FoHF industry is eyeing the opportunities opening to help insurance companies bring this down to a more realistic and affordable level.

“[Solvency II] is still a very difficult area. Again we are in a very fluid period. One of the key things that is really down to the insurance companies is the risk management process and the way in which they address risk.”

What the true capital requirements will be in the end is an open question. This is something still under discussion with individual regulators as well as part of the Solvency II legislation. The challenge for FoHF groups such as Aberdeen is in creating ways that will give insurance companies a way to use the entire investment universe, including hedge funds.

“For us it’s key to work with the insurance companies, to discuss with them, to help them in terms of presenting the risks and the issues that flow from hedge funds and how managed accounts can help or even the way that a hedge fund strategy may be wrapped to give [the insurance company] a low capital requirement. I think these things are all on the table as potential opportunities but we are still slightly early. Some of these elements are driven by the conversations between insurance companies and regulators.”

In the US the regulatory onslaught has been of a different nature. The sheer number of pages devoted to legislation in the Dodd-Frank Act and its subsequent enacting guidelines and various measures have left many hedge funds reeling from the amount of detail and compliance measures needed. However, McCaffery sees the US as generally positive for the industry, particularly as it has pushed many talented traders into the hedge fund industry.

While this has significantly increased the talent pool, the impact of the regulations could be “an issue” for FoHFs as well as the underlying managers in which Aberdeen invests as the majority are Securities and Exchange Commission registered. As these rules have been implemented over the last two years, with acceleration over the last 12 months, McCaffery is hopeful the direct impact will be “quite muted”.

Regardless of the impact or not of regulation, growth opportunities still abound for Aberdeen. The biggest area of opportunities outside of the US is Asia. “It’s a very different environment. The capital is in a very few hands – sovereign wealth funds and government-linked organisations. But there is also the way they are looking to increase how they utilise hedge fund strategies,” explains McCaffery. “We are seeing a number of very customised or very particular mandates starting to come out. That’s very encouraging when we are looking ahead to how we think the business will grow.”

On the indigenous manager front, progress has been a bit more mixed. “We have already seen some mini cycles over the course of the last few years,” he says. The growth of emerging managers has flagged recently but now he is “starting to see some managers bringing out new funds or new managers being developed in the region”. This is encouraging, particularly as the variety of styles is expanding as managers shift from equity-orientated trading to a more macro or debt strategies. “Managers are beginning to utilise a much bigger toolkit from the area. From a manager point of view, we are very encouraged.”

Asian exposure
As an international business Aberdeen has a large exposure in Asia. McCaffery has several members of his own team based there carrying out local research. The group has maintained a high profile in the region as a manager for 20 years. This, he believes, has created “a very positive impact, creating investor flows over time”. In future he expects to build not only on the company’s expertise in asset management but also to leverage its considerable local presence and expertise in order to attract more local capital at the same time as assessing local investment opportunities.

In and outside Asia a major focus of interest for McCaffery’s team is emerging managers. The ability of new managers to tap into sources of alpha is one way he expects to make the FoHF business relevant to investors who, if left to their own devices, are prone to concentrating on the larger, more established managers.

This is one of the areas that will be a determining force for funds of funds, a way they can differentiate what they do and how they add value, according to McCaffery. Most investors, even the larger ones that are most familiar with hedge fund strategies, find it difficult to find, invest in and monitor emerging managers. “We look at emerging managers as a key source to our future.”

Smaller managers are able to deploy capital in areas where larger funds may struggle to find alpha opportunities. As an example, McCaffery points to equity long/short where over the last two to three years many large established managers have struggled to perform. Smaller managers have been looking at a different segment of the market and making good returns, according to McCaffery.

He sees emerging managers as a vital element of alpha for investors but admits there is a lot of work to do to get investors to feel comfortable putting money with newer funds. A lot depends on the strategies being favoured. “With many strategies you can have the access and the opportunity set increased by going down and rotating into smaller managers,” he says.

It has become somewhat trite to say it but McCaffery believes the one-size-fits-all approach is well past its sell-by date. To survive, FoHFs need to be able to access new sources of alpha, display their skills by ferreting out new talent and being able to mitigate the risks associated with investing in emerging managers.

“It’s really about understanding and looking at those managers we think will be performance-orientated and will manage capacity very effectively.”

While enthusiastic about emerging managers, McCaffery is not thinking about moving into seeding. Although “an exciting area” he is content to stay as an early investor, seeing seeding as something that “wouldn’t naturally sit with the fund of hedge funds business because of the conflicts of being a major investor”. Being an early investor brings some benefits, not least of which is an ability to negotiate better fees and terms for investors as well as tapping into performance generation. “To go that next step into seeding really would be something that is a private equity profile,” he says. “You need to have the investment understanding, the business model. It’s something we haven’t done.” He does not, however, rule out the possibility that his colleagues in the private equity part of Aberdeen may be looking at the opportunities seeding may offer.

For any early-stage investor there are always concerns that the operational risk management structure will not be up to scratch, particularly for institutional investors. McCaffery believes his edge here is in having an experienced and well-resourced team on the operational due diligence side. Because of the size of Aberdeen and its own internal structure, McCaffery can tap into considerable resources and expertise in this area.

“You can’t expect some managers that are setting up with smaller amounts of capital to do everything that is true institutional grade. But they certainly can move along that pathway and have goalposts to achieve that standard. The key aspects that they need to put in place would be corporate governance considerations such as the infrastructure, down to such simple elements as valuation policies, the way they set up their service-level agreements. That is something we work with them on, discuss with them and hopefully are able to give guidance.”

Emphasis is on corporate governance. “It’s something that we take very seriously,” he confirms. Conversations with managers around this have become common and that, he believes, is positive for the industry. Aberdeen takes a positive and proactive approach to working with managers on improving corporate governance, encouraging managers, no matter what their size, to incorporate best standards.

McCaffery firmly believes that by meeting higher standards managers will improve their chances for success. “The goal for all of this is that we have a better industry, that it can hold its head up very high. Meeting standards doesn’t impact on the investment strategy. It’s making sure that it’s creating that comfort for all investors to look at the industry in a much more positive way.”

Another area where FoHFs are being challenged is in meeting investor expectations. Confidence in hedge funds, and particularly in FoHFs, has been shaken. However, in a low interest rate environment where deleveraging has still not been completed, investors need somewhere they can find value and growth.

“The key thing is to have a starting point of what are you trying to achieve. If the FoHF adviser is able to understand what the investor wants from its portfolio, it is much easier to manage expectations of the impact hedge funds will have on the overall investment,” says McCaffery. “We are going to try and build this allocation or, more importantly, this incorporation of hedge fund strategies into the portfolio. It’s about mitigating risk and trying to enhance returns. More importantly you are trying to create something very different.”

Finding out exactly what an investor really wants to achieve is the goal and from that a suitable portfolio of hedge fund strategies can be constructed. “Managing expectations for the future I think will be difficult,” he continues. “It comes down to having a much deeper conversation than that which maybe took place in the past and not thinking about allocation as this thing over here on the end of the portfolio but actually as part of how you incorporate into the overall portfolio.“

Performance isn’t the only aspect, but it is an important element. “I don’t think that you can ever forget performance entirely,” he admits. “It may be a case that [investors] will expect you not to be the outlier on the upside but certainly systematic underperformance is not going to be acceptable either.”

Admitting his crystal ball is “a little cloudy at the moment”, McCaffery does have some ideas of what strategies may play well in 2013. Unsurprisingly, he tips credit, especially the mortgage-based sector in the US.

But any predictions are fraught with uncertainties, he says. The European crisis is still real. The European Central Bank and its various policies for dealing with the eurozone problems as well a low or negative growth have been largely untested. The ability to generate growth in the medium to longer term is the only thing that will make debt levels come down, according to McCaffery. The problem is that this is unlikely to happen in the short term. The consequence of this continued deleveraging and slow growth for markets and hedge fund strategies is profound. “Some of the macro-orientated managers are still finding the environment very difficult to negotiate, but those who look at both emerging as well as the G10 markets think [2013] could be quite an encouraging year. We see asymmetric trade opportunities that are still around and managers can try and capture these.”

He is particularly interested in long volatility-orientated managers. While it may feel as if volatility is going nowhere, it can suddenly hit currencies, government debt and other markets, creating opportunities for managers. “Those opportunities we feel are possibly around if we see policy mistakes or the perception of mistakes,” he says, adding there will always be space for the sector specialists, particularly those that can run a balanced portfolio as well as with a long bias. “But in terms of broader risk factors, we are slightly wary of the major market equity credit profiles and being too exposed.”

While 2013 is likely to continue to test hedge fund strategies, McCaffery is determined that Aberdeen’s FoHF business will meet the challenge, increasing its relevance to investors and continuing its expansion as it aspires to become a major player in the industry.

Aberdeen Asset Management’s history

1983: Aberdeen Asset Management established when a group of investors, including current chief executive Martin Gilbert, bought a £50 million investment trust in Aberdeen.

1991: Listed on the London Stock Exchange under the name Aberdeen Trust (name changed to Aberdeen Asset Management in 1997).

1990s: Continued growth, taking on assets in Asia and Europe and setting up offices in Singapore and Hong Kong.

1997: Acquired Prolific Financial Management from Scottish Provident, which made the company a UK top-10 unit trust manager.

2000: Branched out into direct property, forming Aberdeen Property Investors through acquisition of Barclays Property investment (UK) and Celexa.

2000: Purchased Murray Johnstone (UK), an international equities and bonds managers, and Equitilink, an Australian manager of domestic assets and US closed-end funds.

2003: Sale of UK retail unit trusts to New Star, bringing the company £87.5 million. This, among other acquisitions, helped the company to acquire Edinburgh Fund Managers.

2005: Acquired the UK and US institutional businesses of Deutsche Asset Management.

2007: Moved into the Australian market with additional purchases from Deutsche Asset Management and increased US assets with fund management businesses from Nationwide Financial Services. Another acquisition was DEGI Deutsche Gesellschaft für Immobilienfonds, which manages around £4.6 billion of assets in property funds.

2008: Acquired Goodman Property Investors in the UK and announced business alliance with Mitsubishi UFJ Trust and Banking Corporations, Japan.

2009: Completed acquisition of the bulk of Credit Suisse’s asset management business, begun in 2008.

2010: Acquired assets and contracts from RBS Asset Management and RBS Asset Management Holdings.

2012: Aberdeen Asset Management joined FTSE 100 for the first time.