Audio: Culross Global Fund: Culross Global Investment Management

Winner: Best diversified fund of hedge funds over 10 years

In a world where political intervention is one of the primary drivers for markets, assessing the macro environment is challenging, to say the least. But this is the starting point for everything the Culross Global Fund does. The macro outlook informs the thematic approach to investing taken by the fund of hedge funds (FoHF).

"Macro trumps micro. What you can do is have a certain amount of macro insurance which may or may not be effective against the precise risk that you end up confronting," says Christopher Keen, partner at Culross and co-portfolio manager of the fund.

When constructing the portfolio, Keen asks two questions. First, what other alternatives would be interesting to provide some cushioning at times against these risks. The second is "how closely connected are the things that you are contemplating doing to the kind of risks that you are most concerned might disrupt markets".

This insurance comes in the form of allocations to macro funds.

The emphasis on thematic investing started a while ago and came from the background of both Keen and his business partner Nigel Blanshard, founder of Culross and co-manager of the Culross Global Fund. They first formed a bond because of their work in global fixed income.

Blanshard started his career in finance in 1980 as a fixed income portfolio manager at INA Insurance (later Cigna). He became head of the fixed income division in 1986 and three years later took up the roles of chief investment officer and joint managing director at the then newly founded Century Asset Management.

Keen began his career in 1973 as a stock trader and arbitrageur, moving to the Bank of Kuwait in London as a foreign exchange and fixed income trader in 1975. After three years he established and then headed United Bank of Kuwait's asset management unit and finally became CEO in 1986. He joined Culross in 1999.

Together with Keen, Blanshard sources and develops the investment themes that form the basis of the Culross approach. He also selects and reviews hedge fund managers.

It was their work in fixed income which led Blanshard and Keen to believe in the benefits of constantly reviewing and monitoring the macro climate. "For us that is the logical as well as the familiar starting place for thinking about investing," explains Keen. "Our thematic approach is routed in that [conviction] and in the notion that the best place to begin designing a portfolio of any kind is with a set of expectations about what you think is going to happen."

Armed with a macro view of the world, themes are then identified by monitoring central bank data and commentary, fund flows, regulatory changes and crowded trades. Once a theme is selected, further analysis is done by speaking to individual fund managers as well as market contacts and using third-party research.

Two of the fund's current biggest themes are residential mortgage-backed securities (RMBS) opportunities and new world order credit spreads that attempt to capture the recovery in corporate credit.

The portfolio is constantly evolving as allocations are tweaked every month to reflect the managers' views of the world. This is played out through allocations to around 30 underlying managers.

The fund's allocation to RMBS has been slowly picking up momentum over the past year, starting at 10% in December 2011. By November 2012, it had grown to 16% of the total portfolio allocation.

"As time has passed we have become more convinced that the fundamentals of the housing market in the US and the fundamentals of the non-agency mortgage market were becoming more positive and that the way markets were valuing the securities involved was a bit behind the game," says Keen.

He is even more convinced of this now than at the start of 2012. "All the indicators show that the US market has in fact turned. That's cause for a revaluation of non-agency mortgages or at least those whose valuation depends partly on the amount that can be recovered in the event of default."

Keen also believes the recovery will impact the willingness of borrowers to maintain payments. "It's that belief that has led us to increase our exposure to the RMBS space."

More allocations to these areas are likely in future. Keen says the idea may be broadened out to include other forms of structured credit such as collateralised loan obligations (CLOs) or collateralised mortgage-backed securities (CMBS).

Another area Keen has his eye on is new world order credit spreads. This was around 14% of the portfolio at the start of November 2012. The idea behind this exposure was the fact that in the post-crisis environment there was a good argument to be made for a recovery in corporate credit from the subdued levels of 2009, according to Keen.

There were several reasons for this conviction. "The corporate sector in most geographies is the only sector that is coming out of the crisis stronger than it went in. There were technical issues, liquidity issues, issues with structured credit that would have legitimately put off a significant proportion of the investor population," he continues, adding, "But we thought going back to 2009 that credit was a pretty good proposition. That theme has been in the portfolio for quite some time."

Both portfolio managers have been tracking the changing face of the global credit market. Top of the list of changes is the emergence of a high-yield credit market in Asia. Next are credit managers coming out of investment banks post-Volcker rule, creating more capacity in this area as well as potentially more competition for deals. An allocation to long/short credit strategies was a result of identifying these opportunities and other changes in the credit market.

The safe haven for the fund's portfolio is arbitrageurs, which make up 11% of the allocation. Opportunities in this area are emerging as capital devoted to these types of trades vanishes as a result of the closure of proprietary trading desks at many investment banks.

"That's probably most visible in government bond markets where issuance is enormous. The banks' participation has rapidly reduced and the major buyers of those securities, which are central banks, don't participate in the auctions," says Keen.

Bear risk hedgers provide insurance for the portfolio. These strategies are negatively correlated to the portfolio's net long exposures and produce good profits in times of market dislocation. Exposure to macro managers has been maintained primarily for this purpose. However, this strategy has become a bit more difficult to implement, says Keen.

A tail-risk hedging industry has developed that did not exist three years ago. "This now has capital subscribed to it, not just from investors in alternatives but all over the place," explains Keen.

"You can see the effect of that in the historic shift in, for example, the structure of the pricing of volatility. You can also see it in the behaviour of CDS and the circumstances in which the basis between CDS and cash bonds goes bonkers by comparison to how it might have behaved in the past," he adds.

However, Keen sees a number of structural difficulties when there are periods of market stress in capturing sufficient returns without sacrificing better opportunities and without finding "yourself in the position when you pay too high of an insurance premium in periods when markets are more benign".

Allocation to this theme has fluctuated throughout 2012. The highest level reached was 21% in September, dropping to 12% – almost half – by November.

From time to time themes are deleted or added as opportunity sets are identified. Decisions to add a manager are in part based on finding someone who is able to add diversification within a theme.

[Pictured: Chris Keen, Culross Global Investment Management. This award was sponsored by UBS.]

"If we feel we have got the territory covered, then our process calls for a systematic re-evaluation of the people that we have got compared with the people who we might regard as our direct competitors. Where we find an enhancement, then we will switch. Where we don't, we will add."

Newer, smaller managers are preferred additions to the portfolio. "For us there is no value to be added by our picking up a manager that all of our clients have heard of and can find on Google just as easily as we can," says Keen. "Our focus is on finding managers that are not so visible or whose process is not so easy to access."

There is no magic answer to sourcing new managers, says Keen. It is about shoe leather and having an open door and an open mind.

Although new managers entering the hedge fund market find it a more difficult proposition than before 2008, particularly on capital raising, Keen says there is still plenty of talent to be found, often in niche strategies.

Culross itself is a small FoHF manager. Total assets under management are $500 million. The company's core belief is that in investment, size is an enemy. Being large is "inconvenient" because it limits the risks the FoHF is able to take as well as its speed and flexibility.

Having a diverse portfolio is one way of managing risk. Caps are put in place at manager and theme level. No more than 8% of the portfolio can be allocated to one manager and no more than 30% can be in any one theme.

For Culross, timely reporting is crucial. Underlying managers must, at minimum, provide monthly reports and in some cases they are more frequent.

Risk management must also take into account the macro environment. Aside from the intervention of politicians and central bankers in the markets, political risk is another factor that could throw up some surprises over the next year, believes Keen. He lists a number of potential risk factors including the instability of the Middle East, political and economic changes in China and the continuing eurozone crisis.

Notwithstanding these challenges, Keen is upbeat about the future for Culross. He is a firm believer in the company's ability to add value by finding new managers and identifying the best investment themes for the current macro environment.

Fund facts
Full name of fund: Culross Global Fund
Portfolio managers: Nigel Blanshard and Christopher Keen
Name of investment management company: Culross Global Investment Management
Contact information: Charlene Zahra, investor relations ([e-mail]) or Cynthia Scicluna ([phone]; [e-mail]; www.culrossglobal.com)
Launch date: December 31, 1999
Assets under management: $365 million (November 2012)
Net cumulative performance since inception: 155.5%
Annualised return: 7.63%
Annualised volatility: 4.82%
Sharpe ratio: 1.38
Strategy: global macro
Share classes: US dollar, sterling, euro, Swiss franc
Administrator: Maitland Fund Services (British Virgin Islands)
Auditor: Deloitte
Custodian: HSBC Institutional Trust Services (Ireland)
Legal counsel: M Partners
Domicile: British Virgin Islands
Listing: Irish Stock Exchange
Management fee: 1.5%
Performance fee: 10% over a hurdle of 5%
Minimum investment: $100,000
Lock in: none
Redemption/liquidity terms: redemptions are on a monthly basis with 65 days' notice

Past awards

2011
Winner: Hedge Funds Review FoHF of the decade and Best performing diversified FoHF over 10 years
Shortlist: Best performing diversified FoHF over three years

2010
Highly commended: Hedge Funds Review FoHF of the decade

2009
Winner: Best performing diversified FoHF over three years
Highly commended: Best performing diversified FoHF over one year

2008
Winner: Best performing diversified FoHF over one and three years