Aberdeen Orbita Capital Return: Aberdeen Asset Management

Winner: Best diversified fund of hedge funds over three years; Shortlist: Best diversified fund of hedge funds over one year; Best diversified fund of hedge funds over 10 years

Almost 60% of the underlying allocations in Aberdeen's Orbita Capital Return fund of hedge funds (FoHF) is to relative value.

The reason for this is closely tied to the fund's mandate to generate returns regardless of market movements and without significant beta exposure to the equity or bond markets.

Manager selection is driven by a combination of bottom-up and top-down analysis. The investment team uses Aberdeen's proprietary indicators to gauge what is happening across markets, looking in particular at correlations and volatility.

[Pictured: Andrew McCaffery, Aberdeen Asset Management]

"When we look at that bottom-up process [we make sure] we are getting the highest conviction managers for the types of risk profile and risk factors that we are trying to draw out from the overall portfolio," explains Andrew McCaffery, global head of hedge funds.

There are typically 20-30 underlying managers in the portfolio but there are no defined limits on how many can be added, just a belief that a large number of managers will intensify risk on the downside. The top 10 managers each have between 4% and 8% of the total portfolio allocated to them.

The fund is conservative by nature. It aims to be low volatility and non-directional, targeting volatility of between 4%–7% and returns of 4%–6%.

Besides its strong tilt towards relative value strategies, the fund also has a healthy exposure to global macro managers, which make up around 13% of allocations. The rationale for this is that these managers will act as a hedge overall.

Portfolio construction is a combination of strategic and tactical allocations. Strategic positions are held for 12 to 18 months while tactical allocations have a much shorter holding period, typically one to six months. The focus is more on getting the strategic allocations right rather than tactical allocations where decisions are based on risk trends and the perception of how the market cycle is evolving.

For example, in 2011 the portfolio shifted to address what Aberdeen saw as downside risks stemming from the risk-on/risk-off environment. "Markets were clearly developing to become more volatile again and much more focused on the evolution of the sovereign crisis in Europe," says portfolio manager Antonia O'Connor, head of fixed income and credit strategies at Aberdeen Solutions, which houses Aberdeen Asset Management's fund of hedge funds and multi-manager funds.

"What we really wanted to do was make sure that the portfolio was insulated against potential bouts of volatility. This decision led to an allocation to tail protection," she adds.

In the risk-on/risk-off environment, O'Connor says she prefers to invest in managers with robust risk management and strong stop/loss policies. She is also looking for managers with "a trading-oriented approach who can respond dynamically to shifts in sentiment and market moves".

Diversification of managers is also important. McCaffery says that although managers may appear to be different, over time when looking at what investments they implement, there are some similarities.

Allocations are reviewed on a monthly basis, at which point O'Connor and her colleagues assess changes in the macro environment and the capital markets. They review the convictions they have about each manager in the portfolio and whether those have changed.

Over the past year markets have been heavily influenced by central bank actions, in particular the US Federal Reserve's announcement of a third bout of quantitative easing and the European Central Bank's outright monetary transactions. This has driven the risk-on/risk-off market sentiment. The fund seeks managers that can take advantage of that environment.

"It is about meeting the needs of that absolute return profile through time. If something might influence that significantly, we would then adjust the allocations. It is very much a strategic outlook and, therefore, it would have to be quite a significant shift," explains McCaffery.

A defensive position was taken by the fund going into 2012, which included the allocation to tail risk protection. Long volatility managers were selected as the best way to gain tail protection rather than specific tail risk protection funds.

"One of the key things was to think about that negative correlation, how do you capture that, where is that going to stay really consistent," says McCaffrey.

"Market relationships can change but the one thing that is likely is that if you see markets become dislocated, if we move from the liquidity hopes back to a solvency concern, that is going to mean that we will see volatility ripple through markets. Therefore we want to be exposed to cross-market volatility," he adds.

Long volatility is a good way to mitigate risks because even good managers may not be able to move positions quickly enough. "Also it helps to create a smoother return profile over time which is something that is very important to us."

However, volatility has been lower than expected. While that has not served the fund as well as hoped, it has helped smooth returns, notes O'Connor.

The macro managers that were added as a portfolio hedge will "not necessarily provide the same level of negative correlation that we hope to see from the tail risk protection managers but nonetheless defend well and hopefully provide some absolute return if liquidity was to dry up or if we were to see a significant increase in volatility," says O'Connor.

"Similarly we looked to reduce some of the more aggressively positioned managers in the portfolio and those we felt had inherent equity market beta in their strategies. For example, that was reflected to a large degree in our multi-strategy manager allocation in some of the event driven strategies."

During 2012 the fund has also added two niche tail risk protection strategies as well as statistical arbitrage, equity long/short and mortgage-backed/asset-backed securities (MBS/ABS) funds.

Funds investing in MBS were allocated to in the wake of the 2008 crisis. That has increased during the last couple of years. This has been a strong contributor to returns in 2012, particularly in the second quarter, even though it is a relatively small allocation.

"What has been driving performance [in 2012] has been some of the more risk-on exposures or those that tend to perform well during a period of more benign markets and when risk appetite is increasing," says O'Connor. The team thinks MBS exposure will continue to contribute to returns in future.

Risk management for the fund begins during the due diligence process. An assessment is done of the types of risk that a manager is taking and how they monitor and manage those risks. Over time what McCaffery describes as ‘sanity checks' are done.

"However much we look for best of breed, we get some differentiation at manager level. You have certain risk factors, which aggregate within a portfolio. We are looking at whether those are consistent, how they evolve and if they are also consistent with what we expect – ie, the sanity check."

Operational risk management is an important factor in overall risk management. Aberdeen's operational due diligence team was set up more than 10 years ago. "Every time we look at a fund, and especially when we look at investing into a new manager, it's not just that you know who the custodian, administrator, prime broker and other service providers are but actually that you look at the agreements that they have," says McCaffery. This is because agreements are not standardised, especially for early-stage managers.

"It is very important that we have the resources to look at the operational, legal and overall infrastructure framework. They have to give us confidence about making investments," he adds.

Going into 2013 tail risks are a major concern, says O'Connor. Under a scenario where it is right tail risk and the world's solvency issues are solved, the fund is likely to have positive returns but underperform its peers. However, she accepts that left tail risks will be more likely in 2013.

She admits that it is difficult to position for an extreme left tail event. O'Connor hopes if that does happen the allocations to tail risk strategies and global macro managers will help the fund to outperform.

"We would hope to outperform on the downside and are likely to underperform in a very strong market," she concludes.

Fund facts
Name of fund: Aberdeen Orbita Capital Return
Portfolio manager: Antonia O'Connor
Management company: Aberdeen Asset Management
Contact details: James Whiteman, Aberdeen Asset Management, Bow Bells House, 1 Bread Street, London EC4M 9HH ([phone]; [e-mail])
Assets under management: $1.5 billion (at September 30, 2012)
Launch date: July 1, 1998
Net cumulative performance since inception: 157.18% (at September 30, 2012)
Annualised return: 6.85% (at September 30, 2012)
Volatility: 4.97% (at September 30, 2012)
Sharpe ratio: 0.9 (at September 30, 2012)
Strategies covered: multi-strategy – relative value, global macro, niche, credit
Share classes: US dollar, sterling, euro
Administrator: BNP Paribas
Prime broker/custodian: BNP Paribas
Auditor: KPMG
Legal counsel: Maples and Calder
Domicile: Cayman Islands
Minimum investment: $250,000
Management fee: 0.6%
Performance fee: 7.5%
Lock in: none
Redemption terms: quarterly on 37 days' notice

2011
Shortlist: Best performing diversified FoHF over three years
Shortlist: Best performing diversified FoHF over one year