Shaun Port, chiefinvestment officer at fund of hedge funds manager BDO Stoy Hayward Investment Management, says the firm selects managers with a un

Shaun Port, chiefinvestment officer at fund of hedge funds manager BDO Stoy Hayward Investment Management, says the firm selects managers with a unique, often contrarian perspective, and usually with depth rather than breadth of focus, but only if they are supported by an organisation robust enough to survive and prosper.

HW: What is the background to your funds of hedge funds?

SP: BDO Stoy Hayward Investment Management began offering funds of hedge funds with the launch of our Fitzwilliam Balanced fund in September 2003 and the Fitzwilliam Growth fund the following month. The Fitzwilliam Commodity Plus fund was launched in February 2006. Current assets under management are around USD300m, spread nearly evenly across the three funds of funds.

The principals comprise myself as chief investment officer, senior hedge fund analyst John Smutniak and portfolio manager Kristian Cassar.

HW: Who are your key service providers?

SP: Our accountants are PKF, our law firm is Carey Olsen and our administrator is IAG, all in Guernsey.

HW: Have there been any recent changes to the management team?

SP: We've been strengthening our team aggressively this year. We recruited John Smutniak from LyonRoss Capital Management in New York, where he was a portfolio manager for balanced and aggressive portfolios, and we hired analyst Dev Jadeja from Old Mutual Asset Management in the UK. More recently, Rahul Saito joined us as an analyst from RMF in New York and, before that, Tokyo.

On the due diligence side, which operates on a completely separate reporting line to preserve its full independence, we added a new analyst in March. With a staff of 10 the team is more than double today what it was just a year ago.

HW: What is your investment process?

SP: Top-down macro views play a bigger role than at most of our fund of hedge fund competitors. We do not feel we need to have an allocation in every hedge fund strategy. Too often, it seems that bigger fund of funds firms tend to have an allocation across all strategies without an ability to tilt this according to the macro environment.

All investments start with our view of the macro climate, backed up by a team with strong macro experience. I am an economist with a long background of developing portfolio strategies for central banks, public pension schemes and sovereign wealth funds, and am supported by our global macro economist, Catherine Macleod. John Smutniak was an economics and financial journalist at The Economist for several years, and brings his own unique perspective to global markets.

Starting with that robust top-down approach, we are always asking ourselves where the macroeconomic winds are likely to blow the various hedge fund strategies over the coming year.

For example, we like to think that we were ahead of many peers in our understanding of the current commodity super-cycle. We understood the likely depth of the current global banking crisis before many others, and that has had a significant impact on how we run money. We have long been proponents of emerging markets and, despite the current sell-off, feel that the macro fundamentals of these markets will make them attractive in many specific ways for several years to come.

Manager selection is a rigorous process, backed by a robust due diligence approach. While we never bend on our strict requirements, we are probably more nimble and willing to act expeditiously when we see opportunities in managers.

HW: How many funds and strategies are in your portfolio?

SP: At any given time, our managers may fit into any of the dozens of hedge fund strategies. But we tend not to think in terms of what are often vague definitions used in the hedge fund world, but rather how individual managers in a strategy area or a geographic region contribute to the portfolio in concrete terms.

Having said that, we have tended in recent years to shy away from most convertible arbitrage and quantitative equity market neutral strategies, as well as from most forms of quantitative macro managers. We much prefer discretionary macro managers, and have had good results especially with those in the past year. Typically, we have between 20 and 35 managers in each portfolio, depending on the fund profile.

HW: Are you linked to any hedge fund indices?

SP: No, all of our products are designed as absolute return vehicles. While we may benchmark ourselves internally against hedge fund indices, such as the HFRI Conservative Fund of Funds Index for our balanced offering, we do not directly link ourselves to index performance, believing that superior fund of hedge funds performance involves going off the beaten path to find unique strategies allied to the highest standards of risk management and internal controls.

HW: What makes a manager or strategy special enough to select it?

SP: The first criterion is a manager's unique perspective, often contrarian, in their space, an ability to articulate why they believe their strategy will prosper, and to back this up with a track record.

Next we look for an organisation that can deliver results over time, one that is robust enough to survive and prosper. Our due diligence team has independent authority to reject a manager if internal processes are not adequate.

We tend more toward including niche and truly uncorrelated strategies, such as electric power trading and certain areas of direct lending, to name two examples. We want managers who are experts in their space, rather than merely having been, for instance, a good equity manager at a long-only shop.

In general, we prefer deep and extensive expertise in specific markets and asset classes, rather than big multistrategy programmes, no matter what the pedigree of the manager. There are exceptions of course, but we prefer depth to breadth in a manager, and feel we can create portfolios that offer diversification on our own.

HW: What are your criteria for removing managers from the funds?

SP: We monitor our portfolios rigorously for the basic and essential criteria for hedge fund investing, such as appropriate size of assets, commitment of the manager, risk management process and continuity of staff. There are hard rules about what a manager can and cannot do. Style drift is certainly one reason for removing a manager.

Most of the time, however, the decision is more subtle. Often the trigger for removing a manager will be our sense that his or her process of idea generation and ability to take advantage of global macro conditions and trends has diminished. There are many solid and well-run hedge fund strategies and managers, but few are able to produce superior risk-adjusted returns in all macro conditions.

The challenge is to understand the currents in which various strategies operate, and then to choose the managers which are best suited to thriving in that climate. We do not like to trade in and out of managers, but at the same time we will not hesitate to redeem a manager if it is warranted. We put the interests of our investors ahead of any relationship with a hedge fund.

HW: How many managers do you have on the substitutes bench?

SP: For any strategy, we may be looking at anywhere from a half-dozen to many more than that. The key is not the number on the bench, but our ability to understand the processes that make a manager suitable to come into the portfolio at a particular time. We see hundreds of managers over the course of a year, but only a few will make it into our portfolios.

HW: What events do you expect to see in your sector in the year ahead?

SP: In the commodity space, we are still long-term bullish on the fundamentals in supply and demand terms, not only in energy but in agricultural commodities and many metals. We would not be surprised if the current deleveraging process in commodity prices continues for some months, but at the same time we have assembled a portfolio with managers who are nimble enough to take directional bets that can profit in down and up markets. Longer term, we think inflationary forces will push the commodity super-cycle along for several more years.

We think the coming year will be a good one for macro managers. The return of volatility to currencies, to emerging market debt and equities and to other asset classes bodes well for a flexible, discretionary macro approach.

We think that the global credit contraction will provide a good climate for well-managed direct lending and asset-based lending programmes. Whatever the impact of the global bailout plans, credit will likely remain restricted to many borrowers despite promising fundamentals, and we are looking to take advantage of these opportunities.

HW: How will these developments events impact on your own portfolios?

SP: We are likely to lean ever more into the global macro space. We are continuing to build out our commodity fund of hedge funds with managers who can profit from current volatility. We are also looking to pursue lower volatility and more liquid programmes in our balanced portfolio.

Unlike many in our space, we think the current global equity market dislocations may prove an excellent opportunity for emerging market investing, both directional as well as arbitrage strategies.

HW: What are your views on the SEC and FSA restrictions on short selling?

SP: One financial commentator recently referred to short selling as the "free speech of financial markets", and we tend to agree.

We think that history has shown that short selling is rarely the cause of a company's problems, it is more likely just a symptom. Regulators obviously need to do what they feel is in the best interest of the overall functioning of the financial markets, but banning short selling seems to us a temporary solution rather than any lasting way to keep poorly-run companies from going bust. (Of course, we are speaking here of covered shorting, not the 'naked' sort which is a whole different question.)

Looking at recent experience, it is hard to see that banning short selling has done anything more than delay falls in poorly-run companies' share prices for a few weeks. Banning short selling does not create any fundamental improvement in a company's position.

HW: What differentiates you from other managers in your sector?

SP: Our whole team is macro-orientated, with strong market views and a willingness to run a hedge fund portfolio according to these views, with strong tilts according to our internal outlook.

We are dynamic, willing to invest in emerging/young managers where processes are robust and world class. We believe there is a sweet spot of fund assets between USD200m and USD1bn, and that investing early in these managers yields the best risk-adjusted results.

The team are generalists, and therefore willing to explore all asset classes and strategies that may be appropriate for our fund of hedge funds investors. We are not constrained by geography or specialisations, and able to spot early trends in alternative assets.

We have a robust operational due diligence process that is independent from the investment team and ensures that the interests of our investors are protected with the most stringent standards of operational excellence.

HW: What are your views on risk?

SP: For us, it is never a question of managers taking on a particular level of risk, but of taking on the right type of risks. We simply don't target a level of volatility or VaR for an individual manager, and believe that such measures, if applied too seriously, can lead a manager to take on the wrong risks or a higher level of risk than is appropriate. Instead, we assess a manager's view of the market conditions and, if we are comfortable, leave it to the manager to take particular positions at particular times.

HW: How do you deal with investors' expectations?

SP: Investors should always expect performance that is in line with the mandate of a portfolio. We believe many of the complaints among fund managers about investor expectations stem from a failure of the manager to explain better how and when their strategy is likely to perform well. It is the duty of a manager, whether of long-only funds, hedge funds or funds of hedge funds, to ensure that expectations are both reasonable and reachable.

HW: How do you distribute your products?

SP: Traditionally the mainstay of our distribution has been the internal private client platform in the UK. BDO has been a leader in catering to the needs of high net worth entrepreneurs and business leaders. It has been a natural extension of our asset management business to offer multi-manager absolute return vehicles to such clients.

Second, we are increasingly relying on BDO's global network to offer our products. BDO has 620 offices in more than 100 countries, and the UK asset management business is the only one to offer funds of hedge funds. Third, our dedicated marketing team is making great strides in pursuing pension and other institutional mandates. Finally, we are involved in a number of white labelling discussions at the moment, and interest is strong.

HW: Are you planning any further launches?

SP: Given our history of product innovation, as most recently demonstrated by our commodity fund of hedge funds, we are always mindful of investors' needs for high-quality absolute return funds addressing the most relevant themes in the global economy.

We are finding some interesting opportunities in the area of distressed funds, both mortgage-related and corporate-related. Credit conditions make asset-backed and direct lending a good area for issuing new loans in areas of the economy that will still thrive amid the current downturn. Electric power trading is an area in which we have developed considerable expertise, and we believe this asset class is likely to see huge growth in the coming years.

There are significant opportunities in these areas, but whether we'd look to launch separate funds to take advantage will depend on our ongoing discussions with our clients.