| David Saunders, K2 Advisors |
David Saunders, co-founder and CEO of K2 Advisors, says the current state of the fund-of-funds business has brought his career full circle. Saunders, 56, started as an equity trader at First Boston and was head trader for Julian Robertson Jr.’s Tiger Management Corp. from 1991 to 1993 before he co-founded Stamford, Connecticut–based K2 with William Douglass III in 1994. That was a time when hedge fund managers weren’t accustomed to revealing their holdings and fund-of-funds managers were there as go-betweens who could push for some transparency from managers and pick the ones who seemed most likely to make money for their clients. Now, however, Saunders is taking an investment approach that harkens back to his days as a trader, when he had to monitor all individual positions in his portfolio on a day-to-day basis. K2, which Franklin Templeton Investments bought in 2012, now manages $10.3 billion in hedge fund assets. Saunders no longer holds those assets in traditional fund-of-funds portfolios, however. Instead, the firm invests strictly through customized accounts that incorporate an updated computerized approach to classic portfolio construction techniques, such as comparing the effects of one asset price change against the others, measuring stock value against correlated movement and factoring risks into projected returns. K2 manages a range of alternative strategies and products that include private funds of funds and customized portfolios. Since 2013 the firm has also run a liquid alternative fund. While the customized returns will vary, the liquid alternative Franklin K2 Alternative Strategies Fund, which emulates many of the firm’s hedge fund positions, rose 4.88 percent net of fees in 2014. Saunders spoke with Alpha about how he makes his investment decisions and why.
Q. When you became a hedge fund investor, you really had no choice but to trust your fund managers. Was that difficult for you?
A: After sitting on a hedge fund trading desk for more than ten years, becoming an investor in hedge funds in 1994 meant moving into an information void. As a trader you have flanks of screens in front of you. You can see and feel trends developing, you can see the correlations and all the sensitivities on the screen. Then as a hedge fund investor at that time, when funds weren’t very transparent, you’d have managers say, “we’ll call you at the end of the quarter with the net asset value and maybe we’ll write a letter.”
I sat down with managers and asked them to walk my team through their positions. We analyzed what we could at the time. The best technology we had was Lotus Notes, which we’d use to build a spreadsheet that outlined each manager’s positions by factors such as market, instrument type, geography and especially by leverage and concentration, which are always key determinants. I’d invest with great managers and pair them with other great managers. It was all qualitative. About 15 years ago investors started to model portfolios based on historical returns. But the problem with historical returns is that they’re based on the assumption that the manager is going to do the exact same thing the next time. You’re assuming it’s going to be a static environment.
Q. Most investors didn’t start thinking about how closely correlated different markets could be until the financial crisis. Was it technology or the crisis that changed your approach?
A. It was a bit of both. While technology and a need for transparency post-2008 drove this industry trend, we started requesting that managers provide data on their holdings around 2002. We did this as a best practice, because we wanted to have similar data to what we had on the trading desks. By 2008 and 2009, though, we had clients who felt they had enough knowledge that they should have an active role in the decision making, and they asked us to become more of a strategic partner.
As the technology for analyzing portfolio data has evolved, we’ve developed a methodology for designing and building portfolios that’s different from anything we used before. We now collect thousands of data points on managers on a monthly basis and also ask hedge fund managers a lot of additional questions, specifically about their underlying holdings, along with questions about such factors as debt-to-capital ratio. If they don’t want to tell us, we walk away. We run this data through a proprietary portfolio construction software program. This enables us to throw all of the data points up on a screen and really see where characteristics and exposures overlap.
Q. So it isn’t enough to diversify through different strategy allocations?
A. No. It’s important to understand how these themes truly work together when building a diversified portfolio. You can have managers that are very diversified from one another by strategy, yet you might be exposed multiple times to the same stock or some of the same risks. You might have allocations in fixed income, equity and natural catastrophe bond strategies that are all exposed to the same commodity risk, even though none of these managers are holding commodities contracts. Other factors affecting diversification include the risk of cancellation. With our underlying data points we can eliminate the risk of having two great managers whose positions cancel each other out. For example, one could have Apple as their largest portfolio holding, while the other manager’s largest short could be Apple. In that case, you could be paying a 20 percent performance fee for nothing, because whether the stock moves up or down, your position is neutralized, unless the managers’ timelines give you diversification.
Q. Can you pick out certain holdings within one hedge fund and leave out others?
A. Once you move into the separate account world, you have the ability to tailor the exposure you want or the asset class you want to participate in. The flexibility we have to move around is incredibly valuable. We now have the capability to make changes nightly. If we make a determination that it’s too risky in one place, or there’s a specific risk we want to isolate and hedge out, we can do that.
Q. How do you sift out all of these variables and risks?
A. We have a team of six people who work on portfolio construction and just over 20 working in research. We also have a risk team that produces a regular 17-page report on each of the hedge funds where we have allocations. The report measures numerous factors, including average monthly return, annualized standard deviation, position by asset class, stress tests, net gross, changes to the portfolio, manager value at risk versus benchmark VaR, and equity capitalization breakdown, to highlight some.
We ultimately employ a mosaic approach to analyzing risks, and we’ve created our own versions of some of these risk metrics. For example, we measure performance relative to value at risk. We thought the Sharpe ratio didn’t adequately capture the risk inside a hedge fund. We like to look at many factors that could affect a hedge fund portfolio — including whether the managers have held steady when markets are volatile, which is important to many investors — and whether they generated alpha when markets were under pressure. We believe by having this information we are really able to see what you’re paying your manager fees for.
Q. Still, the only figures that anyone can measure are historic figures. How do you know what managers might do in the future?
A. Investing is a blend of art and science, and that’s the art part of it. We also have to spend time talking with managers to see if they’re still doing what they’ve historically done.
Q. Is this the future of funds of funds?
A. I do think that ten years from now more investment firms will be doing more tailored portfolio construction, and I think most institutions are going to move in the direction of wanting highly customized portfolios. Ultimately, they’re going to need someone to help them monitor their investments and interpret what risks they’re taking. That’s where firms like ours come in. We’ve actually migrated from being a fund of funds to being more like a multialternative asset provider.
For our liquid alternative fund we now have hedge funds managing assets that sit on the Franklin Templeton/K2 platform. The managers in that fund put in trade instructions, and we see those positions every single night. We also have the ability to strategically rebalance and tilt the fund’s portfolio daily. It’s taken me back to my trading days. It’s taken 20 years, but we’re back and it feels good to be back.
Q. Do you really need hedge funds to do all of this?
A. There’s no replacement for investment talent. You always want to have access to the best of the best.
