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Xiaoliang ZhaoChina Investment Corp.When it comes to investing in hedge funds, Xiaoliang Zhao appreciates the advantages that come with size. As acting head of the fixed-income and absolute-return department at China Investment Corp. , the 44-year-old former hedge fund manager oversees $25 billion in absolute-return strategies for the world’s second-largest sovereign wealth fund, with $814 billion in total assets. Numbers come easy to Zhao, who moved to Beijing from the city of Wuhan, in central China, as a teenager in the late 1980s to train with the Chinese national team for the International Mathematical Olympiad. After earning a BS in mathematics from Beijing University in 1994, he went to the U.S. to get a Ph.D. in statistics from New York’s Columbia University and became interested in finance. A 1999 paper he published with Columbia Business School professor Paul Glasserman on computational methods for improving the estimation of option price sensitivities of term structure models helped him land quantitative analyst positions with First Union Corp., Mizuho Corporate Bank and Citigroup. In 2004, Zhao joined Thales Fund Management, a New York–based quantitative hedge fund firm founded by former D.E. Shaw & Co. executive Marek Fludzinski. In January 2008, after successfully launching and running a $100 million-plus currency portfolio for Thales, he left the firm and moved back to Asia to co-found Hong Kong–based Andante Capital Management. Although the firm’s macro fund generated good returns, by late 2011 Zhao and his partners had grown tired of the challenges of running a hedge fund start-up in the aftermath of the financial crisis and looked for other opportunities. In August 2012, Zhao returned to Beijing as co-head of hedge fund strategy for CIC; this past April he was promoted to his current position.
How long has CIC been investing in hedge funds?
Zhao: CIC was established in 2007. We started investing in hedge funds in 2009. You can see that our department is fixed income and absolute return. Hedge funds are the most significant part of our absolute-return program. The goal is to provide a stable return uncorrelated to the returns of the other main asset classes, like equities, fixed income and commodities, which CIC has a significant exposure to. CIC manages over $200 billion in overseas assets; we allocate about 12 percent of that to our absolute-return program.
The majority of our hedge fund investments are direct relationships. We invest in managers with large assets and long track records — the big-name guys. In addition, a small portion of our investments are managed by a few very good fund-of-funds managers. They help us focus on the niche opportunities — smaller managers, emerging managers.
Do you invest in hedge fund start-ups?
Generally, for our direct relationships we don’t because we need certain criteria — like many years of track records, billions of assets — for us to do a meaningful investment. But for our fund-of-funds program, which is invested through separate accounts, not commingled funds, we do have exposure to emerging and new managers.
How large is your hedge fund portfolio?
Our absolute-return program is about $25 billion, and the majority of that is in hedge funds. So we have a big book. Right now we have a very balanced portfolio. We have macro (discretionary and systematic), equity long–short, event-driven, relative value, and then we have funds of funds.
We always look at our book from a portfolio perspective. We put a lot of emphasis on how to improve it, both from a top-down (strategy allocation) perspective and a bottom-up (manager selection) perspective.
How frequently do you change managers?
I would say we are a long-term investor. Generally, and especially right now, we need to know guys very well to invest. So it takes us years to meet them, visit them, discuss with them, background-check with them before we decide to invest. It’s very slow for us to build high conviction in the managers, and it takes time for us to change the view. We generally invest with managers at least two or three years. Our turnover rate is not very high, but obviously we are very active. We manage our book. If a manager is not doing well and we believe the opportunity is still there, we will reduce, and if he keeps on underperforming, we will get out. On the other hand, we are constantly looking for new investment opportunities.
Can you talk about your investment team?
I moved to the head of the department just a few months ago after being the co-head of hedge fund strategy for about four years. We have a very seasoned hedge fund investment team. We have seven analysts right now, and their average experience is approaching ten years. We also have the support from the entire organization. We have a very stable program and long-term view. You won’t see us change that much on our size or on our commitment.
If you look at the hedge fund industry right now, are you happy with the performance?
I’ll talk first about our program, then we can move to my views on the industry. I think our portfolio has performed quite well since its inception. This year has been very challenging, but we still have five months to go. Our performance is coming back very strong recently.
I still believe in the long-term returns and diversification benefits of our hedge funds. We’ve been able to meet our long-term goal for the absolute-return portfolio of Libor plus a few hundred basis points. For the seven-plus years, we have met our goal and significantly outperformed the hedge fund index.
What’s the secret to your success?
So far, so good. I think that our large size helps. Many top managers are willing to talk to us. They give us some discounts. And our program was very well timed, starting in 2009, right after the financial crisis.
The other thing I want to say is we have controlled or constrained our beta exposure very well. We look at the low-beta guys. We don’t want to get too much exposure, especially to equity beta. From the start of our program, we have wanted uncorrelated returns, so we put a lot of emphasis on that part of the program.
Do you think that performance of the industry overall should be better than it has been, or is it what you would have expected given how much it has grown?
Yes, I think the industry has grown very fast. We have observed that the industry-level performance is coming down, especially last year and the first half of this year — it’s very challenging. But I do think there are cycles in any business. There are ups and downs. As long-term investors, we should not pay too much attention to a year and a half of performance. Overall we should look forward.
First, hedge fund assets have grown very fast, especially after the financial crisis. And the alpha opportunity is growing less fast. The growth rate is much lower than the growth of the size of the industry. So the alpha per investment capital is much lower. But until I see the significant outflow of assets, I don’t think this part of the headwind will go away very soon. The other part is that the alpha is much harder to find. We used to believe that hedge fund managers had an information and technology advantage. For most hedge fund managers, these advantages are disappearing or shrinking very fast. Traditional managers are catching up. And I do not think this trend is reversing very soon, either.
The last thing is the market environment. It’s less friendly to hedge fund managers after the financial crisis. When quantitative easing started, central bank policy dominated markets; it has been very hard for guys to trade or to time the market. QE artificially drove up asset prices. The volatilities are artificially low. There’s a lot of event risk, like Brexit and the U.S. elections. Managers have less experience to deal with all of these factors. These things might hurt hedge fund managers more than traditional asset managers.
These are the three main headwinds against performance, and I don’t think they will change very soon. So the investor and the manager need to have much lower and reasonable expectations for hedge fund returns in the next six, 12 or 18 months.
Over the next 12 to 18 months, what are reasonable expectations for hedge fund returns?
I think the golden age of the double-digit return is far away. It’s not possible to achieve double-digit returns until significant things change. We’d be happy if we get a 6 to 8 percent return. And we’ll be okay at 3 to 5 percent. I will be very disappointed if returns are negative or flat.
How has the balance of power between investors and managers changed?
A lot of people have been discussing that right now, especially because of the pressure on hedge fund performance. But from my experience — I began working at a hedge fund and then moved on to CIC as an asset allocator to hedge funds — I think it’s one industry. Investors and managers are parts of one industry. And we need a good, healthy industry. It’s not us playing against each other. And there are a lot of people like me; many guys I know move from investor to manager or manager back to investor. So generally, we need to work together to make this industry better. That’s my general approach.
It is hard to say which side has power. Even right now if you have a manager who has had good returns, it’s hard to negotiate fees. And also, from my experience, we will always have more negotiating power than many other, smaller investors because of our large size and reputation. So it’s hard to say who has the advantage. But one thing is very important: It is the investor who decides whether to invest or not. The bottom line is, if the opportunity is not good, is not justified, don’t invest.
As investors we have to keep our discipline. Discipline is easier to say than to do. Discipline includes many things: looking for net alpha rather than the return and fees, looking for alternatives, looking at long history and evaluating potential future returns instead of focusing on returns of last month or year.
How important are fees?
Fees are very important. The fee has two parts, the management fee and the performance fee. We cannot just argue that the fee is too high. We have to give the reason why the fee is high. Generally, I’m very constructive working with managers, but there are times that I’m not happy with them.
For the management fee I’ll just give you a couple of real situations. Take a fund that has no performance but, because we are always dealing with big guys, the founders parted with tens of millions of dollars just from the management fee. My understanding is that the management fee is for the manager to hire the right people, to build the infrastructure, to do the research. But if the news comes out that the guys haven’t been making money for a year and the fund still is earning tens of millions in management fees, that’s something that really bothers me.
The other thing is that guys charge the same management fee no matter the size of the fund. The funds do well; the assets double. You will ask, “Why are you still asking for the same management fee?” They will say, “We will expand our research; we will find more opportunities for you.” That’s the general answer from them. But on the other side, the funds don’t perform well and the asset size is halved and we are worried. We’d ask, “Why don’t you reduce the size of your business?” The answer most likely will be: “Don’t worry. We will provide the same quality and breadth of research for you, for the remaining assets.” These two facts cannot both be right.
For the performance fee I very much agree with the idea of sharing under the performance fee structure. But I would also bring up two issues right now. First, performance fees should be measured on alpha, not total return. Looking at 2012 to 2014, the top performers of hedge funds were activists, sector specialists and other high-beta equity long–short managers. They produced high returns, partially driven by market beta, and collected astonishing performance fees. Until we find a solution for the problem, I would prefer to invest in low-beta managers.
The second issue is when to pay performance fees. Right now most managers collect performance fees on an annual basis. High-water marks help but are not enough. For the high-beta managers that performed well during 2012 to 2014, many suffered significant drawdowns over the last 18-month period. Roller-coaster rides leave some investors flat or down but managers still with full pockets. That is not the right way to align interests. The solution is not hard: delaying or partially delaying the performance fee should work.
What should the industry look like?
I think there’s already been an increase in transparency, which needed to improve. In addition, the fees should be coming down. The other thing is that both sides should understand that there are ups and downs of the business. There are cycles of the industry. I think people are putting a little too much focus on the short term. The guys who have two or three years’ good performance, they will ask for a lot of things. They have forgotten history. I think both sides should take a longer perspective.
How do fees factor into your assessment of whether to invest in a hedge fund?
Our decision very much depends on the net performance. It’s not about the fee. If I pay a 3 percent fee and get an 8 percent return, it is still better than if I pay 20 basis points and get a 5 percent return.
What do you think of the idea of hedge funds charging just a performance fee?
Managers have to survive, and we are looking for talented ones. I would think that we should have some reasonable management fee to support a healthy working environment for the managers. But because of improvements in technology, I think hedge funds should be able to bring the management fee lower because the information you get is cheaper. •
