(Above): Ross Jones, CEO and Founding Partner, JTP Partners
London-based JTP Partners was established in 2005 to provide an interface between the academics working on hedge fund replication theories, like Bill Fung, Narayan Naik, and David Hsieh, and institutional investors interested in tailored replication products. Apart from the actual construction of portfolios, JTP also offers an ongoing risk management process for its clients. It played a key role in the recent Universities Superannuation Scheme mandate.
Stuart Fieldhouse spoke to founding partners Ross Jones and Gloria Pilz.
THFJ: How did the idea for hedge fund replication came about?
Ross Jones [RJ]: I ran a dealing room at Gerrard & National for 15 years, and it seemed to me that one of the most important aspects of running a dealing room was to have complete transparency of what your risks were, liquidity in all your positions, and a full understanding of all your operational risks. The same should apply when you invest in hedge funds. One of the biggest worries has to be lack of transparency, lack of liquidity and the operational risks that exist within the traditional methodologies of investing in hedge funds. Historically, I don’t think investors have ever been given a choice – they were told ‘If you want to invest in our hedge fund, you have to buy shares in our fund.’ Reporting mostly consisted of a monthly report showing a pie chart, one that shows the investors exposures as at the end of the month and those exposures might not bear any resemblance at all to the exposures that existed intra-month. I think that’s really what brought Bill [Fung] and us together. We had a similar idea of where things should be going. The first thing we spoke to Bill about was the work he was doing to extract alpha via active risk management and the operational requirements needed to achieve this.
One of the key tasks was to segregate the alpha and beta component of the returns, and identify managers that genuinely produce alpha. The general market trend, we believe, is that there are fewer and fewer managers who add alpha.
Gloria Pilz [GP]: Working on isolating the alpha component of hedge fund returns led to the idea that if hedge fund returns can be explained by general market exposure, then, conversely, it should be possible to create a basket of general market exposure where the return would look like hedge fund returns. These market exposures can be expressed using commonly traded instruments, which purposely, also address our concerns about transparency and liquidity.
THFJ: How do you achieve the transparency required for efficient hedge fund replication?
GP: This is done by looking at the returns, rather than any requirement for transparency of the underlying portfolio holdings. In our experience of looking at hedge funds, we found that quite often, how funds are categorised can be quite subjective. At the end of the day, it is not really what you say you are, but how you behave that counts.
THFJ: Do you see hedge fund replication as a means for new hedge fund investors to get access, or for existing ones to cut down on costs?
RJ: This is not exclusive to potential investors in hedge funds. Hedge fund replication is a relatively new concept but it does have the advantage of being a low cost, transparent and liquid methodology for gaining exposure to hedge fund risk. I still believe there is cynicism around in terms of the performance of hedge fund replication products and therefore building a credible track record will be important to gaining a wider confidence.
I think there are going to be different types of products going forward and we will see the two distinctive approaches emerge. The majority of the existing products are designed to replicate existing indices and therefore use a top down approach for identifying the risk premia that make up the returns; these will be defined as replication products and will be sold in large volumes. We believe that a lot of the larger institutions will want their own bespoke portfolios of alternative beta and therefore will use a bottom up approach, which requires identification of the risk premia that make up the returns of individual hedge fund strategies and a deeper understanding of those strategies. This methodology will be defined as alternative beta and also allows additional services such as active risk management and risk monitoring. These two approaches are very different and the fees charged will reflect this: replication will have lower fees, while alternative beta will have higher fees.
THFJ: How did you get involved with the Universities Superannuation Scheme?
RJ: I was aware that the USS already had an existing exposure to alternative beta and approached them on the basis that we worked directly with Dr Bill Fung and Dr. David Hsieh who were behind the majority of the original research into the subject. We believed that our approach of allowing the investor to define their investment profile, through a bottom up portfolio construction methodology, would appeal. We also had the ability to offer risk management of the portfolio based on parameters set by the investor and were able to advise on the operational requirements to achieve this,
GP: Indeed, the USS had some quite specific ideas about the kind of exposure they wanted and we were able to accommodate their requirements not only in terms of the hedge fund portfolio but also in their ongoing risk monitoring and operational requirements.
THFJ: Could replication therefore form the core component of a core/satellite approach?
RJ: We believe the core/satellite approach, using a replication strategy as the core, is one of the most effective ways of investing in hedge funds. The professors’ research shows that a large majority of hedge fund managers do not in fact provide any alpha, and what alpha there is quite often disappears in fees, especially if they are accessed via a fund of funds. Those managers that do provide alpha consistently are well worth the fees charged and should therefore be part of any balanced portfolio..
GP: Those investors who have no, or little, exposure to hedge funds can use replication as a good starting point for their investment into hedge funds and can then add other more specific investments to supplement it. Existing investors who already have hedge fund exposure of some sort might be missing one or two strategies and therefore can gain exposure to those strategies using replication until such time as they find appropriate managers. As the replication approach is a very liquid type of investment, it can also be a very useful cash management tool.
THFJ: Do you think we’ll see a situation where larger institutions will opt for the tailored approach, while private banks and others will be happy to buy an off the shelf product?
RJ: The larger institutions are likely to be driven by their desire to determine their own investment criteria and are therefore more likely to choose the alternative beta route. The private banks will tend to go for the off the shelf products and then put some form of wrap around it as fees will be a determining factor.
GP: It also depends on how active a risk management role the larger institutions require. There are two sides to the tailored approach: one is designing the portfolio to create the desired exposures, and the other is controlling those exposures, if indeed they want to control them. When we worked with USS, they wanted a managed account because this gave them the transparency and liquidity they were after, at the same time also limiting their operational risk. Control of operational risks is a major concern for many trustees.
THFJ: Can the parameters of the portfolio be changed on an ongoing basis?
RJ: Yes. An important part of our initial discussions will be based on setting the appropriate risk parameters for the portfolio but these parameters are not set in stone.
GP: For example, if the investor wanted to replicate across a range of strategies, you might ask for a specific volatility target. Even in the case where there is no specified target, if the client needed to, we can deleverage very quickly and take some risk off the table.
THFJ: Is there any alpha to be had out of hedge fund replication?
RJ: Clearly. For example, how good is the model in identifying the risk premia that make up the returns? How good is the database you’re using to determine the returns of the various hedge fund strategies? What instruments are used to represent the various risk premia identified? This is quite important, in order to limit the cost of slippage.
Another example would be the choice of which strategies and what leverage to use when constructing the portfolio. We found that the professors’ model, with the use of lookback straddles, tend to outperform in times of extreme volatility.
GP: If you replicate an average, it implies that you will be replicating the good as well as the ones that are below par. We don’t want to replicate the under performers. If the filtering system can identify them, then that is already value added. Also key is looking at the factors. The professors are constantly on the look out for new factors that demonstrate hedge funds are doing something different, and it is very important that you don’t miss that. The ongoing research is very, very important.
THFJ: What does all this mean for fee structures and the traditional fund of funds business model?
RJ: There is going to be a time lag here before this has any major effect. The existing replication products have only been going for one or two years. You could see a mass market replication product with a fee base of as low as 50 basis points, building up to the more bespoke product, almost hedge funds in themselves, somewhere between 1.0% and 1.5%.
GP: In terms of fees, if you are successful in replicating the average fund of funds, and after fees you match that fund of funds, where would you rather have your money – in a fund of funds or a replication product? I would suggest a replication product, for the simple reason that replication products have transparency, liquidity and few of the operational risks associated with traditional hedge funds. How much value do you place on the fact that you are not invested in a fund, sometimes with redemption penalty or lock up periods?
RJ: Looking at it from a fund of funds point of view, if you believe you have the skill to pick managers, you might see replication as a really useful benchmark. In addition, you might find fund of funds managers using replication in certain strategies to bridge a gap where they do not have available managers that fit their investment criteria, but require exposure to that strategy to meet their desired investment profile.
THFJ: I know it is still early days for replication strategies, but they sound like they have the potential to really shake up the way the hedge funds sector does business, and the way it charges. Do you agree?
RJ: The industry had the upper hand when there was more money chasing it than there were managers who could take the money. Managers could dictate the terms on which they operated but replication, we believe, challenges the industry to provide value not just in terms of fees charged but also in terms of the way that hedge fund returns are delivered to the investor from a transparency, liquidity and operational perspective.
GP: In terms of executing, hedge fund replication mainly uses highly liquid, exchange-traded instruments. This is very different from what constitutes a fund of funds portfolio. We’re not delving down into the individual stock level. The replication product is actually seeking to replicate the return and what sort of factors we think can provide these types of returns. Ultimately, these sorts of solutions will give investors a greater degree of control. This industry has been driven by the hedge funds and funds of funds managers up to now. Maybe for the first time it will start to be driven a little bit more by the investors, because they will have more options. That has to be a good thing for the industry as a whole.
BIOGRAPHIES
Ross Jones is the CEO and founding partner of JTP Partners. He began his career in 1977 with Gerrard & National (later the Gerrard Group) and was appointed a director in 1986. His main responsibility was fixed interest market making as CEO of its banking subsidiary. In 1996 he was elected the inaugural chairman of the London Money Market Association. He also served on the executive committee of GNI Limited, the group’s derivatives broking subsidiary, and chaired the group’s risk committee. In 2001 Jones was appointed CEO of GNI Fund Management, the hedge fund of funds business. Most recently, he was a director of Athanor Capital Management, which he left to found JTP.
Gloria Pilz is the risk manager and founding partner of JTP Partners. She was the Director of Risk and CIO at Bright Capital (formerly GNI Fund Management). She was responsible for managing the portfolio of funds of hedge funds and structured products, including establishing the infrastructure for the funds, and selecting managers. She also oversaw the implementation of the firm’s risk systems (it was one of the first fund managers to implement Sungard Panorama). Before Bright Capital Pilz was head of market risk at Daiwa Europe Bank, responsible for proprietary trading and hedge fund seeding. She has also worked as a market maker and prop trader at Chase Manhattan and West Merchant Bank, dealing in a range of different instruments, including equities, and fixed income derivatives.
London-based JTP Partners was established in 2005 to provide an interface between the academics working on hedge fund replication theories, like Bill Fung, Narayan Naik, and David Hsieh, and institutional investors interested in tailored replication products. Apart from the actual construction of portfolios, JTP also offers an ongoing risk management process for its clients. It played a key role in the recent Universities Superannuation Scheme mandate.
Stuart Fieldhouse spoke to founding partners Ross Jones and Gloria Pilz.
THFJ: How did the idea for hedge fund replication came about?
Ross Jones [RJ]: I ran a dealing room at Gerrard & National for 15 years, and it seemed to me that one of the most important aspects of running a dealing room was to have complete transparency of what your risks were, liquidity in all your positions, and a full understanding of all your operational risks. The same should apply when you invest in hedge funds. One of the biggest worries has to be lack of transparency, lack of liquidity and the operational risks that exist within the traditional methodologies of investing in hedge funds. Historically, I don’t think investors have ever been given a choice – they were told ‘If you want to invest in our hedge fund, you have to buy shares in our fund.’ Reporting mostly consisted of a monthly report showing a pie chart, one that shows the investors exposures as at the end of the month and those exposures might not bear any resemblance at all to the exposures that existed intra-month. I think that’s really what brought Bill [Fung] and us together. We had a similar idea of where things should be going. The first thing we spoke to Bill about was the work he was doing to extract alpha via active risk management and the operational requirements needed to achieve this.
One of the key tasks was to segregate the alpha and beta component of the returns, and identify managers that genuinely produce alpha. The general market trend, we believe, is that there are fewer and fewer managers who add alpha.
Gloria Pilz [GP]: Working on isolating the alpha component of hedge fund returns led to the idea that if hedge fund returns can be explained by general market exposure, then, conversely, it should be possible to create a basket of general market exposure where the return would look like hedge fund returns. These market exposures can be expressed using commonly traded instruments, which purposely, also address our concerns about transparency and liquidity.
THFJ: How do you achieve the transparency required for efficient hedge fund replication?
GP: This is done by looking at the returns, rather than any requirement for transparency of the underlying portfolio holdings. In our experience of looking at hedge funds, we found that quite often, how funds are categorised can be quite subjective. At the end of the day, it is not really what you say you are, but how you behave that counts.
THFJ: Do you see hedge fund replication as a means for new hedge fund investors to get access, or for existing ones to cut down on costs?
RJ: This is not exclusive to potential investors in hedge funds. Hedge fund replication is a relatively new concept but it does have the advantage of being a low cost, transparent and liquid methodology for gaining exposure to hedge fund risk. I still believe there is cynicism around in terms of the performance of hedge fund replication products and therefore building a credible track record will be important to gaining a wider confidence.
I think there are going to be different types of products going forward and we will see the two distinctive approaches emerge. The majority of the existing products are designed to replicate existing indices and therefore use a top down approach for identifying the risk premia that make up the returns; these will be defined as replication products and will be sold in large volumes. We believe that a lot of the larger institutions will want their own bespoke portfolios of alternative beta and therefore will use a bottom up approach, which requires identification of the risk premia that make up the returns of individual hedge fund strategies and a deeper understanding of those strategies. This methodology will be defined as alternative beta and also allows additional services such as active risk management and risk monitoring. These two approaches are very different and the fees charged will reflect this: replication will have lower fees, while alternative beta will have higher fees.
THFJ: How did you get involved with the Universities Superannuation Scheme?
RJ: I was aware that the USS already had an existing exposure to alternative beta and approached them on the basis that we worked directly with Dr Bill Fung and Dr. David Hsieh who were behind the majority of the original research into the subject. We believed that our approach of allowing the investor to define their investment profile, through a bottom up portfolio construction methodology, would appeal. We also had the ability to offer risk management of the portfolio based on parameters set by the investor and were able to advise on the operational requirements to achieve this,
GP: Indeed, the USS had some quite specific ideas about the kind of exposure they wanted and we were able to accommodate their requirements not only in terms of the hedge fund portfolio but also in their ongoing risk monitoring and operational requirements.
THFJ: Could replication therefore form the core component of a core/satellite approach?
RJ: We believe the core/satellite approach, using a replication strategy as the core, is one of the most effective ways of investing in hedge funds. The professors’ research shows that a large majority of hedge fund managers do not in fact provide any alpha, and what alpha there is quite often disappears in fees, especially if they are accessed via a fund of funds. Those managers that do provide alpha consistently are well worth the fees charged and should therefore be part of any balanced portfolio..
GP: Those investors who have no, or little, exposure to hedge funds can use replication as a good starting point for their investment into hedge funds and can then add other more specific investments to supplement it. Existing investors who already have hedge fund exposure of some sort might be missing one or two strategies and therefore can gain exposure to those strategies using replication until such time as they find appropriate managers. As the replication approach is a very liquid type of investment, it can also be a very useful cash management tool.
THFJ: Do you think we’ll see a situation where larger institutions will opt for the tailored approach, while private banks and others will be happy to buy an off the shelf product?
RJ: The larger institutions are likely to be driven by their desire to determine their own investment criteria and are therefore more likely to choose the alternative beta route. The private banks will tend to go for the off the shelf products and then put some form of wrap around it as fees will be a determining factor.
GP: It also depends on how active a risk management role the larger institutions require. There are two sides to the tailored approach: one is designing the portfolio to create the desired exposures, and the other is controlling those exposures, if indeed they want to control them. When we worked with USS, they wanted a managed account because this gave them the transparency and liquidity they were after, at the same time also limiting their operational risk. Control of operational risks is a major concern for many trustees.
THFJ: Can the parameters of the portfolio be changed on an ongoing basis?
RJ: Yes. An important part of our initial discussions will be based on setting the appropriate risk parameters for the portfolio but these parameters are not set in stone.
GP: For example, if the investor wanted to replicate across a range of strategies, you might ask for a specific volatility target. Even in the case where there is no specified target, if the client needed to, we can deleverage very quickly and take some risk off the table.
THFJ: Is there any alpha to be had out of hedge fund replication?
RJ: Clearly. For example, how good is the model in identifying the risk premia that make up the returns? How good is the database you’re using to determine the returns of the various hedge fund strategies? What instruments are used to represent the various risk premia identified? This is quite important, in order to limit the cost of slippage.
Another example would be the choice of which strategies and what leverage to use when constructing the portfolio. We found that the professors’ model, with the use of lookback straddles, tend to outperform in times of extreme volatility.
GP: If you replicate an average, it implies that you will be replicating the good as well as the ones that are below par. We don’t want to replicate the under performers. If the filtering system can identify them, then that is already value added. Also key is looking at the factors. The professors are constantly on the look out for new factors that demonstrate hedge funds are doing something different, and it is very important that you don’t miss that. The ongoing research is very, very important.
THFJ: What does all this mean for fee structures and the traditional fund of funds business model?
RJ: There is going to be a time lag here before this has any major effect. The existing replication products have only been going for one or two years. You could see a mass market replication product with a fee base of as low as 50 basis points, building up to the more bespoke product, almost hedge funds in themselves, somewhere between 1.0% and 1.5%.
GP: In terms of fees, if you are successful in replicating the average fund of funds, and after fees you match that fund of funds, where would you rather have your money – in a fund of funds or a replication product? I would suggest a replication product, for the simple reason that replication products have transparency, liquidity and few of the operational risks associated with traditional hedge funds. How much value do you place on the fact that you are not invested in a fund, sometimes with redemption penalty or lock up periods?
RJ: Looking at it from a fund of funds point of view, if you believe you have the skill to pick managers, you might see replication as a really useful benchmark. In addition, you might find fund of funds managers using replication in certain strategies to bridge a gap where they do not have available managers that fit their investment criteria, but require exposure to that strategy to meet their desired investment profile.
THFJ: I know it is still early days for replication strategies, but they sound like they have the potential to really shake up the way the hedge funds sector does business, and the way it charges. Do you agree?
RJ: The industry had the upper hand when there was more money chasing it than there were managers who could take the money. Managers could dictate the terms on which they operated but replication, we believe, challenges the industry to provide value not just in terms of fees charged but also in terms of the way that hedge fund returns are delivered to the investor from a transparency, liquidity and operational perspective.
GP: In terms of executing, hedge fund replication mainly uses highly liquid, exchange-traded instruments. This is very different from what constitutes a fund of funds portfolio. We’re not delving down into the individual stock level. The replication product is actually seeking to replicate the return and what sort of factors we think can provide these types of returns. Ultimately, these sorts of solutions will give investors a greater degree of control. This industry has been driven by the hedge funds and funds of funds managers up to now. Maybe for the first time it will start to be driven a little bit more by the investors, because they will have more options. That has to be a good thing for the industry as a whole.
BIOGRAPHIES
Ross Jones is the CEO and founding partner of JTP Partners. He began his career in 1977 with Gerrard & National (later the Gerrard Group) and was appointed a director in 1986. His main responsibility was fixed interest market making as CEO of its banking subsidiary. In 1996 he was elected the inaugural chairman of the London Money Market Association. He also served on the executive committee of GNI Limited, the group’s derivatives broking subsidiary, and chaired the group’s risk committee. In 2001 Jones was appointed CEO of GNI Fund Management, the hedge fund of funds business. Most recently, he was a director of Athanor Capital Management, which he left to found JTP.
Gloria Pilz is the risk manager and founding partner of JTP Partners. She was the Director of Risk and CIO at Bright Capital (formerly GNI Fund Management). She was responsible for managing the portfolio of funds of hedge funds and structured products, including establishing the infrastructure for the funds, and selecting managers. She also oversaw the implementation of the firm’s risk systems (it was one of the first fund managers to implement Sungard Panorama). Before Bright Capital Pilz was head of market risk at Daiwa Europe Bank, responsible for proprietary trading and hedge fund seeding. She has also worked as a market maker and prop trader at Chase Manhattan and West Merchant Bank, dealing in a range of different instruments, including equities, and fixed income derivatives.
