Contrarians play safe in fresh quest for alpha

25 January 2010 | By Muriel Oatham

Leonard Charlton joined Dalton Strategic Partnership from GLG in 2006. He has managed the Melchior European Fund since it was launched, and will manage the MST European Fund.

Magnus Spence is the chief operating officer of Dalton Strategic Partnership, which he joined seven years ago from Merrill Lynch Asset Management.



Q: What is the background to the launch of the MST European fund?

A: MS: The MST European fund will be a Ucits III version of our Cayman Island hedge fund, the Melchior European Fund. It will be a sub-fund of our Luxembourg Sicav, the Melchior Selected Trust, with hedged share classes in dollars, euros and sterling.

The Melchior European fund was launched in October 2006. It has generated positive returns each year, but has achieved this without taking significant risks. We think this is an attractive proposition to retail investors and multi-managers, which is why we have decided to replicate its investment strategy in the MST European fund.




Q: What type of return will the fund aim to offer investors?

A: MS: Our aim for the MST European fund is not to generate a maximum absolute return, but to generate steady returns, independent of the market environment. We think the role of a hedge fund is to generate returns which are uncorrelated with equity or bond markets. Some absolute return funds do not make money when equity markets are weak, but we are not reliant on strong equity markets to deliver returns.

Equally, we are good at protecting our capital in weak markets. For example, in 2008, we generated an overall return of 6%, achieving positive returns for 10 out of 12 months of the year.

Facing an environment of sustained low interest rates and market and economic uncertainty, many investors aim to protect their capital and avoid volatility. The MST European fund will aim to deliver consistent returns of 5-6%, which we think will be attractive.




Q: How do you manage market volatility?

A: LC: We manage the fund to have a low exposure. On average, there is no net market exposure on the life of the fund, which is unusual. The average European long/short equity fund has between 30-40% net market exposure. But this market neutral position protects the fund from market volatility.

Also, the fund is low leverage. We will not invest more than 150% of the net asset value (NAV) of the fund at any one time, compared with a more typical investment of 200-300% of NAV from other hedge funds. And we are cautious with the amount of risk employed on the fund. As an investment house, we are risk aware and employ active risk management strategies as an integral part of fund management. (article continues below)

 

Q: Are you concerned that this cautious approach may affect performance?

A: LC: No, because we think that losing money is not acceptable.

MS: We do recognise that we will underperform in a raging bull market. But we are happy to do so, as we are confident that the same strategy will lead us to outperform in a bear market.

 

Q: How do you differentiate your approach from other hedge and absolute return funds?

A: LC: Most hedge funds are better at making money on the long side, and are less good on the short side. In the Melchior European fund, we return alpha on both our long and short portfolios. On average, we have generated alpha of 1% per month on our short position, which we think is industry-leading.

And we tend towards a contrarian investment stance. We avoid the crowded, consensus trades, which means our holdings do not tend to correlate with those of our competitors. Consequently, our fund generates a different return profile from its peer group.

 

Q: Can you explain your strategy on short positions?

A: LC: It is a mixture of investment process and psychology. It is not normal human behaviour to sell something that you do not own, hoping that it will fall. And mathematically, it is intuitively better to go long on stocks than short, as there is more potential on upside than downside. This means that the majority of investors focus on buying or owning stocks that they believe will make gains.

But our investment philosophy is to look for short as well as long holdings. We seek out stocks where we think the price will fall, but focusing on companies with business models that are challenged or over-extended.

 

Q: How do you identify those stocks that offer a strong short position?

A: LC: We employ a critical process when we analyse company information. Of course we meet management, but we subsequently conduct extensive analysis of their assumptions. We look at their market, competition, industry strategy and macroeconomic data, valuations, leverage and earnings momentum.

 

Q: Can you tell me about your contrarian stock positions?

A: LC: While we do not discuss details of individual holdings, we do like to stay away from consensus. You often see hedge funds tending towards the same type of trade. For example, in 2008, they were typically long on resources and short on banks.

We try and avoid these crowded trades and instead seek to identify unusual holdings where we think there is a significant profit opportunity. One example would be the stock on which we have made the most money in our short portfolio, a position we have held for two years. Unlike other hedge funds, this is not a bank, but a European listed food company.

Brokers told us we would not be able to make money by shorting this stock. But we thought it was over-leveraged and expensive, trading at 50 times earnings, and we saw fundamental structural weaknesses in the company. Our conviction has paid off.

 

Q: Why does the fund have a bias towards large-cap stocks?

A: LC: To maintain a high level of liquidity. We prefer to be in liquid positions, rather than risk being in holdings that we cannot get out of. While we do hold mid- and small-caps, particularly in our short portfolio, 70% of the Melchior European fund is invested in large-cap, single European stocks.

 

Q: Do you have plans to cap the fund?

A: MS: We will soft close the fund if the total combined size of the Melchior European fund and the MST European fund reaches €500m (£440m).

The Melchior European fund has €50m under management, and we anticipate that the MST European fund will launch with €7-8m, so we have plenty of capacity at present.