Sponsored Profile: Pacific World, the arbitrage strategy specialists

Pacific World Asset Management discusses what it takes to pick the best hedge fund managers.

Established in Hong Kong in 1993, Pacific World Asset Management is today one of the largest homegrown fund-of-hedge-funds boutiques in Asia ex-Japan, managing $800 million in assets. In 1998 the firm developed its first fund of hedge funds in-house portfolio, and by 2001 had built up the experience and expertise to begin launching a range of single-manager, multi-manager and structured hedge fund products, specializing in arbitrage and relative value strategies. The group's flagship Global Arbitrage Strategy Fund Plus has passed its third anniversary and achieved an annualised return of 10%, with volatility below 5%. The fund is listed on the Irish Stock Exchange.

Pacific World's Julian Liew, CFA, senior associate, discusses what it takes to pick the best hedge fund managers.

Why does Pacific World focus on arbitrage and relative value strategies?
Our goal is to provide investors steady, positive returns, with minimum risk in terms of volatility and draw down. Of all the hedge fund strategies, arbitrage and relative value provide the best risk-adjusted returns over the medium to long term, and are generally uncorrelated with bond and equity markets.

How have you reacted to the poor performance among arbitrage funds in 2004?
Low volatility made it an extremely tough year for arbitrage strategies that rely on volatility to generate returns.

But we didn't find 2004 discouraging. Our flagship arbitrage fund of hedge funds returned 5.2% for the year which is favourable in the space that we are in.

We felt that this proved the robustness of our investment process and our ability to protect capital in tough market environments. The challenging period also gave us an opportunity to review our managers and see which ones were really able to deliver. We take a long-term view to investing in hedge funds and we encourage our clients to do the same.

What are the key features that distinguish Pacific World as a picker of fund managers?
Our long-term approach and disciplined investment process have driven our success. When we invest with a manager we are building relationships for the long term, which allows us to access capacity with the most promising funds. We don't tend to trade our funds too often and we're very selective about the funds we invest in - we currently hold below 20 funds in our portfolio. We believe we add more value by being extremely selective about our managers through our process and select the best managers that fit us within each strategy, rather than investing in many managers, which could end up replicating the strategy universe.

Pacific World is also unique in being able to offer Asian investors access to world-class arbitrage managers, and vice-versa. Our high-net worth and institutional clients take comfort in our years of experience and expertise in examining arbitrage and relative value strategies, as well as our ability to meet and communicate with them conveniently in their time zone.

What's the first step in your investment process?
Strategy selection. We look to identify arbitrage and relative value strategies that best suit our return and volatility targets. Arbitrage strategies can be fairly complicated, so it's important to clearly identify and understand the risks involved, the sources of profit for each strategy and what skills the manager should have to execute it. This is where our expertise can add significant value to investors.

Different strategies will be exposed to different risks and macro factors. Even managers in the same strategy group can present very different risk profiles. For example a convertible bond arbitrage manager could be trading plain vanilla strategy, or he could be trading from an event-driven perspective, which may present different risks in the equation.

We then come up with a basic macro guideline for how we should allocate to the various strategies in our portfolio. However, while this gives us a top-down perspective, the essence of our strategy is really bottom-up and is driven by our manager selection.

How do you pick your managers?
Picking the right managers is the essence of what we do. We've developed a methodical and rigorous nine-step process that takes us from initial screening to eventual selection, and this discipline has proved invaluable. The first step is to screen managers based on certain criteria. Besides performance we tend to prefer managers with at least a five-year experience in their respective strategy (irregardless of whether it is in the same fund or not) and at least $100 million under management. Each fund is covered by two of our four analysts. We pay particularly importance to operational and valuation risks during our on-site due diligence visits as we feel that this is an extremely important area that is often overlooked.

Much of the due diligence is qualitative, but we try to maintain objectivity and process by having each analyst fill out a detailed due diligence questionnaire and a grading report that ranks the managers on various criteria.

Selected managers are then taken to the investment committee, which is made up of our other two analysts and Chris Choy, our CIO, which must unanimously approve any funds we invest in. Usually we start investing in funds by putting them in an "engagement" stage, where we invest $1-2 million initially to gain more transparency and information. At the same time, we will also monitor the funds very closely. When we are satisfied with the abilities of the manager, we move to the selection stage where we progressively invest more into the fund.

What kind of resources does this require?
Our investment process is only effective because of the dedication we have to investment in our team and in technological systems to support this process and empower our team.

The investment team members have a broad range of complementary experience, with members having backgrounds in funds of hedge funds, accounting, M&A and fund administration - this last one is particularly important when analyzing operational risk.

We have also invested a significant amount in developing an internal database that we call the Pacific World Platform. This has taken three years to develop and we employ four IT professionals to maintain this system. Besides enabling us to monitor different managers and indices, this system enables us to log the due diligence and grading reports and correspondence we make with each manager, and it allows us to easily access their documents (including their presentation materials, fact-sheets, PPM etc). Our system also enables us to perform comparison and statistical analysis of the different managers in the database. This is an internet-based platform and means that our investment team can easily share and log information while traveling.

Beyond individual manager picks, what's important in portfolio construction?
To ensure that in the aggregate, the managers we invest in are able to deliver the fund's risk/return objectives and protect capital on the downside. We classify the risks that the various strategies and managers present, and monitor how this affects the portfolio in aggregate to ensure we are not overexposed to any particular risks. For example we look at interest rate, volatility, liquidity, equity and credit risk exposure in our portfolios and ensure there is adequate diversification.

On the quantitative side, we study the correlation between our managers and perform back-testing and stress testing analysis. We also perform, as a reference, efficient frontier analysis and run simulation models using our licensed software and our proprietary tools. We also have strict investment and risk management guidelines, with maximum limits for funds and strategies.

And on the qualitative side, we look at many different factors including the quality of the manager, the transparency he offers, risks of the funds and consider factors such as how the liquidity of our underlying managers affects the liquidity of our fund.

How do you protect yourself from underperforming managers?
We are really watching out for deviant and non-performing funds, and looking to make sure that we reallocate our portfolio to optimize the risk/return ratio. We keep a close watch on the performance of our fund and demand weekly performance estimates from our underlying managers. Since we invest in a relatively smaller number of funds, our four analysts can actively follow their performance and keep in constant touch with managers. Anytime a manager significantly underperforms or outperforms we make sure to follow up with a phone call to understand what has caused it. One thing we watch out for is style drift. While it is not necessarily a bad thing for a fund to adapt to a changing environment, we need to watch out for cases where the fund's risk/return profile is changing, as this will affect our portfolio in terms of risks and mandate.

Monitoring the portfolio is not just about reacting to poor performance, it's also about anticipating where the pressure will come in and where the new opportunities lie.

Pacific World Asset Management Limited
Room 3507, Edinburgh Tower, The Landmark,
15 Queen's Road Central, Hong Kong.
Telephone: (852) 2851 9721
Website: www.pacworld.com.hk

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