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VOLUME 10 ISSUE 10 SEPTEMBER 2011

Well-oiled and running smoothly FUND PROFILE 56JP Morgan customises

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rare peek behind the scenes at JP Morgan Alternative Asset Management (JPMAAM) reveals a well-oiled and smoothly running machine, as you would expect from the bluest of blue chip fund of hedge fund providers.

This is not to imply that the New York-based outfit has been complacent in the face of changing markets and client demands since

2008 and before. On the contrary, JPMAAM has adapted in ways that less heavyweight competitors can only dream of.

One evolutionary change is the growth of ‘cus-tomised solutions’, which now account for $5 bil-lion of the $9 billion that JPMAAM oversees. Corey Case, who is chief operating officer and co-heads JPMAAM together with long-time chief investment officer Paul Zummo, sees these individualised

ABy Claire

Makin

Paul Zummo and Corey Case

Customisation takes root at JP Morgan

Sixteen years since its inception JP Morgan’s FoHF remains independent – but with a heavyweight

parent it can turn to for advice

Disclaimer: This publication is for information purposes only. It is not investment advice and any mention of a fund is in no way an offer to sell or a solicitation to buy the fund. Any information in this publication should not be the basis for an investment decision. InvestHedge does not guarantee and takes no responsibility for the accuracy of the information or the statistics contained in this document. Subscribers should not circulate this publication to members of the public, as sales of the products mentioned may not be eligible or suitable for general sale in some countries. Copyright in this document is owned by HedgeFund Intelligence Limited and any unauthorised copying, distribution, selling or lending of this document is prohibited.

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September 2011

mandates as “a growth engine” going for-ward as clients take more control over their hedge fund portfolios.

This side of the business includes $1.7 bil-lion in hedge fund advisory mandates, an area currently in the industry spotlight as funds of funds try to diversify their business models.

JPMAAM is among the fortunate few with the people power, institutional relationships, and the technical expertise to pull this off. The team has put a lot of effort into pulling apart and analysing hedge fund returns to aggregate underlying risk exposures in client portfolios.

JPMAAM has been doing advisory work since 2003, but as Case points out, a recent catalyst for growth in this area has been the increase in hedge fund transparency since the finan-cial crisis, driven by investors’ ‘need to know’. “One of the most important lessons every hedge fund manager learned was that if cli-ents don’t understand what you’re doing, they won’t stay clients for long,” he notes.

Better access to the underlying numbers has meant that JPMAAM has been able to do more quantitative analysis at the manager, strategy and overall portfolio levels than was possible in the past. But despite the time and money spent on modelling manager returns and risk, Case says that decisions at JPMAAM are still 75% driven by human insight. “At the end of the day it’s the people with the right qualita-tive judgment that deliver on investments,” he points out.

In fact, JPMAAM’s basic philosophy has re-mained unchanged in the 16 years since the business was created. JPMAAM launched its flagship fund of hedge funds in 1995 and a sister fund in 2001. In fact the second fund’s launch was written in the debut issue of InvestHedge 10 years ago. These two vehicles account for the bulk of JPMAAM’s commingled funds, though the team also runs various other funds with dif-ferent sector focuses or domiciles.

JPMAAM has kept its identity as a self-con-tained entrepreneurial unit within the parent group, with its own investment and risk teams, operations, accounting, product development and IT support. Case says that it is important for him and his team to be able to control the underlying resources of their business.

At the same time, being part of JP Morgan As-set Management has clear advantages. JPMAAM

is “definitely plugged in” to the larger Asset Management franchise’s wealth of knowledge and information, and to its relationship net-work, as well as having access to its deep pock-ets to fund technology investment.

Some parts of JP Morgan are off limits howev-er, including Highbridge Capital Management, Glenn Dubin’s $27 billion hedge fund, which JP Morgan completed buying in 2009; and Gávea Investimentos, the Brazilian alternatives business majority owned by Highbridge.

Case makes it clear that JPMAAM will not in-vest in any manager in which its parent has an equity stake. “We want to stay third-party and conflict free,” he says. That also goes for the JP Morgan prop trading team that is migrat-ing from investment banking to asset manage-ment to comply with the Volcker rule.

JPMAAM’s 68-member team is centred at its New York headquarters, but also has repre-sentatives in London, Geneva and Singapore. What these people actually do is a good indi-cation of the direction in which Case and his team think the business – and the industry – are headed.

There are 19 on the investment team, which has been run with continuity by Zummo, a founder of the business. A further 18 people work on client solutions and advisory – a number that is consistent with JPMAAM’s book of business.

They are supported by an infrastructure team of 21 (mostly in operations and account-ing), and an additional army of 14 program-mers. The programmers work on JPMAAM’s large, expanding and proprietary portfolio management platform, part of which is cur-rently being adapted to provide a web-based

tool for clients. In comparison with the size of the team, the

number of underlying managers that JPMAAM invests with is relatively small – just 85. Case sees this as a clear competitive advantage, citing JPMAAM’s average manager-to-analyst ratio of four-to-one. Many funds of funds hurt by manager problems in recent years had ana-lysts covering double or triple that number, he points out.

But JPMAAM has never been invested in a fraud. “I don’t think it was accidental. We cer-tainly met with most of them,” he says.

It is all too easy for fund of fund houses to find themselves overseeing too many manag-ers, particularly if they do advisory work, Case says. Big clients often ask them to take a look at a promising hedge fund manager, who they may end up adding to their research list on behalf of the client. “The problem with that is that suddenly you get over-run by the num-bers very quickly,” he points out.

In JPMAAM’s case, the team will not cover managers it decides not to invest with. “We have to manage growth and can’t be all things to all clients,” Case adds.

JPMAAM is also keen not to overdiversify its portfolios, keeping manager numbers for a large commingled multi-strategy portfolio at about 35. Beyond 20 to 25 managers the diver-sification benefits of adding more dramatical-ly decreases, Case points out, but for ‘real life’ reasons numbers need to be higher. “What the quant doesn’t take account of is strategy views and risk appetite, new and unique strategies and the liquidity needs of underlying inves-tors,” he notes.

The team has surprisingly eclectic tastes when it comes to selecting managers, with no hard and fast rules about size or tenure. They are as likely to invest in a $2 billion manager with a 10-year track record as a day one man-ager with $200 million in assets, Case says.

Their choice is to some degree dictated by the investment environment. In 2009, the team favoured larger managers with strong balance sheets who were able to take advantage of huge dislocations in the markets. In 2010, this approach was reversed, with smaller, nimbler managers taking precedence as beta opportu-nities receded.

In this type of volatile environment, big managers tend to do less well. “With larger balance sheets managers find it harder to move capital, and so their best ideas tend not to make it to the bottom line,” he notes.

As for strategies, JPMAAM is equally open-minded, but steers clear of those whose return drivers lack transparency, such as ‘black box’ trend-following commodity trad-ing advisors. Dedicated emerging markets specialists also feature on the ‘avoid’ list, although this is changing as their hedging capabilities improve.

The team has a love-hate relationship with macro, where Case says JPMAAM has

“ If we believe in a manager we’ll monitor him according to his own belief system. If we don’t believe, we won’t invest”

Established: 1995

Offices: New York, London, Geneva, Singapore

AUM (including advisory): $9 billion

Customised solutions: $5 billion, including $1.7 billion advisory

Professionals employed: 68

Investment professionals: 19

Underlying managers: 85

JP Morgan Alternative Asset Management: at a glance

“ One of the most important lessons every hedge fund manager found out was that if clients don’t understand what you’re doing, they won’t stay clients for long”

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fund profile

probably deviated most from the views of its peers and the industry. While recognis-ing that the dynamics of the strategy were compelling last year, the team was unable to find enough ‘A plus’ managers to justify a significant weighting.

The problem was that most managers lacked a convincing story about how their signals would indicate where to invest and when to be heavily hedged. “Good macro managers are right 50% of the time and that isn’t bad – as long as they have terrific risk controls,” Case says.

Underweight macro turned out to be the right decision post-2008 as the strategy failed to live up to its promise.

JPMAAM’s approach to macro highlights important differences among funds of hedge funds in the way they conduct manager re-search. The first step at JPMAAM is to under-stand how managers aim to make money. Only then do team members look at whether the managers’ track records reflect their stated philosophy and process. Many funds of hedge funds take the reverse approach, Case says, screening for performance and then digging into how managers have achieved it.

JPMAAM also gives its analysts plenty of time to research new strategies and managers – a further reason for keeping the manager-to-an-alyst ratio low. In 2010 JPMAAM added 1,000 managers to its database, conducted “signifi-cant research” on 400, and invested with 24.

One strategy that the JPMAAM team is cur-rently excited about is re-insurance, which lacks global capacity following the natural disasters of the past few years. The premiums are good, potential losses modest, and invest-ments have a finite time horizon as contracts are typically re-negotiated on one-year terms.

Event-driven strategies (excluding merger arbitrage) also continue to look attractive, Case says, as JPMAAM is still bullish on the op-portunities created by corporate restructuring.

Some of the other manager additions high-light the evolution of JPMAAM’s hedging strat-egy during the ‘white knuckle years’ – and in particular the advances in protecting against tail-risk. Before 2007, most of the protection was provided by dedicated short-sellers. In 2007 to 2008, JPMAAM added long volatility arbitrage managers to the mix. More recently, options arbitrage and short-biased credit man-agers have joined the line-up.

The aim is to diversify the sources of protec-tion in JPMAAM’s portfolios, while at the same time reducing the amount of capital commit-ted, and increasing the convexity of the hedge (so that its value increases along with volatili-ty). Options arbitrage provides little protection in markets that are down less than 5%, but a huge amount during falls of 10% to 20%, Case points out. “We wanted to be sure we could re-ally efficiently cut off the tail,” he says.

JPMAAM landed its first advisory mandate for a tail-protection portfolio in April 2008. The client, a direct hedge fund investor, was afraid of residual equity risk and wanted to move quickly to protect its portfolio. The tim-ing was impeccable. Within months, world markets were collapsing.

“Fast forward to today and we are having a lot of conversations with clients about our approach,” Case says. Some large investors are already looking to incorporate this form of protection not only into their hedge fund portfolios, but also into their equity and fixed income books.

The trend indicates how sophisticated insti-tutions are starting to ‘disaggregate’ the un-

derlying risks across all their portfolios, Case says. It also highlights how some institutions are moving away from the old view of hedge funds as a separate asset class, measured in terms of volatility and correlations to equities or fixed income. Instead, they are more con-cerned with analysing the different types of risk they are taking on.

The first sign of this shift occurring is in equities, where long/short equity is increas-ingly finding a place in the long-only equity ‘bucket’, Case says. He predicts that funding sources will eventually alter to reflect this approach, with equity-like risk being funded from the equity bucket, and a similar change taking place in funding for fixed income and commodity-like risks.

This wholesale deconstruction of risk, leading to hedged strategies across asset classes, holds a lot of appeal for corporate and some public plans that want to derisk their programmes without giving up re-turns, Case notes.

A typical client may be invested in two or three funds of hedge funds, a few separate ac-counts, and be moving to direct investment with the help of consultants. “The one thing clients are missing as they do this is insight into aggregated risk,” Case says. JPMAAM is now testing a web-based version of its pro-prietary portfolio management programme that will give clients access to the systems and technology that they need to ‘look through’ to their underlying risk exposures.

At least from JPMAAM’s perspective, Case does not foresee that quantifying risk in this way will lead to managers being forced to comply with risk profiles that suit the inves-tor rather than the manager. Asking manag-ers to increase or decrease leverage, or apply other constraints, does not sit well with JP-MAAM’s philosophy. “If we believe in a man-ager we’ll monitor him according to his own belief system. If we don’t believe, we won’t invest,” he says.

If Case has one concern for the future, it is the prospect of unexpected decisions by poli-cymakers, such as the hotly-debated restric-tion on short-selling. On this point, although there is still “not 100% clarity on the direction that regulators want to go in, the good news is that they are taking their time,” he says.

He also hopes that managers will continue to open up to investors, and not revert to their old opaque practices.

As for JPMAAM, Case has no long-term growth target – in fact he is deeply sceptical of such exercises. He and Zummo sit down at the beginning of each year and decide how much capacity the business can cope with, giv-en the team, investment climate and manager line-up. In the past, JPMAAM has twice closed its funds to new inflows on a temporary basis in order to preserve the integrity of returns. “If we come across a similar set of circumstances we would do the same again,” Case says.

JP Morgan disclaimer: FOR INSTITUTIONAL USE ONLY/NOT FOR PUBLIC DISTRIBUTION. The article has been reprinted with the express written permission of HedgeFund Intelligence. Investing in hedge funds may involve a high degree of risk. Managers may engage in leveraging and other speculative investment practices that may increase the risk of investment loss. Hedge funds can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are not subject to the same regulatory requirements as mutual funds. All hedge funds are unique and any investor should carefully consider all risks prior to placing money with a particular hedge fund. Specific risks can be found in the hedge fund’s offering memorandum.

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