For super funds and their advisers

Hedge fund investing … and Australia’s subtleties

Craig Mercer

Craig Mercer, a senior investment consultant at Towers Watson, recently transferred from the UK to Australia to take up the role of heading up the firm’s hedge fund research and advice. His goal: “I want us to be regarded as the leading alternatives consultant in the region.” He spoke with Greg Bright about building portfolios which include alternatives and the differences between the UK and Australian markets.

When the opportunity came late last year for Craig Mercer to move from London to Sydney with Towers Watson, which he had only just re-joined after a stint with a fund manager, he perceived three main points of attraction in the role:

>  Australia has a lot of sophisticated clients

>  He would be working to help build whole portfolios, not only hedge funds, and

>  The Australian market did not seem to be investing in hedge funds as much as in other big markets, providing an interesting challenge for someone with his experience.

After his first few months in Sydney, he can see more of the nuanced differences between the Australian and European markets. There is, of course, the famous Australian emphasis on costs for starters. But there are more subtle differences.

Australian investors tend to be more biased towards using international hedge funds, much to the chagrin of the local managers, but in some strategies, such as global macro, there may be time-zone reasons for this. For an investor to employ a global macro manager based in Australia, there will be greater execution risk because of the time-zone differences with the big markets of New York and London.

Australian-based managers may be disadvantaged in the flow of information, too. The managers may be less-well researched by US and European researchers and funds of funds (FoFs) because of the business constraint of having to be willing to travel more and pay for this. This feeds on itself, retarding the potential growth of the Australian hedge fund industry.

But Mercer points out that some strategies, such as equity long/short, should not be disadvantaged by lack of scale nor their domicile.

“I like to build portfolios of the highest quality funds,” he says. “The US and UK have been proponents of moving to direct investments [into hedge funds] rather than through FoFs. Australia has been a bit slower to move, obviously apart from the very big ones such as the Future Fund.”

But hedge FoFs themselves have changed around the world, largely since the GFC, and are now more likely to offer clients a service which is not dissimilar to what the big asset consultants are doing – building bespoke portfolios of hedge fund strategies. They have also brought down both their own fees and driven down the fees of their underlying managers.

Mercer says: “There has been a fundamental change in opacity in the [hedge fund] industry. There was active engagement on fees as well as operational due diligence. Access today is much greater because you’re taking on extra risks, such as investment lock-ins.”

Towers Watson has a dedicated global team of alternatives specialists, covering hedge funds, private markets and operational due diligence. In Australia, Mercer is one of the senior members of an alternatives team that specialises in hedge funds as well as private equity, real estate and infrastructure.

Mercer started his career in the late 1990s with Aon Consulting in London, working on manager research, including hedge funds. He joined a specialist investment advisor and fund manager, Stamford Associates in 2002, then went from there to the former Watson Wyatt in late 2005. He then went back into funds management six years later, setting up the London office and heading risk management for a US-based hedge fund manager, Dalton Investments LLC, which was founded by James B. Rosenwald III. Mercer enjoyed working with Rosenwald and has maintained a close relationship with the American manager after he moved back into the asset consulting world in the latter-half of 2013.

“Jamie [Rosenwald] is a value guy,” Mercer says. “His main strategy is to take significant activist positions in smaller companies. We had some mutual relations from before and it was a natural progression for me [to join Dalton].”

Mercer was involved in equities research in Asian and Japanese equities in the early 2000s, where there were many opportunities at the time in heavily discounted securities. He had been an investor, through Dalton, and worked on creating niche products for clients, including developing concentrated portfolios. Towers Watson provides advice to a charitable foundation established by Rosenwald in 1998.

Even though Dalton had the relatively comfortable FUM of US$2.57 billion, the new regulatory burdens in Europe, showed Mercer how difficult it was for smaller firms to cope. What this means, Mercer says, is that there tends to be some herding among investors towards the larger managers. He believes the jury is still out on whether smaller managers will tend to outperform and is involved in further research on this subject at Towers Watson.

“I’m not sure,” he says of the small/big question. ”I think there is a core asset size that affords the greatest flexibility. I think that about $2-5 billion [in FUM] may be a sweet spot for both investing capital and managing a firm successfully through market cycles. On the other hand, there are plenty of examples of bigger or smaller managers outperforming over time.”

When he thinks about building a portfolio for a big investor, he says the three most important things are the ‘belief set’ of the organisation, the liquidity they want and the returns they expect – “to build something which is truly tailored to their needs”.

From his own perspective, he also has three main premises by which he would like to invest. He believes in the value of margin  of safety – “buying $1 value for 50c”; he believes that behavioural biases have a pervasive effect on markets, where the swings in emotions because of fear and greed create opportunities; and, with respect to risk, he believes this is a concept, not a number, and should be defined as “the permanent impairment of capital”.

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