For VFMC, alternatives boom in the gloom

The $31 billion Australian government-backed asset manager, VFMC, has reaped big rewards from its belief in the hedge fund managers it backed five or more years ago, reports Simon Mumme.

In its latest performance figures, which show a headline return of 12.7 per cent, gross of fees and tax, against the 10.9 per cent gained by its benchmark in the year to June 30, the absolute return and private equity portfolios run by the Victorian Funds Management Corporation (VFMC) were standout performers.

The absolute return portfolio boomed 27.1 per cent over the 5.9 per cent gained by its benchmark, the UBSA Bank Bill index plus 2 per cent annually, while its private equity book gained 26.5 per cent over the 13.05 per cent achieved by its benchmark, the ASX 300 Accumulation, an index of the largest 300 listed companies in the Australian market.

Justin Arter, VFMC’s CEO, says the performance was due to the “snap back” performance of underlying hedge fund managers, many of whom experienced substantial client redemptions at the height of the financial crisis.

VFMC was not among the redeemers from these large, sophisticated, “east coast US” hedge funds, whose strategies range across credit and equities, Arter says.

Rather, it saw an opportunity to up its stake with managers as new capacity became available, earning itself “some kudos” with the big hedge fund shops in the process.

“We tend to try and partner and make a substantial investment with managers, so we’re not a tiny part their fund. We’re material.”

VFMC’s current private equity portfolio is, generally, about three years into an expected seven-year lifetime, Arter says, meaning its recent outperformance is not attributable to a “harvesting” of investments.

The program does not extend to emerging markets, where the operational conditions required for private equity investing are not as mature as in developed markets, Arter says.

“Private equity depends on real transparency, on books and records, on the rule of law. It’s a real deep dive. It’s seven years.”

He acknowledges the difficulty of consistently measuring the unlisted portfolio’s performance against its listed benchmark – the listed market moves ahead of the private market, providing a mismatch in returns which makes comparisons difficult – but questions whether private equity indexes, such as that run by State Street, are mature enough to be used by large institutional investors.

Buy low and be wary

The current VFMC team was established last year with the appointment of Arter. This followed a turbulent period in which its former CEO, Syd Bone, and investments chief Leo de Bever walked at different stages of the financial crisis.

The team is “acutely aware” their headline three- and five-year performance falls below benchmark, even though many of them, including CIO Justin Pascoe, were not at VFMC during that period.

Arter says the team has been strengthened by the expansion of its strategy unit, a team of four led by Peter Osborne, a former chief economist with Merrill Lynch Australia, which provides analysis and guidance to its asset class specialists.

While VFMC consults an expert hedge fund advisor, it does not retain an asset consultant to help develop its investment strategy and views, making the strategy unit an integral part of the team.

It also means the team can implement investment decisions in a matter of weeks, not months, as there is no recourse to an external consultant.

At present, the strategists are warning their colleagues to be increasingly careful when investing – and to be ready for anything.

“The tenor of their analysis has become more and more cautious in the last six weeks,” Arter says.

They don’t see many obvious opportunities across asset classes, but recommend carefully buying assets at the relatively cheap valuations currently available.

Rather than make a decisive call amid chronic European debt problems and signs the US may require a second stimulus, “we’re happy to let things develop over the back half of the year,” Arter says. “We think some strong signals will emerge.”

Or markets may just “churn” along, neither falling precipitously or rallying, in response to the entrenched problems originating from deleveraging in the West.

VFMC’s caution extends to China. The equities team recently visited inland tier one and tier two cities, and were concerned by reasonably high number of newly constructed buildings without tenants.

But in the long-term, the purchasing power that will one day be unleashed by the high personal savings rate in China will be a powerful force of growth, Arter says.