Rafet Eriskin seeks alpha wherever he can. Judging by his track record and the hedge fund portfolio at AP4, he knows exactly where to look.
Over the past 10 years, AP4 has generated an average annualized return of 8.7%, well in excess of the real return + inflation requirement of 5.2%, and also outperforming the income index underlying the liabilities in the pension fund. AP4 has achieved this success as one of the first major global funds to integrate ESG investing into its long-term risk management strategy, having worked since 2012 to reduce its exposure to companies with large carbon footprints.
Senior Portfolio Manager Rafet Eriskin oversees AP4’s hedge fund allocation. What really sets Rafet apart is his innovative and refreshing approach to investing. Novus has served Rafet with portfolio intelligence solutions for his hedge fund book since 2015. Recently, I spoke with Rafet about the secrets to his success. In a five-part series, we’ll explore the tools and strategies that Rafet has used to bolster the returns of Sweden’s largest public pension fund.
I started by asking Rafet about his method for selecting hedge fund managers and diversification, which is what we’ll explore today.
The Fundamental Law of Active Asset Management
Simply stated, a manager’s ability to generate alpha (measured as the IR) is a function of a) their skill in selecting high-performing securities and b) the breadth of their investments. It follows that two managers with similar levels of skill may deliver vastly different active returns if one of the managers has invested more broadly than the other. Under this model, given a certain level of skill, diversification goes hand in hand with returns.
Keep in mind that diversification here does not equal the number of securities in the portfolio. Rather, the Fundamental Law highlights a broader notion of diversification: “In the nature of the bets, in the way they are chosen, in the areas where they are chosen, and in the mental models underlying these choices,” according to Rafet.
The classical sense of diversification (number of securities in the portfolio) often detracts from returns. Equity long/short investing, for example, has excessively diversified, leading higher conviction bets to outperform the rest of the book. (Read here and here for evidence on the matter, and here for a way to take advantage of this concept.)
To achieve the kind of multi-layered diversification Rafet is looking for, he works with industry partners who have built an extensive network of relationships among a wide variety of players in the hedge fund industry. Critical to the success of these relationships is strong philosophical alignment regarding what types of investment risk AP4 is interested in. Over time, these partners have learned exactly what Rafet wants in a fund, and they connect him with managers fitting the bill.
“Our goal is to enhance the breadth of our fund by finding managers with diversified approaches and specialized skills,” Rafet told me.
Managers as agents of diversification
Overseeing AP4’s hedge fund allocation places Rafet at the center of AP4’s search for diversified risks.
When it comes to choosing fund managers, good returns are absolutely necessary for Rafet—but they’re not a sufficient condition by themselves. What he looks for is not just breadth within hedge funds, but breadth among the hedge funds in his portfolio.
“We want to maintain a broad portfolio of idiosyncratic risk taking,” he says.
The key word here is idiosyncratic: Rafet keeps an eye out for managers who choose not to follow the herd. Even a highly skilled manager with a broad investment strategy might not be the right fit for AP4 if their strategy and assets overlap too strongly with funds already in the portfolio.
In addition to qualitative discussions with managers, Rafet uses Novus’ position-look-through overlap to verify true diversification, looking beyond the highly misleading dataset of returns. Figure 1 depicts the overlap functionality within Novus, with dark areas highlighting pairs of funds whose overlap is greatest, thus hindering breadth (see here and here for a detailed discussion on the topic and its value add for investors).
These funds should be diversified, yes, but diversified in a different way from other funds competing for his investment.
In this way, for Rafet, managers themselves become agents of diversification. An apparent paradox—breadth through specialization—begins to make total sense.
Sparking dialogue between managers and allocators
Managers know better than to claim, “I recently generated returns; therefore I am skilled.” (Sadly, some investor relations professionals at active asset managers still prefer to remain quiet with investors when recent returns have faltered, reinforcing a behavior Rafet and others are trying to change.) Rather that dwell on generalizations, managers should demonstrate that: a) they manage a skillfully selected array of diversified bets, and b) their fund has distinguishing characteristics that can add value to a portfolio in ways that other funds cannot.
There is upside to the effort, since true diversification commands a premium. “We have no problem weathering short periods of drawdowns so long as we are comfortable with the true breadth and specialization offered by the manager,” says Rafet.
In the next installment of our series of posts on Rafet and AP4, we look at how he uses greater transparency for better investment decisions, better execution on his fiduciary duties, and better conversations with managers.
Published on January 25, 2019