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Assets grow but retain fingerprint FUND PROFILE 34

Permal embraces change

October 2010

iant fund of funds manager Permal Group has barely paused for breath this year. So far, the $20 billion company has launched five new funds, developed a state-of-the-art risk system, and made several high profile hires.

A common theme runs through these developments. It is the need to offer in-creasingly specialised services to clients. “The fund of funds industry is no longer monolithic. It is very much custom-tai-lored,” says Isaac Souede, Permal’s New York-based chairman and chief execu-

tive, who has been a driving force behind the com-pany for 23 years.

Four of the five new Permal funds have innovative structures or strategies. The most radical concept is

the JP Morgan Permal AIS Fund, a daily liquidity product where Permal allocates among 25 synthetic trading indices developed by JP Morgan. The aim is to capture the return generation of hedge fund strat-egies such as momentum and carry. Far from seeing such products as a threat, Permal embraces them as new ways to use its skills, according to Omar Kodm-ani, senior executive officer at Permal, who sits on the risk committee.

Meanwhile, Permal’s new risk system, CubeRisk, is designed to ‘explain’ performance more accurately than most risk tools, and so can not only isolate manager skill more precisely, but allows the team to construct portfolios (such as the AIS Fund) within very tight parameters.

And Permal’s high profile hires are also part of the trend towards increasing specialisation. One exam-

By Claire Makin

Specialised services are a top priority for Permal in its bid to be innovative and stay ahead

Isaac Souede

Permal develops its

customisation theme

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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.

fund profile

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October 2010

ple is Andrew Rozanov, who joined from State Street in July to head up Permal’s Sovereign Advisory Business. It was Rozanov that coined the term Sovereign Wealth Fund in a 2005 pa-per.

Souede says that it is critical for Permal to keep pace with what clients want, and to de-liver it by delving into the company’s toolkit. “We are using our skill set in a greater variety of situations,” he says.

One reason for the pace of new develop-ment at Permal is its growing US institutional client base – long a coveted market for the company. This has nothing to do with the purchase of a majority stake in Permal by New York-based asset manager Legg Mason in 2005, according to Kodmani. The institutional push has been entirely Permal’s own initia-tive, he says. Legg Mason has a history of leav-ing its subsidiaries to get on with their busi-nesses although Kodmani acknowledges that having a prestigious parent has helped raise Permal’s profile in the US market.

While many of Permal’s competitors reacted to the financial crisis by behaving like rabbits caught in the headlights, Permal seems to have been energised by it. “I truly believe there’s never a good crisis unless you take ad-vantage of it,” Souede says.

Souede divides Permal’s approach into pre- and post-crisis. Before 2008, he says that the company delivered value-added to its clients via long/short, ‘all-weather’ macro, or direc-tional strategies.

Post-crisis, investors’ willingness to listen to new asset management ideas created a major opportunity for Permal, Souede points out. Since 2008, the company has ‘deconstructed’ its approach with increasingly specialised and customised offerings.

To some extent, this has involved a new an-gle on manager relationship as Permal ‘cherry picks’ what its managers offer, and creates new structures to suit clients’ needs. The com-pany has also hired more specialists, particu-larly in operational due diligence, in risk, and in legal and compliance to deal with the new regulatory environment.

Overall, Permal has nearly doubled employ-ee numbers since 2005 to 192. It has also opened its doors in Hong Kong, Tokyo and Du-bai – adding to existing offices in New York, Boston, London, Paris, Nassau and Singapore.

Souede believes that one of the firm’s key strengths is its flexibility. Despite an increas-ingly institutional focus, Permal has its roots in the European high-net-worth market, and first invested with US-based hedge fund man-agers in the early 1970s.

This explains Permal’s New York headquar-ters and longstanding ties with US managers. Most of the company’s employees are based in mid-town Manhattan, including the 41-strong investment team led by Jim Hodge who joined Permal in 1987 and became CIO in 1997. Risk

management is run from London, Permal’s other main centre, by Julian Shaw, who joined in 2004 from BarCap, where he was head of market risk.

There are now 15 funds of funds in the Per-mal family. The two biggest, Permal Fixed In-come Holdings and Permal Macro Holdings (formerly Permal FX, Financials & Futures), have returned 8.5% and 8.1% a year over 10 years, and both have more than $5 billion in assets. The third largest is $2.1 billion Permal Investment Holdings, a 78-manager global multi-strategy fund with a directional bias. It has returned 3.4% annualised over 10 years,

while the MSCI World was down 1.5%. In 2009, the average performance of Permal funds was 16% plus, compared with a return of 9.2% for the InvestHedge Composite.

So far this year, markets have severely tested the funds’ ability to meet their objectives, with a May/June slump followed by a July ral-ly and a rough August. “That kind of rapid one-two test tells you pretty quickly whether your funds are behaving as they should,” Souede notes. Permal Fixed Income is up 4.1% net of fees through August.

A drop in assets from peak levels of $36 bil-lion in 2008 to $20 billion (where they were in 2005) had more to do with banks withdraw-ing leverage from the market than clients

pulling their money out, according to Souede. So far this year, Permal says it has seen net inflows, particularly into its absolute return funds.

As the company evolves, it is determined to retain what Souede calls ‘the genetic finger-print’ of a Permal fund. All the company’s products follow the same philosophy, apply the same beliefs, and are backed by the same disciplined risk management process, he says.

The Permal ‘fingerprint’ includes investing in deep and liquid markets, a relatively high reliance on high-conviction managers and ex-pression of top-down macro views in portfoli-os. Permal avoids strategies that are hard to understand, especially those that are illiquid. “In spite of the talk about illiquidity bringing higher returns, in general it has not, particu-larly over the last decade,” Souede says.

Manager skill is critical to Permal’s invest-ment philosophy. In its biggest funds, the top five managers run one third of the money. They are typically well-known names (for compliance purposes Permal prefers not to name any). “No matter how clever you are on the operational side, the key is still utilising talented managers,” Souede says.

Most of Permal’s portfolios include a long ‘tail’ of positions in newer, smaller managers that Permal hopes will become the stars of the future, but who are also subject to relatively high turnover.

The search for skill has been enhanced by Permal’s new risk systems. These can be used to isolate manager skill from luck, or from the various forms of beta that can easily be con-fused with skill, according to Pierre-Antoine Duvallon, senior quantitative analyst.

Another Permal ‘fingerprint’ is the compa-ny’s expression of top-down views in all its portfolios. This capability has been hugely en-hanced by Permal’s growing managed ac-count platform, which includes engineered accounts as well as pari passu accounts that replicate hedge funds.

There are now some 68 managers on the platform, nearly one third of Permal’s 193 un-derlying managers. What makes the Permal platform particularly interesting is that, like a few funds of funds like Lighthouse Partners, it is pure buy-side, compared with the sell-side managed account platforms set up by the banks.

As well as running managed accounts that mirror hedge funds, Permal increasingly engi-neers ‘pure play’ mandates that cherry-pick from a manager’s skill set. For instance, one credit manager was invited to create a special-ised leveraged loan portfolio for Permal’s plat-form. “As we customise our services to clients we are also getting managers to customise their services to Permal,” Kodmani says.

Long/short managers have been asked for more concentrated portfolios and systematic traders may be asked not to use certain mod-

Post-crisis, investors’ willingness to listen to new asset management ideas created a major opportunity for Permal. Since 2008, the company has ‘deconstructed’ its approach with increasingly specialised and customised offerings

Headquarters: New YorkOther offices in: Boston, London, Paris, Nassau, Singapore, Hong Kong, Tokyo and Dubai AUM: $20 billion Number of funds of funds: 15Number of underlying managers: 193Managers on managed account plat-form: 68 ($4.6 billion)Employees: 192Number in investment team: 41

Permal Group: at a glance

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October 2010

fund profile

ules that Permal believes are inferior to its own. Managers have displayed mixed reactions to

these requests. “The initial conversations were at times a little stressed,” Souede admits, adding that managers cheered up when Per-mal offered improved fee terms.

Some managers go away and do their own analyses of Permal’s suggested modifications.“In quite a few instances managers come back and say ‘We like what you’ve done, can I offer it to my clients?’” Souede says.

“The interesting thing about this approach is that it is a pathway to differentiated re-turns,” Kodmani points out. By focusing on a manager’s particular skill set “you end up with something that fits your own risk param-eters”, he notes.

In July, Permal launched what is probably the second UCITS-compliant fund built en-tirely of managed accounts. Goodhart Part-ners is known to have launched one in 2007. The Active Trading Fund was launched in partnership with Strategic Investments Group, its distributor.

Permal is also looking to broaden its geo-graphical reach, and China has become a key focus. Souede grew interested in China in 2002, predicting that the country would be-come the major driver of global wealth be-sides the US. China is “of great intellectual appeal to me, and a source of alpha for us”, he says.

The Permal MMF (Lux) China Strategy Fund was launched on 1 April 2010. “The timing was impeccable,” Souede says. The index plunged 25% over the next quarter, though Permal China slid only 4%. It is now up 4% to

5% since launch. Souede believes that the increased correla-

tion in equity markets owes a lot to globalisa-tion, but also to the ‘China factor’. This, in turn, has had a major effect on Permal’s asset allocation strategy. Recognising that geo-graphic spread will be of limited use in diver-sifying risk for multi-strategy funds such as Permal Investment Holdings, Permal has in-creased its macro allocation.

At some point, Souede sees emerging mar-kets’ performance diverging once again, as lo-cal consumption becomes an economic driv-er, but believes that is some way into the future.

As for fixed income, Souede believes mar-kets are approaching a tipping point. Towards the end of 2009, the Permal Fixed Income Fund had a 65% exposure to credit sensitive investments. That exposure is now 50% and is

set to fall further over the next 6 to 12 months in the expectation that spreads will compress, even in high yield and emerging markets. “We believe that we will get to the point that it really is return-free risk,” Souede says.

From a macro perspective, Souede sees two possible scenarios unfolding for the global economy. First, developed countries will all fail and become like Japan. Second, and most probable, they will do everything to avoid de-flation and the outcome will ultimately be inflationary.

The implications for fixed income asset al-location, on a two to three-year view, is to shift from cash into more relative-value arbi-trage and hedge strategies, Souede says.

Permal’s long term plan is to locate its ana-lysts close to their local markets. The compa-ny has been so cautious about retaining its core values and culture that it had never based an analyst outside Manhattan until Ste-ve Zhang was relocated to Singapore in early 2009. Analysts may eventually work out of London, Tokyo, and Beijing, Souede says.

Another challenge is to convince institu-tional investors to accept Permal’s directional funds as a substitute for equity, which Souede admits is “a leap of faith”. Permal has had some success with European investors on this front and Souede is convinced that the con-cept will ultimately be accepted.

As Permal continues to evolve, Souede is constantly on guard against diluting the com-pany’s culture and losing sight of its roots. That, he believes, is the most dangerous as-pect of growth. “You can’t forget who you are and what your skill set is,” he says.

Permal’s new CubeRisk system is the brainchild of Julian Shaw, who heads the London-based risk department and is a long-time sceptic of off-the-shelf solutions to risk management.

CubeRisk is designed to isolate which of all the different forms of beta a hedge fund is exposed to. By measuring these risks more precisely, Permal believes that it can build a more accurate picture of a manager’s skill (the residual performance that is not attributable to beta). It may turn out that the manager has none, and is just playing different market factors.

Many funds of funds have similar tools, but Permal claims that CubeRisk is more powerful

than most. One difference is that it draws on statistical disciplines from the non-financial world, such as bio-pharmacology.

While most risk tools give static exposures to a beta over time, CubeRisk places greater weight on more recent returns. Over a three-year period “a zero average is useless” points out Pierre-Antoine Duvallon, senior quantitative analyst.

Another key difference is that CubeRisk looks for the most relevant factors (breakouts by geog-raphy, market cap, asset type, currency and so on) that will ‘explain’ performance. Throw in enough factors and you will get a perfect ‘fit’, but the result will not be much use in isolating

meaningful exposures over time, Duvallon notes. CubeRisk can be used on portfolios of funds as well as at the individual fund level. In isolating performance drivers, it also signals where Permal can buy exposure via ETFs for faster top-down allocation.

Permal is anxious to dispel the notion that its risk team consists of boffins in an ivory tower. CubeRisk sits on the desktop of each portfolio manager, who can run the analytics themselves. “It is an integrated process. We don’t just sit there on our own in some vacuum,” says senior executive Omar Kodmani, who sits on Permal’s risk committee.

Permal’s bespoke risk management system – CubeRisk

From a macro perspective, Souede sees two possible scenarios for the global economy. First, developed countries will all fail and become like Japan. Second, and most probable, they will do everything to avoid deflation and the outcome will ultimately be inflationary

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Important Information: Past performance is not a guide to future results. Performance is for Class A shares, reflects the reinvestment of dividends and is net of Fund level fees/expenses but not sales charges which will reduce returns. Performance for each strategy does not include fees at the Permal Fund level. Performance may be volatile and the NAV will fluctuate. Investors may not receive the full amount invested upon redemption. Indexes listed do not represent benchmarks for the Funds, but allow for comparison of a Fund’s performance to an index. An investor cannot invest directly in an index. Index performance does not reflect fees and expenses. Hedge funds are speculative and involve Risk. Fund of fund risks include dependence on the performance of underlying managers, Permal’s ability to allocate assets and expenses at Permal and underlying fund. Risks of underlying hedge funds include, among others, leverage, options, derivatives, distressed securities, futures, and short sales, and investments in illiquid, emerging and developed market securities or specific sectors. Exchange rate fluctuations may affect returns. Allocations and holdings are subject to change. There is no assurance that the Fund’s objective will be attained. This material is not an offer or a solicitation to subscribe for any Fund, and is not investment advice. Sales of shares are made on the basis of the offering circular only and cannot be offered in any jurisdiction in which such offer is not authorized. The Fund is not for public sale in the US or to US persons and its sale is restricted in certain other jurisdictions. There are restrictions on transferring shares. Investment in the Fund may not be suitable for all investors; investors should consider risks and other information in the offering circular and consult their professional advisers regarding suitability, legal, tax and economic consequences of an investment. To UK investors: This was prepared by Permal Group Inc. (“PGI”) and (i) if issued in the UK by Permal Investment Management Services Limited (“PIMS”), (authorized and regulated by the FSA), it may be transmitted only to persons reasonably believed by PIMS that it is permitted to communicate financial promotions related to the Fund or otherwise promote the Fund under the Financial Services and Markets Act 2000 (“FSMA 2000”) (Promotions of Collective Investment Schemes)(Exemptions) Order 2001, or (ii) if communicated by PGI into the UK may only be transmitted to persons reason-ably believed by PGI, that it is permitted to communicate financial promotions pursuant to the FSMA 2000 (Financial Promotion) Order 2005. The Fund is not regulated under the FSMA 2000, and is not available to retail investors. No protection is provided by the UK regulatory system and the benefits available under the UK Financial Services Compensation Scheme do not apply. To Singapore investors: This material is distributed in Singapore by Permal (Singapore) Pte. Limited, which is regulated by the MAS. To Dubai investors: This material has been distributed by PIMS’ DIFC Branch which is regulated by the DFSA. This information is only intended for Professional Clients as defined in the DFSA Rulebook; if you do not meet this definition you must not act upon this information. To Hong Kong investors: Permal (Hong Kong) Limited is licensed by the SFC for dealing in, and advising on, securities.