In April 2005, Carrie McCabe was sitting anxiously in a meeting of the portfolio management committee of fund-of-hedge-funds firm Financial Risk Management at its ultramodern headquarters just off the Strand in London. The team was discussing its flagship Absolute Alpha Diversified strategy — the core product on which FRM founder and CEO Blaine Tomlinson had built his $13 billion business. Designed to generate consistent annual returns of 5 to 7 percentage points above LIBOR, the strategy’s composition reflected its name: It was invested with nearly 100 hedge fund managers across more than a dozen strategies.
McCabe, who had just been hired as the first CEO of FRM’s 55-person affiliate in New York, was worried that such a broadly diversified fund would hold little appeal for U.S. investors. She interrupted the discussion with a question: “Who would buy that?”
Her new colleagues turned to her with a mixture of shock and bemusement; McCabe realized she had just fulfilled the stereotype of the blunt American. But she pressed on. “I don’t think I can sell a fund like that in the States,” she explained. “I need something more concentrated.”
“Well, how much more concentrated?” Tomlinson asked.
“Indulge me,” she replied. “How about a fund with just ten or 12 managers?”
Their conversation was cut short when Tomlinson had to step out of the meeting to take a phone call. In his absence the group began a brainstorming session about which managers they would choose for such a fund. By the time Tomlinson returned, they had used FRM’s analytics program to create a prototype for a new fund and projected it onto the screen at the front of the room. FRM’s founder was impressed — and a little taken aback.
“It wasn’t like anything we’d ever designed before,” says the 55-year-old derivatives expert. “But I knew when we hired Carrie that we needed someone with a lot of experience in the U.S. who would help define our U.S. strategy.”
In the 15 months since the meeting, the auburn-haired, outspoken 46-year-old from Southern California has done just that. McCabe, who began her career trading Treasuries and mortgage derivatives at Bear, Stearns & Co., has sparked a chemical reaction of cultural opposites, pushing reticient, conservative FRM to support her all-American appetite for risk and creativity. Although the British firm still takes a research-driven, quantitative approach to investing, McCabe has introduced a more consultative, client-centric view of new-product development. Instead of working from the top down and filling in blanks on a product grid, McCabe has encouraged FRM to work collaboratively from the ground up to customize portfolios for clients.
In December, FRM launched a highly focused portfolio of five elite European long-short equity managers for GE Pension Trust and Pepperdine University. That same month, FRM rolled out a slightly more diversified fund with 12 European long-short and relative value managers for DuPont Capital Management, which is using the fund as an exploratory foray into the hedge fund industry on behalf of E.I. du Pont de Nemours and Co.’s pension fund. And in February, FRM won a new mandate for its U.S. diversified fund from the Los Angeles Fire and Police Pension System’s fund.
But the outspoken American intensity with which McCabe has recalibrated FRM’s approach to the U.S. market is still decidedly foreign to the British firm. She has been able to change the business of portfolio design at FRM, but not the culture of the business. Her intimate, client-oriented management style is vastly different from her parent company’s more detached approach. Dramatic as FRM’s recent success has been, Tomlinson has nevertheless just hired a new CEO for the U.S. business, Andy Brindle, a British-born derivatives expert and naturalized U.S. citizen, who has been an adviser to the firm since January. Brindle will oversee hedge fund research, investment management and operations in New York, previously responsibilities of McCabe, who will remain with the firm as president of the U.S. business.
In her new role, McCabe will dedicate her time to working alongside clients and managers to come up with fresh portfolio ideas — in essence, serving as the public face of FRM in the U.S. Her equanimity in light of what might appear to be a demotion is remarkable. “I can deliver the greatest value by being out in the world, not being glued to the office dealing with administration,” says McCabe, who had been logging 100-hour workweeks since she joined FRM. “In addition to my senior management and investment responsibilities, I’ll be free to focus more on clients and managers.”
For FRM, which has 220 employees worldwide and has built its reputation on its broadly diversified multistrategy products, the management shift comes at a critical time. The firm is just starting to gain traction with U.S. investors, who still account for less than 10 percent of its assets. Until recently, the lack of market share in the U.S. was not a major handicap for FRM because so much money was pouring into its funds from Europe and Asia. But increased competition on its own turf now has Tomlinson looking longingly across the Atlantic. Unless his firm can find a way to extend its reach, it will be doomed to remain a regional — albeit powerful — European player.
The challenge of thinking globally and acting locally is not FRM’s alone. The entire fund-of-funds industry is being pushed to adapt and design new strategies as big investors seek less expensive ways to invest in hedge funds.
“We’re really operating in a changed world,” says McCabe. “Sophisticated investors, especially in the U.S., have gained the expertise to perform their own due diligence and make their own decisions. Unless we can prove our relevance by designing client-driven solutions, we risk being left out of the investment process.”
Cost is a big issue for all funds of funds, which typically charge management fees of 1.0 to 1.5 percent and incentive fees of 5 to 10 percent on top of the fees charged by the managers in which they invest. In difficult economic environments the extra layer of fees can swiftly erode the returns of investors, who are increasingly intent on bypassing these middlemen. In addition to designing their own portfolios of direct investments, some institutions are choosing to work with multistrategy shops like Bridgewater Associates, Goldman Sachs Asset Management and D.E. Shaw & Co., which offer investors the freedom to make tactical allocations to different strategies, dial up their exposure to particular foreign markets or asset classes and rebalance their hedge fund portfolios with greater cost efficiency.
The torrent of money rushing into funds of hedge funds has slackened. Although fund-of-funds assets have quadrupled during the past five years, to $415 billion, net inflows have gradually tapered from an all-time high of $103.4 billion in 2002 to just $9.5 billion in 2005, according to Chicago-based Hedge Fund Research. Overall, the $1.2 trillion hedge fund industry picked up $46.9 billion in fresh assets in 2005, giving some indication of the growing popularity of direct investing.
“I don’t think it’s even a question of doing a natural expansion anymore,” says Tanya Styblo Beder, CEO of Tribeca Global Management, which manages about $2.2 billion in multistrategy hedge fund assets for Citigroup Alternative Investments in New York. “There is a race on right now among funds of hedge funds around the world to become the largest, most successful players in this space, because there just isn’t going to be room for everyone.”
FROM THE MOMENT nearly two years ago that McCabe and Tomlinson began discussing the possibility of her joining FRM, the pairing has been a marriage of opposites. Although FRM has long had a successful, quantitatively driven fund development process, the new style of portfolio engineering McCabe has introduced represents a radical departure.
Historically, FRM has excelled at building broadly diversified market-neutral portfolios — “plain-vanilla bond substitutes,” as McCabe irreverently calls them. Today it has four: Absolute Alpha Diversified I, II and III, and Diversified USA. These low-volatility funds, which have little correlation to the movements of traditional securities markets, have held tremendous appeal for pension funds in Europe and Japan looking to supplement and find alternatives for their traditional bond portfolios.
At last count, FRM had about 300 pension funds and other institutions invested across its family of diversified products. The majority of the assets, some 60 percent, come from European investors. An additional 30 percent come from Japanese institutions, thanks to a long-standing relationship with Japan’s Sumitomo Trust Bank, which began investing with FRM in 1999 and bought a 2.5 percent stake in the firm’s management company in October 2005. The U.S. market is the only one FRM has had trouble breaking into, and Tomlinson saw an opportunity when he sat down with McCabe to tap into her close ties with some of the most powerful pension funds on her side of the Atlantic.
McCabe and Tomlinson were drawn together by an almost evangelical conviction that hedge funds, used intelligently, can provide institutional money managers with unrivaled investment flexibility and opportunity.
Tomlinson, who grew up in Cape Town and has an MBA from the University of Cape Town, left South Africa in 1976 because he was concerned that social conditions in the racially segregated country were unlikely to improve. He moved to London with 500 South African rand (about $72) in his wallet and found a job working for Bank of America’s leveraged-leasing group doing structured finance: providing financing for companies looking for high-cost items such as aircraft or industrial plants.
He moved to Citicorp International Bank (now part of Citigroup) in 1983, just as the market for over-the-counter derivatives was beginning to take off, and started structuring and pricing swaps and other derivative products for the bank. He joined the London office of Japanese bank Nomura International in 1985 and began designing innovative new products: One, the “Heaven and Hell” bond, gave the issuer the power to choose the currency — yen or dollars — in which the proceeds were to be paid, so investors would get their principal back in either a strengthening currency (heaven) or a depreciating one (hell).
An ocean away McCabe was making her own name. A native of San Diego, she was one of four daughters and the first person in her immediate family to earn a college degree. “I was the only one of my sisters who went into business,” says McCabe, who completed a two-year analyst training program at Brown Brothers Harriman & Co. in New York after earning a BA in economics from Stanford University in 1981. “The others all went into modeling or fashion.” After getting an MBA in finance from Harvard Business School in 1985, she was recruited by fellow Harvard alum William Michaelcheck, then a member of Bear Stearns’ executive committee, to join that firm’s fixed-income department.
By 1992, McCabe had risen from associate to managing director. Looking for a new challenge, she joined Hong Kong and Shanghai Banking Corp., a subsidiary of HSBC Group Holdings. McCabe worked in its capital markets division in New York, where she came into contact with hedge funds for the first time. Three years later former mentor Michaelcheck launched his own hedge fund, New York–based Mariner Investment Group, and hired McCabe as a principal.
Tomlinson, meanwhile, was also finding his way to hedge funds. In 1987 he left Nomura to launch AIG Financial Products, a new, London-based derivatives team for AIG Financial Products Corp. in the U.S. (a subsidiary of global insurance giant American International Group). The team focused on trading fixed-income, commodity and equity derivatives. Four years after its founding, Tomlinson was overseeing a $3 billion portfolio of assets. His experience at AIG fueled his appetite for complex financial structures — and gave him more entrepreneurial freedom than he had ever had. Although his star was rising fast, he clashed with AIG’s New York leadership over compensation issues and left the firm in 1991.
Tomlinson, then 40, chose not to look for a new job right away; instead, he concentrated on investing his own wealth. At the time, many of the great names in the hedge fund world, like George Soros and James Simons, were still open to new capital. From the outset Tomlinson was attracted by these managers’ ability to capture upside volatility while minimizing downside risk.
“Long-only investing seemed risky and speculative,” says Tomlinson, who relied on his trading experience to understand the managers’ strategies. Data, however, was hard to come by, so he and his wife, Laura, began gathering it on their own and building spreadsheets. In the mid-1990s, Tomlinson had the insight that institutions would become increasingly keen to invest in hedge funds, given their return potential and realized that he was in an ideal position to match prospective investors with managers. The idea for FRM was born. Tomlinson hired four young analysts, who worked in the attic of his Edwardian house near London’s Hampstead Heath, sorting and compiling statistics.
Back in New York, McCabe was about to embark on her next challenge. In October 1996, Blackstone Group partner J. Tomilson Hill tapped her to be chief operating officer of Blackstone Alternative Asset Management, the private equity firm’s fund of hedge funds. BAAM, as it is known, had $500 million in assets under management at the time, most of it the partners’ own money. McCabe was charged with the task of building systems that would enable Blackstone to grow its business and expand its range of products. In 1997, McCabe was overseeing nearly twice as much money as Tomlinson was at FRM. Tomlinson, who registered FRM with the U.K.’s Financial Services Authority that year, had raised $260 million.
Both newly minted hedge fund executives wanted to build businesses that could meet the demands of institutional investors. McCabe coaxed a former Bear Stearns colleague, Halbert Lindquist, out of retirement to help her evaluate BAAM’s portfolios and brainstorm on the development of a centralized data and risk platform. In January 1998, Lindquist was named CIO of BAAM, and McCabe became CEO.
McCabe took a hands-on approach when working with new hedge fund managers at BAAM, which in 1997 invested with the then-obscure Timothy Barakett, at Atticus Capital.
“Carrie is what I would call an investor’s investor,” says Barakett, who had launched Atticus in New York in August 1995. “She is really attuned to looking at the broad context of portfolio management.” Barakett speaks from experience. In 1998, as Russia defaulted on its debt and hedge fund firm Long-Term Capital Management’s implosion rocked the markets, his then-flagship fund, Atticus International, began losing money.
“Carrie called me and asked if she could come in, and we sat down together at our conference table and just talked about the portfolio,” the Atticus chairman and CEO recalls. “She didn’t redeem money and ask questions later; she wanted to know where my head was, how I was looking at risk and whether I was getting rattled by short-term performance. She said she wanted to be supportive, and she really was.”
Atticus has since grown to more than $11 billion in assets, and its core international fund strategy, Atticus Global (into which Barakett merged his original international fund), has had a net average annual return of 26.7 percent since 1996. Its European fund strategy, launched in June 2001, has returned a net average of 28 percent a year since inception. The European fund is now closed to new investment, but when McCabe needed capacity for the customized portfolio that she was building at FRM for GE Pension Trust and Pepperdine, she got it.
During McCabe’s time at BAAM, the group’s fund-of-hedge-fund assets more than doubled, to $1.2 billion. Emboldened by her success and frustrated with Blackstone’s absolute ownership and control, McCabe decided she wanted to run her own business and resigned from the firm in February 2000. Hill took over as CEO of BAAM, which now has $12 billion in assets under management.
McCabe set up her own advisory firm, McCabe Advisors, and continued to assist large investors on their portfolios; they included the California Public Employees’ Retirement System, GE Pension Trust and Newport Beach, California–based fund-of-funds firm Pacific Alternative Asset Management Co. McCabe’s long-standing relationships with these major investors eventually inspired her to consider launching her own fund-of-hedge-funds firm.
One afternoon in the fall of 2004, she met Tomlinson at FRM’s offices in New York to discuss her search for investment staff. At the time, Tomlinson was looking for a chief executive to lead FRM’s U.S. effort. As the two talked, McCabe says, the idea of working together caught them both by surprise. “Once we started that conversation, it just got stronger and stronger,” says Tomlinson, who persuaded McCabe to abandon the idea of opening her own firm and instead join FRM as CEO of its New York operation. “In the back of my mind, I always felt that we should try to develop the U.S. market, and I knew we needed someone like Carrie to help us do it if we were going to have any success at all.”
FRM’S SUCCESS IN Europe and Japan has been built on the strength of its database and analytical programs. From the outset Tomlinson was intent on building a transparent institutional-grade platform that would allow his investors to delve into managers’ performance histories and investment processes. FRM’s quantitative screens are designed to assess the relative importance of security selection, sector and market exposure and risk management to a given manager’s investment returns. The goal: to determine whether that performance is repeatable (see box).
FRM’s core diversified funds account for $10 billion of its $13 billion in assets. In the 1990s, when Tomlinson developed the funds, their largely market-neutral approach owed a great deal to his understanding of the needs of pension fund clients in Europe and Japan.
“Our Japanese clients were really receptive to the idea of liability-focused investing,” Tomlinson says. “And their particular need in those days was to have a bond replacement, so from a portfolio perspective, the diversified funds were ideal for them.”
The challenge for FRM now is to adapt to investors who have vastly different needs — and more interest in equitylike risk. FRM already has about $2 billion invested in slightly more aggressive multistrategy funds; thanks in part to McCabe’s influence, it now has $1 billion in more-opportunistic single-sector funds, including $100 million in its new, highly concentrated European long-short equity fund.
In recent months Tomlinson has been on a tear hiring senior talent. In November 2005 he signed Paul Dunning as the new CEO of FRM’s London business. Dunning, who helped launch the alternative asset management products business at Safra Republic Investments, which was acquired by HSBC Group in 2000, oversees business development and investment management, taking up some of the duties once covered by Luke Ellis, the former global head of manager research in London. (Ellis now works part-time for FRM from his home, although he remains a voting member of the investment and portfolio management committees.)
Dunning, whose résumé includes a stint as chief operating officer for Goldman Sachs Asset Management International in London, brings considerable management expertise to his new role at FRM, and some much-needed marketing savvy.
“Manager research and portfolio engineering are really where our strengths lie,” Dunning says. “I’m here to keep a well-oiled machine running smoothly and help build out the global business. FRM has done a good job of raising assets, but I’m sure we could be more client-friendly — this applies to distributors in particular, but also to our mainstream institutional business, where there is always scope for improvement.”
In July, Tomlinson signed Brindle, a member of FRM’s investment advisory board, to take over the role of CEO from McCabe in New York. Tomlinson says he wasn’t actually looking for a new CEO; Brindle approached him for a full-time job because he was intrigued by the business, and Tomlinson made space for him. Brindle knew some of FRM’s executives in London, having worked for Ellis at J.P. Morgan in the 1990s when the latter was global head of equity derivatives. Brindle spent most of his career, from 1987 through 2005 at the bank, where he rose from associate on the swaps trading desk to global head of credit derivatives in New York.
Currently just 40, Brindle left J.P. Morgan in 2005 to spend time “recuperating from finance,” he says, and served as an adviser to MarketAxess, an electronic fixed-income and credit trading platform, as well as to FRM. Now that he has been named CEO of FRM in New York, he seems appreciative that McCabe will continue to share some of the executive duties. Both will report directly to Tomlinson in London.
“All of my background really is on the trading and risk management side and on product and business development,” Brindle says. “I’m not first and foremost a marketer and a client-oriented person, so it is relieving and refreshing to have someone as my partner who is totally skilled in that area. It gives me more time to spend on the investment process and to look after the office in general. It’s a natural division of labor.”
FRM could not reasonably undertake its new expansion effort without John Beech, its global chief investment officer, and Marc Blieden, who runs the firm’s business risk group: a team of eight lawyers and accountants. Tomlinson hired Blieden away from Cantor Fitzgerald in 2000, about six months after FRM was ensnared in its first — and to date, only — instance of hedge fund fraud. In 1999, FRM’s investment analysts failed to notice that manager Michael Berger, founder of Manhattan Capital Management in New York, had created a fictitious prime broker for his hedge fund.
The lesson was not lost on FRM. Blieden’s team now conducts its own operational due diligence on prospective hedge fund managers. Blieden, who is a member of the investment committee, has the power to single-handedly veto any decision by the group based on his team’s review of a prospective manager’s business, irrespective of his or her investing skill.
The recent shift to a more client-focused approach at FRM has also led to the creation of the business development group, which has drawn its inspiration from Blieden’s team to focus on product development, feasibility testing and implementation. Andrew Stewart, an American lawyer who held joint operational and legal duties in London, moved over to New York about a year ago to lead the effort.
“I think we’ve done two years of work in one,” Stewart says with a laugh. “We’ve pulled together people from all parts of the business — research, portfolio management, finance, marketing, legal, compliance, operations, you name it — and worked closely with them to analyze these new projects from every angle to make sure they work.”
ON THE FAR SIDE of Blaine Tomlinson’s London office is an unusual glass-topped conference table. At its core, on a lower, oval-shaped shelf, is a hand-carved wooden hippopotamus from Africa that stands about six inches high. A smaller hippo sits on a coffee table near Tomlinson’s desk, and above his chair is a framed poster of an enormous, reclining hippo’s posterior, with a plaque underneath that reads, “Le Grand Fromage.”
Hippos, Tomlinson explains with a wry smile, are not as sluggish as they seem. The gigantic quadrupeds, distantly related to wild pigs, are surprisingly fast and aggressive. They’ve been known, he says, to attack and kill their victims with remarkable speed by biting them nearly in half. As a totemic animal, the wily hippo seems a perfect metaphor for FRM: The investment firm may appear at first glance to be resting complacently on its assets, but it can become lethal once it decides to move.
And FRM is now moving with alacrity to reposition itself in the market, starting with the European long-short equity fund that McCabe and the portfolio team designed for GE Pension Trust and Pepperdine University last year. Although it constitutes only a fraction of FRM’s assets, winning a new mandate from GE was no small coup: Typically, the $51 billion fund doesn’t choose to work with funds of hedge funds at all. More than 90 percent of its assets are overseen and managed internally, says Donald Torey, chief investment officer for alternative investments at powerhouse GE Asset Management, which manages GE Pension Trust.
But Torey and his team have been keen to diversify into Europe and are confident in McCabe’s ability to show them the way. “We’ve known Carrie since her days at Blackstone,” says Torey. “And we were in discussions with her about trying to access European managers who fit our profile and style even before she joined FRM.”
Drawing on FRM’s database and analytical tools as well as on her own strong relationships with managers — including Barakett of Atticus — McCabe was able to offer a portfolio that looks and acts like a direct investment. FRM’s European fund began by investing with just five individual managers across six of their funds: Atticus, the Children’s Investment fund, Gradient Capital Partners, Marshall Wace Asset Management and New Star Asset Management. (It has since added a sixth, Cantillon Capital Management, for GE Pension Trust.) The largest allocation to a manager from FRM’s fund is nearly 25 percent in the Gradient Europe fund; the smallest, about 8 percent in the New Star Hedge Fund.
Unlike its core diversified funds, which charge a 1.1 percent management fee in the U.S. (elsewhere it is 1.25 percent) and a 10 percent incentive fee, FRM’s European fund charges a maximum management fee of 0.85 percent and a maximum incentive fee of 8.5 percent above its hurdle, the three-month return on Treasury bills. For investors willing to put $250 million into the fund, the management fee drops to 0.70 percent and the incentive fee to 7 percent.
FRM’s new fund is unusually focused, says Richard Leibovitch, senior investment partner and head of North American business for Switzerland-based fund-of-funds firm Gottex Fund Management. “We’ve recently launched a concentrated fund with 15 managers, and that was a first for us,” adds Leibovitch, whose firm manages $5 billion. “Most concentrated funds still typically have between 15 and 20 managers in a given portfolio.”
From its December 2005 launch through June, FRM’s new European fund delivered a net return of 21.0 percent, despite considerable turbulence in European equities. The MSCI Europe index (hedged to U.S. dollars) rose just 7.9 percent in the same period.
“We don’t even really think about it as a fund-of-hedge-funds product,” says David Wiederecht, co-head of hedge fund investments for GE Pension Trust. “It’s a tailored program designed to give us tactical exposure to European long-short equity managers.”
Despite its customized design, FRM’s European fund is not a managed account; it’s a commingled fund with a Eurodollar share class for GE’s pension fund and a U.S. dollar share class for Pepperdine. Pepperdine’s treasurer, Clariza Mullins, also has known McCabe since the latter’s Blackstone days, when Pepperdine made its first fund-of-hedge-funds investment. Unlike GE Pension Trust, which made an allocation to the new FRM fund from its hedge fund portfolio, Pepperdine’s allocation from its endowment’s international equities portfolio.
“We knew what Carrie would bring to this project,” Mullins says. “While we were newly introduced to FRM, we realized that the firm had existing, long-term relationships with managers in Europe, and that was of real value to us. There is no way we could have replicated this fund on our own.”
As McCabe redirects FRM’s resources to product innovation, there is a danger that its team will be stretched too thin. “If you have 100 portfolios to manage, it’s not the same as having ten,” says London CEO Dunning, sounding a note of caution. “You’ve got to achieve the right numbers for each client with differing objectives and underlying funds. Those issues are manageable, but they are definitely issues.”
Perhaps Tomlinson’s aim in dividing the duties of the U.S. CEO job was to streamline the process of managing FRM’s bevy of new portfolios, which will certainly challenge the investment team in the months ahead. Tomlinson’s decision to hire Brindle — like him, a derivatives expert who spent half of his life in the U.K. — could turn the cultural divide at FRM into an outright clash. One thing it has dispelled is any doubt about who holds the ultimate power to decide the fate and future of the firm.
Regardless of what happens to McCabe, the greatest risk FRM faces is that the firm loses sight of the collaborative, client-centric approach she has fought so hard to implement during the past year. The fact remains that FRM needs someone like McCabe to lead the way into the U.S. market — and McCabe needs FRM’s infrastructure to be able to deliver the labor-intensive niche products that sophisticated U.S. investors want to buy. The partnership could give Tomlinson his greatest opportunity yet to realize his ambition of creating a truly global firm, but only if his fund of hedge funds is able to adapt and fully integrate an unfamiliar — decidedly American — style of business development.
