Hedge Funds Q&A: Karl Rogers, Elkstone Private

Elkstone Private is Ireland’s largest private investment Office, and CIO Karl Rogers recently celebrated 15 months in the role. AlphaWeek’s Greg Winterton spoke to Rogers to learn more about his views on the hedge fund space and how Elkstone sees its applicability for its clients.

GW: Karl, when you first joined Elkstone, the world was emerging from the Covid-19 pandemic, and the world seemed like it was getting back on its feet. But it’s a very different world now. Tell us more about the questions that Elkstone’s clients are posing to you, their concerns – and what you’re telling them.

KR: Yes, it’s certainly been a volatile couple of years with a lot of headline news. The concerns moved quite quickly from covid concerns back to a more ‘normal’ investment picture primarily placed around ESG issues before 2022 hit. Now, questions have moved to the outlook around the macro environment due to inflation, equity and bonds dropping together, and consequently, when to get involved.

We came into 2022 quite well positioned already being underweight in equities and barely exposed to any bonds. Questions more recently have been around when to start increasing weightings in both areas. Our investment committee is looking hard at tactical allocations given the 25% drop in equity markets and interest rates being back on the rise.

Investors currently find themselves at the difficult psychological juncture where at the end of 2021, some said, ‘I’m not buying because valuations are too high’, while now in 2022, people are saying, ‘I’m not buying because prices are dropping’. No-one will time the market perfectly, but with a medium-long term view that HNWIs have, we are starting to see some buying now as we are getting a discount and we will continue to buy on the way down while we move closer to a longer-term equity weighting as we don’t believe that we are at the bottom yet. The market should be witnessing both a valuation compression as well as an earnings compression – I wouldn’t be surprised if there’s still more pain to come in the equity markets.

GW: Your views on the hedge fund space are quite strong. As an allocator, tell us some of the strategies that just don’t pass the test at Elkstone – and why.

KR: I think the best way to answer that question is to provide insight into how we view hedge funds or our hedge fund philosophy. In no particular order, we 1) view hedge funds as a role within an overall portfolio as opposed to an absolute holding or an island within an investment portfolio; 2) hedge funds are a structure and not a strategy - the hedge fund structure can access strategies, markets and managers that the rest of the portfolio can’t reach, which is what we concentrate on for this portfolio allocation, and 3) each hedge fund holding’s goal is to provide diversification and therefore alpha to a core portfolio which tends to be equities and debt or lending.

With that anchoring viewpoint in mind, we tend to overlook the major hedge fund strategies like equity long/short and global macro. This is because we believe that there is a mismatch in these strategies to our philosophy for this part of our portfolio. As we view hedge funds within our overall portfolio, we already have significant equity and traditional market exposure, and for cheaper, and we believe that hedge fund allocations should provide diversification. Diversification from a core portfolio is very difficult to achieve when you are running significant AUM within those markets you are trying to be uncorrelated to. As we are trying to be uncorrelated to our core portfolio, we try to utilise the hedge fund structure to get access to markets and strategies that we believe are fundamentally unrelated to the core portfolio – this is not the case with the major hedge fund strategies we tend to read about across investment media.

GW: What about the ones that do? What strategies and exposures do you like, and why?

KR: We try to concentrate our hedge fund portfolio into managers that either operate in inefficient, non-traditional markets or strategies that isolate their returns on market structural inefficiencies. As an example of each, an inefficient non-traditional market that fits the bill is electricity. This is a market I used to personally trade and so am very comfortable speaking to the inefficiencies that exist, and the fact that when you are trading electricity, what equities or interest rates are doing have no effect on your trading P&L. An example of a structural inefficiency would be copper arbitrage. Due to the physical nature of the metals markets, there can be pricing discrepancies at a geographical level which traders can take advantage of. Importantly for our hedge fund philosophy, traders can isolate their returns on just the structural inefficiency and not the general copper price. This is important as the trade setup of the manager is important when it comes to isolating returns on the inefficiency versus capturing general market exposure which can be done for much cheaper.  

GW: You’re a special advisor to The ESG Foundation. In investing terms, what’s your view of the intersection of hedge funds and ESG? Do you feel that the industry can and should do better, or do you sympathise with those who say that there isn’t enough reliable data, and the data that does exist is too conflicting?

KR: We are already seeing regulators effectively making the ‘the data quality isn’t good enough’ argument null and void. When it comes to hedge funds and ESG, I think they are mismatched. My personal belief is that across the liquid investment universe, we will see ETF and UCITS structures running essentially an ESG sector investment for those with that mandate. I don’t think we will see active liquid managers continue to gather assets with a goal of beating the benchmarks purely down to an ESG tilt.

I mentioned earlier that hedge funds are just a structure. All else being equal, we prefer to use private credit, private equity and venture to provide us access to technology and companies that we believe will bring a true impact and that meets that ESG and sustainable mandate.

Our hedge fund allocation doesn’t have an ESG mandate for that reason.

GW: Lastly, Karl, Elkstone also has initiatives in venture capital and real estate. What’s your overall approach to allocating to ‘alternative investments’ in client portfolios? Do you use some of the same screens as you do in the hedge fund space, or do they differ, and why?

KR: We believe alternative investments are extremely important within portfolios and we are comfortable at high weightings towards them. When it comes down to the interesting question of using the same screens we use in hedge funds for venture and real estate, it’s important to draw out an even more important screening nuance – one of analysing a direct investment versus an allocation to an external manager.

Let’s take our venture activities as an example. We are very active early-stage venture investors with a direct portfolio of 46+ companies where we carry out the sourcing, due diligence, and execution, and provide ongoing strategic help to the company. We also round out the direct, early-stage, Irish exposure from that portfolio with investments into external venture funds. Analysing a portfolio company is very different than analysing a team of people that does the portfolio company analysis and execution. It’s similar on the real estate side as we do the sourcing, analysis, funding and execution of projects internally. This is a different proposition to investing into an external real estate manager which requires a different skillset. Another nuance is analysing an open-ended fund with daily of monthly data points with closed-end funds with quarterly, semi-annual or annual data points.

Even though the analysis of venture, real estate and hedge funds are all quite different with different skillsets required, what does run throughout our portfolio is the investment philosophy for what we are looking for in that component of the portfolio; namely, that each investment is part of an overall portfolio and not its own island and that we must look through the name of the structure in order to determine where it fits, whether that be the hedge fund allocation, real estate, venture, public equity markets, commodities, and so on.

Karl Rogers is Chief Investment Officer at Elkstone Private