Permal, a stand-alone business in the Legg Mason group, is a fund of hedge funds with $20 billion in assets under management. Chairman Isaac Souede spoke to AsianInvestor while he was on a recent visit to Hong Kong.

How do you feel about managers who preserved capital in 2008, but then, having witnessed the advantages of being cautious, didn't switch to having a long bias at the right time last year, so didn't do very well in 2009?
The test of fire is to look across both years. We had a European manager that in 2008 was down 3%, which was an incredibly good performance. He was up 4% in 2009, so he was left basically flat. He didn't play the transition well -- point noted -- but in 2008 the European indices were down 40% and last year they were up about 30%. So the compound for the indices was down 22% and the manager was flat. So he receives his dues.

We had a US long/short manager who was down 30% in 2008 -- he didn't adjust his net exposure, so shame on him. In 2009, if he'd been up 10%, we would have been out of that position, but he was up 40%. So he survived. [There were] managers who were down 20-30% in 2008 and then did nothing in 2009 -- that often means they turned bearish at the bottom. That's no good; they'll find it very hard to raise new capital and should probably be looking for a new profession.

It's a two-year test. You cannot forget about 2008 if you want us to hire you as a manager.

In China it's all about timing, because of the imperfect hedging tools [available]. Now you have macro-economic storms that could cause price-earnings contractions. You might want to think about being taken out of that market, because there's a good chance you might see those 2009 lows of 2400 on the Shanghai index once again. We've already seen that managers can't protect capital adequately. China won't survive an American double-dip recession, because we will go to protectionism. 

China has no respect for the euro. For China, diversification is not leaving the dollar and going to the euro; they leave the dollar and buy natural resources. China has complete disdain for Europe, seeing it as just a collection of countries with different interests. When Europeans come to visit, they give them a few billion dollars of contracts, pat them on the back and send them home.

How did you navigate the crisis?
We held our own and perhaps did a little better than that. There was a test by fire, when the system nearly broke. The strongest have survived, and performance was strong in 2009, as anticipated, though some did not believe it would occur.

The industry is more institutional than it has ever been. That process of institutionalisation will continue in terms of liquidity, transparency and manager mindset. Overall, the storm has passed. There are still things left to clean up, such as managers who have gated and suspended.

Managers are thinking about how they want to run their business going forward; whether they want to stay boutique-sized or upscale themselves because of the regulation being applied to the industry.

What lessons have been learned?
Let's remember that with all these things, it will never happen the same way again. For Permal, there were some 'reinforcing' lessons, such as staying with deeply liquid strategies, as opposed to illiquid strategies. To paraphrase Mark Twain, it's not the return on my money that counts, it's the return of my money. So I think enhanced liquidity in what we do is important.

We acted by having more separate relationships with managers. I don't want to call them 'managed accounts' as it is really a separate fund that only we can access. It could be a multiple of Permal funds using that manager, though.

What drove Permal's move towards that style of manager relationship?
About five or six years ago, I could see there were advantages in making this effort, given the better liquidity and transparency and also the ability to negotiate fees. A manager would ordinarily say 'I have to treat all my investors the same way', but by having a separate arrangement, we can point out that it is now a bilateral arrangement.

Also, product engineering applies, in that I can, for example, ask a manager to adopt a more concentrated portfolio or, for a systematic macro manager, ask him to drop a couple of the modules he trades with. For a gold manager, you might ask him to concentrate on relative value between bullion and stocks. If you do that right, you can add value. Pre-crisis, we had this arrangement with 13 out of the 190 managers we used -- now we are up to 53 managers. We used the crisis to scale this programme up with the help of our parent, Legg Mason.

Will funds of funds start to look more at performance now rather than protections?
A good fund of funds should have been looking for performance all along. Our multi-manager funds were up 16% on average last year, while the fund-of-funds index was in single digits.

I am most proud of our macro allocations. Back in early 2009, we believed discretionary macro managers looked better suited to the uncertain environment than the systematic managers, so we skewed our allocation more towards them in the early part of the year, even though systematic had had such a good 2008.

As it turned out, this was a good move, and the discretionary managers did well, which included some Singapore-based macro managers that we use. They got gold right on the long side; they were short dollar and played a steepening of the US yield curve. Many also made money playing equity indices on the long side in the spring.