Can large institutional fund managers also run successful hedge fund businesses? The traditional hedge fund manager is small, nimble and independent, not to mention better paid. Nicholas Chalmers, associate director of Schroder Investment Management's alternative investment group in Hong Kong, explains how the firm handles these issues.

FinanceAsia: When did Schroders get involved in selling hedge funds?

Nicholas Chalmers: We've looked at the hedge fund market for a long time. We finally got in because the firm had sold the Schroders investment bank to Salomon Smith Barney in 2000, we came into a bit of money and were able to review the business for product gaps. As a result we set up an alternative investment group including structured capital, real estate, private equity products, as well as hedge funds.

We had not done any of this before because we are an institutional house, 85% of our assets are from institutions. We saw no point in hedge funds until we felt the industry was big enough and institutions had enough appetite to get involved. Schroders is not a broker just pumping product.

But how does a huge institutional house ædo' hedge funds?

We are conscious of the debate on whether firms like ours stifle the entrepreneurial environment necessary for the hedge fund business. We decided to set up two separate parts of the hedge fund business: one for a fund of funds and another for single-strategy funds. For the single strategies we wanted a platform to base them on providing a risk management capability and operational, fund raising, marketing capabilities, all of which we already had.

Next, we had to attract talent: both our own high-quality fund managers who otherwise might leave to run their own fund, as well as external talent. We now have two products single-strategy products. One is a global emerging markets long/short fund run by Heather Crighton, our head of Asia and co-head emerging markets long-only business in London, which began in September 2000. And in New York we have a distressed debt fund sub-advised exclusively for Schroders by two former executives at our old investment bank who run a company called Credit Renaissance Partners.

How do you handle compensation?

Heather's deferred bonus is in the fund; she is obliged to reinvest part of her percentage of the carry in the fund, so as to keep an alignment of her interest in the fund managers.

What about the fund of funds part?

Let me say first that having the single-strategy approach lets us understand the business risk, not just the investment risk, of these products. So it makes us a more capable selector of for our fund of funds.

We have two fund of hedge funds. One is a multi-strategy and the other a global long/short fund of funds, both of which began in October 2000. So we are coming up on our two-year track record. We haven't made real money in hedge fund terms but we have protected the capital: they are up 6% and volatility has been kept down to 1.6%, which is competitive with other fund of funds.

Do you rely on indices of hedge fund performance to determine how competitive you are?

Hedge fund indices are imperfect. Our real benchmark is cash. Right now we are slightly short for an absolute return vehicle, with cash at 4%-5%, not the usual 6%-9%.

How big is this hedge fund business of yours?

The total assets under management are about $500 million, with about half in single strategies and half in the funds of funds. The reality is the fund of funds is the mainstream product, but institutions want a three-year track record and other data before they invest. Frankly you can get that level of information elsewhere because we're not quite two years old. Customers can afford to wait. But they cannot afford to wait to participate in single strategies, and we can get this product out the door. Over time, I expect the funds of funds will comprise 70% of our hedge fund assets.

What kind of clients do you have in your hedge fund business?

Again we expect the prospective investor base to be 70% institutional and 30% high net worth, but currently it is the reverse. It is easy to explain a single strategy to high-net worth people. Institutions decide more slowly, they need approval from the board of directors and so on, but when they come in, they do so in bigger amounts.

Who are your main competitors - other institutional players such as yourself, or established boutiques?

I'd say it's both. We feel competition from other traditional asset management houses like Merrill Lynch, Deutsche Bank and Goldman Sachs. We are finding success in places such as Japan where clients like to invest in a brand. But the fiercer end of the competition is definitely against the likes of Ivy or Qwest, boutique funds of funds in the United States that have been doing this for 10 years. For our single strategy funds, we really just compete against the boutiques, some of which in the US have grown to billions of dollars under management. A lot of the traditional investment houses don't have these yet.

How do you compete against these boutiques?

You compete on performance. And some clients take comfort that we are institutional in nature. Investors looking at business risk see ours is low. We have independent risk management that is not just at the hedge fund level. Others of course will say hedge funds are no business for traditional institutional managers.

How much of your current assets are sourced from this region?

We gain 25% of our assets from Asia, currently from Hong Kong and Japan. I'm responsible for Asia Pacific. Japan is the opportunity: pension funds there need absolute returns, and they have the money. We have direct relationships with clients because of our pension business as well as through third-party banks used for our retail business.

In Hong Kong, institutions are not keen on hedge funds yet. The Jockey Club is an exception. Here it is still a high-net worth game, and this retail market likes structured products such as guaranteed mutual funds, not standalone hedge funds. We sell here through our own private bank network, and are also looking to distribute through third-party private banks.

What is the hardest part about marketing your alternative investment services?

It's getting people over the hedge-fund hump, conceptually. We don't want an unstable pool of capital; we've turned away money because the client didn't understand what we are doing. The Hong Kong regulators have helped to raise the profile of hedge funds, but hype doesn't necessarily mean understanding.

Do you find consultants helpful?

Consultants in Hong Kong, Singapore and Australia drive growth among pension plan allocations, but consultants only look at funds of funds. The economics of them to analyze 6,000 hedge funds for a 5% allocation of a client's portfolio makes no sense. But Japanese investors have been allocating to hedge funds before consultants even considered it an asset class. You don't lead in to clients directly via consultants. And Frank Russell has its own fund of hedge funds, which is a conflict of interest.

Why would hedge funds want to be part of your fund of funds rather than an established boutique's fund of funds?

Hedge funds employ us as gatekeeper to reach institutions and diversify out of relying solely on high-net worth clients, which they can access using, say, a Swiss private bank. These may not always be the best funds but they are established.