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Complex H2O funds put under spotlight

H2O Asset Management's stable of bond funds have posted stellar returns, but now they are under scrutiny as Morningstar places Allegro's rating under review.

Following the announcement by Morningstar last Wednesday, the €2.26bn ($2.98bn) Allegro Fund immediately plunged $128m in value, and more than €1.4bn of investor money was withdrawn from six H2O funds, including Allegro, according to the Financial Times.

Morningstar’s decision followed a report by the Financial Times that showed that the Natixis-backed H2O appeared to hold €1.4bn in bonds issued by financial vehicles linked to controversial German financier Lars Windhorst  across six of its funds – Adagio, Allegro, Moderato, Multibonds, Multistrategies and Vivace.

The research and rating company expressed concerns about “the appropriateness and liquidity” of some of the fund’s corporate bond holdings linked to Windhorst, who has faced the insolvency of two companies, personal bankruptcy and a suspended jail sentence.

Two H20 funds – the Allegro and Multibonds – are available for distribution to accredited individual investors via private banks in Singapore.

The Allegro fund, which allows its investors to make daily withdrawals, had a 7.35% portfolio weighting to corporate bonds, of which 4.19% comprised “highly illiquid bond issues by several business ventures linked to [Windhorst],” wrote Mara Dobrescu, Morningstar associate director of fixed income strategies, in the statement.

Dobrescu also noted that H2O founder Bruno Crastes’s appointment to the advisory board of Windhorst’s investment vehicle Tennor Holding raised “the appearance of a possible conflict of interest”.

Crastes has subsequently resigned from his position on Tennor’s board, and he also issued a rebuttal of the issues raised by the news reports and by Morningstar.

He emphasised the “marginal” exposure to the Windhorst-linked bonds within the funds’ global macro sovereign and currency-based strategy, the quality of some of the bond issuers, their portfolio diversification benefits, their prudent valuation policy – and also pointed out that “H2O’s positions are mostly financed through futures contracts and currency forwards, which makes a lot of cash available in the funds”.

For instance, cash and money market placements comprise 56% in H2O Adagio, according to Crastes’s statement. This is confirmed by the fund’s latest factsheet, and the top performing Multibonds fund also has high levels of cash.

In contrast, the Allegro fund seems to have only 5% of its assets in cash.

Balance sheet allocations of H2O Adagio, Allegro and Multibonds Funds

Source: H2O Adagio Factsheet, May 2019


Source: H2O Allegro Factsheet, May 2019
Source: H2O Multibonds Factsheet, May 2019

High risk/returns

It seems likely that the successful use of derivatives and leverage is the main reason for the strong performances of the Multibonds and Allegro funds during the past three years (and longer), rather than single-digit weightings to illiquid corporate bonds connected to a dodgy financier.

As Luke Ng, vice president of FE Advisory told FSA in April: “It [the Multibonds fund] is not run like a traditional global fixed income fund. The key attribute is currency exposure, which has risk and nature very different from fixed income funds.

“It can also invest in the full spectrum of fixed income and use leverage-like techniques to get more than 100% exposure to an instrument. It is more like a hedge fund.”

The Allegro and Multibonds funds have certainly posted outsized returns – unlike the Adagio fund, which seems to behave much more like a conventional bond fund – but their three-year annualised volatilities of 17.30% and 16.34%, might be a little stomach-churning for a typical bond investor comfortable with the steady returns of a normal global fixed income fund (3.38% volatility), according to FE Analytics data.

It is unlikely that investors will be any the wiser about the funds’ investment strategies and techniques by examining their factsheets.

The fund managers have a complex strategy, not easily understood by most investors. According to the most recent Morningstar report on the Allegro fund, the managers can “use derivatives actively on top of cash bonds, and can move duration between 8 and negative eight years”, and “have a leverage limit of 500% of assets”.

The fund takes “high-conviction bets”,  which have included allocating 36% of its cash assets in Mexican peso bonds for a few months in 2018, and the year to end-July 2018,  “currencies (where the managers use plenty of leverage) contributed 21.3% of the fund’s 28% gross return”, according to Morningstar.

Illiquid concerns

The reaction to H2O comes against a backdrop of concerns about Neil Woodford’s holdings of illiquid securities in several of his mutual funds and in the wake of allegations about illiquid investments –  also linked to a controversial businessman – made by GAM’s Absolute Return fund.

Inevitably, commentators are focusing on the relatively small amount of Windhorst-linked corporate bonds held by the H20 funds.

Perhaps more troubling are the complexity and opacity of the funds’ wider strategies, which are surely beyond the understanding of all but the most sophisticated, professional investor. There are few clues in the published material, and the managers have been shy about enlightening outsiders, including declining two requests for an interview with FSA earlier this year.

H2O Adagio, Allegro and Multibonds Funds’ performance vs global fixed income average

Source: FE Analytics. Three-year returns in US dollars.

Part of the Mark Allen Group.