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Launched in February 2010, the Melchior Selected Trust European Absolute Return Fund has achieved 10.94% net cumulative performance since inception. It is designed to achieve absolute returns of between 8%-10% a year irrespective of market conditions.

Leonard Charlton, the fund manager, is an obsessive observer of the movements of share prices in the portfolio. Investment positions are traded actively to benefit from shorter-term stock price action and to reduce risk although the fund maintains a low net exposure to equity markets and seldom employs leverage.

The fund takes long and short positions in listed European equities, primarily in large cap and liquid companies. The investment process combines a disciplined, fundamental approach with an active trading overlay.

This investment process is the result of an investment philosophy which encompasses a belief in flexibility, both in terms of investment approach as well as allocation by market cap, country and sector. A wariness of consensus opinions, coupled with a respect for the market is also prevalent, along with conservatism and a belief in using leverage judiciously.

The investment team believes the character of markets is variable and a flexible investment strategy is vital to achieve positive returns in all market conditions.

Consequently, the team looks to distinguish between a benign environment which is likely to reward fundamental analysis or a volatile market in which a trading style is more appropriate. In practice this almost always means a combination of the income statement and balance sheet. The belief is that that earnings are the key drivers of approaches.

The manager undertakes rigorous quantitative analysis of stocks but the balance sheet strength, cashflow generation, asset value and book value are equally important factors for valuation. Scrutiny of the balance sheet is particularly critical in the current environment. Companies with moderate gearing, strong interest cover and limited refinancing risk deserve a significant premium and are likely to outperform.

The fund does not have a bias to growth or value. It also does not have a particular market size. Typically the portfolio favours stocks with strong end markets, attractive earnings multiples and sound balance sheets. The fund manager typically avoids or looks to short stocks on rich earnings multiples and/or with stretched balance sheets.

The selection process involves a vigorous screen which is used to identify stocks with properties such as a positive inflection point, positive earnings momentum, an acceleration in sales growth, an improvement in margins, a turn from loss to profit, a deterioration in operating performance, negative earnings momentum, deceleration in growth, high gearing or other significant deviations from historical valuation multiples

Stocks are typically screened once a fortnight. The company also runs new screens on an ad hoc basis, for example, a trough valuation screen. An example of such a screen is a European stock with a market cap above €350 million ($493.9 million) and positive earnings with an EV/sales multiple less than 10% below previous 10-year trough multiple.

There is also a great deal of qualitative analysis. The fund invests only in stocks that it understands. It typically avoids stocks that are opaque.

The constant focus on time-adjusted return on capital means that if a stock delivers a large part of the expected return within a short period of time, the fund will look to adjust the position size accordingly or even exit the position altogether.

Sector limits are also imposed as part of the risk management process. There is a sectoral limit of 25% of the portfolio and options are used to give asymmetric pay-offs.

The portfolio is also limited to a maximum daily value at risk (VaR of 3%, a maximum gross exposure of 200%, expected gross exposure 80%-130%, and a maximum net exposure +/-20% (beta adjusted).

This Ucits structure focuses on achieving low volatility returns without using leverage or net exposure (+/-20%) through a fundamental approach to stock selection, with an active trading overlay which reduces volatility and enhances alpha generation of underlying positions.

Fund facts
Full name of fund: Melchior Selected Trust: European Absolute Return Fund
Name of portfolio manager: Leonard Charlton
Name of investment/management company: Dalton Strategic Partnership
Contact information: JJ Jardine-Paterson, 3rd Floor Princes Court, 7 Princes Street, London EC2R 8AQ (+44 (0)20 7367 5474; james.jardinepaterson@daltonsp.com)
Launch date: February 2, 2010
Assets under management: $335 million (at March 31, 2011)
Net cumulative performance since inception: +10.94% (February 2, 2010 to April 30, 2011)
Annualised return: 8.70% (since inception)
Annualised volatility: 4.07% (February 2 to December 31, 2010); 4.08% (February 2, 2010 to April 30, 2011)
Sharpe ratio: >2
Strategy: European equity long/short
Share classes: sterling, euro, US dollar (retail and institutional share classes available for all)
Administrator: Banque Privée Edmund de Rothschild Europe (Luxembourg)
Auditor: Ernst & Young (London)
Custodian: Banque Privée Edmund de Rothschild Europe (Luxembourg)
Prime broker: Goldman Sachs International (London)
Legal counsel: Simmons & Simmons (London)
Domicile: Luxembourg Sicav (Ucits III)
Management fee: 1.5% (institutional), 2% (retail)
Performance fee: 20% (with high water mark and 1m Euribor hurdle)
Minimum investment: $250,000 (institutional), $10,000 (retail)
Lock-in: none
Redemption/liquidity terms: daily liquidity (portfolio can liquidate approximately 80% in five trading days)