Wednesday, 30 December 2009

Chart of the Week – Bond Mutual Fund Flows

I often write about the US stock market for a number of reasons. I have been a professional investor investing in that market. The US market is the largest and most developed in the world. The US stock market usually sets the tone and the pace for other markets – correlations are very high between other equity markets and the US equity market. The expression "if New York sneezes London catches a cold" is a truism that could be applied to most markets. Since the globalisation of US portfolio flows first by Capital International and Fidelity and then by US hedge funds the sectoral out and under -performance within stock markets have become global phenomena. Plus the ready availability of data and a long history of data collection and analysis allow investors to use tools based on American market phenomena that should work elsewhere, but if not the market-level call will still prevail. So looking at and analysing the American stockmarket is looking at the world of equities on a week-to-week or month-to-month basis.

I often have a "fact of the week" and "chart of the week". This week's chart is below and comes courtesy of Citigroup's research. It shows US mutual fund flows over the last five years.

This year the stock market has been about bear psychology in the first quarter, and since then about liquidity. I believe in Marshallian K, so to me the rally was mostly explicable by the enormous money creation and liquidity creation we saw in the last 18 months being channelled into financial assets because the real economy could only use it up with a lag. The US economy has started to grow, so towards the end of the year the rate of gain in stocks tailed off, as the real economy started to use the money that was created a year ago.

So having a rally in 2009 was not a surprise. The scale of the rally did surprise me but should not have done – the historical precedent of the Great Crash had an analogous rally – also a 50% retracement, and up around 50% from the low. One of the reasons that I thought that the rally might be significantly smaller was the psychology of investors. The Coppock indicator is based on recovery from trauma. In my mind the Coppock indicator is of limited use. Indeed it is only useful for non-professional investors – it is lagging and confirms only buy signals, but does tell long-term investors that a market is safe. The Coppock indicator is based on 11 and 14 month moving averages. I has assumed that we would have a limited recovery because it just takes longer than a few months to get over the trauma of what happened in the 2H of 2008. It turned out that the balancing item of liquidity provision was so huge that it overwhelmed the psychological imperative in 2009.

I think the chart of US mutual fund flows from the Investment Company Institute tells us a lot about the state of psychology of the US individual investor, and to some extent about the psychology of all investors in equities. We are still very much in the mode of "it is the return of my money that is important rather than the return on my money". I first heard the expression that "cash was trash" in the early '90s. At that point a bull market was still in gear, the bail-out of S&L s had taken place and returns on cash were derisory by the standard of recent decades. There was a compulsion to put money into stocks and other financial assets because there was nowhere else to go. The events of 2008, and the money market fund scandals, and the level of trust in banks all reinforce staying out of money market funds and other cash proxies to a degree. Sales of domestic equity mutual funds have been minimal this year. The positive flows to equities such as they were went into overseas equity mutual funds, as if Main Street didn't want to give its money to Wall Street. Almost by default US mutual fund investors have moved out on the steep yield curve and bought bond funds. Over the last 18 months more money has been put into bond funds than was taken out of US equity mutual funds.

So the current state of psychology of US investors is keep me out of Wall Street, I want the return of my cash, and I can only trust Uncle Sam with my money at the moment, thank you.

The equity market low was mid-March 2009. Eleven months on from there is February 2010. If the trauma of the Credit Crunch of 2008 is mitigated in the period around March-to-May 2010, where will US and other investors put their capital then? Cash will still be trash: even if the Fed raise rates it won't be by much. So a big question for next year, maybe even THE big question for next year is whither inflation, government borrowings and bond yields?

Two prominent hedge fund managers are making big bets on U.S. Treasury yields.

John Paulson’s Paulson & Co. has begun shorting U.S. government bonds, believing that inflation will lead to higher yields, which will drive down the price of the securities, the Financial Times reports. “It will be difficult for the government to withdraw the economic stimulus,” Paulson said in a recent speech. “An increase in the monetary base leads to an increase in the money supply, which leads to inflation.” According to the FT, another major hedge fund, TPG-Axon Capital Management, is also betting on rising yields.

Thursday, 24 December 2009

A Creative Way to Build a Hedge Fund Brand Name – Broadwalk Asset Management

I was listening to trader trainer Michael Martin interview Jim Rogers on his excellent website (, and I heard Jimmy Rogers say that investors should stay with what they know and are interested in. In working with portfolio managers I often ask them which sectors or types of stock they are good at investing in, and which they can't seem to get right. It may be they can't read retailers, or always seem to mis-time growth stocks, but it is very important to eliminate what you are not good at as a trader or investor. I think of it as playing defence to some extent – by eliminating a repeated error, and focussing on what you are provenly good at your returns have to improve.

There may be an element of ego involved – it may seem a sign of weakness on the part of a money manager to leave out a sector or type of stock from their universe. But investors, and ultimately the manager, will only be interested in the scale of returns achieved. So my conviction is to put the ego to one side, check the data, and eliminate areas of weakness. For example I worked with a manager who occasionally dabbled in the financial sector, but whose major strength was in consumer-related sectors. Analysis showed that the hit rate (percentage winning trades) was a lot lower in financial stocks than in other sectors, and I advised leaving the financials alone. Losses in the financial positions were slightly larger than those typically tolerated. If anything the stop-losses should have been tighter and positions sized smaller initially.

The ultimate specialism is sector funds, a strategy area I hope to return to shortly in more detail. In Europe we have begun to be used to hedge funds specialising in sectors, though they are a well established and successful phenomenon of the US hedge fund industry. Investor interest in sector hedge funds should be strong – the return data suggests they can offer enhanced return and lower correlation with markets if the funds have an appropriate framework for portfolio structure. The evidence for this contention is stronger at the manager level than at the index level - there is scope to add a lot of value to a portfolio hedge funds through manager selection in sector funds.

I came across an unusual sector fund this month. The Broadwalk Select Services Fund, run by Charlie Cottam, is Europe's first "Services" sector focused fund. The Fund has been going since June last year, and it has been going rather well. Most hedge funds made money in the first half of 2008 and lost more than their first half gains in the second half of the year. The Broadwalk Select Services Fund was up 1.3% over the last seven months of 2008 through putting in four down months and three up months. Obviously the average up-month in 2008 was bigger than the average down-month!

Charlie Cottam preserved capital well in the first few months of this year, and did better thereafter: through the end of November the Fund is up 44% for the year. The relevant market index for the fund is the FT-All Share Index (the Fund concentrates on UK companies), and that benchmark was down in four months of 2009, and the Fund managed by Broadwalk Asset Management was down in only one of those months. Over the whole life of the Fund the FT-All share has been down 14.6%. According to the manager he didn't get properly invested until February/March of this year, but once he did he made excellent returns through stock selection – the net is now about 80%, and the fund is concentrated (large position size).

The manager of the Fund claims two forms of competitive edge: better information and original analysis. The original analysis comes from Cottam's experience on the sell-side. As a chartered accountant himself he sees accounting issues not well understood by those analysing the service sector specifically. He may have a point as there are few sell-side analysts in the sector with similar tenure as an analyst. The manager himself sees an advantage in his ability to use his been-through-the-cycle experience to turn around his conception on a company and stock quickly – he can grab an emerging opportunity at the time when other analysts are getting out their apocryphal pen to write a research note.

Cottam is an experienced sell-side analyst, and in that may be a true edge as he was company broker to 33 UK corporates. This unique arrangement for UK quoted companies – a corporate brokership for each quoted company – gives the appointed broker a privileged position in terms of access to management. Cottam has kept his company network intact as he has moved to the buy side. His management contacts and experience of individual management teams based on their historic behavior helps Cottam to spot the early warning signs of change in outlook for companies and sectors. His sell side experience enables him to understand the flow information on stocks and their relative positioning in the market.

So Charlie Cottam uses his deep experience in service companies to extract alpha – staying with what he knows and is interested in. He has also taken steps to reinforce his edge by keeping senior management engaged with Broadwalk – last year he initiated the Broadwalk Business Services Awards. This is the second year of the Broadwalk Business Services awards to recognise outstanding achievements by quoted companies in the business services sectors. The UK often leads the world in business services -it is one of the less well-known success stories of the economy, and these awards are a step towards raising its profile. The categories and 2009 winners are: Company of the year (Aggreko), CEO of the year (Nick Buckles, G4S), Chairman of the year (John Peace, Experian), Deal of the year (Balfour Beatty - Parsons Brinkerhoff), Small company of the year (Hargreaves Services), and Entrepreneur of the year (Michael O'Leary, Ryanair).

I think this is a terrific example of creative thinking by a hedge fund manager, and Charlie Cottam's entrepreneurialism and unusual means of brand building are to be commended.

Wednesday, 23 December 2009

Inferences from a List of Larger Hedge Funds

Looking through Barron's Market Lab I came across a table of the biggest hedge funds in their univese. There are nearly 1100 single manager hedge funds listed in the newspaper. As is typical in the analysis of hedge funds it may not definitively contain the biggest hedge funds – even the most comprehensive databases may be missing nearly 40% of the largest hedge funds in the top 100 I was told recently – but still it makes interesting reading.

Biggest Hedge Funds in Barron's Market Lab (all data as at end October 2009) 

In terms of strategy representation, and taking account that Barron's reports CTAs separately, there are a several points worth making:

  • Equity long-short is well represented, and it is striking that emerging market equity hedge funds make it to the list.
  • Managers running strategies in fixed income are represented by a credit fund and two mortgage-backed securities funds. Five or maybe more years ago some fixed income relative value funds would be amongst the largest individual hedge funds.
  • Global Macro remains a big strategy – three representatives of global macro present.
  • There is only one CB arb fund in the list – five years ago there would have been several big CB arb funds in such a list.
  • Event-driven funds are under-represented compared to the percentage of industry assets invested in them. Dedicated distressed bond funds are absent (pace universe bias). A couple of multi-strategy event-driven funds are large enough to get into this top 20.
  • It is striking to see a fund in what is considered a niche investment strategy making it to a list of very large funds. The Dexia Index Arbitrage Fund deals only on the most liquid equity markets, and the asset size is a reflection of both the (loyal) client base of the managers, Dexia, and the steady return profile of the Fund.

To generalise from a small sample (1100 self-selecting funds from a universe of maybe 6000 single manager hedge funds):

  • Amongst the very largest funds are multi-strategy funds running $3bn-plus of capital in a single fund structure. This reflects the industry trend towards multi-strategy replacing single-strategy funds in relative value investment strategies particularly.
  • Emerging market investing is now a permanent part of the range of strategies employed by investing institutions, and even after the yo-yo performance and redemptions of the last two years emerging market hedge funds can still rank amongst the largest funds.
  • Hedge funds investing outside the United States are amongst the largest. This particular ranking includes a European specialist (Odey European) and a UK specialist (Blackrock's UK Emerging Companies Fund) as well as emerging market funds. Asia investing is absent on a dedicated basis.

Tuesday, 22 December 2009

Quality Factors in Equity Hedge Fund Returns This Year

In 2008 one of the disappointments was the returns of market-neutral quantitatively-driven equity strategies. The difficulties were focused as much as anything else in the seemingly illogical behaviour of quality factors last year. I recently inquired to a senior researcher in equity quant about factor returns this year, and again quality factors have driven returns in unexpected ways. The behaviour of quality factors helps to explain equity hedge fund returns across different styles this year, and so I have included the following abstract from the research of this quant published at the beginning of this month:


Discerning the direction of the Quality trade remains the key issue for investors. Discussions of investors seeking to take money off the table heading into year-end and positioning themselves in a more defensive posture are not borne out by the behaviour of our Quality index.

Market Commentary

It has been a tough year for Quality. And it has been a tough year for stock picking. And these two facts are not unrelated. Indeed, over the past 9 to 10 months, the key to successful stock picking has been to understand the direction of the Quality trade.

The big news in the quantitative factor space, and really the market as whole, this month has been the underperformance of High Quality stocks relative to Low Quality Stocks. For the month, we saw High Quality stocks underperform Low Quality stocks by approximately 2.9%. For our quality index, this is a big move since, in general, our quality index runs at approximately 1/3rd the volatility of the Russell 1000. In other words, if our quality index were scaled to have the same volatility as the Russell 1000 index, we would have seen an approximately 8.5% down move in our Quality index this month. Clearly something is happening.

Backing up for a second: as most people are aware, the rally in the market that started around mid-to-late-July coincided with a very strong move upwards by low quality stocks. Specifically, we saw low quality names outperform high quality names by approximately 5.2%. Whereas the low quality junk rally in March was primarily focused around companies with distressed balance sheet and low stock prices, the July rally was much more broadly focused. Here we saw low quality companies of all stripes outperform. Companies with poor historical profitability outperformed. Companies with low quality of earnings (i.e. non-repeatable earnings) outperformed companies with high quality of earnings. And companies with low quality balance sheets outperformed those with high quality balance sheets. In short, the late summer rally was coincident with low quality stocks of all stripes outperforming.

Since that time, we have seen a reversal in quality and then this month a subsequent continuation of the low quality trend.

Now this stopped around September 16th as we headed into earnings season. From there to the end of October we saw High Quality outperform Low Quality stocks by approximately 4.5% as investors positioned their portfolio defensively and braced for what by all respects they feared would be a tough earnings season. Note, again these are large moves, if scaled to equivalent Russell 1000 vol, this would be a 13.5% move in a month and half.

This turned around again on October 28th, with another strong low quality rally emerging coincident with strong earnings announcements by banks, basic materials and commodity producers, consumer goods companies and REITs – in short, bellwether companies for any weakness in the recovery. As these decidedly good earnings numbers provided assurance of the recovery's continuation, investors took off defensive positions and piled back into the early stage cyclical recovery trade names. This trend has continued virtually unabated ever since, with the Quality index experiencing positive returns on only 6 of the 20 trading days last month (November). Discussions of investors seeking to take money off the table heading into year-end and positioning themselves in a more defensive posture are not borne out by the behaviour of our Quality index.

Perhaps the most surprising element to us was that the quality index has continued its downward march late last week even on the news coming out of Dubai, which instilled some measure of fear in the market. We would have expected a flight to quality on Friday as the story broke and world equity markets lurched down. But it didn't happen. Our Quality index continued to inch downward on Friday (-4 bps) and then again on Monday (-23 bps), as even geopolitical fears did not send investors fleeing to safety.

As we head into year-end, the pressing question is: do we anticipate a rally in Quality? Absent a high-impact geopolitical event, we see two scenarios under which the Quality rally can end. Namely, investors can become concerned about slowing growth and thereby move into a more defensive posture in their portfolios.

We believe the most likely cause of a pull-back in Quality is the likelihood that investors take money off the table from the strategy as valuation of low Quality stocks is no longer compelling. By most metrics that we use to judge, low quality stocks appear to be fairly to slightly richly priced.

Monday, 14 December 2009

Flows to Liquid and Branded FoFs or all FoFs? carried this story today:

Deutsche Bank’s Hedge Fund ETF Reaches $1 Billion Mark
December 14, 2009

The db x-trackers db Hedge Fund Index ETF has reached more than US$1 billion in assets under management since its launch in January of this year. The exchange traded fund that tracks the asset class via an index.

"The db x-trackers Hedge Fund Index ETF is the first of its kind to provide exposure to the performance of actual hedge funds. It is not a hedge fund replicator,” explains Stephane Farouze, global head of hedge fund derivatives at Deutsche Bank. “With the introduction of the ETF we have enabled investors to access an important portfolio component in a new way. Underlying the index is a diversified pool of hedge funds from the, transparent, risk-monitored and liquid Deutsche Bank X-markets Hedge Fund platform.”

Thorsten Michalik, head of db x-trackers at Deutsche Bank adds, "Besides investing into actual hedge funds, the intra-day liquidity is clearly a unique advantage of our Hedge Fund ETF - daily volumes of over 50 million Euros are not unusual. We’re aiming for the db x-trackers db Hedge Fund Index ETF to become the world’s most recognized product for transparent and liquid investments into Hedge Funds."

The db Hedge Fund Index is asset weighted to the hedge fund industry and linked to the range of hedge funds available on Deutsche Bank’s X-markets Hedge Fund Platform.

The db x-trackers db Hedge Fund Index ETF is available in US Dollars, British Pounds, Euro and Swiss Franc share classes and is now listed in the UK, Germany and Switzerland.

From Simon Kerr:
This story says something constructive, but is it constructive about the HF industry or Deutsche Bank? In isolation the story says somethings about the power of DB marketing of financial products. But Friday also saw Europe’s third largest hedge fund firm, BlueCrest Capital Management, announce that they had raised £101 million ($164.5 million) through a new share issuance for its BlueCrest AllBlue fund.The publically-listed BlueCrest AllBlue fund now manages approximately £440.3 million, and serves as a feeder fund for the BlueCrest's fund of hedge funds vehicle.

The confluence of the two stories gives a sense of something emerging - liquid forms of funds of hedge funds with some branding are attracting interest? The corollory should be net positive inflows to funds of hedge funds in general. If we don't see that in 4Q flow data, does that mean that the old form of fund of hedge funds really has peaked (as a proportion of the industry assets)?

Friday, 4 December 2009

Non-Confirmations Dissipated

Well, we are here again: another signal day near market highs on an index. The index is the NYSE Composite this time. The same short term sell signal came up on the COB 21st October on the S&P.

However, there is a different set-up:

*The market has been in a trading range for 3 weeks rather than running up and then giving a reversal signal. This gives a reversal signal less predictive success.

* You may recall that recently Bob Prechter was pointing out some non-confirmations - some indices were failing to hit new highs at the same time as the broader market indices. Apart from the AMEX, all the major indices have hit new highs since Prechter's comment, so those non-confirmations have gone. The DJ Transports and Utilities indices appear to be breaking out to the upside.

* There is not a clear non-confirmation on the advancing - declining issues indicator (second graphic). So breadth is in line with price at the broad index level.

* The market is going up with less short term thrust on each up-leg. Volume confirms this.

*Yesterday's down day was on the biggest volume for a month on NYSE trading. Was that a clean-out cathartic day? Even on the big volume down day there were a lot more new highs than new lows on the various stock exchanges.

The probabilities have shifted to less negative scenarios by market action over the last week or so. In particular the break outs to new rally highs by various industry sub-groups allows for some market leadership. The postive seasonal bias may kick in this month, particularly after a positive November. Some hedge funds are still gunning to make their year, though others will be planning how to spend their performance fee bounty already. On balance a trading environment with a positive bias.

relevant link: 'December Effect' Bodes Well for Hedge Funds, Equities'

Information Flows to Hedge Funds 2 - Twitter

The best article on information searching for hedge funds that I know about was by Colin Maclean of Scottish Value Management. You can find it on "The Hedge Fund Journal" website at this link.

The search for an information edge goes on. Any source will do. The newswires carried this story recently:

"Traders are using software developed by US-based technology StreamBase to monitor "tweets" for price sensitive information.

The software plugs into Algorithm-based automated trading platforms that have been used by traders for years. But rather than searching Reuters or Bloomberg the software now scans

Streambase - whose client base includes Royal Bank of Canada and London-based hedge fund BlueCrest Capital Management - was commissioned to develop the software by several "unnamed" clients."

Wednesday, 2 December 2009

Podcast 2- A Discussion with UK Equity Portfolio Manager Nick Shenton at Polar Capital

Click on the links to download or play the sound files (embedded player available).

Part 1 (7 minutes 51 seconds)

0.30 Joining Phil Hardy at Polar Capital

1.50 Idea generation

4.40 What Phil Hardy brings to the process of stock selection

5.15 Harder to find shorts now

6.30 Shorts can work faster than longs

Part 2 (10 minutes 50 seconds)

0.25 Websites look at daily

1.35 Websites useful for company insight

2.58 Segro as an example

4.50 Recent investment book reading- Niall Ferguson, "The Greatest Trade Ever"

8.37 Risk/Reward for UK equity trades

9.05 Two other influential books - "Soros on Soros" and "Inside the House of Money"

With thanks to Nick Shenton CFA who works on UK equity hedge fund and absolute return products with Polar Capital Director Philip Hardy

The Greatest Trade Ever

By Gregory Zuckerman
Reviewed by Alexandra Scaggs from

Ever wonder how a single trade can create a legend? Gregory Zuckerman outlines how just such a thing happened with John Paulson and the rest of the characters who profited wildly from the collapse of the real estate bubble."

In The Greatest Trade Ever," Zuckerman, who writes The Wall Street Journal’s "Heard on the Street" column, focuses as much on the personalities and characters of the investors as on the bubble and collapse that increased their wealth exponentially.

Players here include Paulson, whom Zuckerman characterizes as a reformed playboy and true skeptic; Paolo Pellegrini, a Wall Street outsider who went to Paulson for his last shot at a career; Jeffrey Greene, the Hollywood version of a big-shot investor; and Andrew Lahde, the young West-Coast investor who cashed out and left finance for good.

The book addresses how deals are made and how personality counts just as much as the financial mechanics behind the trade, which may be why Paulson has come out with a statement saying he is “disappointed” with the book. But Zuckerman shows that in finance, office politics can matter as much as smarts.

Tuesday, 1 December 2009

Ari Kiev and the Trader Trainers

I'm sad to record that Ari Kiev died this week - you can find an obituary in The New York Times. Ari Kiev was a psychiatrist with interests in several areas including depression and suicide. He applied his knowledge and techniques to new fields including working with top tier athletes and traders in markets. And in working with traders he expanded the armoury of techniques of trader trainers.

I first came across trader trainers about ten years ago. To be clear, I'm not writing about Richard Dennis' turtles experiment, though that itself is an interesting topic. Trader trainers such as Van Tharp and Scott Kaminski (and Ari Kiev) work with investors, typically short-term leveraged players in markets, looking to improve their outcomes. These trainers teach time-tested methods and approaches that have worked for the very best traders in markets. I have a book case full of investment and trading books – biographies, historical accounts, academic papers and classic writing on investments. I rate the "market wizard" type books particularly highly for giving helpful insight. Those who truly invest, that is operate with a long holding period and rely on fundamentals rather than technicals, have a wide variety of approaches and methods. Those who trade for a living (short term, and price and technically focussed) and are successful at it do not vary to anything like the same degree. Kiev's practice with traders concentrated on the classic elements, adding his own technique.

There are a number of core activities, skills, disciplines and attitudes for successful traders. These are what Ari Kiev spent much of his time putting across to his trader clients. He was first brought into working with traders by Steve Cohen of SAC, who recognised parallels in trading with top-performing athletes, and had heard of Kiev's work with the sporting elite. Kiev was retained by SAC and worked part of his week in Connecticut in one-on-one sessions with SAC's traders. In the course of time Kiev codified his thoughts and put them into print. So you can read what and how he trained traders in his classic "Trading to Win" (1998), and other titles. I would also recommend Ari Kiev's podcasts.

Of all the trader trainers I know about, it was Ari Kiev's approach and methods I have referred to most over the last year in the course of my consulting work with hedge fund managers. Consultants on the investment and risk management processes such as myself have to tailor their work to the specific portfolio manager or team that is the client at the time. When it comes to the trading part of managing a hedge fund, Ari Kiev's techniques and tools will be part of that body of work on which we draw for years to come. A good legacy in work terms.


The photograph above is from The New York Times website (see first hyperlink above).

Monday, 30 November 2009

Risk Management in Hedge Funds –The Role of the Risk Manager

The extract below is taken from an article by Michael Langton, Head of Sales at Quality Risk Management & Operations (QRMO) Limited, that makes some interesting points. It was first published in IPAsia in January 2009. For the full article go to IP Asia or EurekaHedge. Only one sentence has been edited from the extract. The article first looks at risk management in financial institutions before turning to hedge funds specifically. The extract begins at the joint of the two parts.

What's wrong with Risk Management?
…Continuing with this example, risk management simply becomes a regulatory-required function to senior management that should only be put in place to appease the regulators, but one that under the surface of it has no real independent authority to balance the risk/return profile for the organization. Furthermore, the far more insidious fact of the matter is that investors will think they are investing in a prudent or well-structured institution and their capital is protected by these highly paid professionals.
Hedge funds are unregulated financial pools of money provided by qualified professional investors. The rationale for the existence of this industry is that traders can utilize their special skill sets to generate absolute uncorrelated returns for its investors. However, as with financial institutions, the compensation scheme is still asymmetrical in this industry and could arguably be even worse. This is because the hedge fund manager has the discretionary right to decide whether the fund needs to have a risk management infrastructure in place. It cannot be denied that there are some well-disciplined hedge fund managers that attempt to incorporate best practice risk management and operational infrastructures through the active use of and stringent adherence to a well thought out rules-based structure. However, they tend to be exceptional cases in the hedge fund industry as a good portion of them are purely return focused instead of risk-adjusted return focused.
Some fund managers consider themselves to also be the “risk managers”. Surely, their role as a trader is the first-line risk manager as they can actively manage their portfolio and adjust the risk-return profile dynamically. However, it should be recognized that they still need to have a risk manager in place as an independent verifier that the fund manager is adhering to the risk guidelines and rules put in place. The role of an independent risk manager is not merely to provide risk measurement and reporting but to also setup the necessary risk and valuation policies & procedures and risk limit structures and to monitor the market condition changes and related market exposures of the fund.
The most important role is to execute all risk policies & procedures as stated in the offering memorandum and additional guidelines provided to the investors. Unfortunately, risk policies & procedures execution is usually ignored and not enforced. In fact, some hedge funds can have very presentable and detailed risk policies and procedures, but they are simply for showing the investor how they perform their “prudent” risk management functions. They rarely delegate the authority to the risk manager to execute actions like stop loss or position reduction if limits are breached, for example. If a fund has a risk manager but the de facto person in charge for actions taken on limit breaches is still controlled by the fund manager, the independent risk management function should be called into question. There is a lot of talk about the need for better risk management, particularly given the current state of affairs in the global world markets. However, the focus should not be on better risk measurement, although this is still important. Instead, the real focus should be on corporate governance in ensuring that a proper risk management structure is in place and that it is independent, continuously adhered to and fully transparent to the investor. In essence, corporate governance will always be the key to good risk management. As such, for the future of risk management to be successful, its function has to be directly reportable to investors instead of internal management. Such a structure should carry out these two key functions:
· Greater transparency on what the institutions/funds are investing in (esp. on derivatives) and the accurate and timely reporting of their true risk-return profiles; and
· Risk management function must be truly independent from the profit making function, so investors can truly enjoy absolute upside return from the profit maker but still have downside protection from the risk manager
This structure will make the profit maker consider the risk elements of his strategy more carefully because they will know that the risk manager has the authority to enact his duties as per the agreed risk policies and procedures. Ultimately, risk management should no longer be viewed as a “regulatory-required” function but as a “value-added” function in the investment decision-making process. The “value-added” does not derive from making money, but rather from capital preservation, particularly in down markets.
Experience, discipline, communication and common sense are always the essential elements of a good risk manager. Some market participants misunderstand that having expert quantitative staff and a sophisticated risk system is sufficient. This misperception stems from a false sense of comfort that can come from the risk managers’ utilization of a lot of different mathematical models (e.g. VaR, Monte Carlo, auto-regression, scenario analysis, etc.) through the use of expensive state-of-the-art technology to assist the risk manager’s decision process. However, these quantitative elements and technologies are not the only factors needed to determine whether the organization has a robust and proper risk function. More importantly, an experienced risk manager needs to effectively communicate with the profit makers and understand the risk and return of each product/portfolio while also demonstrating these risks to senior management and investors.
In summary, inevitably regulation will always be tightened post-crisis, which will, in turn, prompt the need for more robust risk management to avoid crises from happening again. However, this time, regulators and investors should consider demanding changes at the highest levels of the corporate governance structure. These changes will need to grant the risk manager a more independent role which can directly report to investors (especially within the hedge fund industry), so that risk management can play a more pro-active role. It goes without saying high quality risk managers that have a better understanding of risk will also be a key to successful risk management. Importantly, sophisticated risk systems and quantitative models are not the only components of a solid risk function. In some cases, good old common sense will be a better suited method to justify particular actions to a given situation. (end of extract)

From Simon Kerr:
I have enjoyed a privileged position over my 11 years in the hedge fund industry. From 1996 when I attended my first hedge fund conference in London (there were 5 paying attendees, way out-numbered by speakers), I have met many first-rate hedge fund managers. I now apply the insights they have given me in my consulting work, and in my own investments. One conclusion I have reached from meeting first-tier managers is that the very best hedge fund managers have a keen appreciated of risk management. An understanding of what risks they are currently running and how those risks might change, subject to market dynamics, is a core competency for them. The kind of preparation for the trading day undertaken by the likes of Paul Tudor Jones and Steve Cohen is one of the reasons for their successes, and both include elements of risk assessment as part of their preparation for battle. They get/produce relevant risk information for their style, they think through various scenarios that can happen to their exposures, and they plan responses. A good local example is Lee Robinson of Trafalgar Asset Managers in London.
Robinson’s view is that market crises in reality happen with a greater frequency than generally perceived. “Markets have had serious moves almost every year this Millennium,” he has said. As a consequence Robinson has disclosed that the bulk of their work on a trade at Trafalgar is preparation. “We are prepared for the worst,” was how he summed up the rehearsal of various possibilities (mark-to-market difficulties, drawdowns, shifts in volatility, and redemptions) that might be experienced en route to the planned exit points. He said that the aim is not just to avoid losing money, but to avoid the forced liquidation of positions. He has succeeded in that aim: the graphic below reflects that his event-driven Trafalgar Catalyst Fund made absolute returns of 4.83% last year. Since inception the Trafalgar Catalyst Fund has compounded at 9.7% (in the USD Class) versus 2.2% for the HFN event Driven Index over the same period.
NAV of the Trafalgar Catalyst Fund (USD)since inception
Lee Robinson has made a conference speech titled “Lessons from the Crisis”. He made it in November of 2007 (not 2008 or 2009!), so he was ready for the unfolding crisis from having seen warning signs in the previous few months of 2007. In his presentation he talked about portfolio management. He stated that it was easy to have investment ideas, but difficult to mesh together those ideas into a coherent portfolio, and even harder to make that portfolio robust to varying market conditions. He cautioned that investors in hedge funds should look closely at funds that exhibited high weekly and monthly correlations, and to beware of funds that had high concentrations of risk. Robinson continued that all portfolios are essentially short liquidity and at risk to mark-to-market movements, but that all great portfolio managers have tools to combat these problems. Robinson suggested that carrying long put option positions below spot which defines the downside more clearly, and being short interest rates and short credit will all help, or if you like, are examples of such tools. Lee Robinson concluded that “The best managers are not the ones with defined upside and a wide range of possible downside outcomes. They are the ones with defined downside and a wide range of upside.”
Whilst the tools Lee Robinson suggested may be specific to his event-driven strategy, a more widely applicable point can be made: portfolio construction has to take account of the possible outcomes for the asset class/specific securities including downside and liquidity risks, and particularly tail-risk. The best hedge fund managers manage whole portfolios not just select securities or investment themes they like (longs) and dislike (shorts).
My second major point is that risk managers work best when they work with and alongside portfolio managers. This applies whether in a long-only firm, a hedge fund management company or some combination. Several good examples come to mind. At Augustus Asset Management, the fixed income specialist part owned by GAM, Risk Manager Amy Kam sits in with the portfolio managers and is part of general discussion on trading strategies and the dialogue on portfolio level risk and rates. Augustus uses stress-testing, simulations (Monte Carlo), and sensitivity analysis in the arsenal of risk assessment tools. The risk control framework goes beyond the managers’ spreadsheets and is externally supported (by Riskmetrics) and working with GAM’s wider risk analysis capabilities.
The physical location of the risk manager in the office suite is indicative of their hierarchical position in the firm and their level of significance to the portfolio managers. It is one reason why, even on a brief visit to see a manager, a look at the trading room is always useful. An example of this is Charlemagne Capital in St.James’s London. The office space is a little tight so it would be all too easy to place the risk manager in a room adjacent to the analysts and PMs. But at Charlemagne the risk manager is too integral to the investment process for him to be squeezed away from the hub of investment activity. The risk manager at Charlemagne Capital works with the portfolio managers day to day on their portfolio construction challenges and not just reporting to investment team heads Julian Mayo and Gabor Sityani once a week.
The final point is that risk management is most effective when it is an element of the investment culture rather than a segregated function. Too often the risk manager can be seen as part of the oversight of fund management activity rather a core element within it. The risk manager as part of compliance or as a policeman looking for infringements of policy may be useful for marketing purposes but is unlikely to play well with the star portfolio manager. There is a chance that the risk manager will be seen as having no relevance to the men and women running the money. This quasi-regulatory attitude and structure is very limiting and indeed isolating for the risk manager. The senior management of the asset management businesses whether hedge or long-only can do something about these potential difficulties by recruiting a risk manager with the right attributes – they should be bright, open, engaged with markets, experienced, have good judgement, and be both quantitatively capable and have good people skills.
This is a long and demanding list of characteristics, and perhaps its length makes clear how difficult it is to find the right person for these roles. The attributes are also those of the best hedge fund managers – which is why the hedge fund managers are often also their own risk managers!

Wednesday, 25 November 2009

The Limits to Fundamental Conviction – Clarium Capital

In August 2007, perfectly catching the first public intimations of a financial downwave global macro manager Clarium Capital, then of San Francisco, dispatched a manager letter that took a negative view on economic growth, real estate and the stock market. In the letter they wrote ""We have begun a post-Long Boom phase that can be called the Long Goodbye. Returns during the Long Goodbye will be lower -- perhaps half as much -- than those of the Long Boom."

The firm argued that the developed world has entered a period of lower returns in which interest rates and economic volatility would increase while growth in corporate profits and global expansion decline. To adjust to this new reality, the firm explained that people must work more, consume less and compensate for lower returns by using more leverage -- borrowing more, that is. The prudent response would be to work longer and cut consumption, but up to that point the reaction had been just to borrow more, Clarium said.

Chillingly, Clarium predicted "that higher leverage has made markets much more vulnerable to outside shocks that will force "painful" de-leveraging and a reduction in liquidity." Clarium built these economic scenarios and market forecasts into portfolios through several investment themes. One was being short the US Dollar, and another was shorting shares of leveraged companies. In the second half of 2007 and early 2008 Clarium made stand-out returns on these themes (see table).

2007 Returns

2008 Returns

Clarium's excellent research had also put them into the camp that believed in the peak oil concept, making oil prices more sensitive to small changes in the demand/supply balance, and giving prices an upward bias over the long term. As it turned out, Clarium's investors didn't have to wait for the long term to arrive and for a payout on the long energy positions Clarium ran – in the first half of 2008 the oil price accelerated to the upside and Clarium's returns reflected big long exposure to energy, gaining 11.2% in May 2008 and 16.0% in June.So in the middle of last year Clarium Capital's principal, Peter Thiel, was a "Master of the Universe". In the first six months of 2008 his Fund was up 57.9 percent. Significant inflows followed the turn of the year returns, and by the end of July 2008 Clarium Capital Management had assets under management of $7.3bn.

Clarium's Peter Thiel, source:Bloomberg
Clarium stayed short of the US Dollar and long energy as the start of the second half of last year, so in July and August gave back some of the gains of the first half of 2008. Bets against the world's reserve currency, the US Dollar, in a time of crisis would not have helped returns at the time of the collapse of Lehmans and the follow on problems at AIG and the UK banks (October/November last year). So after a bang-out first half, Clarium ended 2008 having made a small loss of 4.5%. Better than most hedge funds across all strategies, but the Clarium returns in the second half of 2008 were worse than the peer group global macro managers, and across the whole year the small loss was delivered to investors with very high volatility. Many macro managers run steepener trades as portfolio insurance for a liquidity crisis, so many macro managers were positive in each month of the final quarter of 2008. Clarium didn't carry that insurance and had losses in two out of three months. Like the whole industry Clarium Capital suffered major redemptions in 2008, but the scale of some of Clarium's monthly losses hastened investors to the exit. AUM were $2.5bn at the end of 2008.

2008 Returns

Peter Thiel has been quoted as saying recently that "There was a degree to which the financial economy has been extremely decoupled from the real economy." He has noted that he didn't expect the S&P 500 to rally 62 percent, its steepest advance since the Great Depression, at the same time that the proportion of Americas without a job rose to a 26-year high. The Clarium fundamental call has been that the economic recovery would be at best constrained."A real, sustainable recovery is not possible without productivity growth," said Clarium's Chief Economist Kevin Harrington. "The recovery is not real," he says. "Deep structural problems haven't been solved and it's unclear how we will create jobs and get the economy growing again -- that's long been my thesis and it still is." He continued, "The government has helped stabilize the banking system, but I'm not sure we have a path toward sustainable growth, partly because consumers are dealing with debt and other issues, even as an energy crisis looms. It always feels unpatriotic to be negative. But too few people are focused on the real problems."

Thiel himself is of the same mindset: "I don't think that a recovery is impossible. I do think its quite hard to get to a situation where you have a lot of growth in the economy without running into basic constraint problems.

 "The key thing in the US is going to be doing more with less. If you try to do the recovery by just doing more of the same and if the recovery is going to consist of going back -- to the housing bubble, going back to leveraged finance, lending money again like crazy, going back to 2005 -- it just seems to me like you're setting yourself up for a real problem. I think you would run right back into four dollar a gallon gas prices and it would sort of correct itself [back into recession].

"Longer term I'm hopeful. I'm not wildly optimistic…But I don't think it gets driven by the financial system or even has that much to do with macroeconomic policy. I think it basically has to do with getting innovation working again. I think that's a very long term trajectory. I'm pessimistic in the sense that I don't think people are focusing on that enough."

Implementing these views Clarium was long the Yen and Dollar in the first quarter of 2009. . The Dollar positioning in the first half reflected an implicitly deflationary view, and Clarium has been long of high-quality bonds based on the view that fear will prevail in markets in 2009. That fear in terms of stock markets peaked in March, and since then stock markets have rallied hard. It appeared to the investment professionals at Clarium that valuations on equity markets quickly became rich, and they have shorted stocks into the middle of the year. And paid for it:

2009 Returns

Global macro managers are paid to take a view on how the economic environment is going to impact market prices. If markets reflect the fair values of stocks, bonds and the parities of fx rates global macro managers have no trades to put on. They trade on where prices are going, given their view on the dynamics of economic growth, final demand, inflation and job growth, in the context of markets subject to the emotions as well as the rational thinking of investors.Modern form macro funds aim to have five or six themes running in their portfolios. The themes are only distinct to the extent that they are uncorrelated. So if two trades are long yen call options as a probabilistic bet that the carry trade unwinds in emergencies, plus a yield curve steepening trade then there are two trades that will work for the same scenario, and they will be tightly correlated when you expect them to work. Long gold and long index-linked bond trades can be thought of the same way. Late last year was a period when correlations between positions were either +1 or -1. So it was very difficult to construct trades with a macro take on markets that were not very correlated (positively or negatively).
Many managers in macro use VaR type measurements of portfolio risk. This methodology is flawed but still useful for macro managers because it allows risk assumption across different asset classes to be measured on a common basis. Although macro managers are not as micro-controlled as equity hedge managers in risk-assumption boundaries they can and do vary risk assumption according to shifts in markets, including regime change, which is what we saw in the Autumn. So macro managers have a free choice about maintaining, increasing or cutting their risk assumption as market values move, just like hedge fund managers in other styles.
One of the tenets of running money, particularly for other people, is that you earn the right to take risk. On an individual level Peter Thiel did that by co-founding PayPal, and so started Clarium with capital which was merited. The annual return series for Clarium given below shows the classic global macro pay-off profile: the portfolio is run as a series of bets some of which become highly profitable. In concept a global macro fund runs a series of themes are run to give a chance to smooth out returns, and losses are limited by three things: trades which have natural downside protection (like the bond floor of convertibles, or a hard asset value), strategies are put on with delineated stop-losses from the outset, and options are used to implement the views. So the return series should look like a strip of option positions – occasional big pay offs interspersed with dull returns (small losses and small profits).

Annual Returns of Clarium LP

In the case of Clarium several of the tenets of running money, and running money in the modern global macro format specifically have been broken. These are matching stop-losses with the risk/return profile, diversification of theme, and arguing with the market without a suitable limit.There have been 14 double-digit monthly returns in the Clarium performance history, both gains and losses. That scale of monthly return is only feasible with the use of leverage. The use of leverage carries the inference of high conviction and/or investing capital in low volatility assets. Soros used leverage (re-hypothecation) on his bond positions in his heyday, and traded forward currencies in large size using the implicit leverage of forwards with no margin in low volatility instruments. So leverage per se is not a bad thing, and in normal markets is necessary to potentially generate 20% absolute returns from low volatility instruments.

Soros used to load up on a position when it started to turn his way - the foot-to-the-floor version of risk assumption. That is the investment hypothesis had been tested in the market and shown to be positive, so reinforce the winners. Contrarily, the markets are very good at teaching lessons in humility – so if a position started to ship losses Soros was all over it , and mentally able to cut it and re-visit at a more opportune time. So capital was dynamically applied at Soros Fund Management with the feedback loop of the P&L delivered by the positions in the market.

The other feedback loop that managers use is the fundamentals – have they mapped out as forecast? Is the road-map of the progress of the macro factor turning out as expected at this point? Some, indeed many, managers will argue with markets (running a negative P&L) on the basis that their fundamental view is being borne out in the real world away from traded markets. So if trade deficits are the key factor in monitoring fx rates at the time, and the trade balance is progressing as expected then managers give themselves the right to argue with the markets for the time until their conception is generally recognised in FX cross-rates. Of course there may be other factors influencing the fx rate, and the rate of progress may not be as laid out in the road-map. There is room for judgement, but not for behavioural biases counter to the facts.

In the case of Clarium the losses of August and October last year are prima face evidence that the tenets of macro management were not being followed. If there were effective stop losses at the portfolio level or by theme and the portfolio themes were indeed non-correlated then a single month's loss should not reach 13 or 18%.

As stated, last Autumn was exceptional in the shift on volatility and correlation. However part of what investors pay for in the modern hedge fund world is superior risk management. Exposures should be cut at a hedge fund at the portfolio level to ensure that the target maximum monthly loss should not be breached. Clariums' track record from 2002 to 2007 showed 3 monthly losses of 11% or just over 11%. Given the size and number of positive months that maximum monthly loss was (just) tolerable. But a loss of 18% was not and is not. Exposures should have been cut intra-month so that the target maximum loss was not exceeded. As much as anything else that was a logical reason for investors to withdraw their capital, as they did towards the end of last year at Clarium.

This year is different again. It is clear that the Clarium view on the economy is the same now as it was at the beginning of the year. That is fine – it has been a disappointing economic recovery in some senses, and so in macro-economic terms Clarium have been broadly correct this year, and may be borne out on their forecasts beyond this year. How those views have worked out in traded markets has been less successful – Clarium were down 15.8% by the end of September.

It looks like September 2009 has been a signal month for Clarium Capital Management. The Clarium Fund lost 8% in the first 14 trading days of the month. Between between Sept. 11 and Sept. 19 Clarium cut leverage from 4.2 times down to 1.4 times equity, and closed the month with a loss of 8.1%.

I would contend that the commercial position of Clarium Capital Management LLC was different this year than during the rest of Clarium's history. The large losses of August and October last year, the withdrawal of investor's capital last year, the increase in frequency of losing months, and the fact that the Fund is well below its high water mark (so vulnerable to staff losses) all shout to me that the remaining capital ($1.6bn at the end of September 2009) should be run more conservatively than hithertofor.

I do not think that managers in the position that Clarium was in this year should argue with the market to the extent in terms of scale and time that Clarium did. Being right on the economy only mitigates the position to the extent that positions in markets make money. There are natural limits to risk assumption in global macro, and to an extent Clarium lost some of its degrees of freedom in that regard from the outcomes last year. This year the natural limits to fundamental conviction for the firm should have kicked in a lot sooner than September.

The above was put together using material from various sources. I acknowledge the use of quotations and data from Bloomberg and The New York Post. The use of appropriate feedback loops and money management are core concepts used by Enhance Consulting, Simon Kerr's consultancy.
useful link: manager letter (April 2009)

Tuesday, 24 November 2009

Apologies to Polar Capital

In a recent post ("Lack of Transparency Traduced") I mentioned that on-shore products would do well to follow the example of hedge funds in regard to communications with investors. UCITS III funds are the new vehicles for fully regulated absolute return funds from asset management companies, and as an example of incomplete communication I mentioned an absolute return product from Polar Capital, having seen a monthly newsletter.

I had not appreciated that I was in receipt of an edited version of more full monthly letter. So my apologies to the managers of the Fund and Polar Capital's marketers that their efforts were mis-represented. It turns out that the same sort of information is provided by the firm for its hedge funds and its absolute return range.

I hope the information provision by Polar sets a good example for those that launch absolute return UCITS products in the future, following the high standard set in the hedge fund industry.

Non-Confirmations Multiply according to Prechter

Although I am not an Elliott Wave technician, they do have market influence. Hence awareness of leading practitioners is a useful background input. Robert Prechter is such a practictioner. Bob Prechter's "Elliott Wave Theorist" newsletter published the 23rd November notes that the DJIA has achieved a 50% retracement of the fall from the 2007 high to the 2009 low, and has done so in 50% of the time it took to fall.

The following is taken from the same publication:

"Non-confirmations continue to multiply, as no other significant market index – among the S&P, NASDAQ, Transports, Utilities and the broader Value Line indices – joined the Dow in making a new intraday high today.

This morning's high occurred 39 minutes into the session, immediately after an upside gap in the DJIA during the session (his italics), an extremely rare event…I am betting that it was an exhaustion gap, not a continuation (wave 3 of 3) gap.

After 8 months of rally and a 52% retracement, I believe I have seen enough to recommend that traders move to 200% short. Those who were "maximum leveraged" for the 2007-2009 decline and reinstated half their positions on the recommendation in the August 5th issue may return to their full former holdings now."

Prechter's services can be found at

The NYSE cumulative advance/decline indicator is a measure of market breadth. It is giving a non-confirmation at the moment - the NYSE Composite hit a minor new high a week ago, but the advance/decline did not then or since. Non-confirmations are useful to give confidence for high conviction calls on the market. The evidence is building for a high confidence bear entry point.

Friday, 20 November 2009

Significance of Hedge Funds to Gartmore

Gartmore is to obtain a Listing on the Stock Exchange. The press release for the announcement states that as at 30 September 2009, Gartmore and its subsidiaries had £21.8 billion of assets under management ("AuM”) including a range of 14 equity long-short funds that make up £3.8 billion ($6.1 billion) or 17% of AuM. Since July 2009, Gartmore has had over $1 billion of net inflows into its alternative funds, but it received £924 million ($1.54bn) of net inflows in the third quarter of 2009 across the whole Group. So equity hedge funds contributed around two thirds of the net inflows in the third quarter this year.

In addition 87% of the hedge funds were above their high-water mark as at 30 September 2009, and these funds were up by 17.3% for the 9 months ended 30 September 2009. So it looks like the profit growth of the business will be a function of the returns of the hedge fund unit next year. That is how important hedge funds can be in the asset management business.

Wider implications of a Gartmore flotation were covered in the podcast on this blog on hedge fund M&A: