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)


  1. Correct on all points of thematic macro investing. Also correct on investor tolerance to losses and implications for risk levels

  2. All in all, an insightful and very well written article.

    Highly recommended.

  3. Spectacular article.