Wednesday, 16 March 2011

Working in Equity Market-Neutral – A Q&A with ABACO Financials

ABACO Financials Fund is a market-neutral equity fund with a European bias dedicated to investing in the Financial sector. The portfolio of long/short positions is structured to generate absolute returns by capturing relative value within the sector while targeting low volatility. The return stream produced for their growing list of investors has a high proportion of alpha in it, and the returns have low correlation to markets and to most equity hedge funds. Given the significance of the finance sector to the market turmoil of 2008/9 and to the prospects of European economic recovery since, the fund has been interesting to follow, not least because of the excellent market letter the managers produce.

The three investment professionals in the team have different overlapping roles: Inigo Lecubarri comes from the sell-side and spends the majority of his time on research; Louis Rivera-Camino has a background in portfolio management and works across all aspects of running the portfolio, and the following Q&A was conducted with Martin Deurell whose primary responsibilities include trading and risk control for the fund. The interlocutor was Simon Kerr.

Q. You had a very good performance in 2008, an excellent 2009 for a market-neutral fund and somewhat disappointing 2010 to follow. What happened last year?

Out of financial funds we did okay, but we were up only 2% after fees, and we are very far from happy about that. There are a number of reasons why financial funds did not do as well as other long/short equity strategies last year, and the biggest of them was the impact of the macro environment.

The over-riding theme for financials in 2010 was definitely macro, and teams like the ones we have really concentrate on financials from the bottom-up. That is where our effort is concentrated - in building our deep understanding of the individual companies and the drivers of stock returns. Yes, we'd like to think that financial specialists like ourselves would have a better chance of understanding the impact of macro factors on the universe of stocks we follow, but that is not the same as being any better at forecasting the macro-environment.

Post fund launch in 2003 the biggest macro driver was EuroLand convergence – that lasted through to 2009 in various ways. Making money for a sector fund was mostly about the attractiveness of one stock versus another up until 2009 - and then it changed.

From the environment of 2008 onwards, only the funding issue remains the same in 2010 – so the issue for financials is not the cost of funding. The markets treated stocks the same whatever their cost of funding – they all went down without discrimination.

The second headwind we faced in 2010 was the lack of consistent, strong long-only flows and outflows in our sectors of the stockmarket. These flows are important for the well-informed investors (such as hedge funds, and prop capital) to position against and take advantage of. Investors in hedge funds correctly buy into the idea that their (hedge fund) managers are able to anticipate investing institutions moving into sectors and stocks like tracking elephants moving in a forest. But in 2010 the investing institutions didn't move – flows went into ETFs and indices (country selection) dominated. If other categories of investors buy a banking ETF to take exposures that doesn't help a fund like ours which is market-neutral, and needs differential returns within sectors to drive returns. We are starting to see signs of flows out of bond funds and into equity funds as an asset allocation switch, and if that persists at the retail, or institutional level, that is going to help us.

Q. Was there anything you could have done differently last year to take account of this macro dominance?

If I was being hyper-critical I would say that we didn't put enough effort into tracking the impacts of macro factors in real time - you know, looking at the CDS market and what they say about our stocks. I have traded options in the past, so I know that looking at the implications of CDS pricing is like a put option determining the pricing of the underlying equity. The CDS market says something about where a stock might trade, but the CDS is structured around extreme events, and in any event the CDS market is a lagging indicator. So yes the equity has tended to move in a 1:1 relationship with the CDS, but that type of relationship may be unique to the time we have just been through.

At this point it seems the analysts who follow the financials sector are putting a lot of emphasis on their own take of the macro environment. This could even be at an extreme. There is so much emphasis being put on the macro component that the macro may still drive the individual equities in the first half of 2011.

Q. Does this have any implications to how you shape your portfolio?

Well it doesn't mean that I want to take a directional net long posture to equities, or the equities of financial stocks. As a generalisation, exposure to equity in financials is less attractive than fixed income at this point.

I think you can look for a rights issue to be a trigger for individual stocks. From the time when banks raise new equity they seem to outperform – Deutsche Bank is a case in point. It has out-performed since it raised fresh equity capital. The capital-raising by Nordic banks certainly helped their stocks to perform, though admittedly the operating environment they faced was not as adverse as for banks in some of the other territories. There is going to be a lot of issuance of capital in financials – some big equity raisings are coming in the next few months because they have to happen.

Q. Is capital raising good or bad for the bank stocks then?

The capital raising helps in a couple of ways. In raising fresh capital the banks are taking positive steps to meet the tougher capital adequacy rules. Also when banks raise equity they take big write-offs – so the asset value of the remainder of the assets is perceived as a harder (more credible) number. That said a number of the banks with investment banking business are still tight on capital – Barclays, Deutsche Bank and the French (universal) banks – the Swiss banks are probably okay for capital.

There are cross currents in looking at investment banks. There are negative regulatory impacts for them – they have to raise fresh capital and/or cut the levels of leverage they employ. The margins in trading have to come down – not just outsourcing of trading, but the intermediation of exchanges in OTC will bring down margins through increased transparency. Where they do lending, the net interest income may be softer looking forward. But their commission income should be up, and the prospects for M&A are good so long as they don't get too competitive on fees. We have them in the Fund, but I don't have a strong view on them myself. I don't have to – my colleagues Inigo (Lecubarri) and Louis (Rivera-Camino) sponsor the investment holding-period positions in the investment banks into the Fund. I do trade them quite often, but as the trader of the team I can tap into the expertise of the others for a strong fundamental view.

Looking at universal banks with significant investment banking operations like Barclays is difficult – they have an investment banking operation as well as retail banking and an SME business. You can't look at your DCF model and say this is what Barclays Bank is worth. There are just so many parameters changing all the time, and such a balance sheet that you never quite know about the quality of assets. It is very difficult to pin down a risk/reward on a trade and say that this is worthwhile taking a position here, even doing peer group comparisons.

There are a lot of (sell-side) analysts working on investment banks, but they all seem to do the same thing. They want to understand how the business is doing in the next two quarters – but that only seems to be used to justify the current share price. And talking to management and reading Dealogic about issuance seems to be about as far as they go. Yes the deal flow is the gravy in the business model, but in the present environment in particular, investors have to understand the balance sheet. No -one pushes the management on the balance sheet, and management is reluctant to talk about it on a current basis.

Q. Given the American investment banks report quarterly, do they give you insight into the European banks, or they too much outside your scope?

For our scope of fund it is valid to look at Morgan Stanley and Goldman Sachs. Goldmans has proved to be a different animal than the others – it always bounces back. Their network amongst politicians is first class, and they deal for so many clients that they are right on top of what is happening in flows in sectors. So the trading record is outstanding for good reason, but then again proprietary trading will be wound down, and some top people there seem to be leaving. I have successfully traded GS shares last year, but I felt I was a child playing with fire in doing it, and I have less confidence in my risk taking there this year. In general we are not massive experts in trading things on that side of the pond.

Q. How do you work with the sell-side as an information source?

We use the sell-side analysts for generating and testing ideas on a theme, and for tactical level trading. The hedge fund world is not like private equity – so we don't have the luxury of fixing a fair value for a stock and waiting four years for that value to be realized. We have to deal with regular valuation and marking our P&L to market. That means we have to be more aware of what the market is doing to valuation in the shorter term, and what the market is thinking on a stock.

So we tap into what the sell-side comes up with for ideas – sometimes the brokers' analysts will highlight something that we have missed in our screening. Our role then is to filter what is a good idea and what is a bad idea, and do more work on them. Sometimes what you initially think of as a good long idea can turn into a short position once you have checked out the market positioning on a stock - if the idea reflects the consensus on a stock we might consider going the other way. So then it's a "Short" not a "Long" and we can investigate the timing of taking a position.

Q. So if you are not taking many recommendations what do you use the brokers' analysts for?

We think you have to know all the analysts in the sector to know where the consensus on a company is. They can tell you where "the market" is on a stock, analytically and in terms of market positioning (holdings). The brokerage analysts can plant a seed of an idea – something that could be developed. And if you can find a good analyst it is good to test our ideas with them – to bounce ideas off them. If you can find an analyst who takes the opposite view from you, that is also useful to an investor. You need to test your argument – if you are a bull you need to test out the case of a bearish analyst by talking through his thinking. So then you know whether it makes sense to go against him. That is very very useful for a sector specialist fund manager.

To give you an example in a tactical sense, when we are approaching a company's results announcement- say consensus is at one level and an analyst comes along with a forecast outside the consensus. We might look at it and say to ourselves that the non-consensus analyst is right and the consensus estimates are wrong. In that case we can go long, say, and when everyone upgrades their forecasts the stock will go up. Or maybe the nasty figures are already discounted, and again the stock will go up on the earnings release.

Q. How do you differentiate between the analysts?

Of course the longer you have been in the game the better you know which are the good, and which are the bad, amongst the sell-side analysts. Also with experience you can trust a certain analyst – I know he is good on that stock, and someone else is really good on that bank. To find the analyst that is the expert on the Street on a company is very powerful. If you know the one that has done the most work, that knows the company intimately from following them over a long period of time, it is worth a lot. You may be able to ignore the other analysts on the company. I admit that it is a rare thing, such confidence in an external analyst, where they are the clear number one or two in knowledge on a company. But it can have a good pay-off. It can put you as an investor in a psychological disposition where you can comfortably take bigger risk.

We are fortunate in that we have such an analyst working in our own team. Inigo has been the number one ranked analyst on Portugese and Spanish banks, and to some extent he can tell others about what is really going on! This gives us a genuine edge in some stocks compared to the market.

Q. Would you say there are differences between how a hedge fund would use a buy side analyst and a sell-side analyst?

There is a substantial difference between the buy-side and the sell-side analysts on the risk/reward for a view on a stock. The sell side analyst has to live with his recommendation for a lot longer period of time. We have the luxury on our side of being able to moderate our view, as expressed in our position size, as we go along.

Q. Your presentation shows you as having specific responsibility for risk control. Are you the one that has to place the stops on positions?

It is not just my input on this. I carry out the dealing for the Fund but my colleagues put their own ideas into the Fund, and they propose how wide the stops should be. I don't apply a blanket hard stop. What I prefer to do is to place the stop in proportion to the volatility of the stock. So a more highly volatile financial stock will have a wider stop on it than a stock which acts in a less volatile way.

Also it is not as straight-forward as it sounds - looking at one position in isolation. We have related positions in our portfolio, so we may have put on two (hedging) short positions against one long position. So the catalyst for action can't be one share price in isolation, even if the P&L on that may be negative – there could be a long position down 40% and the shorts are down 35%, for a net loss of 5%. So the trigger level of an 8% loss has not been reached and so the stop would not be effective even if the three stocks are each down more than 30%!

There is another factor in the frequency of taking losses - the size of the P&L of the whole Fund has an impact. When the fund is doing well, and the P&L is positive, it is natural that the balance sheet of the fund is higher than when we have had to take losses. So it is much easier to run the profitable positions, and not be compelled to close the losers when the whole fund has a positive P&L (for the year).

Investors in the fund should also appreciate that there are some exit tactics to be deployed. So even where there is a stop level, not the whole of the position is changed all at once. I prefer to sell, say, half a long position at a level and then wait to see how it reacts for the remainder.

Q. Thanks for your time, Martin. You have given us a good insight into how you work with the Street, and how you manage the volatility of your fund so well. Good luck with the alpha harvesting in 2011.


Terms: Management Fee: 1.5%, Performance Fee: 20%, Redemptions: Monthly, Lock Up: No

The interview was conducted on the 12th January 2011.

Another article on ABACO Financials Fund can be found here.

Thursday, 10 March 2011

Bridgewater Associates in Numbers

Among the 1100 staff at Bridgewater there are as many as 130 client service personnel looking after around 300 clients.

  Bridgewater manages $87bn in assets.

    Ray Dalio's total remuneration for 2010 will be of the order of $3bn.

     The flagship Pure Alpha Fund produced its best year ever last year with a return of 44.8%.

      Pure Alpha was up 8.7% in 2008 when 70% of hedge funds were down.

       Bridgewater Associates is 36 years old this year.

        Asset growth has been at the extraordinary rate of 25% per year for the last ten years.

         Over the last 20 years the Pure Alpha Fund has produced a compound annual return of 18%.

   About 30% of the employees at Bridgewater quit or are fired in their first two years at the firm.

DATA SOURCE: AR magazine

Wednesday, 9 March 2011

The Grind Continues for Many Hedge Fund Managers

Whilst there is a constituency within the hedge fund industry which have obtained the Hollywood version of the trappings of success in the financial sector - the cars, the ranches, and the (part-owned) private jet - there is also a very long tail of funds which have not been in performance fee nirvana for some years.

Barton Biggs gave a very good  insight into the under-reported downside of running a hedge fund business in his book Hedgehogging. He told the story of an acquaintance who had put in a good year for performance, so collected a handsome performance fee for his added value. But as the manager's style of investment wasn't suited for subsequent market conditions, the following years were rough. The fund manager had to attend all his usual company meetings, read copious amounts of material, track stock market shifts, talk to his investors and put his ego on the line by selecting stocks. He had to put in long hours running his own small business as well as being a full-time professional investor - dealing with accountants, lawyers, budgets, planning, and hitting deadlines for regulatory filings and statutory reporting. All this while not making big money - in fact the big money of the fat year was ploughed back into the business for the subsequent lean years.

There are many challenges running a small business. In the hedge fund segment, in which the spoils go to the victors of the war of performance, not the least of the challenges is to retain (smart, professional, and mobile)  staff  who have no prospect of a bonus for some time. When the average hedge fund fell 19% in 2008 that presented the challenge of returning 23.4% to get back to the NAV of the start of that year. For most hedge funds that is two good years of returns. So staff could only get paid a meaningful bonus at the end of year three - that is, get paid at the start of year four! Hence staff defections from the hedge fund losers of 2008 was a theme of 2009 and into 2010.

The business school tenet for running a business like managing hedge funds is to build your expenses to be in line with your regular revenue, i.e. on the management fees. The performance fee is often characterised as the gravy in the meal, but if the base diet is thin gruel then gravy is not what a diner wants as a supplement.

And small gleanings are what have been available to many managers. It was reported here in a recent article that around half of Europe's largest hedge fund manager groups had not gathered more assets in the middle six months of last year - so the base revenues of the businesses were not expanding. However, by the end of September last year only 5% of the assets of the largest managers in Europe were not qualified to pay performance fees because of the high water mark feature. So by extension, with a further five months of positive hedge fund returns, most of the world's large hedge fund groups are now accruing performance fees. The well known names who run these businesses will be able to buy a larger house in the Hamptons if they choose. The more socially sensitive of them will be able to fund another urban academy in a deprived neighbourhood.

However, there are many dedicated hedge fund managers who will not be in a position to fund such largesse, or even take a house in Vail for the season. Eurekhedge reports that fully 42% of hedge funds are still below their end 2008 NAV at the end of February.

Thursday, 3 March 2011

Hedge Fund Radio - 7th March

You are cordially invited to listen to me join in the smorgasbord that is the Monday, March 7th edition of the Sony and Wincott Awards-nominated hedge fund radio show "The N@ked Short Club".

The programme host is pseudonymous; there is loose talk on hedge funds; and there is some heady music...
                      is all combined for an hour of unique radio.
Tune in to "The Naked Short Club" on Resonance FM.

The guests next Monday, apart from me, are: Stephen Oxley- MD, Paamco; Stephen Pope- CEO, Spotlight; Tony Greenham, Head of Finance & Business- New Economics Foundation; Joy Dunbar- Editor, Absolute UCITS; John Davey- Senior Research Analyst, Bestinvest; plus, "by low latency Tantric link from the US," expert investor, commentator and seminar meister, Mike Gasior- CEO, AFS. Cultural content comes from BH Fraser, the City Poet.

The show, the Naked Short Club, is broadcast live from 9-10pm (London time) on RESONANCE FM (104.4FM within London / online worldwide via

London Losing its Allure as a Trading Centre if Guggenheim Partners' Decision Making is Indicative

The politicians don't believe it when the British Bankers Association or AIMA say that tax-paying talent will leave the country, or when supply-siders say that the percentage tax take is hurting growth from entrepreneurialism. But there is evidence. UK based firms (including large cap names) have moved their tax domicile to Switzerland. Hedge fund firms founded and grown in London have opened offices elsewhere in Europe to avoid increasingly high personal tax, and to take some corporate revenue out of the UK. Several high profile leaders of hedge fund firms have left London. 

These are examples of indiginous tax paying people and entities moving outside the scope of the UK tax authorities, but there are also decisions being made not to come into the UK tax environment. London is the long-standing hub for global financial activity in the European time zone. There is no doubting London's historic position and ranking. Their is a complete range of markets in the UK's capital from capital markets to insurance and shipping to commodities and foreign exchange. So the talent pool is broad and deep, and the service support infrastructure is excellent for any sector. It is possible to find lawyers and outsourced I.T. firms and back office capability across the spectrum of tasks in London. London is expensive, particularly for real estate, and the physical infrastructure is strained, but it mostly works and everything necessary to start a business is readily available. 

The positive factors for London may not be enough any more. Guggenheim Partners LLC is a privately held global financial services firm with AUM of $85bn and offices in nine countries. It is setting up a proprietary trading platform to take advantage of the decline in bank trading with proprietary capital. Outside the United States Guggenheim Partners has offices in Dubai, Dublin, Geneva, Hong Kong, London, Mumbai and Singapore. The new venture, Guggenheim Global Trading (GGT), will have an Asian office (place to be decided), and it was a shock to read today that the European office for GGT will be in Geneva.  

These kind of decisions, to not come to London rather than actively leave the UK tax and regulatory burdens behind, are not headline grabbing and not something that can be taken as positive proof of the case. But there is collateral evidence that London is losing its allure as a trading centre.

Addition of 12th April 2012
It is unlikely to be related to recent tax changes in the UK Budget, but another hedge fund manager has left London for a lower tax regime. Changes on the FSA register show that the senior investment and operations staff of Tyrus Capital are no longer under the UK regulator's jurisdiction. Tyrus Capital was set up by Tony Chedraoui, the well-regarded former head of Deephaven's European investments, and is one of Europe's top 50 hedge fund firms by size.  Reports suggest that the management of the $2.7bn of assets run on an event-driven basis has moved to Monaco. 

Hedge Fund Tax Drain (June 2010)
Mixed Messages on Health of HF Business (Nov 2010)

Tuesday, 1 March 2011

Europe’s Big Hedge Funds Not Growing from Net Subscriptions

Every six months the UK's Financial Services Authority conducts the Hedge Fund Survey (HFS) and the Hedge Fund as Counterparty Survey (HFACS) to help the regulator analyse the systemic risk posed by hedge funds. The latest surveys were conducted in September/October 2010, and the results were released yesterday.

The surveys give invaluable insights into the state of the European hedge fund industry. The HFS asks selected FSA-authorised investment managers about the hedge fund assets they manage and the large funds (equal to or greater than US$500 million in AUM) for which they undertake management activities. So the survey is top-down by size, but given the concentrated nature of the industry the survey well reflects the European industry as a whole, the UK regulator overseeing funds controlling around 80% of the European end of the industry.

The September 2010 survey covered about 50 investment managers with just over 100 funds qualifying by size. Together these firms reported approximately US$380 billion of hedge fund assets under management. The FSA estimate that the HFS captures approximately 20% of global hedge fund industry assets under management. Major American hedge fund groups with a London office, such as Highbridge and Moore Capital Management, will be in this survey.

There are a number of interesting and significant results in the survey:


1. Net subscriptions for large funds were negative in the six months to September 2010.
Aggregate assets under management increased in the survey period due to positive performance. But the picture of subscriptions and redemptions was more mixed. Approximately one half of large funds in the September 2010 survey reported a decline in AUM driven by negative net subscriptions (Chart 1). In aggregate, negative net subscriptions reduced assets under management by 0.8% versus the aggregate assets at the start of the survey period.

Chart 1. Distribution of Change in Large Hedge Fund AUM for the 6 months to end September 2010

source: FSA
2. There was little change of the size of hedge fund assets in side pockets
"Assets under special arrangements due to their illiquid nature, such as in 'sidepockets', remained largely unchanged at 11% of aggregate NAV, suggesting no improvement in the quality of these assets," according to the FSA.
3. Large funds in Europe have recovered to their high-water mark
Assets below their high-water mark have declined to less than 5% of total surveyed assets, down from 43% reported in the October 2009 survey. So the profitability of European hedge fund management companies should be much improved in 2011.

4. Hedge fund managers in aggregate have been able to agree a lengthening of their term of credit.
The term of financing has been 'pushed out' in aggregate, with a reduction in short-term financing of between 5 and 30 days and an increase in financing terms of 31 to 180 days (Chart 2). This gives more potential for stability within the portfolios, as positions will not have to be reduced because of a shortage of short term finance, as can happen when short term financing is rolled over on a frequent basis. The leverage providers are overwhelmingly the prime brokers.

Chart 2. Financing Term – Percent of financing by days

source: FSA
5. The average excess collateral held by prime brokers is as at the low end of the 5 year range.

The Hedge Fund as Counterparty Survey suggests that the average excess collateral is currently around 90% of the base margin required (Chart 3).The FSA notes that there have been developments in hedge funds' cash management which may impact the movement of collateral, such as an increased use of custody accounts for excess collateral.

Chart 3. Average Excess Collateral Held by Prime Brokers – Collateral as a percent of base margin

source: FSA
6. Commodity futures positions of hedge funds has become an issue of note to regulators, and should be one to investors and the funds' managers.

According to the FSA the footprint of surveyed hedge funds within markets is generally small when measured by the value of their holdings, suggesting that in aggregate they do not have a major presence in most markets. However, the regulator for most of Europe's hedge funds states that there are potential exceptions in convertible bonds, interest rate and commodity derivatives. Hedge funds have been nearly 5% of the open interest in commodity markets in the last year. These positions might be held for reasons of medium term value, but for most hedge funds the holdings are governed by momentum-based tactics. So the exit may become very crowded in some of the smaller commodity markets where hedge funds are relatively new, if large, market participants.
7. The relative decline of funds of hedge funds within the industry is illustrated again

FSA survey data shows (Chart 4) that the large hedge fund groups have well diversified sources of capital for their larger funds. A surprise in this analysis is the low percentage of capital of large hedge funds routed via funds of hedge funds – only 28% (or less) of capital of large hedge funds was contributed by funds of funds (and other funds). There may be some under-estimate of total holdings of endowments and pension plans in this data, as these institutions and HNWIs may have hedge fund exposure via FoFs as well as through direct holdings. However it is difficult to refute that funds of funds are contributing much less of the capital of large hedge funds in 2010.

Chart 4. Sources of Hedge Fund Capital for Large Funds at September 2010

source: FSA
Parenthetically, the FSA survey suggests that hedge fund managers themselves own over $30bn worth of their own hedge funds.