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.


Thanks.



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


The interview was conducted on the 12^th January 2011.
Another article on ABACO Financials Fund can be found here.

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

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.

Hedge Fund Radio - 7th March

You are cordially invited to listen to me join in the smorgasbord that is the Monday, March 7^th 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...
                               ...it 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 http://resonancefm.com/listen).

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. 

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

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.

A Shift in Risk Appetite?

I believe in Marshallian K – so excess money creation goes into financial assets if the real economy doesn't need it. This is what is going on now in American financial markets. We are seeing narrow money creation but not broad money growth. The St. Louis Federal Reserve is showing that the current money multiplier is less than 0.9, that is, printed money is not being multiplied by the banks to the typical extent (2.0-3.0).

What is interesting so far in 2011 is the change in where that money is going. In my last article I made a logical case for flows into stocks rather than bonds based on valuation. I doubted that the flows of mutual funds would reflect that logic, but I have been proved wrong by the data releases* of the Investment Company Institute since. Here is a table showing mutual fund flows on two time frames – the top part of the table is monthly data and the bottom part is weekly data for mutual fund flows this year.

U.S. Mutual Fund Flows

Source: Investment Company Institute

The Table shows some interesting shifts. The pattern last year was for positive bond flows and negative equity flows. Whenever equity flows went net positive last year it tended to be because positive flows to emerging market mutual funds outweighed outflows from domestic equity mutual funds. So for three quarters of the year in 2010 there was a large negative bias towards mutual funds investing in American stocks.

Towards the end of the year holders of mutual funds caught on to the increasing fragility of the finances of municipalities in the States and there were net redemptions from muni bond funds. The outflows from muni bond funds have continued this year. There has been a minor pick up in flows into taxable bond funds this year, and it looks like straight switching within bond mutual funds to safer havens. Net flows across total bond funds are a small positive – and really quite small compared to last year's positive net flows. So the key word in the bond mutual fund story in 2011 is small.

The key words in equity mutual funds investing in 2011 to date are growing and domestic. After some minor end year tidying up, the U.S. mutual fund investor has continued to buy overseas equity focused equity mutual funds as before, but the new new thing is the emergence of significant buying of domestic equity mutual funds. The market for mutual funds in the United States is not like in some European territories where the largest investor in a UCITS funds can be the sponsoring insurer or bank. In the United States, apart from money market funds where institutions own around a third of the assets, mutual funds are held by individual investors. Individuals own 89% of bond funds and 91% of equity funds. And the man in the street in the US has been buying domestic equity mutual funds to an extent not seen in at least four years.

Whilst individual investors are recent converts to the attractiveness of equities, institutional investors crossed that line some time ago and at this point are expressing fervour for the concept.  The Merrill Lynch Fund Manager Survey for February (survey period 4th-10th February) contains extreme conviction on the part of institutions. The Survey overview states "The February FMS is one of the most bullish in years. Institutions have record equity and commodity overweights, very low cash levels and the strongest risk appetite since Jan‘06." It also says that "Hedge fund net exposure rose to 39%, highest since July’07. Cash balances fell from 3.7% to 3.5%, triggering our FMS cash trading rule equity sell signal." 

A mirror of the rated attractiveness of equities is an aversion to bonds in the Survey - nominal bond allocations were very low; the lowest since April of 2006 and near record lows. This is the corollary of the view on inflation (and implicitly commodities) that expectations for global inflation were the highest since June of 2004.  There is a consistency of world view too in the consensus for economic growth. Just 13% of respondents expect the global economy to weaken in the next 12 months. 


Parenthetically it is interesting that professional money managers express the same sentiment now that mutual fund flows have expressed this year  - a strong bias towards the equity markets of the developed world rather than emerging market equities. The expressed appetite for U.S. equities is the second highest ever in the Fund Manager Survey. 

The mental positioning, and Dollar positioning, of investors in equity markets combined with expressed survey views on growth and inflation give a clear road map for contrarian investors. For example I would suggest that the views of Hugh Hendry put across here (Hugh Hendry's views) were for something other than where the consensus has got to. Equity markets are overbought, and extended to the upside. However, overbought conditions can persist and there is little internal inconsistency in the market action for a tape reader to find. One of the market observers I respect puts it that the broad market "continues to demonstrate bullish resiliency".

*Flow estimates are derived from data collected covering more than 95 percent of industry assets and are adjusted to represent industry totals in the weekly data. Data for previous weeks reflect revisions due to data adjustments, reclassifications, and changes in the number of funds reporting.

Stocks over Bonds for 2011

Just over a year ago I featured as my Chart of the Day the mutual fund flows for U.S. bond funds and equity funds. At that point I summarised the attitudes of retail investors as "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 updated chart (Fig 1 below) shows that 2010 had more of the same, that is, huge inflows to bond funds and net outflows from equity mutual funds.

                                  Fig 1. Monthly Net New Cash Flows to U.S. Mutual Funds by Asset Class

As at the previous point of review (December 2009) the logical case now is very strong for a preference for equities over bonds based on valuation. Looking at the P/E ratio of American shares in isolation the case is not particularly convincing as Figure 2 shows. The S&P 500 trades at 13.6x forward four quarter earnings – this level is neither cheap nor dear in an absolute sense. But the context is very constructive: inflation is low at the consumer level; interest rates, whether real or absolute, are low and will remain so for some time; and earnings growth may be a positive surprise in 2011 as expectations are low.

                                    Fig 2. P/E Ratio of U.S. Stocks based on 12m Forward Estimates

The earnings surprise at the market level could come because expectations are low and the American corporate sector is well set in several regards. First the operating leverage is good after staying lean and mean, and hiring has only recently begun. Secondly the level of the Dollar makes the U.S. internationally competitive (and exports accounted for 1.1 percentage points of the 3.2% increase in real GDP in 2010). Thirdly, and this will be very important this year, unlike the consumer and the government, the corporate sector has a good balance sheet in aggregate. I place an emphasis on the balance sheet because there is good scope for capital spending as well as hiring, and, most importantly for investor psychology, conditions are good for a lot more mergers and acquisition activity this year.

However, even if the earnings growth for 2011 only turns out to be in line with the current consensus, a strong case can be made for a preference for stocks over bonds on the basis of relative valuation. This is illustrated in Figure 3.

                                                      Fig 3. Yield Comparison for Stocks v Bonds 
                                               (Earnings Yield on S&P500 v Real Yield on 10 Year Treasuries)

The widening gap between the real yield on the highest quality bonds and the earnings yield on American blue-chip stocks (the inversion of the P/E ratio) reflects the neglect by investors of stocks relative to bonds. The risk premium for stocks now is higher than it has been for more than 80% of the last decade, and at nearly 3.9% is 1.6% higher than the average over the last 10 years. The logical case is very strong - on the basis of valuation investors should switch out of bonds and into stocks.

On the basis of investor psychology investors won't switch. The aversion of the man in the street to anything to do with Wall Street will continue. ETFs have continued to grow whilst equity mutual funds remain out of favour suggesting that Americans don't want to give money to stock-selecting money managers. Individual investors are dis-engaged with markets to an extent rarely seen before. In short, America has fallen out of love with stocks.

Top Macro Manager Talks Through Set-Ups, Triggers and Sizing Positions

This week I heard a presentation by a senior trader at one of the large global macro hedge funds which has been in business for nearly 20 years. He put across several insights into the way of working of those who engage in the strategy. The particular trades under discussion were in foreign exchange, in the Euro/U.S. Dollar, during last year.



Fundamental Set-Up

In FX there are three elements to the fundamentals that should be aligned for putting on a position, according to the trader. The first is valuation. In FX there are several valuation models which are commonly used though each has limitations. Purchasing power parity (PPP) for a currency pair is a value which is unobservable in markets, and is a conceptual level that actual FX rates pass through without pausing. Extreme deviation from PPP is taken as an under or over-valuation. The Economist uses the price of the ubiquitous McDonald's meal to calculate the "Big Mac Index", a guide showing how far from fair value different world currencies are. The Big Mac theory, which is based on an observable purchasing-power parity, says that exchange rates should even out the prices of Big Macs sold across the world.

The second element of the fundamentals to consider is the interest rate differential between the two countries on each side of the currency pair. This is not a static element, as the FX markets (spot rate) move with forward forward rates. So expectations of future interest rate differentials are what count. The relative growth outlooks of the two economies is what the senior trader emphasised in getting a handle on interest rate differentials. For my part I would say that the perceived prospects for medium term inflation are now taking a much bigger role in the mind of the market than hithertofor in looking at interest rate differentials.

The third fundamental element to a good FX set up for a macro trader is the policy environment. Last year presented a classic opportunity (in looking at Euro related trades) in that European politicians/central bankers commented on levels and movements in traded rates (CDSs as well as bond auctions and FX parities). Some of the great macro trades have been set up by governments attempting to talk down markets when their policy objectives clash with what the markets discount as sustainable. So last year was a classic of its type in this regard, though interest rate policy specifically was a stale issue according to the bulge-bracket macro trader. That is, changes to interest rate policy were not expected to be a driver of the market condition for the trade under consideration in the time-frame envisaged. For trades at the market level like those illustrated here, and particularly in FX it is very important to understand the market drivers at the time. The graphic below indicates what the macro trader stated were the major drivers for the €/$ level last year through the different phases.

Technical Set-Up

The technical set up for a macro trade can be about flows and positioning by the various categories of market participants (say hedgers, speculators and governments). For example, the Commitments of Traders report for listed US futures showed there were very high levels of Dollar bear positions just before the monthly employment report for July 2010 released on the 6^th August last year. So the positioning in the market shifted the odds of the labour market data being bad enough to move the Euro up further versus the Dollar. That date marked an interim top for the Euro versus the Dollar.

The other form of commonly used technical set up is pattern recognition, which in its crudest form is chartism. Along with the rest of the market, the senior trader from the well-known global macro firm was onto the break in the multi-quarter uptrend for the Euro (versus the Dollar) that occurred in December 2009. The Greek debt crisis powered the multi-month fall in the Euro which lasted into the middle of 2010. The break in trend of itself is often a good entry point for a trade, but as FX markets have lots of minor reversals against the major trend traders have to have tools to identify the second and third high quality entry points as the new major trend unfolds. In the middle of January 2010 there was a good secondary entry point on such a short term reversal – as is typical the secondary entry point corresponds to a support/reversal level on the previous major trend – in this case around 1.45 on the €/$ in the period 13-15^th January.

This secondary, high-quality entry point can be illustrated in another trade mentioned on this website – in Gilt futures (see here and here).

Technical Set Up for Trade in Gilt Futures Showing High-Quality Entry Point

The significance from a money management perspective is that the second entry point - as the security price accelerates away from a key support or resistance level - can be a higher conviction entry point than the first. This is because the investment hypothesis ("the market is going to go down", say) has been tested by market action and passed the test. So depending on style, the macro trader can trade in several risk units at the second entry point. In no way is the second entry point a secondary entry point!

The global macro trader also disclosed the use of a particular tool to assess sentiment – the world wide web. The fund monitored the occurrence of the phrase "quantitative easing" on the web in August, September and October to ascertain the degree of dominance in the minds of investors.


Trigger

Global macro trading is often about assessing the persistence of action by the various actors in the market drama. It was interesting that the senior macro trader said that the trigger for putting on the position was often the behaviour of the markets themselves. Note that the crucial observations are across markets, not necessarily from market action within the market under consideration. So for the €/$ last year the maturity of the Euro rally that began in June was under consideration in August by the trader because the co-movements of the S&P500 (as a proxy for global equities) and the fx rate diverged. The €/$ and the SPX had synchronised price changes for a period of some months, but over the first few trading days of August days the S&P was flat whilst the € was still appreciating against the $. For the macro trader this signalled a change of behaviour was imminent for the Euro/Dollar relationship because the S&P action signalled at least a pause in the driver for the FX rate (the slowing US economy). To quote the trader directly, "divergences between markets are the best clue for market behaviour. A correlation break that lasts for one-to-two days and can indicate a movement to follow that lasts for 2-3 months." He also stated that more than 50% of a macro trader's insight comes from understanding the message of the markets, that is the behavioural inference is key. Like many traders, including those with a macro framework, the presenting macro trader only puts capital to work if the market has already started to move in the direction he wants to play.


Sizing

Sizing of positions in macro is usually a function of risk/reward and correlation. The senior trader didn't mention correlation himself in this regard, so we'll concentrate on the potential profit and loss as the key input to position sizing. The target price and stop loss levels for positions in markets are typically placed at or near significant support and resistance levels – the difference between current price levels and these two levels gives the upside/downside ratio for the potential trade. The potential loss between current levels and the stop is used to scale the maximum position size. A loss of say 5% on a position that is 20% of the gross equity of the fund would give a portfolio level loss of 1%. If two percent loss at the fund level for a single position is the outer bound then a 3% loss to the stop would equate to a 24% of equity maximum position size. The principle is determine how much you are prepared to lose – "anything else is bad discipline, or has ego in it," admonishes the trader.

This particular macro fund also uses drawdown from peak as an additional risk limiter at the level of the individual trader. So the risk capital of the trader will be reduced if his P&L is down 5% from his own peak, and he will be out of the market for a period if he loses 10% from his peak P&L, even if he is still positive on the year.


Closing the Position

The macro trader acknowledged his belief in the concept of reflexivity – Soros' concept that positive price changes themselves impact how positively investors think about the market – such that prices can waterfall down or continue upwards way beyond most expectations. Conceptualising potential price changes and unusual market impacts helps macro traders mentally prepare for a range of market outcomes. But still an all, positions have to be closed even after exceptional profits – so what feeds into the decision making at the closing of a trade? "A position should be reviewed when a price target is hit, and should be closed for sure when a lot of the market has joined you in that position."

How do you make money in macro trading? – "You need to take risk aggressively to make money, but you need to take it well." 



One of the reasons I posted this article is that the trader uses several methods I use in my own style of investing. If you run a hedge fund and would welcome input on your processes (investment, research and risk management) from my consultancy or want to persuade me to share my expertise full-time contact me on s-kerr@tiscali.co.uk 

Chart of the Day – Funds of Hedge Funds Flat-line in Asset Flows in North America

My Chart of the Day comes from The Eurekahedge Report which looks at 2010 hedge asset flows and investment returns. The chart compares the monthly asset flows to North American hedge funds and funds of hedge funds since the start of 2008. The contrast in flows in the recovery phase is very striking: single manager hedge funds net redemptions stopped four months earlier than net redemptions to funds of funds; and there have been net subscriptions to single manager funds in most months since April 2009, and net subscriptions to funds of funds have flat-lined over the same period.

Monthly asset flows to North American hedge funds vs North American funds of hedge funds

The North American component of the hedge fund story is very constructive at the single manager level. Not only have NAVS recovered well since the Credit Crunch but in doing so last year the Eurekahedge North American Hedge Fund Index was ahead of the S&P 500 until the last month of the year. Over the last three years North American single manager hedge funds produced annualised returns of just over 7 1/2 %, versus 5 1/2 % for the Global Eurekahedge Index. Indeed American hedge funds produced better returns than funds managed from other developed regions in each of the last three years. So American single manager hedge funds have done better in performance terms than those in other regions.

The three year annualised returns of North American funds of funds are negative according to Eurekahedge, just as the MSCI North America had negative returns over the same period (to end November 2010). Further the 3-year annualised standard deviation of returns of funds of funds is the same as that for single manager hedge funds. So that on a three year basis funds of funds have not delivered absolute returns, and the volatility of returns over that period has not been lower than single manager funds (which historically had previously always been the case). So the return-for-risk argument is weak for funds of funds relative to single manager funds in North America.

As a source of capital for the whole hedge fund industry American investing institutions have become dominant. Survey evidence shows some recovery of appetite amongst institutional investors in hedge funds – questions on investment intentions produce a net positive balance from respondents on a consistent basis since the end of 2009, with US investors more positive than investors in other regions. But the "intentions" have turned into net positive flows only for single manager hedge funds in aggregate (though around 30% of funds of hedge funds report net inflows in the second half of last year). There several plausible explanations for the contrast in flows depicted in the chart.

The gap in performance between single manager hedge funds and funds of funds may have got too wide for investing institutions to bear. Historically there were a few years, over the course of decades, in which multi-manager hedge funds out-performed single manager hedge funds. So in those years there was a (relative) pay-off for strategy allocation and avoiding the under-performers and blow-ups – which is for what investors pay funds of funds. It was commercially crucial that funds of funds did that in the key year of 2008, and they didn't, as a whole. It is now many years since funds of funds in aggregate even got near single manager returns.

Given the return records for single manager and multi-manager hedge funds the additional layer of fees in the latter cannot be justified in the minds of institutional investors. Fund of funds' management fees have been falling for more than a decade, reflecting the balance of supply and demand over that time. In contrast single manager fees have held up much better, with the exception of the immediate post Credit Crunch period. Indeed Eurekahedge record that the average management fees for single manager start-ups in 2010 was higher than for 2009's start-ups.

A third plausible explanation for the difference in asset flows to the two hedge fund sectors in North America is the increased accumulated knowledge and experience of the investing institutions there. The model seems to have shifted. For most of the last decade funds of funds were the mechanism for investing institutions to allocate to hedge funds, but a knowledge transfer has taken place. The senior staff at institutions now have a familiarity with hedge fund concepts and can interpret hedge fund data readily. Whilst funds of funds companies can demonstrate advantages in due diligence process, depth of understanding of investment strategies, and risk management and portfolio construction of funds of funds compared to the dedicated resources available to most investing institutions, the latter can now comfortably find these capabilities on an out-sourced basis. External advisors for strategic decision making and tactical monitoring of hedge funds have usurped the role of the dedicated funds of funds. The same tasks are being carried out, but maybe by a combination of a very small dedicated in-house team with input from an external advisor on a fixed fee basis. A number of funds of funds companies may be retained by investing institutions to give a plurality of opinion and form of analysis, for benchmarking, but experienced investing institutions may not feel the need to pay the old fee scales. Plus the marginal increases in allocations to hedge funds by pension plans is increasingly going to direct investing in single manager funds.

In each of these regards the North American part of the industry is in the vanguard. Most of the assets of the hedge fund industry are managed by managers in the United States. For a U.S. investor to visit (and allocate to) an American hedge fund manager is a lot easier than for a Japanese investing institution – hence there will always be a place for funds of funds for Japanese investors in hedge funds. American investing institutions are the largest contributors of capital to the hedge fund industry at the moment, and will be for some time. Given all the above - relative performance, regional strengths, fee structures etcetera - plus the fact that large, branded hedge fund groups are highly likely to be American, is it any wonder that 85% of the global flows into hedge funds are going into American single manager hedge funds? 





To see more postings on multi-manager hedge funds click on "funds of hedge funds" in the LABELS gadget on the lhs of the page.
 

Cevian Capital II Ranks High on 2010 Returns

Europe's largest activist fund, the €3.5bn Cevian Capital II, has had a(nother) banner year – up over 34% in 2010, after a return of 35.7 percent in 2009. This puts the Fund very close to the top of the ranking for hedge funds of any style, ahead of almost any other equity hedge fund, and given that most of the other top-ranking funds are a fraction of the size of Cevian II it again confirms the quality of the management. Without doubt founders Christer Gardell and Lars Förberg are amongst the most impressive managers of capital I have met. So I thought I would share some thoughts from Lars Förberg that were elucidated during a session in October last year under the auspices of The Greenwich Roundtable.



First here's a bit of background on the firm and what it does, and the talk should illustrate the principles outlined.

Cevian Capital was founded in 2002 by with the launch of Cevian Capital I, a fund dedicated to activist investments in the Nordic region, and in which Carl Icahn was a significant investor. In 2006 Cevian raised its second fund, Cevian Capital II which had a remit to invest in companies in Northern Europe. To put the wider remit into practice Lars Förberg moved to Zurich, whilst Gardell remained in Stockholm.

Cevian Capital's version of active ownership creates value by (i) acquiring substantial ownership positions in undervalued public companies and (ii) realizing their long term value potential through change. Cevian generally invests in companies overlooked or misunderstood by the market and in many instances out of favor with investors. Cevian targets investments where there is a meaningful opportunity to enhance the long term value by improving corporate governance, operational performance, corporate strategy and structure.

Cevian manages a concentrated portfolio of 8-12 companies at a time, with significant ownership positions in a limited number of publicly listed companies and is typically one of the largest shareholders in its portfolio companies. Consequently, Cevian maintains a strong commitment to oversight of each of its investments.

The investment process of Cevian is in two stages. Prior to investing, Cevian commits considerable time and resources to evaluating and analyzing prospective investments. All investment decisions rely on a well established and rigorous proprietary due diligence process, including comprehensive financial, commercial, operational and legal analysis. In the second stage Cevian looks to work constructively together with the management and board of directors of its portfolio companies, aiming to increase the company's long term competitiveness and create value for all shareholders. Cevian frequently participates on boards and nomination committees of its portfolio companies.

Lars Förberg

Three Questions for Lars Förberg

Question One: Is Europe Falling Apart?

To the first question, is Europe falling apart, the answer is clearly no. Sure, there are immense macroeconomic issues in many parts of Europe, notably in the south, what many people call Club Med or the pigs. That is Portugal, Italy, Greece, and Spain. These countries are over-levered. They have big deficits. They're not easy to run politically.

Having said that, the most difficult countries -- Greece, Portugal and Ireland -- only account for 6 percent of GDP of Europe. If you add Spain to that, you go 10 percentage points higher. This is still a small part of Europe, and it's not big enough to bring the more healthy northern and central Europe down. And what is interesting is that fiscal and labour market reform of almost unprecedented scope in the problem countries is going roughly according to plan.

Question Two: Can Europe Compete?

On the second question, can Europe compete -- a common view is that Europe is ridden by Euro-sclerosis, an inability to grow and compete based on regional labour markets, militant unions, punitive taxes, and generous social security. In some countries this is true. But when I look at our home market, Scandinavia, and German speaking Europe, i.e., Norway, Sweden, Finland, Denmark, Germany, Switzerland, Austria, you see a different picture. Look, for instance, at the statistics over which countries are the most competitive in the world, and I'm now using the World Economic Forum's global competitiveness statistics. You'll find Switzerland number one, Sweden number two, Germany number five, Finland number seven. As in parenthesis, U.S. is in the middle of these being ranked at number four.

Also interestingly, these numbers go hand in hand, leaving the U.S. aside, with where you will find the most fiscal sound countries. These northern European countries, I imagine, have limited budget deficits, if at all. And a country like Sweden, as an example, has been running budget surpluses for almost every year since the mid-nineties. Another characteristic of these countries is that they all have a strong industrial base geared towards exporting and being the home of a number of successful global companies with strong market positions, excellent product and services, and wide ranging distribution capabilities. These companies benefit from the global economic growth driven by emerging markets, and they have shown an ability to adapt to the changing market environment. I will come back to these companies a bit later.

So, the somewhat short answer to the second question, is Europe competitive, is two-fold -- a strong competitive northern Europe and a somewhat weaker south. One thing I'd like to add here, though, is that when you look at most of the countries that are now successful and most competitive, they went through major reform to get there. Germany did that in the early 2000s after the reunification of the problems that that led to in Germany. Scandinavia did that in the mid-nineties following the financial crisis in a number of Scandinavian countries. These reforms, many times orchestrated by the social democratic governments, led to labour productivity growth way above peers, many times at the level of 5 percent year after year.

Many of these same measures are now being undertaken in the currently weak countries - the fiscally problematic countries in southern Europe. This is being forced by the financial crisis. Examples of these efforts are major deregulations of labour markets, fiscal savings of up to 10 percent of budgets, restructurings of the pension systems, and VAT hikes of 5 percentage points. It's difficult to tell, but in a rosy scenario, these changes can lead to pretty benign environments in southern Europe and have attractive effects in the medium term. But that's something I wouldn't bank on, though, because the political situation is difficult and will continue to be difficult and uncertain over a couple of years, in my estimation. But what should be noted is that the financial crisis is used as a tool to move through structure reforms that are well needed in many parts of Europe, especially in the labour market.
 

Question Three: Attractive Opportunities?

So, on to the third question -- where do we see the most attractive investment opportunities in Europe right now? Well, we are an activist fund operating primarily in northern Europe, buying into equities, so I will back up the earlier comments by what we're doing. What we think are the most attractive investment opportunities right now are the companies I mentioned before -- the equities of the globally oriented companies out of Scandinavia and Germany.

You can still buy these companies as they are for double digit cash on cash yields, and get companies with excellent products, strong market positions, and full exposure to the emerging markets. Prices vary, though, and I don't believe there's going to be an over the line bull market, but I believe that with selective stock picking there are immense opportunities. I'll give you a couple of examples that we have put on into our concentrated portfolio of ten companies.

One example is the German crane manufacturer, Demag Cranes AG, in which we bought more than 10 percent of the share capital over the spring. Demag is the global leader in its field and has the largest installed base of industrial cranes globally. This is important because that means a great opportunity for stable earnings servicing this installed base. The company was undervalued because of its late cyclical nature, but also because there were some question marks over its strategic -- future strategic direction. Therefore, we could buy the company only paying for the service business which is 35 percent of the business, and getting 65 percent of the business - the equipment business - for free.

Another way to see it is that we bought the company paying an enterprise value equivalent to 50 percent of sales. This is for a company that we think will make 10 percent EBIT margin on a sustainable basis.

Another example is Panalpina World Transport, one of the global leaders in freight forwarding, which is based in Switzerland. This company we could buy early this year for a price reflecting the difficult conditions of the logistics industry during the slump. If the company comes back to its normalized earnings level, it will mean a doubling on our initial investment. If we manage to close the company's underperformance to its peers, which is our job as an activist, it will be a 3x investment.

On top of having these sound companies with attractive valuations, I think Europe has offered and continues to offer great opportunities for restructurings. Many companies have been unexposed to active ownership due to a legacy of passive shareholdings, unengaged board members, and value destroying cross share holdings. I believe there is a tremendous value potential in the existing unwieldy corporate structures, operational inefficiencies, underutilized balance sheets, and entrenched boards and management teams that are not pressured to perform. And in most parts of Europe, the corporate governance framework is there to unlock these inefficiencies. The restructuring opportunities, the low valuations, are coupled with one of the greatest opportunities that is not in the share prices today, and that will soon come to fruition, which is restructuring in terms of M&A.

If you are on the right side of M&A, there is tremendous opportunity to make great returns. And I point to a few factors that is driving this. One, corporate restructuring has been absent over the last two years. We all know why. So, there is a pent up demand and appetite. Two, the debt financing is there, both for industrial companies and private equity firms, and corporate cash is at all time highs. Three, the ability to make these M&A decisions is back in the boardroom: markets have stabilized; there's better visibility, and you don't have to focus on your short term crisis anymore. If you as a CEO had brought a big acquisition to your board a year ago, you would have gotten no traction. Now it's a totally different story.

When this M&A boom will happen is difficult to know. It's going to happen. Will it be three years ... three months from now, six months from now, or within a year, I can't say, but it's going to happen.

So, I think these three factors in terms of low valuations, restructurings, and the M&A opportunity, have created some very attractive opportunities in Europe from our vantage point in what we think, at least in northern Europe, is going to be a relatively benign macroeconomic environment.



Q&A


Q1. To marry what you're seeing in terms of micro opportunities with the macro, I was wondering, have you come across situations in your portfolio where macroeconomic or regulatory risk that one of these companies, say the crane company, in the tough economic environment, dwarfed what you saw as the micro economic opportunity. So what you thought was a great value turned out not to be because of macroeconomic risks?

A. (Lars Förberg): You're saying with a macroeconomic environment is it too tough for these companies? Well, when we buy companies that are cyclical, like at Demag, the crane manufacturer, yes, it was a cyclical company. But we would not buy it if we had to rely on a macroeconomic upturn. I think this is the attractive thing. We could buy it paying only for the servicing business. That servicing business is really something, and this was in a slump. So, this servicing business is typically something when you're a core manufacturer or, which Demag sells to, you need these things to function.

It's almost like an elevator business. So, we could buy into this company only paying for this business which is very stable. An elevator business has to go there. You know, it has to run. But we've got the equipment business - 65 percent of the business for free - so we're covered on the downside because we're not paying for the macroeconomic upside, but we're getting that if it comes. I think it's going to come, but it doesn't need to come for it to be an okay investment. If the macroeconomic environment swings up, which it's doing, it's going to be an excellent investment. So, that's the way we think about it.


Q2. Have you thought about playing on the fixed income side at all - corporate fixed income?

A. You know, there isn't much corporate depth in that. I think if you have a credit fund in Europe you have a lot to do two years, and then you have nothing to do for five years. It was a great opportunity two years ago. Then there were many of the convertibles trading maybe at 35 percent of par - very attractive opportunities, companies that you know would survive maybe with equity infusion but they were not going to go dead. But I think that opportunity is gone from my perspective. I think the opportunity in (European) corporate bonds is not there now.

I think when you look at the macro there are a number of issues in terms of how Europe is going to grow, and I think a common view is that Europe is not going to grow that much. When I painted a pretty positive picture of Europe, I was not talking about the GDP growth numbers. I pointed to the Export-oriented companies that have global market positions. If we do something in the domestic oriented sector, which we do limited of but if we do, we only do situations where we can increase the profits of the company by, say, 50 or 100 percent by cost-cutting, typically, or by restructuring in terms of selling off non-core assets because I don't think you should expect in Europe domestic demand to drive growth.

The joker could be Germany, actually, which has been a laggard for many years in terms of domestic demand - consumption demand being very low for many years. But you have a situation in Germany where the unemployment is at its lowest for probably 20 years, and so there could be consumption growth coming in Germany, which would surprise the markets, I think. But it's not going to make a huge lot of difference if you go from 1 percent growth to 3 percent growth. You're not going to make much money from that, so in the domestic economy you have to find special situations.


Q3. There's been a concentration on bank debt in Europe, as opposed to corporate fixed income. So there's not enough in play in the distressed and high yield and corporate bond markets. Does that make it difficult for an activist to get purchase to force through labour reforms in target companies? Europe needs labour reform to make the economies more flexible. That's what the activists need isn't it, flexibility?

A. I think restructuring in Europe is much easier than generally perceived from a legal/cultural perspective. There are countries in Europe where the companies have already restructured. In Germany it used to be impossible to restructure a company ten years ago. It's completely different now. After the agenda 2010 laws that were passed by the social democratic government in the early 2000s, you can restructure in Germany.

And you have to remember that these companies, and many of the countries of Europe, are very dependent on exports. And the governments and the unions know that the companies have to be successful, otherwise it's going to be a problem in terms of employment. They're subject to global competition from China, from the U.S., from everywhere. And therefore many times you have a consensus among the stakeholders (the boards, shareholders, unions, and governments) in cutting costs.

In the countries where I operate (Germany, Sweden, Finland, Denmark, Norway) you have, by law, unions on the boards of companies. And you would think that's going to be problematic in terms of restructuring a company. It's actually the other way around because the unions understand that if we don't do anything to improve the company we're going to be out of business. They hate underperformance more than shareholders do or as much, I should say.

Now, southern Europe is a different thing ... if you look at Spain and Italy and so on. But I think we're seeing labour reform there, and in Portugal as well. And I think that that's the good thing, that the crisis is used to reform labour laws. I think in terms of Greece, we should recognize that it's not that relevant. We talk a lot about Greece, but it's like in a discussion about the U.S. talking 50 percent of the time about North Dakota. It's not that significant.


Q4. So can Europe split – into a fast-track Euro with a slower Euro for certain countries? There are countries that were thinking of leaving the EU, though there are a lot of logistical issues with that?

A. I think politically it's a no-starter. When Europe looked this spring at the budget problems in Greece it took some time for Germany to come around and help bail Greece out. That was a purely political calculation, and I think rightly so. What they did was to wait to endorse a bailout package until Greece had committed to more far reaching reforms. So, it was more a political process than anything else. I don't think a two-speed Euro is going to happen.

I should say, though, I personally voted as a Swedish citizen against the adoption of the Euro a few years ago. I'm a Euro skeptic - there are a lot of problems with it that we're seeing in a country like Greece where they should have a lower currency. But look at Estonia, for example, a country which was not with the Euro, but they were locked in terms of parity with the euro, and they made an internal devaluation by lowering the salaries of government employees by 25 percent an incredible process to adjust their economy to staying with the locked in currency rate with the Euro. They managed through that, and hopefully they will manage through that in Greece as well.


Appendix- Key terms of Cevian Capital II 

A full profile of Cevian Capital can be found at The Hedge Fund Journal

Consulting One - Team Working in Hedge Funds

There is no such thing as a perfect hedge fund – we are all trying. So in my role as a consultant to hedge fund portfolio managers (PMs), I am usually carrying out remedial work in some dimension. Sometimes it can be about the positioning of hedge funds commercially, but usually it is about what the portfolio managers are doing. I'm going to write a series of articles about my consulting work – this is the first.

One of the key elements I have to investigate in my consulting work is the relationship between team members. I'm going to discuss one project I did with two joint-portfolio managers of an equity long/short hedge fund. This discussion is to raise issues and to describe ways of working. The team in this case comprised two members, PM "A" and PM "B", and they ran reasonably successful long-only products. There are three topics in this snapshot – the ground rules were not well established in this example, there were some important differences in style (personal and investment style) that got in the way of successful team working, and one of the portfolio managers had an unusual trait which had a bearing on his money management style. Finally I have included some of the solutions I gave to the portfolio managers and their boss.



Ground Rules

It is not unusual for a team to move from running long-only money together to managing a hedge fund. In doing so there will, of necessity, have to be new rules of engagement. Clarity of the decision making process is very important, for internal purposes (for accountability and reward), and for external parties like potential investors. It is important that there is agreement about the specific roles to be taken, and that there is a buy-in from the off of the structure adopted. A successful agreement or understanding will have a level of detail in it that may surprise some.

One of the most basic areas not made explicit in this case was the fund's objectives and the consequences that follow from that. The two portfolio managers did not have a common, agreed understanding of what returns would make the fund they both ran commercially attractive. Therefore they did not feel the need to measure their portfolio level risk and monitor it - where they taking too much or too little risk? They just didn't know.

Another consequence of this lack of commerciality in terms of return profile is that they had no notion of what was a the worst monthly loss they could sustain without putting themselves out of active consideration by investors. The worst monthly loss is a key metric both internally and externally. Internally the metric gives an implication of where portfolio level stops should kick in. Externally it is one of a number of measures that give investors an idea of what the whole risk profile should be like – number of winning-to-losing months, drawdown, recovery period, and what is a good and bad month for the style of investment.

One of the issues which provoked some tension in the relationship between the managers was how they split between them the sectors of the equity market they worked on. It was fine, and indeed seen commonly elsewhere, that the market was split into two – one half invested in by one portfolio manager. The tension, such as it was, arose because PM B did not want to be excluded from investing in some of the sectors covered by PM A. It was never satisfactorily covered in discussion at inception in the mind of manager B, and that oversight hung over discussions in the ensuing two or three years.

It is quite usual for a PM in a team of portfolio managers to be able to initiate positions without reference to their partners. But how the team will react to change for the positions (in size or price) does need to be covered in the ground rules. Is there any right of veto, is there a different scale of decision made when the partners don't agree? Once a position is owned is it subject to hard or soft stops – do both partners have to adhere to review and exit levels? For the fund and team under discussion one of the partners was much more engaged in challenging the positions initiated by the other partner. Whilst the partners whose positions were under discussion saw this as a personal style point (one partner was just more vocal/forthright than the other), the other partner saw such challenging discussions as part of the investment process. This difference in perception and therefore activity could easily undermine a relationship under pressure because of returns.



Differences Between the Portfolio Managers

Having had some preliminary discussions for an overview, and discussed at some length how the two portfolio managers spent their time and what structure they had in place in their investment process, some clear points of difference came through. To explore these further I conducted separate structured interviews – asking the same questions to each portfolio manager gave a chance to compare attitudes, preferences, and perceptions of the two team members. To put the following list of differences into context I quote from my written report on the managers: "The managers have fantastically complementary philosophies on the market. They get on very well on a personal basis. In fact they have worked incredibly well together with some quite significant differences in tactical approaches (strategy being broadly agreed)."



Differences in Time-Frame

PM B is more comfortable with the shorter term time-frame that running a L/S hedge fund usually requires. Specifically B is much more willing to incorporate the current implications of market action into his market view by stock than PM A.



Differences in seeing Companies and Stocks

They have a similar level of respect for each other's views on companies (specifically differentiating between stocks and companies). However, when looking at equities of companies (shares) portfolio manager B can be as dispassionate about shares as he can about companies. This is in contrast to PM A – who is still prepared to argue with markets when he likes the company, even when the share price action is saying that the market does not agree with the positive (or negative) view of the company in the short term. So the feedback loop from owning the shares – the P&L – is negative for the position and getting worse (e.g. if it is a short the shares are going up) and that message from the markets, even if it is just about short term timing of the position, is being ignored.



The Fall-back Input - is it Technical or Fundamental?

(or to put it another way "short-term or long-term" or even "stock market or real world")?

Through the structured interviews of the portfolio managers it is possible to tease out where there are differences between the team members on research time. For example, in this case PM A suggested that they needed to have 300 company meetings a year, PM B thought that 100 meetings a year with company management was enough. The different perceptions of what was needed fed through to the weighting given to the fundamentals. Or, as likely, reflected the biases the managers brought into the discussion. Under pressure PM A will rely on the fundamentals to win out, whilst PM B will listen to the message of the markets and will be prepared to cut losing positions.



Conviction or Confidence?

Operators in markets, particularly traders, but to a significant degree portfolio managers as well, bring with them the baggage from their previous life experience to their decision making. So sometimes in analysing a team it is not that there are subtle style differences so much as one of the team is coming from somewhere else attitudinally (or characteristically). There can be a one-sided difference, if you like. Portfolio manager X brings with them epsilon, whilst portfolio manager Y has acquired a trait of zeta.

Through the structured interview it came through very strongly that PM A (or the Alpha member!) had a strong conviction that the most important characteristic of a successful portfolio manager was confidence. It is true that someone operating in markets has to have the belief in themselves sufficient to take on the markets, but the very strong emphasis on confidence manifested itself in the investment process in this case. This happened in two ways.

The first expression of individual confidence, if you like an assertion of confidence of an investment view, was in position sizing. Having done the analytical work PM A would take what I would consider a large position for his initial holding in a stock. Almost by definition the stock was bound to be perceived as under-valued by the market at the point of taking the initial position. If the market further under-valued that (long) position by marking the shares down (causing a loss) this would create a "better" (cheaper) buying opportunity, so PM A would have some bias to expressing confidence in his initial view of the shares by buying more. But the more important point is the size of the initial holding – he may or may not add to the position. Portfolio manager B would take an initial position of less than half the size of that taken by PM A, and look to add to it.

The second expression of confidence was the maintenance of positions of large size. PM A would always look for a further up leg in longs he owned for fundamental medium-term reasons. PM B would have a bias to trim successful positions as the positive momentum waned (to top and tail the positions). There was clear anchoring by PM A in sticking to previously successful positions, and to cut them would, in his mind, be an expression of a lessening confidence in the initial research.





Recommendations and Suggestions to Address the Issues Raised

In this particular case I wrote a 30-odd page report to the CIO of the firm as well as presented my conclusions to the portfolio managers that ran the equity long/short hedge. In the report I made a series of tiered written proposals – key recommendations, other recommendations, and finally at a more elective level, some suggestions. In response to the issues raised above here are some of the Recommendations and Suggestions forwarded:

• You should select what you consider to be "high potential" company meetings for both PMs to attend. This will enable higher conviction positions to be established at an earlier stage with a common background on the company.
  
• Be very clear and explicit (shared between you) on the reasons for having a position in a stock. Indeed there may be five potential drivers for a stock to go up (or down), but you must be clear why you own it (are short of it). The stock position should be in a portfolio for reason of how it will contribute to the portfolio characteristics (factor bets) as much as any stock specific reason (factor). This allows you to control portfolio shape in an informed way. Drift in any one position may not matter, but when aggregated across a portfolio, factors like capitalisation effects will turn you into heroes or zeroes promptly in the hedge fund format. Own positions for a reason and stick to it.
  
• You both have to have the capacity to invest in all sectors of the market.
  
• You need a few mechanistic rules that you can apply to take even more of the emotion out of decision making:
  

1. Automatic locking in profit/reducing exposure after a stated return. So a trading position that gives a 15% plus return in two weeks is completely sold, an investment position that gives 25%-plus return in a couple of months is halved automatically. The trading position can be bought again if it is equally attractive at some point. If the fundamentals still justify a larger position (they have improved since original position taken) then the investment position can be made larger.
   
2. You need a review level and hard-stop level per position. I suggest a 10% loss on book should be a review level, and 15% is a hard stop level (sell whole position, no exceptions). As a reminder the ABC Large Cap Fund has a hard stop at 8% for non-core positions and a hard stop of 10% for core positions, and the ABC Europe Fund has 5 and 10% respectively.
   

• Either can initiate a position, as at present. However there must be a vote before ADDING to a position – both PMs must agree.
  
• Just as you need to know yourself to be an investor, you need to know your partner if you have joint and several decision-making, rather than having a presiding genius. Because you demonstrate some differences in personal style, there are times when you don't understand where your partner is coming from. I suggest that you complete a Myers-Briggs Model™ (Extravert, Introvert, Intuitive, Sensor, Thinker, Feeler, Judger, Perciever) questionnaire. This is particularly relevant for times of stress – we each revert to a fall-back way of operating and this is the kernel of what you need to know of each other for managing money as a team. If you understand more about where each other is coming from (not intellectually but in personal style) then you will be able to tolerate the differences more easily.