A Defensive Approach

Flexibility and discipline are the key to making money in all market conditions

Originally published in the April 2009 issue

Angus Murray of Castlestone Management explains how he came to create successful hedge fund Porcupine Global Macro Plus, and why he has taken the decision to open it up to retail investors through a new feeder fund, Porcupine Absolute Return…

It’s alarming how many investment funds have collapsed in the past 18 months, registering losses of 50%, 75% or worse. The most concerning factor, however, is that most of them had no choice. Take the example of a long-only stock index fund, such as a FTSE tracker: most are not permitted to strategically move to cash, and hence when the UK stock market decides to take a nosedive, such funds are forced by design to lose money. The same applies to almost any long-only fund – when the whole market is dropping, managers can do little to limit the slaughter, and are often forced to rely on stop-loss triggers to rein in losses. A typical stop-loss protection will then bar managers from getting back into rallying markets until the next investment period. In short, the limitations that are placed on a fund’s investment activities, while always designed to protect investors, may often end up losing them money when abnormal market conditions occur.

To design a fund without such limitations, with the maximum flexibility to invest or not depending on market conditions, is not hard. But to create one that works, you need an intensely disciplined and consistent investment process and an effective, focussed risk-management technique. Rather than putting restrictions on what you must buy and when, the regulation can be shifted to enhance the management process. It was with that intent that we at Castlestone Management initially designed Porcupine Global Macro Plus, our hedge fund with a difference. We wanted a truly defensive fund, one that wouldn’t be tripped up into losing money by its own investment mandate, and which could really focus on capital preservation when the need arose. We kept the strict guidelines for the investment process, not for limiting what we had to invest in or when we could buy or sell.

Cast your net wide
When it came to selecting target asset classes, the decision was made to limit exposure to long and short positions in the four core asset classes of equities, fixed income, currencies and commodities. Investments are generally made into the major indices, which maximises liquidity. The decision was taken early on to avoid traditional high-risk, high-return assets such as emerging market stocks and their currencies, reining in the potential investment universe to just G7 assets. That’s a wide pool by any fund measure, but we felt that any narrower mandate could lock us into money-losing strategies or bar us from attractive potential investments.

We are pretty conservative on leverage too. Maximum gross exposure can’t go above 500%, while individual sector exposures are also limited. We are incredibly strict on entry points, price targets and stop limits, but these need to be constantly modified to fit current volatility levels. If you stick to rigid targets and stop losses, you can’t trade at all in volatile markets when investment potential can be at its greatest.

The general philosophy of the fund is 100% fundamental, and revolves around the belief in structural inefficiencies in the global markets. Markets tend to become mispriced in response to liquidity cycles, business cycles, economic data releases, and geopolitical events. We seek price inefficiencies in the market through our investment process, which allows us to detect imbalances and manage their evolution. We don’t look for hour-by-hour trades – most investments are held for weeks, not hours – because that’s more a computer modeling approach, not the global macro top-down fundamental approach we are pursuing.

Has it worked? Undoubtedly. Since the strategy began trading as a managed account, it has never had a loss-making year. Even in the market tumult of 2008, we had only two loss-making months. None of us is happy the credit crunch happened, but there is a certain relief in having your investment strategies vindicated: we designed the fund to flourish in good times and bad, so it’s been a silver lining to the whole financial calamity that Porcupine at least performed to plan. Funds were collapsing nationwide: our average annualised volatility was still below 10%.



A new investor base
We initially designed Porcupine as a purely institutional investment. Hedge funds are by their nature considered high risk, and additionally Castlestone Management didn’t have a retail arm when we created it. It’s only in the past five years that we have designed funds for financial advisors to offer to their retail investors, and back then they weren’t clamouring for hedge fund exposure either. How things have changed. In the wake of the market carnage of 2007 and 2008, hedge funds such as Porcupine, which have earned their stripes in the tough times, have a great appeal to the retail investor. While we wouldn’t sell anything as sophisticated as Porcupine directly to a retail client, professional financial advisers, such as those who had sold our commodity, agriculture and precious metal funds to clients, are now asking us for access to Porcupine.

Hence we took the decision this year to create a retail-appropriate feeder fund, Porcupine Absolute Return, which finally opened in March. We aren’t the only managers opening up the hedge fund market to retail investors – Brevan Howard is expanding its investor base, as are others. By taking in minimum investments of $10k rather than $500k, we can open up the fund to traditional offshore portfolio bonds and such like. Will it work? Well, it has so far, but only time will tell. Investors have been badly burned with their traditional investments, in traditional restriction-heavy funds. Perhaps the time of the retail hedge fund is finally here.

First Tier – Qualitative

Initial Investment Ideas
– Identify the broad market themes
– Network of international contacts
– Independent research consultants

Primary Research
– Economic data analysis
– Monetary and fiscal policy
– Geopolitical issues and political bias

– Demographic and structural economic shifts

Idea Generation
– Fund flows
– Sentiment indicators
– Pricing relationships across asset classes
– Quantify scenario analysis of expected changes verse consensus
– Liquidity analysis

Tier Two – Quantitative

Position size determination
To determine the position size of the trade the managers run through a series of checks examining;

1. Pre trade risk / reward relationship
2. Timing of the positions in relation to market view
3. Examining correlations risk with other portfolio holdings
4. Expected rate of return and price targets
5. Optimal instrument to implement trade idea
6. Changes in market dynamics

All trades are viewed as notional exposure of NAV – (Capital at Risk)

Angus Murray is Founder and joint Chief Executive of Castlestone Management which also runs the Aliquot suite of commodity funds. He is a manager of the hedge fund Porcupine Global Macros Plus and its feeder fund Porcupine Absolute Return.