Absolute Return

Originally published in the December 2011 issue

The following is a sponsored statement by GAM

In an environment of stagnant growth and political intervention, delivering positive performance has become a major challenge. Investors with looming liabilities are becoming less and less interested in relative returns. And as correlation between asset classes continues to increase and managers begin to run out of tactical plays that work in directionless markets, the ability of benchmark-appraised strategies to deliver is becoming less predictable. Indeed, many absolute return approaches have disappointed this year.

But GAM’s approach to absolute return investing differs from the mainstream – seeking out innovative solutions that aim to take advantage of evolving economic conditions. Its suite of absolute return funds brings a unique range of investment strategies to the market, combining creative investment thinking with the company’s impressive pedigree for risk management.

Taking advantage of market turbulence
Prolonged levels of elevated volatility are becoming increasingly challenging to trade. Many in the business have emptied their tactical toolboxes trying to exploit market uncertainty to no avail. But for the team at DCI LLC, a boutique, San Francisco-based credit manager responsible for GAM Star Diversified Market Neutral Credit, current market conditions only serve to benefit the investment strategy. Stephen Kealhofer, DCI’s Chief Investment Officer and one of its co-founders, believes that the macroeconomic environment we face now – and are likely to continue to face for the coming years – presents significant mispricing opportunities for those who know how to exploit them. “Market-neutral strategies like ours can prove extremely efficient during volatile periods” he says. “The more volatility levels increase, the more mispricing opportunities become available in the market.”

DCI’s combination of intensive credit analysis, cutting-edge quantitative systems, active diversification and a genuine market-neutral approach aids the delivery of uncorrelated returns. The fundamentals of the approach stem from the team’s core belief that credit markets are inefficient due to their reliance on rating agency data. They overcome this by employing proprietary technology incorporating the findings of research first begun in the 1960s to calculate the credit default probabilities and spreads of a broad spectrum of companies, taking advantage of occurring information gaps. Full automation of this process could leave the approach potentially exposed to companies with significant uncertainty in their capital structures. As such, analysts oversee each stage to ensure the models capture accurate valuations from the most liquid section of the CDS market.

The strategy has low-to-zero correlation to both equity and fixed income markets and diversifies risk by holding a large number of small positions. This approach has led to critics challenging the firm’s confidence in its holdings, asking “Why can’t you just pick the winners?” But Kealhofer disputes this idealistic attitude, stating “Lots of our competitors waste resources trying to time the market, which is difficult to do successfully over a long period, and therefore introduces additional risk. We think we can pick the winners, but by taking lots of small bets over time, we ensure that no one name can bring down the portfolio. And being market neutral, the portfolios are never dictated by market direction.” The odds of each position having a 100% chance of paying superior returns is not realistic. But if each holding has a 60-65% chance of delivering a good return, then the odds for positive performance are stacked in the team’s favour.

Right now, dramatically widening credit spreads suit the team’s approach. Volatility typically brings with it convergence, therefore the more elevated levels become, the higher returns are likely to be. In a sense, the strategy is ‘long volatility’ – able to perform in all environments but benefiting particularly from widening spreads. Recent performance has been aided by the zero percent exposure to the banking industry – due to rising default probabilities on both sides of the Atlantic – and very limited exposure to southern Europe.

Capturing upside via out-of-favour names
In contrast, Gifford Combs, Managing Director and Portfolio Manager of Dalton Investments, LLC, which manages GAM Star Global Selector, an active global equity strategy, is starting to see value in select US financials. The Santa Monica-based investment house’s value-driven strategy has a strong track record of absolute returns over the long term. Combs, who began his career under the guidance of Warren Buffet, has recently become bullish for the first time in three years in anticipation of more profitable times ahead. He believes US banks have been subject to the same barrage of regulatory measures as their European counterparts, despite being largely shielded from the sovereign debt problems threatening the industry. This has left them with substantially more tangible capital, higher reserves and greater liquidity than ever before. But despite this solid operating base, US banking names continue to trade at lower valuations to European ones. The result is a raft of high-quality, low-price opportunities. GAM Star Global Selector put its large cash position to work during the third quarter of 2011 to take advantage of them. Combs cites: “In the past, you would have to work 20 hours a day for 10 years to have the chance to buy Goldman Sachs stock at book value – should you be made a partner. Now, you can buy in at a considerable discount to book value without even getting out of bed.”

Putting cash to work through August and September unsurprisingly impacted short-term returns, but this has set the strategy up for strong performance to come. The defiant early call by the talented stock-picker has left investors with a portfolio of high-quality names, possessing significant upside potential, which are unlikely to be priced so cheaply for long. Those who have a historic knowledge of Dalton’s approach will know such a move would not have been made without conviction. The strategy only trades out of cash for an opportunity where most of the downside risk has been eliminated, leaving it exposed to less risk than that of the market overall. Fair value opportunities do not make the grade: “I don’t want fair. Fair is for the other guys – I want cheap!” enthuses Combs.

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GAM Star Global Selector has delivered for investors when many others have failed thanks to the manager’s strict adherence to value, distilled with a pragmatic outlook. “There are no guarantees in investing,” states Combs. “The most important thing is to protect your assets. If you fall in love with your ideas you can end up with a portfolio of fairly-valued names that suddenly drop in price. One must remain ruthless, buying good quality companies at a discount and selling them when they get close to fair value.”

Such discipline provides the strategy with a bright outlook. Its positioning is targeted and flexible: pockets of value will be harvested as they arise, and the strategy is able to react to sentiment shifts as they occur.

Positioning ahead of the crowd
Market sentiment also shapes the strategy of another of GAM’s absolute return offerings: GAM Star Keynes Quantitative Strategies. Investing in equity, fixed income and currency markets globally, the systematic macro strategy is based on Keynesian theories of market behaviour, harnessing inefficiencies to deliver returns uncorrelated to traditional markets. Manager Dr Sushil Wadhwani, of the London investment house Wadhwani Asset Management, uses a series of quantitative financial models that are highly sensitive to changing market dynamics, allowing the strategy to scale into and out of trades, allocating assets to markets where the team sees the best opportunities.

Wadhwani’s approach capitalises on the strong influence of human emotion on investor behaviour. He states: “According to Keynes, when momentum takes market prices to extortionate levels, you need to look to other indicators for guidance. When there is market consensus, investors converge, but at some point sentiment will shift, which opens up opportunities.”

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This Keynesian influence differentiates Wadhwani’s approach by the nature of the model inputs, which include both price and non-price (behavioural) factors. The inclusion of these soft indicators adds a forward-looking element to the strategy, allowing Wadhwani to position ahead of sentiment shifts. As such, momentum is exploited and positions are exited before a significant shift occurs, maximising upside and limiting downside.

This agile, uncorrelated approach places high value on the liquidity of the underlying instruments that comprise the non-linear models. Combining these qualities with forward-looking positioning means the approach can prove particularly advantageous in volatile and dislocated markets. For example, back in June 2011, investors were being bombarded with alarming headlines and dismal statistics as concerns mounted over the eurozone crisis and the raising of the US debt ceiling. Taking non-price factors into account, the Wadhwani models were positioned long fixed income in anticipation of a further slowing in economic growth and an escalation in sovereign risk. Through July, growth did slow, sparking a rally in bonds and short-rate futures and delivering a one-month gain of 3.2% for the sterling class of the fund.
This defensive stance was maintained as summer rolled into autumn, benefiting from rising risk aversion and the elevated levels of volatility that followed the US government losing its AAA status and the attack on the Italian bond market. Returns for the third quarter reached 3.8% – while global equity markets dropped 14.8% (as measured by the MSCI World Index hedged to GBP).

Dr Wadhwani warns his investors that the economic situation we now face is becoming increasingly uncertain. But staying true to his principles, he is keeping an open mind and adjusting to new inputs as they arrive to retain the models’ agility.

The value of diversification
For investors searching for an alternative source of beta, GAM launched its first catastrophe (‘cat’) bond fund in December 2004. A UCITS-compliant version was launched in October 2011. Seeking to capture structural return from the cat bond market, the strategy is fundamentally uncorrelated to traditional financial markets, with returns driven instead by the occurrence of natural events such as earthquakes or hurricanes. As such, it provides an excellent source of diversification for investors, with an attractive risk/return profile.

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Managed by Connecticut-based Fermat Capital Management, LLC – one of the most experienced cat bond managers in the world – GAM FCM Cat Bond has returned 8.5% p.a. since 2005. The team’s depth of experience enables insightful and thorough bond documentation analysis, and when paired with their proprietary modelling capabilities, their ability to accurately price cat bond risk is unparalleled in the market. Fermat’s bespoke systems overcome the biases and inconsistencies of commercial cat risk models, improve on their accuracy, and are able to assess, price and manage the impact of tail risk within their portfolios more efficiently. The effectiveness of their approach is evident in their long-term track record of consistent results in this strategy.

The fund is up 8.9% in 2011, with a maximum drawdown of just 0.6% – despite the record-breaking losses suffered by the insurance industry in the first half of the year following disasters in New Zealand and Japan. In fact, both events were relatively benign for the cat bond market, and again highlighted that the strategy focuses on 1-in-100 year events, rather than 1-in-5 or 1-in-10 year events. Liquidity remained high, bonds continued to be tradable in the secondary market and average discounts modest.

Looking ahead, the outlook is extremely positive, according to manager Dr John Seo: “The net effect on our market is that it is going to spur issuance (the third quarter saw record issuance of a little over US $840 million), and actually increase spreads – and we did not have to take the losses to get those types of effects.”

So, while many absolute return strategies have struggled to deliver as the global economy evolves, GAM’s offerings are answering the tough questions being posed by markets. Breaking the mould and challenging the norm are essential qualities needed for survival as effective positioning is becoming increasingly challenging. Innovative thinking combined with market-leading managers and processes offer the best chances for long-term success.

Craig Wallis is Global Head of Institutional and Fund Distribution and is responsible for overseeing all aspects of GAM’s institutional and mutual fund businesses globally including client acquisition, servicing, reporting and product specification. Craig’s previous positions with GAM included responsibility for GAM’s fund operations and the role of managing director of GAM Fund Management Limited. Before joining GAM in 1997, Craig held senior financial and business development positions with M W Marshall and NatWest Markets in London. He qualified as a Chartered Accountant with Peat Marwick in 1988 and holds a BSc (Hons) in Economics and Accounting from Southampton University.

All return figures are shown net of fees to 31st October 2011 unless otherwise stated.