Armajaro Asset Management

Emerging markets fund taps commodities investment themes

Originally published in the May/June 2009 issue

Amid the 2008 financial crisis and the ensuing flight from hedge funds, Armajaro Asset Management LLP provided its investors with a place of refuge from the storms. Its three existing commodities funds generated positive performance and managed to attract significant additional allocations from existing and new investors.

This saw Armajaro break into The Hedge Fund Journal’s 2009 EUROPE50 ranking in 43rd place with assets under management of $1.6 billion. Combined with Armajaro’s securities and soft commodities origination, trading and distribution business, the asset management arm is set to grow with the launch of the Armajaro Emerging Markets Fund.

The timing of the new fund owes much to the credit tsunami of September 2008. Portfolio manager Michel Danechi had spent the previous year as head of emerging market equities with Lehman Brothers International, building up the London-based business to a 35-strong team. In that role he oversaw the derivatives and cash portfolios and coordinated Lehman’s expansion into Eastern Europe and the Middle East.

That background, and Danechi’s 15-year track record in emerging markets and derivatives, proved an ideal spring board for him to join Armajaro and begin putting in place an emerging markets fund. Richard Gower, the chief executive of Armajaro AM, says the move shows the firm’s ability to expand opportunistically, while tapping areas related to its core expertise.

“I think one of the leading indicators in emerging markets is commodities,” Gower says, discussing the rationale for the fund in an interview at the group’s airy Mayfair townhouse in Charles Street. “Because Armajaro has such an enormous fundamental knowledge of commodities it does give us a steer as to what might be going on in emerging markets. The other thing is having the opportunity to bring Michel, whom I’ve known for 15 years, on board. He has a fantastic track record and expertise.”

The fund is to deploy a macro focus to trading in fixed income, currencies, equities and equity derivatives. Its investment universe will initially concentrate on Eastern Europe, the Middle East and Africa, though, when assets under management pass $200 million, Danechi plans to expand the team to trade markets in South America and the Far East.

Emerging markets downturn is cyclical
“My basic premise is that emerging markets have learned from their past,” Danechi says, noting the Asian, Latin American, Turkish and Russian crises over 1994-2001. “Emerging markets are more used to this kind of financial upheaval so the level of consumer debt was never as high and the total leverage in the system is not as high as you have seen in the Anglo-Saxon world. The basic premise is that you are seeing a cyclical downturn in emerging markets, not a structural downturn. And you can get out of a cyclical downturn much faster.”

This view is shared by the International Monetary Fund (IMF), which has forecast that 80% of incremental future growth in the world economy will come from emerging markets. Much of this growth, Danechi says, is going to be commodities-led, along with an additional stimulus boost from national governments in countries with reserves or from the IMF or European Bank for Reconstruction and Development in countries that have debt.

“A lot of fiscal stimulus is going to find its way through the system given that the balance sheets in many emerging market countries are not as constrained as in the West,” Danechi says. “This stimulus should find its way through the economy much faster than you would see in Western Europe, the UK or US. The prime example of this is China where we have seen the stimulus go through much faster than you saw in America or the UK.”

Not surprisingly, a key aim of the fund’s strategy is to find investment themes that tap into nascent consumer demand in Asia. Such demand should be a prime beneficiary of stimulus measures. Consumers are also an up and coming force in other emerging markets, particularly in Latin America and South Africa.

“Most of Asia is very much an export led model and they have suffered tremendously for that,” says Danechi. “The next stage will be led by local consumers who are coming up from a very low base.” The message is simple: growth in consumption across large emerging market populations will be more economically transformative than incremental growth from the already high consumption base in developed economies.

What is especially pertinent about the current investment backdrop is that good economic prospects in some emerging countries are matched with very tough prospects in others. This affords the fund the opportunity to make some big long wagers and some short sales.

Macro plays target divergence
“The divergence theme in the performance in some of the countries is becoming quite clear,” Danechi says. “The macro plays that can be put into place because of the divergence in performance are quite big. For example, in emerging Europe you have the better off countries versus the worse off countries. You have disaster areas like the Baltics, the Balkans, Hungary and Ukraine which are in severe economic trouble mainly because they have been running current account deficits which cannot be financed when there is such a credit crunch. They will have to contract and suffer a lot more than the other countries such as Russia, South Africa, even Poland, let alone Brazil and China.”

A typical macro play for the fund could be selling government debt in a poor performing country and buying the debt of countries with better prospects. The same trade could be put on through going long in stock markets with good prospects and shorting less attractive markets, most likely through index futures.

About half the fund’s assets will be split between forex and fixed income plays. The remaining half will be allocated to equities and equity derivatives. The bigger allocation to equities than either forex or fixed income underscores, in Danechi’s eyes, the importance of commodities in emerging market investing. “I think that is where a lot of the opportunity sets are, especially as we are going to look for a lot of the triggers and catalysts coming out of the commodity plays,” he says. “And that is best played through either sectors or individual companies.”

Typically the fund will be invested in five to ten themes. One current theme is that Russia is more attractive than the market perceives. The key reason for this, in Danechi’s view, is firmer oil prices. That has helped Russian markets to rebound, underpinned the rouble after a sharp devaluation, staunched current account outflows and stayed the authorities from stimulus spending that saw the country’s reserve fund fall from $600 billion to an estimated $380 billion now.

“The charts showed a break-out for the oil price and the rouble started stabilising,” Danechi says. “Bonds and the index then broke up. If you look at these macro plays you can say it was very clear that the recovery would happen. The technical side shows you the timing of the break-out and shows that the end of February was a good time to get into the market.”

But he is anxious to stress the importance of understanding the mechanics of the big fall that occurred. “A lot of the fall was not due to valuation destruction but a lot of equity linked financing by the locals,” Danechi says. “And this financing just has to go through the market. When the banks cannot provide money for financing and you are hitting these margin trigger points, the forced liquidations drive the equity market down very fast. Basically it overshot on the downside.”


Russia leads exposure
In the start-up phase, the fund will have 25% exposure to Russia, 20% to South Africa and 15% to Turkey with the remaining split among Hungary, the Czech Republic and the Middle East. The net exposure is expected to be between minus 50% and plus 125% with a maximum gross exposure of 200%. To dampen the gut churning volatility that typifies emerging markets, the fund will generally spend some 10-15% of its profits on downside protection. Most often this will mean buying out of the money options, mainly puts or puts spreads, in any of the fund’s asset classes. If such optionality is not available in emerging markets, the fund will use European indexes and the S&P 500.

“That’s what’s saved me in the past in crises,” Danechi says. “You need to have something in place when the crisis happens since usually they come fast and furious. If you do have someprotection you give yourself a little bit of extra time to be able to get out of the positions. The other key point is not to be married to your positions and be happy to cut them. Generally in emerging markets when things start getting bad, they get really bad.”

The fund will also hedge with different asset classes to dampen downside volatility. In the fourth quarter of 2008, for example, currencies were the most stable and the easiest instrument to use to hedge. By November, even though equities markets had suffered sharp falls, the rand, the rouble and the Turkish lira were initially resilient. This marked a change from how different asset classes have behaved in earlier emerging market crises when the forex market has typically served as the leading indicator.

“In November-December, there was $250 billion that went out of emerging markets,” Danechi says. “But because the general reserves of the emerging markets central banks were so high, they were able to cope with that. Countries that couldn’t got IMF and EBRD lines.” That stability was buttressed by less leverage in the forex market and a different investor. In comparison, stock investors were highly leveraged and underwent forced liquidations.

“You had the ability to hedge a lot of your equity positions through the forex market be it the rand or lira or the rouble or any of the other currencies for that matter,” Danechi says. “There is different timing in the reactions of the different asset classes. That’s what creates the different opportunities.” Now that the worst part of the crisis looks to have past, outflows from emerging markets are being replaced by net inflows.

On risk management, Danechi subscribes to the view that only the paranoid survive. “The first key of risk management is to be really worried and not like to make losses,” he says. “If you are in a position and you feel uncomfortable with that, you need to cut the losses quickly and hopefully run the profits for longer. That axiom has worked well for me over the last fifteen years in emerging markets and before for five years trading the Japanese market.”

The fund also has set risk parameters. Most positions are 2-5% of the portfolio with a 10% cap on any single issue. There is also a 50% limit on a particular sector or country.

Monthly risk meeting
“Obviously Michel has his own disciplines and controls, but we have a formal monthly risk meeting and at that risk meeting we have a committee of people with expert knowledge in risk management,” says Gower. “One of the principal people on that committee is Martin Lambert who was the risk manager for Phibro for a period of about 15 years when it had one of the biggest trading balance sheets in the City.” Armajaro’s risk management set-up features a daily profit-and-loss statement for each fund risk report and a different independent director is rotated on to the risk committee for each fund for its monthly meeting.

In each of the fund’s investment buckets the net exposure is separated out and the delta is calculated for each issue or name. From that country, sector and asset class exposure is worked out. “We developed a matrix of risk measures so we know at any time where the risk is,” Gower says.

The unusualness of the Armajaro name belies its simple origin. It is an acronym of the first two letters of the founding partners’ children ordered to put the firm at the beginning of the alphabet.

“When Anthony Ward and I started in 1998 I was working on structured notes and he was working on commodities,” Gower says. “The model was really very strong because I was able to produce risk free money month in month out. That meant in the early stages when Anthony was trading principally in cocoa with our money he was in a very strong position. If conditions were not optimal he could sit back and the securities business would cover the overhead which at that stage was pretty modest.”

The firm ran on that model for about four years and as Ward’s trading success grew Armajaro began moving into other areas in the commodities field. Processing of cocoa beans began through a joint venture with Petra Foods Limited. Previously it had begun buying cocoa, mainly from Ghana, and then moved into warehousing, shipping and selling it around the world.

In 2004, the commodities investment management business launched. “It was a natural progression for us,” Gower says. “We realised that there was considerable investor appetite for commodity exposure.”

The first fund was the Armajaro Commodities Fund headed by John Tilney, who came from a 20 year stint with Marc Rich. Subsequently Ward launched the CC+ Fund that trades in cocoa and coffee. Next came the Czar+ Fund, a joint venture sugar ethanol product with Czarnikow, one of the sugar industry’s oldest established names.

“We didn’t have a plan to develop into as many areas as we did,” Gower says. “We were ambitious but we didn’t envisage that the early years would be quite as successful and that gave us the opportunity to buy into other assets that we might not otherwise have had.”

“In order to get into a country like Ghana and employ the number of people we do and create the infrastructure you really need some money,” Gower says. “Those early trading profits gave us opportunities to go and expand. What I like now is that the diversity of the group gives us a great deal of stability.”

Indeed, the turnover of Armajaro Holdings, which spans securities trading, investment management and commodities businesses, was $1.6 billion in the year to August 2008. Over 1,000 people work for the company and its various subsidiaries and associated subsidiaries around the world.

“If you look at our hedge funds model – and this has been a very tough time for all hedge funds – the Armajaro group has got that infrastructure behind it and its got the securities business that is now in its 11th year,” Gower says. “It means we are a substantial group but we still have an entrepreneurial ethos. That is reassuring for investors because they know that the infrastructure here is very thoroughly put together.”

Armajaro is planning to continue with measured expansion. “We do have a pipeline of funds going forward but our principle concentration now is to get Michel’s fund up and running, and get some numbers on the board,” Gower says. “We are always on the look out for very talented traders. We’ve got the resources to be able to put funds together. When things come up in other areas we would consider them on their merits.”

Biography: Michel Danechi
Prior to joining Armajaro Michel was hired by Lehman Brothers in London to build and head the emerging markets equities team. Prior to that Michel was Head of London Office and Head of EMEA Equity Trading at CA-IB International Markets (part of Bank Austria Creditanstaldt) where he was responsible for pricing and structuring EMEA equity derivative structures. He also managed and traded the firm’s prop book. Michel has navigated the turbulent trading environment in emerging markets since 1994 and built a comprehensive network of relationships throughout the region. He has a MBA from the London Business School and a BSc (Hons) in Economics from the London School of Economics and Political Science.