Brevan Howard Systematic Trading Fund has been seeded with $300 million and will be managed by a joint venture with David Gorton, co-founder and CEO of fixed income quantitative specialist London Diversified Fund Management. Gorton will be the chief investment officer of the joint venture, DG Systematic Trading LLP. The planned fund listing is for BH Credit Catalysts Ltd, which runs directional and relative value catalyst-driven trading. It is operated by ex-Morgan Stanley trading chief David Warren whose firm DW Investment Management LP is a specialist credit manager based in New York that manages money exclusively for Brevan Howard. Both funds use Brevan Howard’s platform for risk management, treasury management, trade processing and valuation.
In a recent visit to Brevan Howard’s airy Baker Street head quarters CEO Nagi Kawkabani discussed the new funds and the business case for them. He began by explaining some key characteristics of how credit manager Warren trades. “He structures trades,” says Kawkabani. “He works as Brevan Howard works. He’s very much a trading fund and by trading we mean he manages his P&L and trades across multiple dimensions. He will trade in volatility, in credit spreads, in direction, correlation and default assumptions. He doesn’t need the market in spreads to either contract or expand or for companies to pay off or not pay off. David can make money in any market condition and has minimal correlation with credit indices.”
Warren uses a multi-strategy approach to credit, trading distressed, corporate credit and asset-backed securities. The aim is to avoid being pigeon-holed into the same trades and deploy capital where there is the best risk/reward. Warren was one of a handful of credit traders to make money in 2008 before hitting a home run in 2009 with a 35% return. In 2010, the strategy is up 8% to the end of October. All of this came with a maximum drawdown in three years of 1.5% and a worst month of around minus 1%.
In 2008, most of the fund’s P&L was in ABS, though in 2009 it was much more balanced between ABS, distressed and corporate. During his three years with Brevan Howard, Warren’s net exposure averages out at net flat. Kawkabani likens Warren to a credit diversifier being at different times long and short the whole range of credit risks. The strategy is running $1.8 billion and has capacity for considerably more capital.
“Most credit strategies as far as we are aware are either deep value or carry,” says Kawkabani. “He doesn’t do either.” Instead, Warren looks for where something may be mispriced and where there is a catalyst within a relatively short time frame for it to pay off. If a trade works, Warren manages the P&L to fix the profit and harvest the returns. If a trade doesn’t work, the position is cut and new trades are explored. “David acts as a diversifier because he is a trader in multiple dimensions,” says Kawkabani. “He’s not monotone in what he does.”
As the portfolio manager, Warren controls investment decisions, but Brevan Howard sets overall risk limits, provides the operational infrastructure, and manages counterparty risk and treasury. Risk management for the fund is run by Rupert Cox, who has more than 20 years’ risk management experience and works under the supervision of Aron Landy, Brevan’s Chief Risk Officer. The fund operates within Brevan Howard’s risk management framework which applies stop losses to individual trades as well as at trader and fund level.
Systematic trading JV
The joint venture with David Gorton to launch DG Systematic Trading came after a lengthy search by Brevan Howard to find the right team. Brevan Howard views systematic trading as just another form of trading with a trader, not a quant, in charge. Gorton is that trader and one with a 15 year track record. The venture potentially marks a new beginning for Gorton as London Diversified has seen AUM fall well below $1 billion following a drawdown in 2008.
“It was very hard to find a trader that had built systematic models and that we felt comfortable with,” says Kawkabani. “David has an incredible track record and 15 years of success. We know he had issues in 2008 but anyone can have issues for a year. It doesn’t detract from a 15 year track record. He is someone of the highest ethical standards. We trust him.”
Though London Diversified specialises in fixed income relative value strategies, Gorton ran a systematic trading model with between $50-300 million over four years. Gorton’s trading record in fixed income and rates align him closely with the investment focus of his new partner. What also impressed Brevan Howard was that the track record of the systematic strategy was very similar in terms of drawdowns, Sharpe ratio and returns to commodity trading advisor fund leaders Bluetrend and Winton Diversified.
Quantitative with reality checks
The approach of putting a trader in charge, Kawkabani says, ensures that the quantitative modelling has reality checks. “It is not just model building,” he says. “It’s far more complicated than just building a moving average cross-over. It’s how you inform the model with your experience and how you calibrate it over ever changing market regimes.”
The environment in late October offers a pertinent example. Many CTAs have a big long bet on a further round of quantitative easing. Going long QE 2 means being long duration, short the dollar, long commodities, notably gold, and long equities.
“Historic testing would suggest that these multiple positions offer diversification,” says Kawkabani. “In fact, they offer very little diversification. The model believes, based on past volatility and correlations, that it’s a perfectly acceptable risk profile. We know it’s not,so David Gorton reduced risk. He didn’t tinker with positions or introduce discretionary overlays; he simply took down risk across the board because the diversification that the model believes it had based on its prior experience wasn’t the case. A trader understands this.”
The aim is to make a good model perform optimally. But it is more than that: given the unprecedented nature of market events and responses from policy makers, it is also a question of preventing a fund from blowing up. The thinking is that a smart trader can spot trouble where it isn’t obvious to a quant and definitely not obvious to a model.
Low rates sap returns
Brevan Howard is launching two new funds at a time when the Master Fund is managing around $25 billion, making it the world’s biggest global macro fund. An era of zero interest rates means that double digit returns are much harder to come by than before 2008. The trade that has worked well in 2010 is being long duration such as 10 and 30 year government bonds. The Master Fund caught some of that as well as the euro weakness trade earlier in the year and the short dollar trade in the autumn. The fund’s 3% gain to end-October also reflects some negative performance in trading the short end of the European yield curve earlier in the year.
The Master Fund seeks to make a reasonable, risk adjusted return on trading in environments when volatility is modest. When a big break occurs, the aim is to exploit it, generally by being structurally long volatility, and make outsize returns. Thus in 2008 it made 20% net of fees. In contrast, the 2003-2006 period saw a 10% annualised return with performance in individual years ranging from 8% to 14.5%. With interest rates rising over the period from 1% to 5%, the fund compounded at an average rate of 7% over cash.
“The prospects for the Master Fund today are exactly what they have always been,” says Kawkabani. “Unless there is some sort of break we expect that we will, in a very disciplined and risk controlled fashion, be able to generate somewhere between 300-400 bps to 800-900 bps over cash depending on how many things we get right or wrong in a year. Hopefully we will make another 2-3% this year. If something breaks between now and the end of the year we will do better. I don’t know when or what will break, but we are pretty comfortable something will break in the next couple of years because the situation is very fluid and unstable. When that happens we expect that will make substantial out-sized returns. That is what the Master Fund is designed to do and that is what we have delivered.”
Presence in UCITS
As Brevan Howard has diversified the funds offered to investors, it has begun to build a presence in UCITS funds. It was an early mover in the onshore sector, putting $250 million into the UCITS Absolute Return Bond Plus Fund. The fund is currently being overhauled, but that hasn’t stopped Brevan Howard from developing UCITS funds that target FX trading and emerging markets FX and rates.
So far, Brevan Howard has found that most of the money coming to the onshore funds is from UCITS fund of funds and private bank platforms. For Kawkabani the jury is out on whether institutions really want absolute return funds in a UCITS form. He stresses that UCITS is not a replacement for hedge funds.
“We are very clear to investors buying our UCITS that they aren’t buying a hedge fund,” Kawkabani says. “They are buying something that has hedge fund attributes in terms of an absolute return focus and the quality of the manager. They get a subset, and a pretty good subset, of what we do in the hedge fund, but you are not getting the hedge fund. For certain investors there’s real value: the absolute return is a lot better than a unit trust and they get regulatory comfort and the liquidity. But for all of that you are going to give up some alpha, there is no question.”
With the expected end of year listing of BH Credit Catalysts Brevan’s AUM in the closed-end listed sector is set to grow well beyond the $2.9 billion it currently runs in BH Macro and BH Global. The funds have carved out a niche with investors owing to the returns generated during the credit crunch and their daily liquidity. Compared with UCITS funds, these are pure hedge funds and that undiluted exposure looks to be becoming more attractive to institutional investors.
Brevan Howard is also expanding to South America with a research office in São Paulo, Brazil. The LATAM office will be headed by Mário Mesquita, formerly a deputy governor of the Brazilian Central Bank from 2006 until earlier this year.
“It is a continuation of our ability to follow markets more closely,” Kawkabani says. “When somebody you want comes along you try to incorporate him in your business. He is the right guy to help us make money in markets where we already invest.”
When asked whether emerging markets will increasingly offer more opportunities to investors than developed markets, Kawkabani says, “That’s a pretty fair bet.” He adds, “They are developing their own domestic capital markets and consumer finance. There seems to be, to a greater or lesser extent depending on the country, a growing awareness of prudential management by governments. That will create investor confidence. There is no question there are more trading opportunities now than there were three, four or five years ago and we expect that trend to continue.”