Capital Fund Management

Transition completed with growth being rekindled

Originally published in the June 2012 issue

In 21 years of investing, Capital Fund Management has overcome changes in investors’ preferences and counterparty fraud, but its biggest challenge was recovering from the tragic death of the firm’s founder Jean-Pierre Aguilar in a gliding accident in July 2009. Though Aguilar was the firm’s founder and controlling shareholder, he was much more than that as both a man and a mentor. Yet the most remarkable thing that happened after Aguilar’s passing was that CFM not only survived, but prospered handsomely and grew. “Jean-Pierre was an extraordinary person, he was extremely charismatic and his genius was in being able to bring together very different types of people and to create a real company that would survive the death of its founder,” says Jean-Philippe Bouchaud, one of the firm’s four senior partners. “And I think we have to give him a lot of credit for just having the sheer intelligence to do that.”

Surviving Sentinel
CFM had already survived one scare. In August 2007 Sentinel Management Group, a US cash management firm, froze client withdrawals citing credit market volatility. Sentinel’s management were recently indicted in the US on federal fraud charges for allegedly defrauding more than 70 customers of more than $500 million. CFM eventually recovered the lion’s share of client money. But that lesson about counterparty instability served the firm well. Realising the extent of the difficulties at Lehman Brothers, CFM withdrew from the prime broking arm just ahead of its weekend collapse in September 2008.
The Aguilar tragedy a year later meant that the leadership team – Jean-Philippe Bouchaud, Philippe Jordan, Marc Potters and Jacques Saulière – had to grapple with an unplanned succession. But their battle hardened experience from 2007-2008 had spawned a strong sense of solidarity among the team.

“Though Jean-Pierre was the founder, he had always been very wise not to impose his decisions without very detailed compromise and discussions about everything the company would do,” says Bouchaud. “Even though he was the main shareholder and the founder, he acted as one out of five. This collegiate approach is how the four senior partners continue to manage the firm today.”

If the principal of consensus among the partners helped to ease the transition, then the Sentinel and Lehman shocks taught them how to manage during a crisis. “So I think we were, strangely enough, well-prepared,” says Bouchaud.

AUM doubled
Certainly, the business has carried on growing, maintaining CFM’s position as France’s biggest hedge fund group. It is now managing $5.8 billion, double the assets under management of three years ago. Performance and the transition of the firm to a new ownership structure have both had the effect of attracting new investors and bringing in bigger allocations from existing ones.

In 2011, when many commodity trading advisors as measured by the Managed Futures component of the Dow Jones Credit Suisse Hedge Fund Index lost -4.19%, CFM performed strongly (see Fig.1). The Stratus strategy, which is running $4.4 billion and is currently closed to new investors, returned 15.6% in 2011. The Discus strategy, which is running $3.2 billion (including $1.8 billion from Stratus) returned 21.6% during the year. It remains open with estimated capacity of $5 billion.

Neuberger Berman invest
The ownership of CFM evolved further at the end of 2011. Dyal Capital Partners, a private equity fund managed by Neuberger Berman Group LLC, acquired a 25% interest from Jean-Pierre Aguilar’s estate with the remainder of the founder’s interest purchased by senior CFM management. Dyal, which invests in institutional hedge fund companies worldwide, has shareholders from a number of sovereign wealth fund, institutional and family office investors. The remaining 75% is owned by the CFM’s senior directors and employees.

“Dyal is a passive investor and good partner,” says Bouchaud. “It is an expert in our business and understands that the governance must remain ours. We are very free to run the business and 25% of the profits go to Dyal which, for us, is a very good solution.” The model is that of a long duration investor with a permanent capital vehicle, thus not requiring a realisation event.

CFM’s core investment focus is on the Stratus and Discus strategies. Stratus is a single balance sheet and can invest in any type of quantitative strategy. It invests in Discus through a managed account. Discus is a so-called narrow sleeve with a focus on futures and forex trading. The overall trading universe of Stratus comprises over 3,000 equities, 1,000 equity options, 20 forex pairs and 200 different futures contracts. The strategies are combined within Stratus to deliver a smoother return series through diversification (see Fig. 2, 3 & 4). CFM has estimated there is a 99% daily VaR budget of 1.25% and Stratus has a return objective of above 15% per annum.
Pure science origins
For many years, CFM focused entirely on finding technical models. This reflected the firm’s origins in pure science and mathematical research. Indeed, Bouchaud’s original business relationship with Aguilar was through a company they set up called Science & Finance SA, which allowed the former to carry on with his scientific work on a consultancy basis, while working exclusively for CFM on financial research. “I think that what has changed a lot is that now we have really become fully aware of market mechanisms, of the economic trends behind all of that and we understand much better what we’re doing in this regard,” says Bouchaud. “We had come from science and mathematics backgrounds so for us the obvious thing at the beginning was to look for technical models. It was an easy way to access the market for us because it didn’t really require deep financial knowledge.”

AS CFM and its research activities evolved, it designed models that delivered a better form of causal analysis. Initially universal models keyed on behavioural biases and price changes, anticipating mean reversion and momentum trends. Gradually the universal models became equally weighted with fundamental models with the latter employing more cause and effect-based models. They might be based on a much deeper understanding of the relationship of commodities prices to, for example, changes in inventories or, say, the relation between the price of copper and the forex value of the Australian dollar.

“We have diversified a lot of the type of strategies that we’re using, by being much more idiosyncratic,” says Bouchaud. “We have moved from this universal approach to modelling financial times series to much more of an idiosyncratic way of pinpointing effects that might exist in some contracts, but not in other contracts.”

A super academic approach
The historical backdrop to the formation of the London CTA community featured a mix of academic and market research. In the US, CTAs were more derived from market savvy traders whose background was generally derived from experience in trading futures. In continental Europe, meanwhile, TransTrend in the Netherlands, which is the leader with AUM of over $10 billion, evolved from the experience of Gerard van Vliet, a grain trader.

At CFM, the approach is resolutely academic. The firm retains close ties with a number of universities, sponsoring scholarships and research. Indeed, Bouchaud is a part-time professor at the Ecole Polytechnique. Along with co-CEO Marc Potters, he has published the book ‘Theory of Financial Risks and Derivative Pricing’ which features new statistical models of returns and correlations, extreme risk control and option pricing beyond Black-Scholes. Keeping engaged with new research is also undertaken with Bouchaud serving as the editor in chief of Quantitative Finance, a leading journal.

“We are more academic than many people might imagine,” says Bouchaud, noting that associates at CFM have published dozens of papers to aid understanding about how markets behave. “We are among the very few hedge funds or CTAs that have been actively involved in academic research since inception. I think it’s important for us to also contribute to the public debate about why markets are volatile or whether high-frequency trading is destabilising or stabilising. We have a role to play in these debates.”

New research areas
CFM is continually probing news areas with research. Behavioural finance is one subject which is under scrutiny to help create longer term trading models. Another research focus is impact. When a trading programme buys, it pushes prices up and when it sells, prices are pushed down.

“It is very unfortunate because part of your profit gets dissipated by your own impact,” says Bouchaud. “That’s how capacity gets limited. On the other hand, understanding in detail why there is impact and how you can maybe reduce it is something that we’ve been thinking about for 10 years. A lot of the academic papers we publish are around this micro structure/impact theory.”

Thinking on a much longer time scale is being applied to so-called agent based models. Here fictitious economies are recreated by putting agents on a computer with simple rules governing their decisions about, say, buying a house or taking a loan. The aim with recreating fictitious economies is to allow macro variables to be predicted in a more efficient way than in the models used by central banks which proved to be of very little use during the financial crisis.

Investing in ideas
“Jean-Claude Trichet (the former governor of the European Central Bank) said in 2010 he had been abandoned by conventional tools,” notes Bouchaud. “He called for new ideas for macro models and monetary policy models. I think that the role of CFM has always been to invest in very long-term research. We may have research projects that last one, two or five years. We’re not afraid to invest in ideas and I love would these ideas to come to fruition one day.”

The research programme and CFM’s physical separation from the London CTA industry, the world’s biggest CTA cluster, is a key part of the Paris-based firm’s pitch to investors. CFM’s concern to be distinct from its London peers is such that the firm has a policy of only hiring direct from universities. It doesn’t hire researchers with a background in financial research or poach scientists from rivals.

“We believe that the only reason why investors might be interested in us rather than the big London CTAs is if we can add something, if we can do something different from the crowd,” says Bouchaud. “So, I think that the last two years have shown – 2011 was a very good year for us – that it’s possible to be in the CTA space and do something different from the main players there.”

Regulation and hedge funds
Like other hedge funds, CFM is used to being regulated, not only by its French domestic regulator, the Autorité des marchés financiers, but by the Commodity Futures Trading Commission and the Securities and Exchange Commission. Like other managers, CFM is grappling with some uncertainty as it gears up for the new regimes coming into being through the AIFM Directive and the Dodd-Frank Reform Act.

“The problem is that you have to be sure what the regulation is about to make decisions,” Bouchaud says. “And there’s a lot of uncertainty right now. On the other hand, I think CFM has always been in favour of regulation. I think the hedge fund industry needs regulation. We’ve always seen ourselves as here to stay in a long-term sense.”

CFM’s latest strand of research is the development of a systematic long-only equities strategy expected to launch in early 2013. It will aim to encapsulate in models what investors do on a much larger scale.

“We have all the tools we need to do that and it would be a natural extension to what we are doing,” says Bouchaud. “But, at the same time, it means that we have to be more institutionalised. And I think regulation is a good way to institutionalise the industry.”

New institutional investors
Over the years, CFM has aimed to draw in more sticky money. That’s seen more pension funds and endowments become investors, lessening the proportion of money from funds of funds and high net worth investors. Having a long-only fund will also serve to bring CFM to a range of new institutional investors.

“I think CFM requires a lot of investment, research, technology and data,” says Bouchaud. “If we want to stay ahead of the curve, we need to continue investing, and so we need to have a stable AUM base. I think adding this extra leg, a long-only leg, will diversify the business.”

But that probably won’t be all. Other quantitative funds, some with high capacity, are possible, perhaps in other asset classes such as fixed income. The expansion means that CFM is planning to boost its head count by half over the next three years.

“Now, I think that, for the first time, we have a clearer horizon,” says Bouchaud. “We have stability with an AUM that’s substantially higher than we’ve ever had in the past. So we hope to be able to conduct these projects appropriately.”