The CQS Diversified Fund, offered by the London-based asset management group headed by Michael Hintze, showed how properly conceived diversification can work for convertible and credit investors. The Fund’s 7% slide during 2008 made it a relative winner, while a 20% gain in the first nine months of this year is a strong rebound just months before its third anniversary, typically the time when many institutional investors begin to consider allocating to a fund (see Fig.1).
CQS Diversified is an actively managed fund of CQS-managed funds run by senior portfolio manager James Peattie with assets under management of $135 million at 30th September 2009. Diversified invests in five strategies run by the manager: the CQS Convertible and Quantitative Strategies Fund (CQS Fund), CQS Directional Opportunities Fund, CQS ABS Fund, CQS Asia Fund and CQS Credit Long/Short Fund (see Fig.2)
Diversified opened in early 2007 after clients expressed interest in investing in multiple CQS funds, but wanted to know the best way to do so. Peattie, then a special situations portfolio manager with the CQS Fund, went to work modelling and back testing a process to allocate across the funds in a way that would optimise the risk/return balance. The investment objective is to return 12% to 15% net per annum with controlled volatility and an investment limit of 40% in any one CQS fund.
On 2008, Peattie says: “It was a disappointing year to me but the Fund did control the downside risk. We wouldn’t have been able to do it without the spread of businesses in CQS,” he adds, giving special credit to the directional short bias run by the ABS Fund’s portfolio managers. “They recognised what was happening when the ABS market started to go wrong. They took their long positions off the table and were very selective in identifying issues within the broader market. Their understanding of how bank funding was being reduced, and the implications of this, provided a useful insight across the whole CQS trading floor.”
To hear Peattie discuss portfolio management and the risk profiles of different hedge fund strategies makes it clear why he was hired by Hintze first to work on the CQS Fund and then deployed to develop Diversified.
Peattie started trading convertibles and risk arbitrage in the mid-1980s with LF Rothschild, Unterberg & Tobin and knew Hintze, who was then honing his trading skills at Goldman Sachs. Peattie then moved on to do risk arbitrage and trade interest rates, convertible bonds and derivatives at Oppenheimer, where he eventually headed the international arbitrage desk. A move to Smith New Court saw him continue to mix trading, research and risk management, until the broker’s takeover by Merrill Lynch, who demanded that he specialise. Peattie saw a gap in the market and plumped for a research role in convertibles leading him to comparative analysis of different asset classes.
“You have to know a bit about debt,” says Peattie. “And a bit about equities, currencies, credit and rates – you’ve got to know a bit of everything. Decomposing convertibles is difficult. There are lots of moving parts and extra value that can be extracted.”
A three year stint running the global convertibles business at Dresdner Kleinwort Wasserstein preceded Peattie moving to CQS in 2003. In setting up the Diversified Fund almost four years later, Peattie aimed to combine the relatively small convertibles asset class with other asset classes to develop an efficient frontier – the place on a risk/return curve where minimum variance and maximum return intersect.
“That was part of the research I had done,” he says. “When people asked what we would do about asset allocation, Michael knew what I could do and asked me to take a look at it and to apply my knowledge to the funds we manage.” Peattie also had hands-on experience with a range of hedge fund strategies. “Michael came to me to design this and get it to work because I had the skill set to do it,” says Peattie. “He put a lot of trust in me to get on with the job and make it happen.”
Through optimal allocation and combining short and long-term factors, Diversified is designed to deliver lower risk rather than an average risk of the underlying funds. The risk and reward of each fund is plotted over time and forward modelled. That historic data is combined with a Black-Litterman model and Peattie’s proprietary efficient frontiers model to consider various combinations that optimise the return while limiting as much as possible the risk.
In modelling forward, Peattie takes a view on what risk each fund is taking and the opportunity set for the strategy, and adjusts exposures. The see through via the Diversified Fund to the underlying CQS funds can be higher than would occur with a typical external fund of hedge funds manager. This is due to the investors in the Diversified Fund having automatic access to all the fund information available to investors in the underlying funds. What’s more, because all the funds are CQS products the risk platform for each fund is the same.
Investors in Diversified get some preferential liquidity terms. The five underlying funds have either monthly or quarterly liquidity with varying notice periods. Diversified works with this parameter but also has a 5% special liquidity available each month. Thus weightings can change on a relative basis as well as be affected by performance should one fund, say, drop 10%, while another gains 20%. At each month end and quarter end, Peattie can adjust exposures (within the limits specified above) or let them ride, subject tothe 40% exposure cap to any one fund.
Diversified charges a 50 basis point management fee and no performance fee additional to the 2% management and 20% performance fees the Fund pays the underlying CQS funds (one, the Credit Long/Short Fund, charges 1.5%). Effectively, investors are paying to have Peattie analyse the funds and provide a non-correlated product with a different risk/return profile. Diversified doesn’t use leverage at fund level and Peattie doesn’t attempt to influence how the underlying portfolio managers invest. Rather, he allocates and redeems on his analysis of how a particular fund is likely to perform on a relative basis.
“It is a formal process,” says Peattie, discussing the mechanics of allocation and compliance. “I try to make it as non confrontational as possible. I am looking to see what people are expecting to do. My input is to analyse the data and get their input on where they see the opportunities.”
In turn, the portfolio is balanced among the funds taking account of underlying risk/reward and volatility expectations on a medium term
The five CQS funds are underpinned by a broad research platform with 20 analysts including 12 focusing on credit. There is a large variety of strategies in specific funds such as Directional Opportunities and ABS, while the CQS Fund focuses on convertible strategies.
“It is a disciplined investment process,” says Peattie. “We worry about the downside before we worry about the upside. Michael has a huge amount of experience and attacks risk in a sensible way.”
The risk/return continuum
The Directional Fund is the highest risk/return product run by CQS. The multi-strategy basis of Directional allows Hintze to adopt the best ideas from across CQS, including trades that don’t fit in any other bucket.
In contrast, the CQS Fund is at the opposite end of the continuum with a lower risk/return profile. This leaves the Asia Fund and the ABS Fund in the middle. The Credit Long/Short Fund, which launched in April to trade credit strategies via liquid credit default swaps and bond strategies, also occupies the middle ground in its risk/reward profile. In addition to gauging market exposure, Peattie, Hintze and other members of the Diversified Investment Committee focus on the degree to which funds are inventory intensive. The CQS Fund, because of its focus on convertibles, is a high inventory strategy as is the Asia Fund; the CLS Fund, as a greater user of derivatives, is a lighter inventory strategy.
Buying derivatives incurs minimal cash outlay to finance margin calls. By comparison, a convertible arbitrage fund needs to finance its inventory of convertibles even though it may also hedge out the credit risk and equity delta. The dependence on financing meant that convertibles and credit funds, in particular, got hurt in 2008 when redemptions from those strategies and recalled prime brokerage lending forced some managers to sell at distressed prices.
“That is why those strategies have made the best recoveries this year because funding has returned and they mean revert,” Peattie says. “That was one of the things we found in doing our analysis and which changed our allocation profile this year. We took a serious look at what happened and which strategies mean reverted.”
The analysis looked at what returns different trading strategies generated in the year that followed a down year. Indeed, as 2009 has gone on, it has become clear that the investment environment for convertibles is at its most attractive in two decades.
The start of the allocation is to take a look at the risk-reward profile of each fund. The Asia Fund, for example, is more directional since shorting rules mean it isn’t possible to hedge out as much equity risk in Asia as can be done in the US or Europe. Within the CQS Fund are embedded interest rate, credit and equity risks.
“I do look at everything on a risk/return basis,” Peattie says. “Hedge funds are easier to do this with than more directional strategies since they have less beta. People argue about short bias as a diversifier but if you have convertibles you have short bias in there anyway.”
Day-to-day, Peattie models how he expects the strategies to perform. Different portfolio combinations are examined and Black-Litterman models are deployed to analyse that. Once a month the investment committee meets and the chief investment officers of the funds assess how much risk they have and what the opportunity set is. He then explains the allocation changes he is expecting to make with the most substantial changes typically occurring quarterly. It is important to note that Peattie operates with the same information as other investors in the underlying funds and can only buy or sell a fund with a NAV determined by a third party administrator.
“I get what I need from the risk team,” he says. “I can aggregate and see what the delta is. Sometimes this is an appropriate risk. But we can take a look across all the funds and see what is the aggregate delta, what is aggregate credit risk, what happens on the jump. Not just where we are on the little moves but what happens when there is a big move – to see where the portfolio would run and see the underlying fund VaRs and what happens when I put them together – so being able to look and see what it does to the aggregate Greeks. I make one decision a month,” he says. “I’m not going to micro-manage.”
The Diversified Fund, of course, has one preferential term in that it can re-allocate 5% of the portfolio monthly. Peattie is characteristically cautious about how he uses this.
“The limits between how much liquidity and how much special liquidity you’ve got have to be factored into what you are trying to do,” he says. “You don’t want to be reallocating needlessly as it will use up all the fund’s special liquidity. You don’t need to make changes for the sake of it. “Weightings do change but it is a fairly gradual evolution. Intra quarter changes tend to trend over time as you have increasing or decreasing risk in particular strategies. The only big jumps are at quarter ends when people focus on predicting risk and opportunities for the next three to six months.”
He adds: “What we are trying to do is play the probabilities. If we manage the risk and reward of these funds correctly we will get something a little bit better and get a good performance on a relative basis.”
“What we got right in 2008 is that we shifted down on our exposure to inventory strategies,” Peattie says. “It was partly driven by what we learned from the ABS team in terms of what was happening to funding and whether that would spread. We also reversed that and went very much more into inventory strategies from March and April this year (see Fig.2).
During the same period, the allocation to the Asia Fund went from 6% to 16%, while the CQS Fund, which had fallen to just 15%, rose to 29%. On the other side, exposure to the ABS Fund fell to 20% from near 30%, while Directional Opportunities has been stable in the 15% to 25% band. Credit Long/Short underwent a broad strategy review so the allocation was constrained pending evidence of how it would perform.
In any event, the Credit L/S Fund only launched in April and as a trading strategy it didn’t correspond with the investment priority from spring onwards to push money into inventory strategies. “Before 2008 we were probably less bold about changing the allocation,” says Peattie. “Now we are happy the whole process works. It has done what it should have done. The returns dipped but have recovered and gone ahead of previous highs.”
One interesting thing about the performance of the various CQS funds is how correlations change. The CQS Fund proved more correlated to markets last year, while the Directional and ABS funds were less correlated.The returns also show that the correlations of the funds to each other are continually shifting, moving from being correlated in some environments to being negatively correlated in others. Diversified allows an investor to invest in the strategies but in a way that cuts risk and optimises returns.
“It is an easy way for an investor to get an allocation to CQS without making the more difficult choice of selecting a particular strategy,” says Peattie. “I’m trying to maintain the return, but dial down the risk. The proof of the pudding is in the eating. Net returns, I think, have been reasonably satisfactory.”