Infinity Fund Limited is a trading fund where positions are taken across three asset classes Fixed Income/Equity/Foreign Exchange, and where a component of the decision-making is a macro view. Most of the positions are held for periods ranging from a few hours to a few days, though up to a quarter of the NAV can be in relative value positions that can be in place for months. As usual, the strategy and style of the fund have come about because of the career path of the key individuals. Chief Investment Officer David Brown describes these influences:
“My skills come from the organisations I have worked for. From being on the graduate programme at HSBC I learned about derivatives. When I worked at the Bank for International Settlements in Basel I learned about portfolio management. In particular I picked up how to see where portfolio managers will recognise value in the markets, which has been a key insight for me. Then at Rabobank, working as an investor in markets on behalf of the bank,I learned a couple of things: to recognise value in selecting my investments, and to find a way to be solvent at all times. So one of the questions I ask myself before implementing a strategy is “can I remain solvent until the market buys into my strategy and I can realize my profit?”
Whilst Brown may be the key decision-maker he enjoys some high level input on trade analysis from fund director Nouriel Roubini. Roubini is Professor of Economics at the Stern School of Business, New York University and has his own macroeconomic consultancy Roubini Global Economics LLC. According to Brown, Roubini’s insights into the dynamics of trade and the drivers of economic growth in the US and globally are the starting point of the trade strategy analysis for Infinity Capital Management.
A key concept for this manager’s style of operation is that he always has some capital at work in each asset class (plus the relative value component). The Infinity Fund always has at least 5% of NAV in each of the four fund components. This is vital to the style of management because the combination of the P&L of the positions in the fund and the Value-at-Risk of those positions is a major part of the manager’s read on the markets.
Infinity Capital Management Limited uses as a standard a 95% confidence interval and a two-year data history to calculate the VaR of the whole portfolio and of each of the holdings. The risk analyst Sidney Ngone produces forecast VaRs across three time-horizons – 1-day, 5-day and 20-day. The VaR figures calculated are expressed in US Dollars and in basis points, and the measurement in basis points of fund value (or NAV) is the focus of management attention.
The risk management reports include cells in the spreadsheets that are conditionally formatted to flag VaR and P&L changes that are outside the 1-in-20 days expectations of the forecasts at the whole portfolio and position level. As an example, Table 1 shows portfolio level forecast of VaR and P&L outcomes for the first few trading days of January this year.
The reports were telling the manager that the fund had over-performed in three of the first four trading days of the month for what was owned, given the correlation and volatility of the holdings observed over the previous two-years. It is almost certain that the manager will know exactly from where the ‘super-performance’ is coming, though there are position level reports for his and others’ benefit. For this particular example the profits were coming from equity positions: after a few days of January American stocks were up 4%.
“That kind of move is enough for a wholemonth’s return from equities,” says manager David Brown. “After a move like that I like to lock in the profit, so I cut the equity exposures.” This is visible in the last row of Table 1, which shows 1-day VaR reduced to 7 basis points.
Of course the manager had a decision to make in this example after the first day’s trading of the new year. A daily P&L of 96 basis points is a handsome week’s return in its own right for a trader. Similarly after the second day of the year, the same pressure to take profit existed. There is always that two way pull – to leave exposures and run your profits, or lock in the gains. This money management element of the investment process of Infinity is determined in the manager’s head. There is not a mechanistic decision rule as there would be at a fund running a statistical arbitrage or systematic CTA strategy. The manager is making a judgement call on short-term asset allocation using a combination of three things: the outputs of the risk measurement capabilities of the firm, his own experience and the guidance of the two fund associates, fund director Professor Nouriel Roubini and Michele Bina, the chairman of the firm’s risk committee.
Michele Bina, an alumnus of S.G. Warburg (he worked in equity structuring and then the Advisory Division), is the chairman of the risk committee. His frequent travels to the Far East certainly give him a different take on the world from London-based Brown. Bina receives daily a full set of risk reports – exactly the same as those seen by David Brown himself. On most days, when neither is travelling, the manager of Infinity Fund has a daily conversation with his risk overseer. Bina plays the part of the “reasonable man” in discussion, and is a sounding board for the investment manager’s thinking on his holdings. Amongst the reports that may be covered is the risk summary report. This shows the most significant risk factors in the fund as a percentage of the fund value and as a proportion of total fund risk. Recently the dominant risks reported were short 10yr US Treasury note March 06 futures (27% GAV; 58% of the VaR forecast risk), and long EUR/USD Mar06 futures (5% GAV; 36% of the total VaR). Michele Bina’s questions to the investment manager tend to be on how the portfolio is constructed. The summary risk report also goes to some members of the Advisory Board to the investment management company, one of whom backs up Michele Bina in his role.
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The important point for the investment process is that the normalised risk reporting of positions and variance of actual volatility from expectation as reflected in the daily P&L gives the investment manager information. As there are always positions in each asset class (plus the relative value component) the manager has a handle on how volatility is ebbing and flowing in each area, as well as how his own positions are faring. “I like to sell abnormally high volatility and I like to buy unusually low volatility,” says Brown. He says he thinks of the positioning as building a trade as cheap options.
Sometimes the exposures are literally through options, and in this the manager sees an edge. “We can often be directional in our position taking, and that tends to be riding a trend,” explains Brown. “But we have no advantage versus the market in directional risk taking. So I see purely directional trades as weak trades. We have also witnessed recently trendless markets, by which I mean American markets where we are concentrated, as acting more in balance than they used to, as risk taking has been segmented through different players buying what for them are suitable tranches of risk. We prefer to allocate capital where we see a fundamental imbalance, and we use volatility as an indicator for timing, as well as telling us whether option premiums are cheap or dear.”
At the moment David Brown sees US equity markets as fairly priced, but even at fair value he sees scope for a 10% rise this year. The US economy is going well, according to the manager, so he has a bias to looking for good entry points for US stocks (and indeed a re-entry point for a Nikkei Index position). At the moment Brown will tend to put on equity exposures through NASDAQ futures, and this can be augmented by option plays around the future. He also has a bias against paying for single stock option premium, which probably comes from the preference to buy value. However, because he is watching for volatility spikes at the asset level, he feels comfortable being a seller of expensive short-dated single stock option premium. These positions often have a maturity in only a few days time, and as time decay for options is very progressive, the odds of making money can be very heavily stacked in the sellers’ favour.
To balance these outright risk assumption positions the Infinity Fund also has relative value positions and very conservative collateral holdings. “One of the lessons I learned at the BIS, the world’s only AAA+ rated bank, was that collateral must be kept in very secure assets, so most of the NAV of the fund is in T-Bills,” states David Brown. On the fixed income side, as with all traders, he prefers to have a positive carry. “To have 40-45 bps in the bag at the end of the month is a good starting point to take risk from,” he explains.
It may be a surprise to read that the manager of the Infinity Fund does not spend every working day glued to a screen, even though the holding period of most of the positions is short and it may be considered a trading fund. This is where the macro element comes in. David Brown spends a lot of time in the United States of America for a European-based manager. He spends as much as over a hundred days a year there. He likes to track what the top-down views are on the economy: Brown will meet economists and strategists from the brokerage houses and independent research outfits and economic consultancies. Partly this gives him the chance to fix what the consensus economic outlook is for the US economy, but it also provides an opportunity to determine what his variant perception is (what is not discounted in the markets). In a minor way, visiting the country also allows Brown a first hand read of the state of the economy in America.
This consultation process gives Infinity Managing Director Brown a central view on what is happening in the economy, but the extent to which this view is reflected in the strategies is largely determined in his head. Then come two key feedback loops to the whole investment process.
The first feedback loop is one that in the hedge fund business is honoured more in the breach than the observance. Infinity Capital Management has an advisory board that was introduced at the start of 2005. There are three members of that Board, one of whom tends to give input onbusiness matters, and one, Professor Roubini, is the member of the advisory board that provides the feedback loop to the manager on economics. In many instances in the hedge fund business an advisory board is an adornment but not an active part of the investment process as it is at Infinity. As mentioned earlier Professor Roubini has his own macroeconomic consultancy, and by engaging in dialogue with him investment chief Brown fulfils his wish of having more than one voice on asset allocation at the firm. The monthly meetings of the advisory board serve to provide some level of balance in the discussion on the relationship between economics and markets.
The second feedback loop is the P&L of the positions. Even on an intra-day basis the manager will be aware of where his profits and losses are coming from and how much they are “beyond normal daily moves”. This signalling mechanism works for the sell discipline as well as for buying. “If the behaviour of the market is statistically unusual we will take profit, even if we like the market fundamentally,” states Brown. That said, for a strongly trending market there are times for a macro manager to keep his foot to the floor, and times to ease off. Brown’s attitude seems to strongly reflect one of Dennis Gartman’s Rules of Trading, which is that “Trading Runs in Cycles”.
Gartman has put it that “those of us who trade for a living know that there are times when every trade we make (even the errors) is profitable and there is nothing we can do to change that. Conversely, there are times that no matter what we do – no matter how wise and considered are our insights; no matter how sophisticated our analysis – our trades will surrender nothing other than losses. Thus, when things are going well, trade often, trade large, and try to maximize the good fortune that is being bestowed upon you. However, when trading poorly, trade infrequently, trade very small, and continue to get steadily smaller until the winds have changed and the trading “gods” have chosen to smile upon you once again.”
Brown implements this mindset by having tighter limits for losses at the portfolio level than for profits. In effect he is less tolerant of losses, though that does not mean he is psychologically incapable of buying down. “I have been known to double up,” he says, “though only after checking the fundamentals remain as we originally perceived them, and it is not common.”
One of the circumstances which shows that Brown acts like a proptrader is when he generates a profit on a trade. “When we have generated more than enough profit on a trade (which for us is 20 basis points in a month on the NAV from each asset class) then I look to use the excess profit,” he says. “For example, say I make 30 bp on a fixed income position then I know I have 10bp to play with. I won’t necessarily look to put something on in the same asset class. In fact, I prefer to enhance the return profile in another asset class so that there is better diversification. So I would do things like use the 10 bp to buy a short-dated near-the-money option premium on NASDAQ futures.” Such deliberate diversification is a relatively new phenomenon at Infinity, and is a manifestation of the manager’s keenness to be fit to attract institutional capital.
As can be seen from Table 2, the track record of the Infinity Fund divides into two different phases. The first two years can be characterised as driven by the priority of high absolute returns. At the fund level Infinity Capital Management for 2005 and from now on targets a return of 12-15%, and the manager’s intention is to have a return series with much lower volatility whilst hopefully keeping a healthy proportion of the previously achieved absolute returns. At its simplest this has been achieved by using only a small proportion of the leverage previously applied. But equally as important is the new emphasis on internal diversification, the lower tolerance of losing positions, and a heightened awareness of the significance of monthly reporting in the hedge fund business.
In the newer style of running the fund once over 10% return on a year-to-date basis the manager acts more conservatively than previously. The operational mode becomes as much “keep capital” as “make capital”. When one of the capital allocations to the three asset classes shows a monthly fall of 4 or 5% the manager tries to cushion the risk that was taken (mostly through options), and often tries to job the particular market to make back some (but not necessarily all) the losses.
One of the notable features of the outcomes of the new style compared to the old style is in monthly losses. Obviously the scale of losses were significantly higher in 2003 and 2004 – as much as 20% losses in a single month, contrasted with a largest monthly loss of 1.2% in 2005. But more telling is the frequency of monthly losses. There were nine losing months out of24 in the first two years of trading. Last year there were two monthly losses and one of those was a scarcely visible dimple (a loss of 10 basis points). The manager has spent 2005 putting on exactly the same sorts of trades as the previous two years, but says himself that the returns of 2005 were not solely due to the size of the capital traded. In the first two years a lot of the returns came from equities, but more recently the manager has made more of his returns from FX and Fixed Income. David Brown’s view is that the markets have been in better equilibrium in 2005, and that will have limited opportunities compared to 2003-4. Sounding like a classical global macro manager he says “our biggest trade is always volatility, so if the markets give it to us we will make more money.”
David Brown is out to develop Infinity Capital Management as a business and has added resources to do it. The development of an advisory board was a first step, the arrival of Sidney Ngone was a second, and the third to have taken place was making the management company a regulated entity (under the UK’s FSA). The next obvious step is much more difficult to implement, as Brown wants to procure some help with running the money. This will enable him to take a real break, and have someone share the burden of idea generation and portfolio management. It will be the key hire for the medium term at Infinity.
Although it may seem somewhat isolating to be working with only one other dedicated team member, the reality is better than that. The chairman of the risk committee and the advisory board do provide independent and trustworthy voices for Brown to listen to. In addition the manager shares his office space with another macro-style hedge fund management team (the Abraxas Fund), so he has another flow of market information to tap into.
It is uncommon to find a genuine proprietary trading approach in the hedge fund format. It is rarer still in Europe to find it implemented by one talented individual rather than in a “super prop shop” that has left an investment bank. That makes the returns achieved by David Brown these last three years as truly noteworthy. He has transmuted his style of management in an effort to produce a return series that is attractive to investors other than high net worth Individuals. He has admirably succeeded in changing the return series, but as yet runs only $10m through a style of management that would accommodate 50-times that capital with little pressure to style-drift from size. What remains to be achieved is attracting the institutional capital flows, and there are several AUM thresholds to cross toget to the necessary scale to be able to market to them.