GAM Trading II’s 12-year track record is a 9.76% annualised return to the end of 2008 and with no negative years. It re-opened in February 2008 and has about $2.5 billion in assets under management.
“I think in the near term an environment of uncertainty, whether it is being driven by economics, politics or regulation, is generally good for trading strategies,” says Arvin Soh, the fund’s investment manager. “Trading strategies do well in volatility, they do well in uncertainty. As long as we continue to see such an environment it is going to be good for these types of strategies. The result will be that in relative terms this is where the assets will be going to.”
DE Shaw Oculus is the fund’s biggest holding. Brevan Howard, Tewksbury, Global Trading Strategies and Tudor round out the top five positions, which amount to nearly 35% of the portfolio. That marks an evolution away from some of the more multi-strategy macro managers which made up around 40% of the portfolio at the end of 2005 when GAM closed the fund to restructure it. At the time, the fund had AUM of $4 billion and was very concentrated among 21 managers.
“The question was: were we comfortable with that?” asks Soh. “Was there a reason why the portfolio should be more diversified? That concurred with a period in time when we saw that the correlation of the trading strategy to the equity markets was increasing. We had to start thinking is this still really a trading fund? So we closed the fund and began the process of diversifying the portfolio.”
GAM’s review found that some of the big macro players with 20-year plus track records and a large amount of AUM figures weren’t really global macro anymore. Instead, asset growth among the firms meant they had evolved into global multi-strategy operations with equity, credit and emerging markets books. Consequently, correlation with equities was increasing.
Correlation concerns
In turn, that led to concerns about how the portfolio might be damaged during an end of cycle period of poor equity market performance. It would be fine for a trading strategy to be long equity indices in a short term trading environment, but Soh felt a structural bias in the portfolio to equities over the longer term would increase correlation.
“In the current environment or one that is not quite as severe, returns will be poor for equity strategies and risk assets, but good for fixed income and usually good for currencies so then they become negatively correlated,” Soh says. “But if your strategy is comprised of managers that have dedicated equity long/short and credit long/short books then correlation isn’t going to come down in an environment like this or at least not easily. We felt that those types of managers could still have a role in the portfolio but it had to be much smaller.”
Over 2006 and 2007 GAM reoriented the fund to find what Soh calls the “true macro managers”. Invariably, this involved homing in on pure macro players as well as a number of specialist funds. A typical manager would have less than a $1 billion in assets and might focus on just fixed income, or currencies, a certain commodity class or emerging markets.
“We began the process of moving much more towards specialists,” Soh says. “Now the portfolio has about 35 names in it. There is much more of a focus on smaller managers who focus typically on just one asset class or in some cases even a sub-sector of an asset class.”
The move to diversify proved prescient. The impact of the credit crunch meant that the current market environment has favoured trading funds. One important factor in this is that trading, CTA and global macro strategies are highly liquid, and so are able to better absorb volatility and minimise investment risk.
The recruitment of some 20 new managers brought challenges of its own. One was that many of the managers had limited track records. This meant Soh and his team needed to calculate expected returns, volatility and correlation of each manager’s strategy and how that would impact these measurements at the fund level. At the same time, the firm bolstered its quantitative resources, especially in the analysis of risk management.
A key to the approach is analysing the likely return profile of a manager across the economic cycle. Soh would then adjust for what the returns are expected to be in different environments and assesses how that would complement the fund’s risk-return characteristics. The qualitative analysis is focused on what role a particular fund might play in the portfolio, whether it is better than something already in it or whether it is different altogether.
Take the hypothetical example of an emerging market manager who gave a 15% return each year from 2005 to 2007, with volatility of 10% and a worst drawdown of 5%. “I would look at that data and say it has been an extraordinarily low volatility environment,” Soh says. “But it’s emerging markets. It’s got a lot of tail risk. We just haven’t seen it happen. So therefore that type of return profile is not what we are going to see going forward.”
Can CTA returns endure?
The success story of the hedge fund industry in recent quarters has been the outperformance of a number of CTA and global macro managers. They have attracted a growing proportion of AUM as overall industry AUM has fallen sharply. But such systematic strategies eventually suffer a period of underperformance. The question is when this will occur.
“These models decay over time,” Soh says. “They’ve got to be constantly assessing their models and adding to their research staff, trying to look at new approaches because eventually it will stop working. We see the same thing on the discretionary side. There is typically decay in returns relative to volatility.”
The trading strategies GAM runs split into two groups. Soh manages the stand alone trading product along with David Smith, chief investment officer for GAM’s Multi-Manager team, who also manages the diversified strategies, which incorporate equity, credit arbitrage and trading funds. The differences in the approaches are becoming increasingly evident to investors.
“The multi-strategy approach is very bottom up – involving balance sheet and cash flow by looking at individual companies,” Soh says. “The trading strategy is the exact opposite. It’s very top down. It’s much more focused on technical price indicators and not as focused on the value indicators. There isn’t a mean reversion tendency as there is in many of the equity and credit strategies, and liquidity is greater. Because the approach is so different we would expect that the return profile and correlations should be different.”
Accessing top managers
The unprecedented scale of hedge fund redemptions has hit the industry hard. In some cases, funds have invoked gates to the consternation of investors. At the same, it is arguable that the investment opportunities for those with cash are unprecedented. Indeed, few managers, including some of the most highly coveted, are closed to new money.
It’s put to Soh that manager access – traditionally a key differentiator for a very well established operator like GAM – removes an important part of the appeal a fund of funds can offer. Soh counters that his fund will be much more aggressive to hold a particular manager to account – say on the risk budget – than an investor or multi-strategy chief investment officer will be.
“In multi-manager firms, what happens is the actual willingness to cut risk is really, really low,” Soh says. “Many managers were aware that ’08 was going to be bad for risk assets. Did we actually see a true change in the direction of the book? Many managers said the focus would be on liquidity. Did we see those managers move to more liquid portfolios? We didn’t.” He blames this on multi-manager CIOs needing to appease portfolio managers who will quit if their risk budgets are cut.
“We are very specific,” Soh says. “We say this is the metric we gauge you on. If you don’t achieve those we redeem because, otherwise, we cannot reliably construct a portfolio that achieves our targets. It gets more complicated for (a multi-strategy CIO) when someone is brought in-house and there are plans for him over the next 10 years. Their willingness to say ‘I’m cutting that risk down’ is much less than it should actually be.”
He cites two key additional advantages of funds of funds. One is the design to be non-correlated over a market cycle. The second is having the team and resources – GAM has its own proprietary database – to find managers that others can’t find or have a harder time finding.
GAM Trading II has a target return of 8-13% annually measured over a market cycle. Understanding how cycle drives returns, drawdowns and impacts correlation is an important part of the portfolio construction and monitoring of allocations that GAM does.
“If it is something in the cycle, it may be OK if the manager is not performing within their normal target range because it is a bad environment so it might not warrant dropping the manager,” Soh says. “Alternatively, if there is a fundamental change in the way in which the underlying fund is managed and we think something needs to be done, that’s when we make a change in our portfolio. We’re not macro managers,” he says, adding that GAM doesn’t use overlays to compensate for, say, currency movement. “Our job is to create a balanced portfolio and to manage that risk accordingly.”
Soh expects the thickening regulatory environment and constraints on capital to see an exodus of a better calibre of portfolio mangers from bank prop desks. “We have conversations all the time with traders to either try to convince them to launch or if they are going to launch anyway, have the conversation as part of a process to get to know them early, normally before the fund is even launched,” he says.
The other impact of regulation is the upheaval caused when financial market rules are being added and frequently changed. “It is much more political than what we have seen previously,” Soh says. “That complicates things and there are regulatory and tax changes. Do I think all of this is going to change the opportunity or change things around? I do. But at some level that is also uncertainty and that is good for the strategy.”
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