GLC Diversifies to Limit Performance Volatility

Using CTAs, macro and stat arb to engineer returns

BILL McINTOSH

GLC, the London hedge fund group, leaves nothing to chance with risk management. The firm, founded in 1992 and one of London’s oldest hedge fund managers, is now comfortably ensconced in the penthouse floors of the Ingeni Building in Soho. In over three decades of market making, managing CTAs and prop desk trading, including a long run at Bankers Trust before founding GLC, Managing Director Lawrence Staden has seen many hedge fund managers disappear. It is something that profoundly affects his approach to managing assets.

“Running a hedge fund isn’t about making money,” Staden says in an interview with The Hedge Fund Journal. “There will always be opportunities to make money. The important thing is to stay in business and not blow up. That’s why I’m so focused on risk control. If you don’t get risk control right, at some stage you are going to blow up and then it’s all over.” Likening the hedge fund industry to a primal struggle, he adds: “It’s all about survival. I’ve seen so many talented people go out of business. The reason is they get involved in illiquid stuff or they take too much leverage.”

GLC’s 18 year history is divided into three distinct periods. When Gilbert Hall, Staden and Caroline Moxon set up the firm – GLC is an acronym of their first names – it had a handful of staff. It was housed within the managed futures fund operator GNI Fund Management, which provided back and mid-office services, leaving Staden and Hall to focus on research and trading. The arrangement worked well and GLC, then principally a CTA, grew throughout the 1990s. Being within GNI also introduced Caroline Hoare to GLC, since she worked closely with the fund in her role as a GNI director providing legal and operational support. Indeed, it was only after Hoare agreed in 2001 to be CEO for an independently operated GLC that Staden and Hall moved the firm out of GNI. Setting up independently with its own store front marked the second period in GLC’s history which lasted until 2004, when Hall and Moxon, retired to pursue non-business interests.

Funds added in 2006
In 2006, GLC moved to a broader multi-product offering. This ushered in the launch of new funds featuring three sources of CTA alpha: Directional, Behavioural Trend and Carry (only available through their flagship internal multi-strategy fund – Diversified); one equity statistical arbitrage: Gestalt and a discretionary global macro strategy: Global Macro led by co-portfolio managers Steven Bell and Aston Chan. In recent years GLC’s two biggest funds, Gestalt and Global Macro, have performed well for investors, with a positive return in 2008 and more than 12% and 24% returns in 2009 respectively. In addition, for the three years through 2009, their flagship Diversified Fund, with AUM of $329 million, has returned an average of 18% annually. All of this has helped GLC grow assets under management to over $1.5 billion.

In significant ways, GLC followed naturally from what Staden did at Bankers Trust in the late 1980s and early 1990s where he was a market maker, running the gilt and treasury market desks. During that time Staden and his colleague, Iain Bratchie, oversaw the bank’s capital allocations to model driven trading across market making, systematic prop trading and discretionary prop trading – areas that remain central to GLC. Bratchie joined GLC soon after launch and remains director of quantitative research.

“My whole career is really sticking to my knitting,” says Staden. “I’ve innovated but within my areas of expertise which are market making, prop trading and systematic trading.” He likens GLC’s 15-strong trading team tomarket makers, adding that he sees his own role in this way. “With market making you get paid for adding liquidity. In markets with excess demand for liquidity, you tend to get paid for providing that liquidity.”

The Gestalt Fund, GLC’s stat arb offering, has recently begun market making in US equities after doing so in European issues for 12 years. “It really isn’t rocket science,” says Staden. “You go in and add liquidity and the alpha is given to you. The problem is hedging the risk. The Gestalt Fund is all about risk control. You saw what happened in August 2007 and September 2008 – we made money in both months – but many of our competitors didn’t because their portfolios weren’t hedged properly. For us the alpha is easy in market-making products because you are providing a service to the market. It is also a long-lived form of alpha. But the problem is the risk characteristics. When something big happens in the markets you can get run over by the express train. The key to it is risk control. We cottoned on to this pretty early on.”

Hedging is key
With market making the importance of hedging is primary. Any market making strategy is going to be gamma negative – that is, it will have lots of up months and a few big down months. To manage market risk in Gestalt, GLC uses a beta hedge. “If your view is you like the alpha but not the risk characteristics, then the thing to do is use something to hedge that exposure,” Staden says. “If something is gamma negative, which most hedge fund strategies are, the best thing you can do is employ something that is gamma positive to offset that risk. There are various things available. You could go out and buy volatility, but we don’t do that because it is quite alpha negative as you tend to lose money if you just go out and buy volatility. What we do is run a trend model in the background of Gestalt, which we call our beta hedge. It is there to hedge implicitly the beta you get from running a market making operation – it has done a fantastic job and halved the volatility of the programme.”

When GLC looks for a new strategy to expand its offering it generally starts with an intuitive idea. If data supports the strategy it validates why the approach might make money. The reason for not using data alone is straightforward: if the manager understands why a strategy works then there is a better chance of understanding the conditions under which it might stop working.

“Because we understand why we are making money we understand how we might stop making money,” says Staden. “An even better example of that is the original Directional programme (which traded from 1992 – 1998), which basically made money out of there being too much liquidity in the FX market. When that liquidity went, coincident with the introduction of the euro and the advent of the EBS (trading system), we closed the programme because we knew how it made money. If all you have got is statistics then the only way you can justify closing down a programme is after you’ve lost money. Because we understood what we were doing, we were able to turn if off before we got hurt.”

With Gestalt, GLC found that statistical models gleaned from bond markets transferred well to equities markets. “The statistical basis of it is a number of mean reversion models which we previously ran in bond markets – our original expertise,” Staden says. “We came up with various sophisticated models and actually found out that you didn’t have to be terribly sophisticated as almost any mean reversion model would work. The clever bits are in the hedging. Anyone can make money doing mean reversion. The trick is to avoid getting kicked in the teeth from time to time. That’s the key to it.”

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Thoughhigh frequency trading continues to grow its share of total market volume, GLC only devotes a small amount of Gestalt’s risk to such strategies. Staden qualifies his experience as running groups of traders rather than running machines. The aim is to use computers to complement traders rather than just boost the speed of execution. “The models we produce aren’t given to machines to trade,” says Staden. “We give them to people and say use your wit and judgement to try to outperform the market. If you are using a machine and you get the middle price you are doing a fantastic job. If you are using people with skills over and above what you can get from machines you can deal at better prices than the middle-price. You have to give people discretion. The trick is giving them the right amount of discretion. Too much discretion and suddenly they are trading a different strategy from the one you intended. But if you give them too little discretion then they add nothing.”

The second biggest fund in GLC is Global Macro, founded in 2006 by ex-Deutsche duo Steven Bell (a director of GLC) and Aston Chan. Bell, former Chief Economist at Deutsche Bank, has known Staden since his Bankers Trust days. At GLC, Bell and Chan run a liquid trading strategy continuing from their macro and global tactical asset allocation experience at Deutsche Asset Management. Their discretionary and fundamental-based approach has added a new dimension to GLC’s systematic background. The Global Macro investment team returned more than 24% for 2009 and has achieved near-zero correlation with major macro sector indices in its four year track record. The fund’s distinctive value-orientated style coupled with a liquid investment universe has bolstered GLC’s stable of uncorrelated alpha sources.

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Changing priorities
First at GNI and then at GLC, CEO Hoare has seen how investors have taken an increasing interest in operational due diligence and risk management. “When I first started in this business, the only thing investors were interested in was performance,” she says. “They only wanted to see the track record and meet Lawrence as the portfolio manager. Now it is very much a 50:50 focus on performance and infrastructure.”

Hoare says the new focus on operational matters is an evolution spurred on by rapid growth in the absolute return investment sector since the millennium. “It’s been a gradual process as investors have become better educated,” Hoare says, noting the impact of increased regulatory scrutiny and growing allocations from institutional investors, particularly pension funds. “I wouldn’t say we’ve changed what we do,” she adds. “People just ask us a great deal more about it. We draw a distinction between risk control and risk monitoring. Risk control is what Lawrence and the traders do and it is built into the models. Risk monitoring is done on my side of the business. We produce more reports because people are now asking for them.”

A recent addition to the GLC management team is Ted Logan, head of business development, who joined from Aspect Capital. His focus is to grow the business organically and strengthen client relationships. “I am trying to take what’s been done and expand the client diversification geographically and in term of the investor profile,” he says. That means tapping into regional consultants and institutions in new areas as well as making a greater push with private banks.

“Part of my mandate is to engage with investors and see how we can deliver our strengths to meet their needs,” Logan says, discussing the balancing of his focus on growing channels of distribution and developing new investment products. “There is no immediate plan to provide something that is a brand new source of alpha and put it out with a different wrapper. The goal of my role is to leverage GLC’s given strengths in the most efficient manner. What we’ve seen throughout the whole industry is that it has become a much more investor centric business. What’s important is to communicate with investors more efficiently and in a scalable manner while maintaining strong client relationships.”

Diversified returns
Throughout GLC’s time managing assets, the internal multi-strategy Diversified Fund has blended different trading exposures (drawing on five allocation options: Gestalt, two CTA funds, Global Macro and Carry) to provide an optimal mix of potential returns and volatility control. As the firm’s strategy offerings have evolved, so has the mix within the multi-strategy fund. The result is that the current make-up of the fund differs markedly from its composition in the early 1990s. The mix is reviewed semi-annually and changed annually with investors given a month’s notice of allocation changes.

“We don’t strategically trade the strategy,” Staden says. “We don’t say: ‘This is going to do well so we will up it or that is going to do poorly so we will cut it’. All we do is change the allocations to try to minimise the volatility.” The last change occurred in December. Carry increased from 10% to 15% and macro from 30% to 35%. Directional fell from 40% to 35% and Behavioural Trend from 40% to 35%. The changes were made to reduce prospective volatility.

“We just adjust it in response to the correlation matrix,” he says. “I see my job as trying to reduce that risk. There is enough going on in the strategies that if you get the risk down you will reap the reward; it’s all about risk reduction. Within the Diversified Fund, we have a wide range of uncorrelated strategies that reduce the risk. The real risk in hedge funds is the fat tails, the really nasty months when a fund might lose 20%. It is hard to model those fat tails because you don’t get many observations however far back your database goes. But we do know with liquid instruments that the fat tails are less fat than with illiquid instruments. That’s why we’ve never strayed too far from the very liquid universe.” Thus the European and US equities Gestalt trades are the top 500 issues by market cap while the CTA and Global Macro funds trade mainly liquid futures and FX.

In Staden’s conception, what’s special about GLC is the synergies it generates from combining traders, quants and economists. “Here everyone is pulling in the same direction and we all get paid out of the same pot,” he says. The firm has a very high retention level and most of the senior personnel have been with it for many years.

Observer of change
With over two decades in managing assets, Staden has had a ring side seat to the changes that have swept the hedge fund industry. “It is so hard to get across how different it was then,” he says. “It was a real cottage industry in those days.” His overriding observation is that the stakes have grown enormously and that has brought increased responsibility.

“The main change is just the amount of money,” Staden says. “In 1995 we had $250 million and we were one of the biggest CTAs. The numbers have got so much bigger because of institutional money so the whole business has become much more institutionalised. There is far more focus on process. If you are managing a HNW’s money and they give you $10 million that individual can do what he likes. If you are a pension fund trustee giving that authority to a third party you have a duty to do due diligence. That’s really what’s changed.”

He adds: “I’m happy with it. I feel happier running pension fund money than any other kind of money because I can see you doing some good for society. We’ve always had a duty of care. But the people giving you that money have a duty of process. That’s the thing that has changed. The money has become bigger and with that comes the additional responsibility for process. I think it is positive that the industry has become much more professional. Now it is not enough to do the right thing, you have to prove you are doing the right thing.”