H2O Asset Management

Originally published in the May 2011 issue

The rapid rise in assets for H2O Asset Management is indicative of how investors’ priorities about risk management and alpha generation are having a significant impact on the European alternative funds sector. Founded in July 2010, H2O expects to be managing $2 billion before its first anniversary, making it among the fastest growing fund groups anywhere.

Clearly, backing from Natixis Asset Management, the giant French fund manager, which is a 50% partner in the venture, has played an important role. So, too, has the lengthy track record of founding partners Bruno Crastes, the CEO, and Vincent Chailley, the CIO, in absolute return portfolio management. Their quick growth shows that investors have an appetite for entrepreneurial launches with proven managers in a boutique-type structure when it is underpinned by the strong legal framework and risk infrastructure of a fund management leader like Natixis AM.

H2O’s chief investment objective is to provide clients with what it terms de-correlated alpha. This is fertile ground for attracting institutional investors who in the recent financial crisis found that many of their specialist managers, whether in alternative or traditional funds, suddenly showed high correlation. The result was hefty drawdowns on a scale for which few investors were prepared.

Alpha correlates to asset classes
“Most of the time the alpha that is available in each asset class is correlated with the asset class itself,” Crastes says in an interview at Natixis’ offices inthe City where H2O is lodging before moving to new offices in Mayfair.

“It means that if assets were allocated to, say, an equity specialist, the alpha would be quite tightly correlated with the directional performance of the asset class. By segregating the beta from the alpha by means of passive products on the one hand and alpha products on the other hand, we can make sure that outperformance comes out less correlated. At H2O AM, we provide alpha on top of reference asset allocations.”

The investment process at H20 sees Chailley and five other senior portfolio managers discuss and propose trades on an ongoing basis with Crastes, who also serves as an investment manager, having an oversight role to approve portfolio changes (See Fig. 1). Front office risk monitoring tools in quasi real-time are run by the fund managers in order to carry out proper risk budgeting and risk control. Natixis performs an independent risk control function and can intervene if it believes risks are not being monitored properly. The process means that H2O cannot act as judge and jury on its risk exposure, and investors get an extra layer of scrutiny.

An absolute return product, in H2O’s conception, is something where the engine or performance nucleus is stable over time. The firm’s different products are designed, in the first instance, to match preset risk levels rather than performance targets. Risk-adjusted alpha is what the team strives to deliver. Its 15-year track record exhibits a risk-adjusted alpha, or Sharpe ratio, of around 0.8. It means that the team has delivered an 80% yearly return per unit of risk.

Core funds offered
The product offering is organised around four core funds named after four music rhythms (from slow paced to rapid paced): adagio, moderato, allegro and vivace (See Fig. 2). The first and third products invest solely in global bond and credit instruments and in currencies; the two others, Moderato and Vivace, invest in global equities as well. The equity component of the latter includes a directional (beta) view, relative value positions between countries and sectors as well as long or short plays on individual stocks.

Adagio, the lowest-risk fund, has an ex-post volatility objective of 1.25% and aims to deliver performance of 1% over cash. Moving further up the risk continuum, Moderato has a 2.5% volatility target and seeks to deliver 2% over cash. Allegro embraces more risk with a 5% volatility target and a return target of 4% over cash, while Vivace is the biggest risk taker with a volatility target of 10% and a return target of 8-10%. Each fund comes in a UCITS wrapper offering daily liquidity and full transparency.

Objective diversification
“The recipe for a good absolute return strategy is to blend many different strategies to create objective diversification,” says Crastes. “The key element of an absolute return product is to have two engines. One is the ability to create value in your market calls or arbitrages, and the second is to generate value by being able to translate diversification into performance. These are the key elements.”

Transforming diversification into performance is, of course, the one free lunch in asset management. The aim is to proceed in a north-westerly direction in pursuit of the efficient frontier: the place on a risk/return curve where minimum variance and maximum return intersect. Through optimal allocation and combining short- and long-term factors, each H2O fund is designed to deliver a lower combined risk rather than the average risk of the underlying positions in the funds. The risk and reward of each fund is plotted over time and forward modelled by H2O to provide position combinations that cap risk and optimise returns.

By drawing a line between what is absolute return and what is not, a portfolio is able to transform diversification into performance. In the classical way of doing capital allocation, risk is checked to determine if a fund is well diversified and diversification is an end in itself. The aim with this approach is to push the fund’s global risk below the sum of its individual risks. The absolute return approach, instead, has risk as a specific target at the top of the process. The objective of the absolute return strategy is to increase the return through a good risk allocation and then good diversification for a given risk target.

Creating risk-adjusted alpha
“In the end, the lynchpin of any investment strategy is the ability of a fund manager to create risk-adjusted alpha,” says Crastes. “Any investor can buy an exchange-traded fund or an index fund if the performance of a particular asset class is desired. If money is entrusted to a fund manager it means the investor expects the manager to deliver risk-adjusted alpha. A good absolute return manager is someone who understands this. The efficient frontier boils down to asset allocation. When you diversify your portfolio you do so along the efficient frontier based on past returns. This is very different from absolute returns strategies which are much more based on the structural risk-adjusted alpha.”

Classical diversification relies on past risk metrics and correlations. Since a future financial crisis will always differ from ones in the past the process is inherently unstable, especially when markets are volatile. Instead of classical diversification, H2O looks to achieve objective diversification.

“This allocates risk to completely different strategies which are objectively diversified,” Crastes says. “An example: if you give risk budget to a manager doing technical patterns – he can be objectively diversified with a manager making decisions based on economic considerations. This diversification is more robust because the correlation pattern is more stable. The best way to protect the NAV when you have downturns is to multiply the diversification axis.” In other words, don’t hold bonds and equities on the assumption they are objectively diversified since at some point equities will go down when it becomes clear that interest rates will go up. Suddenly, what looked diversified is anything but.

Using volatility to diversify
One way to get enough diversification to protect a portfolio is through purchasing volatility. It is the only asset that is always negatively correlated with all other asset classes. It may make sense to be structurally long volatility since it is a reliable source of diversification, but it is expensive. Volatility comes in a variety of formats whether in formal index contracts, of which the VIX is one, or in straddles and options instruments.

Each of the four funds (See Fig. 2) is designed for a particular time frame. Adagio is designed for investors with an investment horizon of one year. Moderato is set up for investors with a time horizon of two years. Allegro has got a risk that is the same as a 10-year bond and Vivace is just below equity risk but with a much more stable risk profile. All four funds use fixed income arbitrages coupled with an absolute return strategy to generate exposure with Allegro designed to be a substitution for bonds, but not be affected by yields increasing or declining.

The six investment managers, each of whom is a specialist in a particular area, work across all the strategies. Each manager has a different sized risk budget based on investment committee decisions. This changes over time as risk profiles alter. Each strategy has a minimum of a 12-year performance record so there is a good ex-ante capability. Performance is either structural or conjectural. With the former risk is kept quite steady, while with the latter it is reduced and increased depending on market conditions.

Times change, errors do, too
Investment history is littered with the mistakes of earlier fads. Funds that bought equities in the late 1990s or Japanese stocks a decade earlier when each sector was at a secular peak are obvious examples of sub optimal allocations of capital. With liability matching now a key investment objective there has been a great bias to investing in fixed income instruments notwithstanding the record cyclical gains in bond prices across the yield curve. The prevailing consensus is that real yields will remain stable and low and that, in any event, inflation-linked bonds offer appropriate protection.

Crastes, however, believes that the consensus could be wrong. “If real yields go up, the losses will be very big,” he says. “It could be a surprise, especially with inflation-linked bonds. Many people are buying on the basis that they are zero-risk bonds. But that is not right. It is zero risk at maturity only. Between now and maturity there is a lot of risk. If real yields go up, capital goes down.”

What H2O does is structure strategies that link an investor’s time horizon with their risk budget. Thus a long-term horizon can have a higher risk budget, while a shorter-term horizon will have a lower risk budget. This allows the risk that is generated to be spread over a very large investment universe and helps a fund avoid being trapped into very expensive asset classes at certain points in the cycle.

The end of QE II
In the current financial environment, the most significant near-term change looks like being the transition to follow the end of the second round of quantitative easing (QE II). A bevy of literature from academic theorists, economists and investment bank strategists has grown up to suggest that the transition will be smooth. Much of the thinking seems to be that because the news is in the market its effect is already reflected in bond yields.

“Markets are being greedy,” says Crastes. “They want to get the most of QE II. Investors will buy right up to the end to get the last basis points. That is one of the reasons 5-year US Treasuries are so expensive. Everyone is trying to get the last basis point.”

The result of the continued buying means that 5-year US interest rates are at about 2%. This is despite the US recovery continuing, suggesting that a yield of 3-4% is probably warranted. In the scenario that the US economy continues to improve through the summer Crastes believes that there is a good likelihood 5-year Treasuries will yield over 3% by September.

“If you lay down the hypothesis that the US economy will do well – and we believe there are many grounds for it to do so – we believe that 5-year Treasuries are a sell but you have to get the timing right,” he says. “The good timing is now (mid-April through end of May) because, with the Greek problem in the background, everybody has bought the 5-Year Treasury to hedge themselves against risk aversion. We think selling now makes some sense.”

He adds: “If you lay down scenarios based on probability you are not long the 5-Year Treasury right now if you are a six to 12-month investor rather than a two-month one. You can always find reasons why it makes sense to hold the 5-Year Treasury – for example, until recently oil prices were rising – but it is not the central scenario. Rationality leads you to be very careful with 5-year rates. On the probabilities, it is not a good investment.”

Greece is attractive
One area that H2O thinks may offer an attractive risk reward trade off is Greek government debt. Crastes doesn’t rule out a restructuring but not until 2013-14. In the interim, there is an interesting opportunity with 30-year Greek bonds, priced at 52 in early May, yielding nearly 10%. In sum, this is already pricing in a haircut of nearly 50%. This level is similar to Argentina’s default back in 2002 which was the worst sovereign debt hair cut in recent times.

Crastes’ expectation, however, is that because Greece is part of the European Union, the restructuring will be more friendly to investors. This could see an eventual re-pricing of the 30-Year Greek bond to the mid-70s or higher with a worst case scenario of the bond falling to the low 40s. It means the risk is about 20% but the potential reward from a rebound in bond prices is around 50%. In addition, investors get paid 10% a year to wait.

“The Greek 30-Year bond is at a level where the risk reward is good,” he says. “It is better than buying a US 5-Year bond with a yield of 2% where the risk reward is very poor and the chance to make money is very thin.”

Another short bet for H2O is commodities, which it plays by being long the US dollar and short commodity-driven currencies such as the Australian and Canadian dollars. The portfolio managers believe that price levels matter and that a trend reversal could be close.

“We think we have reached levels on commodities and the greenback that fully justify playing against them,” Crastes says. “They are not that far from an inflexion point. There is a lot of speculation in commodities and the profile has been non-linear. At a certain point in time we may see commodities going down and the US dollar going up.

Commodities bulls are much more led by financial purchases than real purchases. In the past the price of commodities was linked to demand and supply. It is a big mistake to think that commodities prices are at this level because of strong physical demand. This is much more linked to the perception of this demand by financial markets.”

Taking on measured risk
Throughout much of the 2000s, euphoria grew in intensity and risk managers commanded less and less authority. Few had real influence and doing business had an overwhelming priority. Indeed, as rates slid over 2007, fund managers lined up in droves to buy collateralised debt obligations for a couple of extra basis points of return at a massive risk. Even though many chief risk officers (CROs) advised against such buys because the risk was not well paid, they were ignored. Now the hang over period is grinding on and CROs are getting revenge by actively constraining portfolio managers.

“This is where we are now,” says Crastes. “All of that creates a lot of opportunity. What we do at H2O is to manage risk/reward instead of risk or reward depending on our mind set! Classical fund managers look at reward; risk managers look at risk. They don’t really reconcile each other’s approach. There are liabilities from the past. We think that in a stressed period there are a lot of opportunities because risk managers are in a position to constrain fund managers too greatly. It creates opportunities for people like us doing risk/reward. The value is neither in the risk, nor in the reward: the value is in the risk/reward.”