Only a few macro strategies have a 12-year record to put before investors and fewer still are offered in both offshore and UCITS formats. One product that does this is M&G Episode run by veteran fund manager Dave Fishwick with a four-strong investment team that includes Eric Lonergan.
Episode’s approach is to couple a discretionary macro style with a finely calibrated model that charts the relative yield of different asset classes over time. The breadth of Episode’s investment universe coupled with its strict approach to historical prices and sentiment has attracted investors looking for some different diversification and correlation characteristics in their macro investments. “Our whole thesis is about measuring risk premia and looking for situations where we see behaviourally compressed or expanded risk premia,” says Fishwick. “The key point at the start is to ask the market what rate of return it wants on all the assets that we can invest in relative to its view of the fundamentals. Yield is the primary valuation screen we are using based on market expectations. We are interested in risk premium relative to what market participants want at any point in time.”
Initially an internal fund
The strategy had an informal and low key launch. In 1999, M&G asked Fishwick to run a modest allocation of capital in a macro strategy for an internal life fund. The performance of this strategy made Fishwick a leading macro manager but the in-house status of the fund meant that neither he nor it was well known to hedge fund investors. Over the next two years institutional investors put money with Fishwick which lead to the fund’s formal launch in 2005.
The profitability of the strategy helped to temper M&G’s attitude to hedge funds, which as a long-only house was relatively sceptical. It also meant that group management was happy for the macro strategy to sit outside the traditional long equities and fixed income businesses.
Pots of capital
The gradual extension of the strategy meant that several pots of capital developed. Each one had broadly the same risk aspect and performance aspiration. This has been largely retained with the exception of the life fund money, where some restrictions apply. The latest extension of the product offering came in 2009 with the addition of a UCITS offering. In principle, the aim is to get as close as possible to running one portfolio across multiple pots of capital. Now the strategy has about $2.3 billion with nearly $2 billion in managed accounts.
Since the strategy’s inception the bulk of the returns have been generated in aggregate equity directional and fixed income trades with a small proportion from foreign exchange. Related fixed income or equity plays are used to generate commodity themed returns due to the difficulty of measuring income streams from this asset class.
Take copper. It collapsed in 2011 after a prolonged period of strong price gains. Fishwick says if he traded it, he wouldn’t know what the payoffs would be. In contrast, if a bond yield moves 150 basis points Fishwick believes he has a sense of where it ought to be given his understanding of the payoffs, the yield to maturity and other factors.
Tangible return focus
The focus on tangible anticipated rates of return for particular assets is the basis of the investment team’s research. Consensus data on interest rates, credit spreads, cash rates and company earnings allow for the calculation (and analysis) of implied rates of return across asset classes. What the market requires in yield is the primary valuation screen.
“We want to be allocating the most capital to the best opportunities,” says Lonergan. “This could be a function of the most extreme valuation anomaly although it might not be. The critical judgement is of a given valuation signal and determining to what extent it is a behavioural episode you want to take on.”
The scope of the strategy includes equity at aggregate index level, both long and short, as well as relative value on a geographic basis. Sector plays also occur. With fixed income, the scope is broad: relative value, directional and yield curve trades, while the use of credit plays has grown as the availability of derivative options has increased.
“What this blend of equity, fixed income, and FX does is provide an ability to get at many of the longer term clear directional themes about real interest rates,” says Fishwick. “It also means you are dealing with a more volatile end of the spectrum in terms of the risk budgeting. The reason we stop at the sector level is that the framework is all about the price of risk in the aggregate and about aiding an interpretation of that. Once you get beyond the sector you get down into the highly idiosyncratic aspects of company fundamentals and there is a higher likelihood of a potential surprise.”
Applied risk taking
It is no surprise that Fishwick began his career in the late 1980s in economic and markets forecasting. He is therefore extremely humble about the science of forecasting and the fallibility of any particular forecast. This framework of avowed scepticism about forecasting markets and prices is juxtaposed with a discretionary application of applied risk taking.
Fishwick analysed the failures in forecasting asset prices and market unpredictability. He looked closely at the quantitative elements of market mispricings and whether it was more about how investors priced their own beliefs about price information or whether it was about inefficiencies associated with information and poor forecasting. He came to the conclusion that it was investors’ mindsets rather than fundamental factors that accounts for most of the volatility in markets.
“It is about the market trying to understand how to price risk in its many forms,” says Fishwick. “Therefore a quantitative, valuation, indicator-driven strategy felt more compelling to me than trying to tell you what Bernanke might say or what the payroll data will be or what the Chinese will do….”
The inherent scepticism of Fishwick’s approach contrasts with the forecasts that often underlie discretionary macro strategies. Instead, the investment team aim to provide an observation about the pricing of risk around different assets and then exploit volatility outcomes that other market participants don’t expect.
Explaining the nub of their approach, he says: “We are going to try to spot situations where people are highly confused about payoffs and mostly influenced by rapid price events or episodes. Where all of a sudden what it has just felt like to own an asset and the associated risk overwhelms your previous belief set about the medium-term pay off: when it is frightening to hold risk and when it might be more comfortable to not have it or be short of it.”
In the post-2007 environment investors have completely recalibrated their views about where interest rate structures, sovereign credits or equity indices are going to be many times. The VIX has soared, plummeted and jumped again. The volatility across asset classes has left many investment managers punch drunk, while dispersion among – and within – investment strategies has ballooned.
An invaluable framework
In such an environment a framework to structure investment decisions is invaluable. With Episode, the framework shows where risk premia have traded across longer time frames, giving clues to whether a price is fundamentally or behaviourally driven. Having a rule-based approach helps to get a sense of whether risk premia is under or over-priced at a particular juncture. There is perhaps nowhere more apposite to apply this criteria than the sovereign credit crisis shaking Europe. Surprisingly, perhaps, Fishwick is extremely cautious.
“You can be super-bearish about Europe now and back that in equity markets as a view-driven, discretionary perspective,” he says. “But our framework says this is not the right time because the odds that are stacked up against you are massive. There is a huge skewed return distribution. Of course you can still make money out of being right about Europe being an absolute disaster, but the payoff structure is lousy relative to where it used to be.”
This contrasts with the ‘pure view’ approach taken by many macro managers. The pitch to investors is that using a valuation framework but with discretion provides a clearly understandable view about what sort of things the managers will do. What’s more, it is measurable and repeatable.
“Whether things go well or badly for us we are at least able to show people using a framework of risk premia why it has happened,” says Fishwick. “And why it may well be that the prospective returns for the trades we have on have improved. There is not an element of ‘if I got that one wrong, I’ll get the next one right’.”
Defining the episode
The combination of quantitative observation and discretionary analysis join in the notion of an episode. A valuation screen determines a predisposition: if something offers very elevated risk premia then it is a possible long play. If it offers insufficient risk premia it is a potential short play. A trade is transacted around an episode and one that typically features rapid price action. In a typical episode market sentiment focuses on a single story. Take the example of Fed Chairman Ben Bernanke bringing in quantitative easing in November 2010. It brought a very aggressive re-rating of both risk assets (like equities and credit) and government bonds. In the latter, Episode made strong returns as the impact of a single variable like QE on economic outcomes faded over time.
Lonergan likes the example of geo-politics to show how perceptions of risk change more readily than actual risk. Earlier this year, as the Arab spring revolutions gained momentum, there was a lot of concern about political risk in Saudi Arabia. Now, however, much of that has evaporated. “But the underlying fundamental issue won’t be that much different,” Lonergan says. “What causes people to focus on it or ignore it is the price of oil. That dictates the psychology of market participants.”
After the Arab spring began and the destruction of the Tsunami hit Japan net equity exposure rose to 65% of the net equity allocation. That has been trimmed back despite the fact that the valuation signal was more extreme in October.
“Now arguably that is because those earlier phases were more likely to be more temporary whereas the current phase has some enduring characteristics to it,” says Fishwick. “If we can get genuine diversification, that allows us to put more capital into positions we believe in, but that depends on the opportunity set. How we think about that is important. We don’t put on positions just to diversify. Every independent position makes sense.”
Volatility characteristics key
The priority for Fishwick and the investment team is to manage the aggregate portfolio based on its volatility characteristics. If the portfolio is moving substantially more than 1-2 points per month the team will assess the volatility characteristics and the correlation of the positions. If the portfolio begins to show unexpected correlation or volatility the exposure is likely to be reduced quickly.
In late July, for example, the portfolio was de-risked very substantially with gross exposure plunging from around 300% to 15% in just seven hours. Fishwick terms it a “dramatic de-risking” in response to the fact that prices were becoming chaotic and volatility and correlation of the positions was acting in unexpected ways.
“When you are in the heat of battle it is very, very difficult to be detached,” he says. “The beauty of the valuation framework is that it helps you not be a headless chicken and get seduced into things.” The valuation framework (sometimes called an equilibrium framework) is based on what is the right real return on an asset across an average
Against this the Episode team use a behavioural finance filter to look at the emotional dynamic of investing. This involves analysing how investors cope with pressure and the emotional impact of winning or losing trades. It is anchored in trying to listen to the market justify its own mood and spot significant changes in the market’s attitude to taking risk. The comparative tools offered by modern electronic media retrieval systems are a valuable source for uncovering how investors feel about owning risk over time.
Fishwick is straightforward in acknowledging that the approach to behavioural finance takes as its point of departure that the team is a part of what it is observing and assessing. The approach is very similar in certain respects to George Soros’ conception of reflexivity which posits that investors’ observation of and participation in the capital markets may at times influence valuations and fundamental conditions or outcomes.
“What we are saying is that we need to understand how we feel about taking risk and how we feel about other people’s interpretation of that at each point in time,” he says. “There is a kind of emotional aspect to the analysis of your interpretation of your intuitive rationale for a trade. If someone asks me why I would put on a particular trade I might have an economic view, a valuation indicator telling me it is the right thing to do. But I also want to know why the market is doing this. This analysis of our own emotions and those of the market is a core driver.”
A shock in 2008
After nearly a decade of evident portfolio management success 2008 constituted a shock. The Episode Fund plunged 30% and though it remains under its high water mark, the average return over the six years since inception is above 5%. For the strategy dating back to 2001 it is a healthy 10.7%.In retrospect two mistakes were made. “Our analysis of the financial system was probably flawed so we trusted valuation indicators too much,” says Fishwick, recalling that by mid-2008 the credit crunch had been around for over 15 months and the market was offering what looked like elevated levels of equity yield. Then valuation Armageddon arrived with a phenomenal drawdown. This highlighted the second mistake: the managers hadn’t been patient enough and were consequently unable to add capital heavily at the bottom of the market when the risk premium was at its most lucrative.
To the end of October 2011, Episode is showing a year to date performance of -0.19%. Fishwick and Lonergan acknowledge that the valuation mis-alignment characterised by juicy equities earnings yields still faces a substantial headwind in terms of market fundamentals and sentiment.
“It is a struggle today because the fundamentals are still very chaotic,” says Fishwick. “We would say, so far, they don’t look as bad as in 2008 where we had massive valuations signals which let us down. But there comes a time when one day it will start working and we won’t be fighting the trend.” He adds: “Today is an interesting time for the strategy: it is highly plausible that both the valuation and our episodic scaling start to work for investors – rather than it just being about us being nimble against a deteriorating trend.”