The arc of Shahid Ikram’s career reflects the increasing sophistication of managing fixed income in an institutional context. He started as one of a team of four managing fixed income at Commercial Union (CU) in 1990. Today the Head of Sovereign & G7 funds at Morley, Aviva’s UK-based asset management business, is part of a cadre of 56 fixed income research and portfolio management professionals. Ikram himself has stayed put, but the firm has grown around him through takeover and merger (eg. General Accident, Provident Mutual and Norwich Union) such that parent company Aviva is the largest UK insurer and the fifth largest insurance group in the world. As new markets and products opened up to UK-based fixed income investors they have been embraced at Morley, and so it was logical that in 2003 it should launch a fixed income hedge fund, the G7 Fixed Income Fund.

The blurb for the fund states that “consistency of return is of the highest priority.” Hedge funds often state that as a goal, but rarely is it achieved to the extent that it has been by Ikram and his team with the G7 Fund. As the track record in Table 1 shows there have been only two losing months in 61. The only drawdown amounted to -0.81. The average annual return of more than ten and a half percent has been produced with a volatility of only just over 2% through the life of the fund, to give a stand-out Sharpe ratio of just under 3.

Some academics have claimed that there is great inconsistency in specific hedge fund returns, and that last year’s winners are highly unlikely to be this year’s winners. This makes the G7 Fund a significant anomaly, as Morley’s G7 Fund was awarded the Fixed Income Hedge Fund of the Year in the EuroHedge Awards 2006, and then again in 2007. As these awards are given purely on the basis of returns and volatility it means that the fund was consistent in the context of its strategy. How this has been achieved was discussed with Ikram in Morley’s offices near the Bank of England.

Ikram joined CU after five years of boom on the Eurobonds markets, so as a young graduate it was a natural place to start. From 1990 he spent two years on credit, looking at the Sterling bulldog market and EuroSterling. Being part of a small team meant that he was exposed to every aspect of the markets. This resulted in him being around at the time of the launch of the first asset-backed issuance in Sterling, for The Housing Finance Corporation. He then specialised in Gilts. Ikram says “At that time we were globalising the process, and through departures I ended up running the Gilts as a component of a globalised government bond management process. This has definitely influenced how I look at portfolios and manage them, as has the actuarial backgrounds of those around me. Also, given we were running portfolios for an insurer as well as outside clients, we were natural holdersof bonds to match liabilities. This is different from the way a proprietary trading operation looks at their holdings and portfolios. For example, being associated with an insurer has given me an understanding of the impact of regulatory change on my markets, both short-term and long-term.”

Ikram has spent 20-odd years looking at the back-end of the yield curve so he tends to have a deeper understanding of activity in that maturity zone than most in the markets. This has had an influence on both shaping portfolios and structuring trades, according to Ikram.

He outlines the pivotal market events of the time. “Sitting in that seat has enabled me to see several blow-ups along the way, such as the LTCM debacle. I was also in the markets right through the convergence trades which resulted from the creation of the Euro. I was also there at the onset of structured products, and saw the emergence of the EuroSterling market.”

Four years into his career at CU, around 199495, he was given UK Gilt portfolios (including index-linked) and segregated pension fund money to manage; his first job as a portfolio manager. As time went on, the mandates for which he was responsible grew wider to include a proportion in credit and overseas bonds. “So five years in I was pitching to clients, and that really helps you get to grips with your process as you have to distil it to something that is easily communicable.” There was very much a fundamental top-down approach to markets – “we were concerned first and foremost with economic growth and inflation,” says Ikram. “We were all about ‘the big picture’ at that time. The views we had on those factors fed into our asset allocation, and everything else was secondary.”

Out-performance in the second half of the 1990’s was about positioning relative to benchmarks and the chimera of ‘the median fund’. How the median fund in the universe was positioned in terms of sector weights and duration was only known in an absolute sense in arrears from surveys. To determine how the median fund was positioned closer to real time took a structured effort.

“We had a junior analyst go through the Financial Times, reading annual reports and extracting what information they could.” By assiduously tracking the performance of peer groups of competitors against benchmarks it was possible to estimate the relative duration of competitor funds and their sectoral allocations. Deriving this information gave an edge. Ikram says that the availability of information makes it much harder to have an information edge in markets these days. Back in the mid-to-late 1990’s the managers at CU were taking risk by assessing the value of UK Gilts compared to overseas bonds, and would implement views on whether taking credit risk was good or bad, whether inflationary expectations were picking up, and in terms of relative duration. “There was very little micro-analysis going on – it was all top down at that point,” says Ikram.

Around the time of the merger of General Accident and CU in June 1998 the assets managed by the fixed income managers doubled overnight, and their investment approach was radically changed structurally. Seventy percent of the assets were designated as lower-risk core portfolios and the balance as more aggressive core-plus. Ikram was charged with running £4 billion of Gilt portfolios in a more aggressive fashion, and the scope was widened considerably. He was given dispensation to use options, swaps, swaptions and derivatives on top. This allowed the underlying portfolios to be run as they were – the same combination of top-down and bottom-up that was previously deployed – but with a greater opportunity set, more diversification and derivative overlays. This was the genesis of the progression to running a fixed income hedge fund.

The bottom-up potential became evident because of two developments. The introduction of the new minimum funding requirement for UK life insurers and pension schemes had a significant impact as there were huge flows out of equities into the long-dated part of the curve. “The UK yield curve should have been a lot steeper than it was because short rates should have been lower for economic reasons,” explains Ikram. “The second development was that LTCM were unwinding so many positions, not just in the UK securities. So we were beginning to see more yield curve volatility coming into the market. So I began diversifying out of directional and cross-market plays, and we started taking more yield curve positions.”

Fund launch

The G7 Fixed Income Fund was launched in early 2003 with £25 million of seed money from Aviva. As the name suggests it invests primarily in G7 fixed income instruments and currencies, with some emerging market and credit exposure. The hedge fund has been well diversified from the off. Risk is spread in each dimension for the G7 Fixed Income Fund. Figure 1 gives a rough idea of how risk is spread around the G7 countries over, say, any twelve month period. But Ikram is keen to emphasise that these are not hard and fast rules so much as a reflection of the opportunity set that the markets give his team. When, for example Japanese markets show a lack of movement, then naturally there will be fewer opportunities there that are tradeable and so the amount of risk put on in Japan will drop.

“We had strong views about outcomes in the US last year, so we had capital at work there,” he explains. For the second half of the year the view within the G7 team was that the US economy was slowing down a lot more than the markets were discounting, so steepening trades were put on and turned out to be very beneficial. “Going back over several decades the US economy has not been so indebted coming into a slow-down, so we saw significant loosening (of monetary policy) being done to have any impact,” he states. However partly because the Fed acted too slowly he does not forsee a ‘V’ shaped recover. The economic effects of the downturn will not be short lived, he postulates. Rather worryingly for the prospects for the US, Ikram sees comparisons with the UK in 1990, when Thatcherism was having an impact on the manufacturing base of the British economy. His second parallel is with the S&L crisis in America in the early 1990s. “My longer term concern, which might not bite now” he continues, “is the effect of the ageing of the Baby Boomers. Consumption is 70% of the US economy, and the economies with biases to older demographics like Japan and Switzerland grow at a slower rate. At some point the dwindling spending of the Baby Boomers will affect America.”

At the moment the fund has several strategies in play in Japan. A member of the team went into the Japanese Ministry of Finance four or five times and took a similar number of meetings in the Bank of Japan. “These meetings gave us confirmation of what we suspected. Our view is clear: the Japanese authorities have a limited toolbox to deal with the slowdown that is taking place,” discloses Ikram. “They can cut interest rates by 50 basis points or get back to their zero interest rate policy.”

The fund contains a blend of relative-value focused ideas, around 70% of the capital, and 30% macro or directional strategies. The strategies include intra-yield curve, cross-product and cross-market relative value strategies. “I look to identify 5 to 7 themes to put to work in the portfolio. A theme may be expressed in one trade or three trades, giving more diversification. So if we identify a yield curve trade, and we think it will work globally, we may have that yield curve trade on in several markets. Conversely, a specific trade based on one bond versus another specific bond may be implemented through an asset swap box, but it can only ever be one single trade,” explains the G7 manager. He aims to make a 0.2% to 0.3% contribution to NAV from each theme, but won’t force ideas into the portfolio – “if we only have five good ideas they will go in, but not more,” he affirms with emphasis. So at the portfolio level the portfolio manager is looking to have 1 to 1.5% of alpha potential built into the fund per month from his 5-7 themes. Of course some themes will be in loss, some take some time to develop, and others will reach their targets and are then closed. “We run the process on a weekly basis, and we look to replace the trades we have closed where we have made our profit targets or hit stops,” says Ikram.

A fixed point in the weekly process is the Monday meeting to implement the top-down part of the process. The four analysts in Ikram’s team start their work in preparation for this meeting on a Thursday night, as it takes a couple of days for them to get through it all. All the bond markets and economies in the universe are assessed quantitatively for value, their cyclical position, and technical condition. This results in one summary number, a score, running from minus three to plus three. The scorecard points to which markets the funds should be actively positioned in. For example it is three years since credit was sufficiently positively scored for Ikram to be involved from a top-down perspective. The process also runs through the potential of some generic cross-market trades, and they look to see whether they should be in steepeners or flattener trades.

Ikram comments: “So, maybe 80 different models go into the top-down part of the process alone. We re-examine those models periodically to see that they are still relevant. We utilise the four quantitative analysts that are a resource for the entire fixed income operation. I sit down with them regularly – everything they do for us is bespoke so has to be owned and managed by us. Their work is all on a project-by-project basis.”

The bottom-up part of the process is carried out by the four analysts in Ikram’s team who each cover a bloc (Europe including peripherals/the US/the UK/and Japan and other Asian markets). The analysts rotate between the blocs to keep them fresh and to learn new things. They travel to become familiar with their regions of responsibility from direct contact. Their manager says “they look at individual bonds to see whether they are cheap or dear. Through macros in spreadsheets they analyse maybe 30 different trades on a pro-forma basis for each bloc. The analysts will also take information from the likes of the forward forward curve which we find it difficult to trade in, but which gives some insight to inform other trades.”

For all the structure, repeated processes and resources applied several key elements are judgements in Ikram’s head. One is trade selection – the four analysts in his team can bring 3-4 trades each for consideration. It is up to Ikram to select the trades and decide how to implement them. Of course sizing of trades is thought through using risk analysis tools, but a view on prospective volatility, and to a lesser extent correlation, is still required. In the second element, the implementation, Ikram clearly has a great feel for timing of trades – not when to put the views on, but over what time-frame the anticipated changes in market could take place.

In looking for a move in rates he has a time-frame as well as a scale of movement in mind, arising out of his technical work he says. The willingness or ability to think in time-frames is essential for the successful useof options in money management, and Ikram has got it. So derivatives specialist James Kenney will attend the Monday meeting and generate option strategies that fit the views and trade ideas coming forward and then work closely with Ikram in refining them.

Lessons from 2005

The assets under management in the Morley G7 Fixed Income Fund rose steadily to a peak of over half a billion dollars in the second quarter of 2005. However the environment for relative value risk-taking was becoming difficult by then. “Volatility in government bond markets was just becoming too low for directional strategies,” says Ikram, “and market movements just weren’t commensurate with our return targets. On top of that we saw central bank policies as appropriate which makes it difficult to put on macro trades. ”

As Figure 2 shows the 12-month rolling returns of the G7 Fund were becoming less compelling on a relative basis, compared to others in the same strategy. Hedge fund investors are very much aware of these comparisons – most funds of funds construct peer groups within the strategies to benchmark their managers against others implementing the same investment style.

By the end of 2005 assets under management were down 60% from the peak through redemptions, as investors pulled money from the strategy generally, not just from Morley. “We carried out a review of what we had been doing. We asked in this assessment: was it our process that was becoming less effective or was it the market environment we had to operate in?” states Ikram. “Our analysis showed that the ideas coming out of our process were 80% right. But we weren’t making money out of them. The market had become range-bound and very much mean-reverting in its action. So we increased the frequency of our trading, lowered the target-levels, and tightened up some of the technical measures we used to identify trades. The aim was to get into trades quicker, get out sooner, and look to play the same idea again. If you like, we had to adapt to what was a pure relative value market environment at that time.”

The new measures worked. The Morley G7 Fixed Income Fund significantly outperformed other fixed income arbitrage funds in 2006. But, typically for the industry, asset growth did not accelerate until the second half of the year when the trend of outperformance was very plainly persisting. Fund assets did not recover to the previous peak until January 2007, and have steadily accumulated since to reach $874 million by February of this year.

Whilst the G7 Fixed Income Fund is now closed, investors will soon have access to the investment process of Ikram’s team via a new fund, which potentially will take assets up to $2-2.5 billion. “The environment for macro focused funds has become rich in opportunity – the disaggregation between asset classes gives asset allocation opportunities,” he says. “Plus the central banks are active again, which creates opportunity from the dynamics introduced to markets. From this we can see certain asset classes coming into play, in credit for example. This means that we think there is more remaining capacity in our macro strategies than in the relative value strategies,” explains Ikram. So a macro focused fund will be launched in the second quarter of this year. It will be run off the existing investment process, but the risk assumption will have a different footprint from the G7 Fund in the continuum of risk, as shown in Figure 3.

The balance of risk-taking in the macro fund will be an inversion of that of the G7 Fund, i.e. it will be 70% macro and 30% relative value. However, there are no hard limits. The emphasis will be on the five to seven themes. This is pretty much the balance of risk assumption in the Brevan Howard Master Fund. Given the nature of macroinvesting, the pattern of return of the new fund will be less smooth than the G7 Fund. The risk appetite will also be higher as expressed in VaR: the G7 Fund is run with a 2% VaR envelope on a 5-day basis (95% CI) and a volatility forecast of 5%; the new macro fund will have a measured VaR envelope of 4-5% and forecast volatility of 10%. “We never got near these limits for the G7 Fund and don’t expect to for the Macro Fund,” clarifies Ikram. “We will probably use wider stops too. So in G7 we cut positions when they made half a percent impact on the NAV and we will use maybe a 3/4% level in the new fund. We have always been selective when we have been involved in macro trades in the G7 fund and we will remain selective in putting on macro trades in the new fund.”

It will be interesting to compare the returns of the Brevan Howard and Morley products – one coming from a proprietary trading background and one from institutional money management. Whatever the outcomes, the Morley approach to running hedge funds, like that of Brevan Howard, exhibits several of the common threads for successful fund management in fixed income. These include:

• Source of alpha – The means of sourcing investment ideas must be repeatable, and with a good hit-rate for the style/strategy.
• Scalability – The core strategy must be scalable to commercial size, and not constrained by either market liquidity or the limitations of the source of alpha.
• Risk framework suitable for source of alpha – The shape of the portfolios and the risk limits for them should be a function of desired risk/return profile (outcomes), the opportunity set given by the markets and the edge of the investment professionals.
• Multi-dimensional risk – The risk measurement and the risk management within a hedge fund operation have to be multi-dimensional. This should include stress-testing, simulations (Monte Carlo), and sensitivity analysis. The risk control framework should go beyond the managers’ spreadsheets and be supported by a risk measurement capability that is independent of the portfolio managers.

There are several features that distinguish the investment process of Morley in managing the G7 Fund. First the initial idea generation is systematic – so all the archetypal trades for the range of markets covered as applicable to a fixed income hedge fund are tested/analysed to see if they may apply at that particular point. Ikram himself sees it as very important that idea generation is separate from portfolio construction. Similarly the top-down environment (the interplay of real economies and financial markets) is assessed on a thorough and systematic basis with back-tested models. This gives rigour and credibility to the scorecard output of the top-down element of the process. So the second distinguishing feature is that the assessment of the macro environment for the strategy is not subjective.

Thirdly, and this is of very high importance for consistent returns, the trade selection and portfolio construction are carried out with diversification as a very high criterion. This is examined for market condition as usual (current conditions including volatility and correlation) and for markets in turmoil (extremes of the higher moments, both historic simulation and stress testing). Whilst the discipline in trading – the fixing of price targets to take profits and cut losses – is important, it is quite commonly observed in most of the better hedge funds. Similarly all the best hedge funds have a time-frame of investments that has a consonance with the time-frame of the risk measurement, and for the particular strategy, it is impossible to manage a successful fixed income arbitrage hedge fund without a fully developed risk assessment capability, which Morley has.

So the resources and processes of the Morley G7 Fund are very appropriate for the task in hand, both having evolved to a significant degree over time. The final distinguishingfeature is Ikram himself. Whilst he says that the top down part of the process meets the bottom up part at the yield curve, you could also say that they meet in him. The bright star of Morley selects the trades and sizes them appropriately and ensures the diversification is effective both pre- and post-implementation.

The experience of 2005 shows that he can be adaptive to markets. Further, his use of derivatives to implement views demonstrates a command of much of the panoply of fixed income instruments developed over the last eighteen years of his time in markets. To come from managing just Gilts to a very successful fixed income hedge fund shows that over the arc of his career path Ikram has learned to use them well.