Old Mutual Global Investors has rapidly re-ignited the former Ignis Absolute Return Global Bond Fund strategy, raising over £500 million as of December 2015, just two months after launching two funds and 11 months after hiring most of the team from Standard Life. So far around 20% of the assets are in the Irish QAIF and 80% in the UCITS, which has a minimum investment of only £1,000, making it a ‘liquid alternatives’ product potentially for retail investors. The Ignis strategy had annualised at a return of 5% with volatility of 3.7% and won The Hedge Fund Journal’s 2013 UCITS Hedge award for ‘Best Performing Fund Over Two Years’. The Old Mutual Liquid Macro (OMLM) UCITS targets volatility of 4-6%, and returns of 5% over cash, which effectively means a 5% handle in early 2016. The QAIF structure, broadly speaking, multiplies the UCITS exposure by a factor of 1.6, so the QAIF targets cash plus 8% returns and 7-9% volatility. When interest rates rise – and lead manager Russ Oxley does expect UK, and even Eurozone, rates to follow the US higher – the return target will ratchet up, because most of the fund is sitting in cash collateral that earns interest.
For some investors the pattern of returns matters as much as, or more than, the level. The asymmetry of the OMLM return profile, shown in Fig.1, is unusual because many investment strategies have a negatively skewed return profile, as do most long-only asset classes. As well as seeking a positive skew, over time Oxley expects OMLM returns should have no structural correlation to any traditional asset class, as there is no structural bias to being long or short of interest rates. Between 2011 and 2014, the strategy’s correlation with conventional asset classes was in fact slightly negative, because at that time the team was running a somewhat contrarian stance, profiting during the 2013 ‘taper tantrum’, for instance. They also did well out of themes around the European crisis and Draghi’s decisive ‘Whatever It Takes’ response in 2012.
The strategy could remain lowly correlated by dint of its investment universe. OMLM trades mainly G10 currencies, rates, inflation and FX, with the latter limited to a maximum of 25% of the risk budget. “We operate in a default-free universe without credit risk,” states Oxley, who adds “some ex-investors found it hard to find a similar fund.” Avoiding either long or short exposure to emerging market debt and corporate credit distinguishes the OMLM approach from some other macro and fixed income-related strategies. The strategy has never traded either asset class, partly due to the background of the team. “We grew up in global rates overlays, so our skill base is in rates, inflation and FX, not in corporate or EM debt,” says Oxley. He also argues that “emerging markets with correlated fat tails would detract from the main aim of providing uncorrelated returns, and we do not want to offer credit-like returns.” Though the fund eschews these two sources of carry, it can sometimes play the carry trade in other ways: “We are agnostic carry, not anti-carry,” explains Oxley.
Accountability for output
Old Mutual Global Investors naturally has no firm-level prohibition on emerging markets, or corporate credit. Indeed in London Old Mutual has a separate fixed income strategy that does trade both. This illustrates the freedom teams have at Old Mutual. The firm has no CIO and imposes no house view on teams. “We hire able teams and allow them to run products that they want to run,” says Managing Director of Alternatives, Donald Pepper. Different strategies are “run quite independently as part of the Old Mutual ethos of accountability for output,” he explains. There can be synergies in terms of sharing data and research, but there is no pressure to share resources. Oxley finds that “the cultural fit is perfect, and Old Mutual gave us a blank sheet of paper to build the best product we could possibly build.” Both the team and Old Mutual are very ambitious for the offering.
Oxley is lead PM alongside Paul Shanta, Adam Purzitsky (senior PMs), and Huw Davies, with Jin Wong working on portfolio management and trading, while Josh Hemming does programming. The team have all worked together for between five and nine years, except for the newest hire, Huw Davies. He comes from an investment bank where he and Oxley had a daily dialogue for 16 years. Davies grew with the process since Oxley started his career as a fund manager on the LDI (liability-driven investment) side. Davies was, to some extent, brought in to replace skill-sets of two team members who decided to remain with Standard Life after it took over Ignis. His sell-side experience is valuable in “forming strategy and casting a cynical eye over the markets,” says Oxley – and as a salesperson Davies also faces clients. Though Davies remains in London, the rest of the team works in Edinburgh, where Oxley “likes to avoid the hustle and bustle of London.”
Wherever the team happens to sit, “Our returns depend on our skill at forecasting the global macro environment,” states Oxley. The wrinkle is that OMLM uses sophisticated relative value techniques to construct trades that optimise its expression of macro views. Though some OMLM trades seem to have a fixed income arbitrage flavour, pure arbitrage opportunities, for risk-free profits when trades are held to maturity, are “a very short-lived phenomenon whenever I have witnessed it,” says Oxley. Instead the fund is looking for relative value structures to action macro calls.
Reveals Oxley, “Macro views are intensely debated within the team,” but in late 2015 they do agree on the big picture that “we are at a mature stage of the interest rate and credit cycles”. Consequently Oxley does not favour the risk/reward of long-only strategies exposed to interest rate duration or, of course, credit spreads
Macro analysis generally arrives at four or five themes for the portfolio, though each theme can be manifested in multiple positions. The China slowdown theme, for instance, has been implemented by going long of Australian government bonds and short of the Australian dollar. OMLM sees China slowing to 3-5% as the economy rebalances from investment to consumption. Yet OMLM does not think a slower China condemns the rest of the world to sluggish growth. Oxley thinks global growth can stay above trend at 1.75% to 2.25%.
Indeed, OMLM’s core macro view, that the US economy is robust, accurately anticipated the December 2015 Fed rate rise. The team expects US monetary policy will continue to normalise, and that interest rates may rise faster than forecast by market consensus. The fund is not seeking to pinpoint the precise dates of rate rises, but rather to profit from those that may occur over the next two years.
OMLM is also more optimistic than convention decrees on European stimulus. Oxley thinks the European economy is already responding to the measures, which may reduce the need for a more aggressively dovish stance. The fund has some short exposure to European government debt, expressing the team’s view that Europe could surprise on the upside. “Given better economic data and expectations from the ECB, the market may be underwhelmed by the future of QE,” foresees Oxley. Indeed, Draghi did in December 2015 disappoint some pundits who had hoped for a bolder expansion of QE. Negative rates in the near term supply economic stimulus that reduces the chances of rates remaining negative longer term, the OMLM managers think. However, Oxley reiterates that the short rationale is OMLM’s macro view – as negative rates alone, as seen on trillions of European government debt, are never a sufficient reason to go short.
As well as macro-driven trades, OMLM looks for structural anomalies. For instance, forward rates between 10 and 15 years are discounting an acceleration of UK inflation to 3.8%, and Oxley thinks this is down to structural demand from pension funds pursuing LDI hedging strategies that create a captive market for the ‘linkers’. He does not think this is sustainable, however, as “some changes announced by Chancellor George Osborne could ease demand while supply will keep on coming.”
Forward Rate Analytics (FRA)
The process starts with these top-down, macro and structural views, and then uses FRA to determine the best way to implement views across the whole spectrum of forward rates, from government bonds, to overnight and three or six-month LIBOR. Derivatives, including options, swaptions, caps and floors, are used for trade construction. Cross-currency and repo rates can also be relevant, as can the basis and correlations between any of these rates as well as their volatility. “It is important to understand the dynamics behind where the rate is,” says Oxley, and he looks at spreads, such as those between governments and swaps, in terms of the drivers for each leg of the pair. The strategy sifts through a matrix of thousands of combinations of possible trades to identify any interest rate curves that differ from OMLM’s macro view of their fair value, or appear to be otherwise anomalous.
Different opinions in fixed income markets arise partly from there being (at least) four possible discount curves for each currency – overnight cash, government bonds, traditional three-month LIBOR, with six-month LIBOR now more common in the UK. These markets are segmented, with “different users in different parts of the market,” Oxley explains, and indeed the habitat theory of market segmentation is one rationale for inefficiencies in many financial markets.
OMLM has a variant perceptionof risk. Its key risk measure and exposure is to specific forward rates, and not to the general level of interest rates or spreads. Forward rates reveal huge diversification, even within the same asset class. Forward rates at different maturities are not just lowly correlated – they can often move in opposite directions, whereas spot interest rates generally move in the same direction. In the jargon ‘shifts’ (parallel shifts) and ‘twists’ (steepening or flattening) explain the vast majority of spot yield curve moves, with ‘butterfly’ moves (that can involve different parts of the curve moving in opposite directions) relatively rare. In contrast, the correlation matrix in Fig.2 shows plenty of near-zero, and some negative, correlations amongst a selection of the forward rates that OMLM trades.
CLICK IMAGE TO ENLARGE
“The forward rate process has evolved and developed,” says Oxley, who started using forward rates in portfolios in 2005 and hired PhD Purzitsky and Shanta in 2008 and 2009 respectively to further build the process, which continues to be refined at Old Mutual. “We timed the move well, with no legacy infrastructure from real money or LDI mandates,” says Oxley. The team previously used proprietary software called ClearCurve, but has now moved to a bespoke Bloomberg approach that was not possible at Ignis due to legacy issues. Though technology is vital, and the team has a dedicated programmer in the form of Josh Hemming, Oxley says, “the process is what is really unique, and we have not found anyone else with the same process.” Davies concurs that he “never saw anyone else run money like this” in all his years of interacting with many pension funds, hedge funds, floor traders and other fixed income market participants.
This is perhaps surprising when the approach was inspired by Bank of England research dating back to the 1980s, and Oxley reckons data quality is decent back to about 1980. Forward rate data goes back as far as that for government bonds and interest rates, as forward rates are, of course, calculated from those curves. The OMLM team has crunched through this data and “The empirical proof backs up the logical proof, and our FRA process offers a different perspective on market prices in the near term,” Oxley confirms.
Counterparty exposures and financing
OMLM’s approach to financing and counterparty relationships is also different from that of many hedge funds. In addition to avoiding corporate credit risk at the investment level, OMLM aims to control credit exposures at the counterparty level and probably has less counterparty exposure than some funds that are financed in different ways. Surplus cash at OMLM is invested in top-quality debt or placed on repo. “Having a large, free balance sheet in a balance sheet-constrained world is helpful,” says Oxley, and he claims the fund is viewed as a very safe counterparty. “As our credit exposure is fully collateralised, we do not need a prime broker,” he points out. Using Credit Support Agreements (CSAs), as opposed to Prime Broker Agreements (PBAs), helps the fund to “keep control and consistency across all counterparties, maintain true economics and avoid paying somebody else’s financing,” adds Oxley. The fund currently has no need to post up-front margin, though it may either pony up variation margin, or get surplus margin swept back.
All of this helps OMLM to obtain very competitive financing costs, according to Oxley. His analogy is that just as secured borrowing, through a mortgage, costs less than unsecured borrowing, through a creditcard, so too repos, collateralised by top-quality G10 government bonds, tend to offer lower borrowing costs. The QAIF fund uses repos to borrow or finance cash positions, and repo rates trade close to GC (general collateral) flat, which is basically central bank base rates that Oxley views as “economic cost”. A nuance here is that the UCITS uses slightly more costly total return swaps to finance shorts, but he remains confident that OMLM is getting good-value funding.
Negative swap spreads
Recently, however, bid/offer spreads around repos have increased, though Oxley thinks this is essentially part of the same temporary phenomenon as are negative swap spreads. Swap spreads at the short end are now providing some camaraderie for European government bonds in the negative yield club. Oxley ascribes this to “regulatory changes requiring banks to hold more risk-weighted capital, which particularly impacts the lower-risk, lower-margin products.” Wider repo bid/offer spreads also mean less capital is available and exert pressure on swap spreads, with Gregorian calendar year-end a particularly tricky time. Another factor highlighted by Oxley is China’s sales of reserves to fund its capital outflows, as this generates a glut of Treasury collateral weighing on longer-term swap prices.
Yet Oxley does not expect the current, and historically anomalous, situation to last indefinitely. To the extent that regulatory rules are widening out bid/offer spreads, this “encourages new entrants that look at the actual economics, rather than the regulatory economics, of the trade,” he observes, and adds, “We have already seen new brokerages entering the repo market, and repo clearing is starting with one counterparty already doing it.” Repos are, in fact, only one of many new instrument types that will migrate to a cleared environment. “These factors could re-establish the arbitrage between secured and unsecured borrowing,” Oxley expects.
Liquidity and innovation in fixed income markets
If the pricing of some fixed income instruments has entered uncharted territory, Oxley finds that – contrary to the cacophony of complaints about market liquidity – OMLM’s markets remain highly liquid. The interest rate markets are an example of a financial market where some degree of valuation subjectivity does not compromise liquidity. Oxley reckons capacity for the strategy is billions of dollars, in line with the previous Ignis fund, which peaked at assets of £4.25 billion. After Oxley’s team left Standard Life, at least £3 billion of redemptions was paid out in a matter of months, reportedly without Standard Life suspending dealing, invoking a gate provision, or imposing a dilution levy. That, arguably, bears testimony to the liquidity of the strategy.
He recognises that the fund could, at some level of assets, run into market impact issues, but thinks these could be surmounted if OMLM “gets better at trading”. Liquidity is a fluid concept and Oxley seems to be somewhat optimistic about the potential for ongoing innovation to enhance liquidity. OMLM currently accesses liquidity over the counter (OTC) from all of the major investment banks, and electronically from some liquidity-sharing platforms such as Tradeweb and Bloomberg.
But the OMLM could tap more liquidity taps in future. Old Mutual is “researching new venues heavily to see how market structure develops, with new repo brokerages and exchanges, new electronic trading venues and futurisation,” Oxley reports. He is actively investigating all kinds of swap futures, with the help of a dedicated consultant, and divides market innovation into two broad trends. ‘Futurisation’ replicates the economics of OTC contracts while the migration and clearing of standardised OTC interest rate swaps onto exchanges, such as Swap Execution Facilities (SEFs), also allow for electronic trading. Clearing, which becomes mandatory for some contracts in Europe under EMIR from June 2016, is helpful, Oxley finds, in terms of “improving pricing transparency and [it] is healthy for price discovery.” Even before the regulatory imperative kicks in, OMLM is currently researching a project looking at voluntary clearing. Oxley expects to see more clearing but does not envisage it becoming universal. “Not every instrument will clear, but those that make economic sense will do,” he expects.
Oxley gives a few examples of those instruments that do, in his view, make sense to clear. The GMEX Constant Maturity Swap is one example of innovation aiming to create extra liquidity that is particularly useful for the OM strategy, given its “breadth across the maturity spectrum,” which Oxley also thinks will be useful for the LDI strategies on which he cut his investing teeth. ICE has partnered with EIRIS to offer a swap future product that also covers a broad maturity spectrum on pounds sterling and euro. CME Group’s DSF (Deliverable Swap Facility) and bundled strip futures are also of interest. “Various DSFs may also appeal to different user bases depending on margin offsets, and balance sheet efficiencies,” says Oxley, and over the next year he expects to diversify his investment toolbox as well as his menu of trading venues.
OMLM has delivered a differentiated return profile, via a distinctive investment process, and has its fingers on the pulse of innovation in fixed income markets. “This is a modern alternative to a government bond fund,” concludes Oxley.