OMG Capital

Trading the crest of volatile European equity markets

BILL McINTOSH

The volatility shown in European equity markets knocked the performance of many managers in 2008. Directional funds were obvious victims, especially those that gambled on substantially net long positions in big cap financial and energy stocks.

For OMG Capital, a London-based equity market neutral fund with $325 million in assets under management, the volatility served to showcase genuine alpha generation skill. The firm’s two funds, OMG Opportunities and OMG Opportunities 2X, have emerged as top decile performers, with low correlation to main market indices. That performance and OMG’s stripped down, no nonsense approach to generating returns via trading European equity markets, has earned its partners accolades from usually tough-to-impress investors since its launch in October 2004.

The paths of the founding partners – Richard O’Hare, Gary Martin and Steven Gee – converged at Société Générale’s Pan-European equities trading desk in the late 1990s where each had senior prop desk duties. “We knew we had a strategy that was portable and could be successfully deployed under our own roof instead of that of an investment bank,” Gee says in an interview at the firm’s Piccadilly offices. The SocGen experience was a formative one in several ways.

“One of the things SocGen wanted from the prop desk, which replicated our strategy, was consistent returns,” Gee says. “A lot of prop desks are only interested in the sum of the parts. A lot of teams I’ve seen are pretty much left alone from one quarter to the next and the bank sees how they have done at the end of the year with very little continual risk assessment and monitoring. We came from a very different environment. At SocGen, it was pretty important what we did on a weekly basis so the team was targeted to deliver consistent returns. This is what we founded our strategy on here.”

Gee likes to sum up OMG’s strategy as one of buying share prices, not companies. The monthly turnover often surpasses 300% of portfolio assets and rocketed to over 800% of gross exposure in October’s market maelstrom. The pure trading approach underlying the portfolio is underscored by the fund’s consistently low net exposure – during 2008 these ranged from between -10% to 10% and -20% to 20% for the unlevered and 2X products respectively.

“That was deemed less important in the initial years post launch by the investment community when all and sundry were riding the beta wave, long and levered,” says Gee, recalling the investment landscape of 2004. “We were therefore getting out performed but we always felt that we would stick to what we do. The end result is a steady approach that delivers double digit (percentage) returns with a low net and it is proving to be very attractive. That was the lesson we got from SocGen and goes back even to our prior careers as jobbers: it was about consistent returns and capital preservation. It has been key to all of us throughout our careers.”

Relationships in OMG go back over 20 years. Martin and O’Hare had headed Salomon Brothers’ UK equity trading desk during the mid-1990s after meeting at stock jobber Akroyd and Smithers, in the mid-1980s. Gee and portfolio manager Yuri Koorland were reunited at SocGen after long stints into the early 1990s at Swiss Bank Corp. Their experience and steady track records meant that the firm only began marketing to investors after it had installed risk management systems, developed full documentation and appointed advisors. The aim was to launch and build steadily on strong foundations.

European-wide trading exposure
OMG’s stock portfolio is typically 25-50% invested in the UK and 50-75% invested in Europe. The spread of allocations by country roughly approximate each one’s proportionate market capitalisation. There are tight limits on exposure levels to forestall overly heavy weightings in any country and to disperse risk. Though the funds have an element of day trading, the lifespan of trades and strategies in the funds extend out to three months, though most trades are for one to five days. The five portfolio managers and two analysts look for the drivers and catalysts that move share prices, including the supply and demand balance driven by major institutional trading activity.

Though there are two funds, there is only one portfolio, with Martin and O’Hare trading the UK book, leaving Gee, and fellow portfolio managers Koorland and Richard Pockney, to trade the European book. The managers sit in an open plan office, working as a single team.

“There is a constant dialogue about the portfolio throughout the day from the opening to the close,” Gee says. “What we tend to do is establish where we want to be in terms of our gross exposure and net exposure at any one point in time. We will also consider whether there are any strong sector themes we want to have running through the portfolio.”

Brian Rawson, another SocGen veteran, and Kenneth Flaherty provide idea generation and research across the large cap equities that comprise the fund’s investment universe. Flaherty is a CFA and has long-only and hedge fund portfolio management experience. Two experienced operations practitioners, Nick Gaze and Shaughan Stephens, act as CFO and COO respectively.

Equity trading veterans
“What we are doing atOMG as both individuals and a team is identical to what we have done throughout our careers,” Gee says. “We aren’t learning new sectors, markets, countries. We are focused on maintaining that experience. For example, Richard O’Hare has traded UK oils and telcos throughout his career, while Yuri has spent his entire career on the European market. We have the experience of how these stocks have operated, how they have responded to results and how they react to extraneous factors such as interest rate moves or a major currency move.”

The portfolio managers are the first to acknowledge the challenges 2008 presented. And this is from a team that traded through the 1987 market crash and the bursting of the dot.com bubble in 2000. That experience and the managers’ trading nous served the fund’s investors well in 2008. OMG Opportunities returned 6.16%, while the 2X levered product returned 11.24%. What underscores the fund’s risk management credentials is that in the 54 months since inception, the unlevered fund’s biggest drawndown was 0.93% in November, 2007. During the first two months of 2009 the funds have delivered 0.63% and 2.04%.

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Gee says the returns show the importance of manager skill. “There has to be a human element to the long/short equity model from the hedge fund point of view because the volatility is so great that if one follows purely fundamentals or momentum, or technical factors, it is going to be extremely hard to provide consistent returns. There were some funds last year that did tremendously well but if one takes the whole universe the end result was -20%, give or take, in the long/short arena. It doesn’t mean that some very bright people have become stupid overnight. Far from it. What it does mean is that the events and the moves of the market were of such magnitude that pretty much whatever strategy one was deploying – pure fundamentals, pure momentum, pure technicals – wasn’t able to deliver a consistent return profile.”

Exposures serve to dampen volatility

The track record means OMG is meeting many investors. Gee expects the fund to show healthy AUM growth this year now that investors, whether high net worth individuals or institutions, are hungry for capital protection with a double digit return profile and 4.5% volatility. If one thing is already clear about 2009, it is that volatility is set to continue and markets will remain unsettled.

“After two months, one could say it has been extraordinarily volatile already,” Gee says. “Will it continue like that? Possibly. Certainly there is no indication at all that we are going to go back to steady, solid growth of 2-3% a month with the occasional shock and markets picking up 20% a year. That just seems very unlikely.”

OMG has no view on whether the market is going to be up 20% or down 20%. The aim is to extract performance in short timeframes and control risk. Gee says directionality is “dangerous” and adds that fundamentals haven’t offered much of a guide to market movements for over 18 months – something he doesn’t see changing this year. “Will volatility be as severe as last year? It seems unlikely but not impossible,” Gee says.

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How the strategy is deployed helps dampen volatility. Gross exposure is capped at 180% and 360% for the 2X fund. No position can exceed 5% with the number of positions generally between 80 and 120. A loss of 3-5% triggers the review of a position and a loss of 10% will bring about liquidation.

Morgan Stanley and Goldman Sachs are the prime brokers and the funds offer monthly redemptions with 30 days notice and no redemption fee after six months. The minimum investment in either fund is £1 million, $1 million and 1 million euro. OMG Opportunities charges a 1.5% management fee, while the levered fund charges 2%; both funds have a 20% incentive fee with annual high water marks.

OMG’s aim to carve out steady, unspectacular returns month after month, has seen it avoid trading in UK bank stocks for some months. “We give banks an extremely wide berth to the extent we don’t trade them,” Gee says. “Our investors are not looking for us to extract 120% in a few days from a stock,” he says, noting that Barclays and Lloyds TSB have swung that much recently. “When those stocks move like that it is exceptionally difficult even for a trading strategy such as ours to participate meaningfully with a high success rate in terms of a win:loss ratio. If we started doing that we would expect redemptions for taking undue risks with our investors’ money. We give out absolute numbers in terms of returns and volatility, both on the upside and downside, and we have maintained that over the life of the fund.”

“A couple of years back capital preservation was less important to investors,” Gee says. “But the same investors who were very happy to be going with the directional guys are now coming to us. People are saying double digit returns, 4-5% vol, that is the type of return number I’m looking for. Everyone wants to make 20%-30%, but the reality is that double digits will be a very good return this year for the industry.”