Pharo Macro Fund

Best Performing Macro Discretionary Fund

Originally published in the April/May 2013 issue

Pharo’s 2012 return of 12.5% came from each of the Pharo’s target asset classes: foreign exchange, local market rates and sovereign credit. In currencies, the Russian rouble, Indian rupee, South African rand and Korean won were positive contributors. In local market rates, domestic government bonds in Russia and Turkey also contributed due to significant yield compression resulting from fundamental macroeconomic and monetary policy developments in both countries. Receiving interest rates in Poland also helped Pharo’s return as the central bank reversed its policy rate hike from earlier in the year as both growth and inflation weakened. In sovereign credit, some of Pharo’s winning trades were in Europe. This is a region which has become of increased interest to Pharo over the last several years as the European sovereign debt crisis has all the hallmarks of an emerging market balance of payments crisis, e.g., fixed exchange rates, uncompetitive economies, high debt-to-GDP levels, and a sudden stop in financing. In particular, Pharo positioned aggressively in Greek government bonds last year as Greece started to catch up on satisfying a number of its bailout conditions and on continued evidence that the EU, and Germany in particular, wanted to keep Greece in the euro.

Pharo takes a short to medium-term trading view. A typical holding period is approximately three weeks, although it can range from only days to several months. The emphasis on more nimble trading renders carry, or interest rate differences between currencies, unimportant. When Pharo is intending to hold positions for only a few weeks, market direction matters far more than carry. Indeed, Pharo has started to have concerns about the underpinnings of long emerging markets currency trades, as both growth and interest rate differentials have compressed between developed and emerging markets. Some currencies, of course, have suffered from their own idiosyncratic negative fundamentals. The South African rand, for example, has faced a severe headwind in the form of a yawning current account deficit. Having sucked in imports for years off the back of significant fiscal and monetary stimulus, South Africa developed a growing financing requirement which became problematic in the last two years as its terms of trade deteriorated, e.g., metal export prices declined relative to oil import prices. The terrible industrial strife in South Africa’s mining sector, credit rating agency downgrades and weakening growth prompted Pharo to be bearish on the rand last year. Pharo has never been a big player in equity markets, but here the manager explains emerging markets’ underperformance of developed markets in 2013 by narrowing growth differentials.

Liquidity has always been important for Pharo. Despite generating a positive result in 2008, Pharo suffered significant redemptions due to its outsized fund of funds investor base at the time. However, given its attention to liquidity, Pharo was able to meet all redemption requests without imposing gates or side pockets. The manager points out that for numerous emerging market currencies, daily volumes are as high as many G10 currencies, such as the Australian and New Zealand dollar. Consequently, it is easy to trade $100 million clips without moving the market a whisker. Currently, government bonds issued by some African countries are likely to be the most esoteric assets owned by Pharo. Plenty of less liquid emerging markets remain off limits, with Ukraine one example.

Risk control at Pharo has many facets. Each of the fund’s seven portfolio managers has their own capital allocation, which provides diversification benefits at the overall portfolio level. Each of the seven managers is subject to strict stop-loss discipline. Managers are also subject to value at risk (VaR) limits. Pharo’s VaR estimates are based partly on implied volatility data which provides a more dynamic VaR estimate than measures based on historic volatility. The manager believes that this component of its risk management framework is one of the principal reasons why it was able to exit 2008 without sustaining a loss.

The collapse in correlations seen since August 2012 bodes well for Pharo’s 2013 outlook. Growing divergences are evident between and within regions. While Asia continues to power ahead, Eastern Europe is not growing so fast and three countries – Poland, Hungary, and the Czech Republic – have cut interest rates. Dispersion is also evident within regions. In Latin America, for instance, Brazil and Columbia have significantly underperformed Mexico and Chile.

All of this greater differentiation increases potential for generating alpha, something Pharo has demonstrated since inception, particularly in its three target asset classes of FX, local market rates and sovereign credit. Its flagship fund’s Sharpe Ratio, since inception in May 2005 and as of February 2013, is 1.2, based on a compounded per annum return of 12.4% and annualised volatility of 9.1%.