Investing in local emerging markets and derivatives looks, on the face of it, like a high risk/high return strategy for extracting alpha from global markets. But tight risk management, combined with an investment preference for highly liquid currency instruments and interest rate securities, helped Pharo Management sidestep the market downturn in 2008.
The firm’s flagship Pharo Macro Fund has returned an annualised 17% since launch in May 2005 and showed strong relative outperformance last year with a 0.01% gain (see Fig.1). Now with $1.7 billion in assets under management, the Macro Fund continues to grow and build on the success of the closed Pharo Master Fund that launched in 2000. The key difference between the funds is that Pharo Macro has eight portfolio managers and substantially greater AUM.
“The diversification effect in Pharo Macro Fund works very well,” says Guillaume Fonkenell, Pharo’s founder and managing partner, and the sole portfolio manager for the Pharo Master Fund. “I manage only 20% of the capital in Pharo Macro so I’m not dominant. Nobody is.” As Fonkenell tells it, the portfolio managers are all experienced generalists who trade all emerging market regions and products with a wide range of discretionary strategies.
One manager’s position can offset that of another and, in theory, two managers in the firm could take opposite sides of a trade as part of a strategy with multiple positions. “We believe in the multiplication of talents,” he says. “I believe that having eight better-than-average talents trading the Macro Fund gives a positive diversification effect, especially if they are all a bit different in terms of personality and experience.”
Range of outlooks
Pharo – meaning lighthouse in Provençal French – was first set up in New York where Fonkenell was joined by partners Michael Skarbinski, a senior portfolio manager, and Jeffrey Hanlon, chief financial officer responsible for financial control and daily operations. Fonkenell set up a London office in 2005 and the firm is planning to establish an Asian office in Hong Kong. The team of portfolio managers includes Chinese, Turkish and Brazilian nationals, giving Pharo a broad range of outlooks with which to tap into returns in emerging markets.
“To run a macro trading strategy it is much easier to trade emerging markets,” Fonkenell says. “Why? Simply because it is in emerging market countries that you find very powerful economic trends and these trends are often relatively easy to spot. For example, China is going to continue to grow. It sounds obvious to say it, but it has a lot of implications for macro trends in the markets. The Brazilian real will continue to appreciate in the long-term and so will Asian currencies. This market trend derives from an economic trend which is relatively easy to spot and catch. Because of this I think it is easier to put macro bets on emerging markets thanto bet on the direction of the yen versus the dollar, or the direction of the euro versus the dollar, or even the direction of the treasuries curve in the US. We have an advantage because it is easier to deploy a macro trading strategy in emerging markets.”
Though Pharo has up to 80% of its macro exposure in emerging markets, it also invests in G10 interest rates and currencies. The reason for the residual exposures in developed market is mainly for hedging purposes. “If you are long fixed income in a lot of developing countries it probably makes sense to be short fixed income in the developed world as a hedge,” says Fonkenell. “Similarly if you are long a lot of emerging market currencies, as we are at the moment, it makes sense to be short some currencies in the developed world like the euro, sterling, or maybe the yen, as a hedge. It is a necessary tool. It would be overly restrictive to trade only emerging market currencies.”
Pharo’s house view is that the appreciation of the main emerging market currencies has a long way to run. It is expected that the dollar will weaken by something between 5% to 10% per year after the big rebound in emerging market currencies this year went some way to cancelling the sell-off sparked by the financial crisis. The actual performance of each currency will vary with each country’s fiscal policy and economic performance.
Asian currencies are judged the most attractive. One reason: they have lagged the rebound in other emerging market currencies, particularly those in Latin America. What’s more, it is only recently that Asian currencies have begun to strengthen meaningfully against the dollar. Pharo expects the Indian rupee, the Korean won, the Malaysian ringgit, the Taiwan dollar and the Philippine peso to appreciate significantly in coming years. Of course the elephant in the room of emerging market currencies is the Chinese renminbi whose value is subject to Chinese government policy. Fonkenell expects the renminbi to be notched up vis-à-vis the dollar at some point in 2010, but concedes that it is difficult getting direct exposure to the currency since it isn’t convertible outside China. “As soon as the spot FX rate will tick up, the forward renminbi market will suddenly anticipate a very sharp appreciation,” he says. Consequently, the fund is long forward contracts on the currency.
One of things Pharo believes differentiates it from rivals is its approach to risk. Not only did the Macro Fund protect investors well during the crisis, it didn’t resort to gates or side pockets. The firm’s policy on trader losses is instructive. For instance, if a portfolio manager loses more than 6.5% in a month, all the positions are liquidated and the manager is banned from the market for one month. There is an even more draconian rule on long-term losses. If a portfolio manager is down 12.5% from peak to trough for the year, the manager has to liquidate everything and sit out the rest of the year. “It means that if you are up, say, 10% in June and then you drop 13% you’ll only be down 3% on the year, but you’ll still be out,” says Fonkenell. “It has happened in the past.” In addition, every trade requires a portfolio manager to set a stop-loss and profit target. When one of the other is hit, the trade is exited.
Another key aspect of Pharo’s approach to risk is a forward looking Value at Risk system. Unlike typical VaR calculations, which are based on historic price variance, the forward VaR calculation uses a probabilistic methodology to give portfolio managers an estimate of their expected performance variance. In October 2008, for instance, the VaR measured by the forward looking system quadrupled because of the rise in risk aversion. The forward-warning system proved prescient, highlighting how risk ballooned when the markets began to gyrate wildly. “To be able to stay within our limits we had to cut risk significantly since our VaR adjusted instantly to the new risk-averse environment,” Fonkenell says. Many other funds that used historic VaR didn’t perceive the same danger, kept up exposures, and then faced sudden, sharp drawdowns. For Pharo, the system helped it exit October with limited positions and a loss, painful but limited, of 5.59%. The combination of stop losses, P&L limits and forward looking VaR unwound risk when the market environment got extremely dicey.
Like the global economy itself, what happens in China is the fulcrum for much of the Macro Fund’s trading. It is a key element on the long side of the Fund’s book even if it borders on the impossible to get direct exposure to the renminbi or renminbi denominated credits. Instead, the managers look to capitalise on events outside China that are tightly correlated to the nation’s gargantuan economic expansion.
“If China continues to grow, and we believe it will, then commodities prices will continue to be bid up,” says Fonkenell. “And all the currencies of the producers will continue to do very well. Also, the Asian currencies will do well because the Chinese growth engine will pull all these countries up in terms of growth. You cannot trade emerging markets if you are not expert on China. In terms of trading, though, there is not a lot to trade in China. The currency hasn’t moved for 18 months. We don’t really trade Chinese equities. That’s not our game. And there’s no fixed income market as such in China. So we spend a lot of time studying China but we don’t trade it a lot.”
In terms of trading positioning, Pharo sees the high Chinese growth rate, buttressed by a successful stimulus package earlier this year, having two implications for the portfolio strategy.
The first is that Asia as a whole, led by China, is going through a ‘V’ shaped recovery regardless of what shape of recovery is happening in the West. This has bullish implications for currency and stock market gains. In turn, that will feed through eventually to interest rates and is likely to mean that Asian countries are going to be the first ones to hike rates. For a macro fund like Pharo that offers attractive opportunities to short fixed income.
The second effect of the Chinese led rebound will be on commodity producers. As long as China grows by close to 10% per year, Latin American commodity exports will remain strong with a knock-on effect on currencies in the region.
“In terms of sovereign credits, the China factor is very beneficial for sovereign credits in commodity producing countries as well as in Asia,” says Fonkenell. “Money will continue to flow to those countries and that is good for the sovereign finances. So we expect sovereign spreads to continue to tighten in the medium term.” The Fund has pulled back from this trade because the managers believe the rally, which saw five year Brazil credit default swaps compress from a 600 basis point premium to 100 basis points in the autumn, has run its course.
But taking advantage of such mispricings has paved the way for the Macro Fund to return 43% in the 10 months to 10th November, putting it on course for its best ever year by a wide margin (see Fig.2). “This year has been exceptional,” says Fonkenell. “It has been a very good year for us. It is because after the shake out in markets last year there have been so many low hanging fruits this year; if you had some capital and risk appetite all you needed to do was collect them. This year is a rebound trade or what we call at Pharo the normalisation trade. You just had to trade normalisation in the market to make money.”
When it is suggested that this is a process of mean reversion, he points out that it isn’t to the previous mean, but to a level that is aligned with the new fundamentals in the market. “Brazil credit default swaps at 6% was just stupid,” Fonkenell says. “You just had to play the normalisation of the Brazilian sovereign credits or the normalisation of the Korean won, which had depreciated 50% against the yen, to make a lot of money. It was the same thing with many other currencies and many other credits. This is really what we did. You didn’t need a long term fundamental view on the markets to do well this year, you only had to accept the fact that systemic risk was behind us. Once you realised this you just had to pick up the low-hanging fruits.”
The main trading approach Pharo uses is pair trades since every currency trade involves an equivalent long and short. Pharo have extended the use of pair trades to other assets, notably credits. The Macro Fund oscillates between directional and relative value trades. Examples of the latter include being long the Turkish lira or Brazilian real and short the Mexican peso, and long Korean won and short the Taiwanese dollar.
“We are also avid users of options,” says Fonkenell. “Many of us have been options traders in a past life! We like to use options to take a tailor made directional view on an asset to limit the downside and try to maximise the upside. Also we trade volatility as an asset class and we use options for that too.” Employing options to trade volatility uses mainly fixed income and currency trades with over-the-counter products the most common, though when it comes to treasuries, the S&P and bunds, the listed instruments are preferred. Unusually, given the theme of exploiting the upside for resource producing countries, the Fund doesn’t trade commodities as a core product. “We do at times trade them but it is usually tactical,” says Fonkenell. “For instance, we might use a relative value trade to be long the South African rand and be short gold futures. We prefer to trade commodities indirectly through the commodity producer currencies.”
Historically the Macro Fund’s net exposure has been near neutral. Since March, it has had a bullish bias after being net short from October to March. On average, the net component swings in a relatively narrow range of 20% to -20%. Gross exposure varies from 100% to a limit of 300% gross. In early November, the portfolio was running gross exposure of 200% with a net of 20%.
Fonkenell expects to retain the long bias until the year end at least. “We see the stars aligned for the rally to continue,” he says, identifying three conditions which are all very favourable for risk assets. One of the conditions is loose monetary policy and interest rates hovering near 0% in the US and Europe, something that Pharo is forecasting to last at least another three to six months. The second condition is the sharp economic rebound in most emerging markets.
“The fundamentals are improving very rapidly,” he says. “A lot of these countries – China, Brazil, India – barely felt the crisis to start with. However, as a result of it, their currencies depreciated and they now find themselves economically sound but with currencies that are much weaker than 18 months ago. So they are going to rebound very strongly. This creates a very favourable environment for emerging market assets.”
The third condition is technical positioning. “Is the global investor community positioned in emerging markets?” he asks. “That’s a clear no. The very narrow community – the specialised funds like us and the few dedicated emerging market funds – are positioned. But if you take the investment community at large, while they used to be heavily positioned in emerging markets, they all exited last year and are only now starting to come back. So the global positioning in emerging market assets is very favourable. I think the combination of these three factors is very positive in the medium term for our markets.”
Yet within that broadly positive macro assessment, Fonkenell is careful to underline his team’s trading discipline. “At Pharo we are tactical traders,” he says. “We flip our positions very often. Despite having a medium term view, which is currently bullish, we are always on the look-out for signs of a technical correction. We then flatten our position or go short to try and take advantage of the short term correction if we can.”
Indeed, in recent months Pharo has tried three times to go short thinking that a technical correction was imminent, but the trades either got stopped out or managers threw in the towel and reverted to a long bias. With liquid currency trades dominating the Fund’s positions, it is feasible to change exposures rapidly to capture short-term trends. With that tactical edge, it’s likely the Fund will swing short again before year end even though Pharo’s medium term view is bullish.
The seemingly endless rise of the euro is another macro event Pharo is following closely. Fonkenell ascribes the main cause of the strengthening euro to emerging market central banks intervening to slow the appreciation of their currencies, while at the same time diversifying their foreign reserve holdings away from the dollar. The upshot may be that the euro at $1.50 is not the end of the road for the soar away currency. In turn, this will raise the political pressure on the European Central Bank.
“As long as these interventions continue the euro will appreciate or will be under strong pressure to rise,” says Fonkenell. “I think eventually the ECB will resort to intervention. It will be the only way to try and stop it. I’m not sure they will be able to stop the appreciation but it will signal a pause. I think it will come to that in 2010.”