Q&A with Pierre Lagrange, GLG Partners

A decade of absolute performance in equities investing

Originally published in the October 2010 issue

The GLG European Long/Short Fund launched in October 2000. During a decade when equity markets delivered no gains, this market neutral strategy has returned over 11% on an annualised basis with volatility of 9%. The fund peaked at $3 billion of assets under management in 2007 and is now managing around $1 billion across a number of different trading strategies. Pierre Lagrange, a co-founder of GLG Partners, is the lead manager of the fund and a senior managing director of the firm. He spoke to editor Bill McIntosh about how the strategy has evolved, why performance can get better and what the impending merger with Man Group will mean for GLG and investors in its funds.

Q: I understand you are aiming to boost annualised returns into the mid-teen range. This is unusual as many managers right now are happy to make high single digit returns. How can you do this in the current environment?

A: I think there is a twofold rationale for why returns can improve. One is the raw material that is available. There are a lot of different tools we can use to extract more value from ideas, and we have been able to take much more advantage of the macro environment in addition to the stock picking. That wasn’t so much the case, say, five years ago with this fund. So I’m very bullish about the fact that dispersion has been relatively narrow, but is now expanding. And though the natural influence on the market is cyclical, we have been able to take advantage of some of the cyclicality.

The second is our ability to learn from our mistakes. Every time we are wrong, we lose less than the previous time on the same kind of event or on something we didn’t plan for. It means we don’t need to recover as much. It was even true in 2008 in some ways. The team we have in place has shown an ability to rejuvenate itself and to constantly improve. We put a lot of effort into helping the risk takers in the fund taking the investment decisions to improve the return on capital employed. We have made progress, but there is still more progress to come. When you put all of this together and combine it with the quality of the people we have been able to attract, something that will be even better with the Man Group transaction, I think we can definitely beat our past performance.

Q: What are some of the features of the macro environment that compliment your approach?

A: First, remember that we don’t make money from the direction of the market. A commonly accepted view is that the market is going to be flat now after the strong move upwards, even though the net return of the market has not been substantial. In our case, we have made money not from the market but purely from stock selection. The macro environment can be played through a lot of different stocks. In Europe, there are so many different regions with different variables affecting them. So there are lot of macro plays you can express through stocks in Europe. We can, for example, express growth in emerging markets in a much purer way with some European stocks than with American stocks. You can also express weakness in demand, banking leverage, cyclical recovery or industrial production in the Far East. It is still a market where you get rewarded for fundamental analysis.


Q: How has the market neutral style of the fund evolved over the decade it has been operating?

A: I think it has been a process of trial and error. The philosophy has always been that what we target is a low correlation with the market return because it is nearly unavoidable that you are going to have some correlation even if you are zero net exposure. For us it is important to isolate what kind of risk factor we are not able to make a lot of money from on a risk adjusted basis. We also want to know what the factors are that are correlating the most to the performance of an individual stock or the performance of the fund.

There has been a lot of work on other factors such as correlation to risk aversion, correlation to sector rotation, correlation to interest rates or deleveraging or correlation to technical factors like oversold or overbought conditions or changing beta behaviour. We realised quite a long time ago that one can spend a lot of time thinking that the fund is market neutral but if there are other factors that are more dangerous for the portfolio those are the ones that require your attention. So market neutrality is only one of the factors that we take into account.

We started 10 years ago with pair trading but that was not an optimal use of the balance sheet. The evolution of the strategy has seen us move from protecting the tail on a three standard deviation basis to having no market exposure, that is, zero net exposure. That is the current framework we are using and it is working very well. We expect to stay with it for a while.

Q: Let’s turn to the period 2008-2010 to date. How did liquidity become an issue in 2008?

A: Liquidity became an issue because of the way we were running the portfolio. We employed the barbell approach with 90% very liquid and 10% less liquid. We made the mistake perhaps of focusing too much on the 90% that was liquid because it seemed to be a sufficient measure of the liquidity of the portfolio. When we saw that things were changing we took action to protect shareholders because we were then in danger of the 10% becoming quite a challenge for the fund. We adjusted quite rapidly. Since then the portfolio has had immense liquidity.

Q: What drove performance and the comeback in 2009?

A: Pure stock selection. If you look at the -15% return in 2008 we were hit by the collapse of Lehman Brothers for a couple of percent. More importantly the market neutrality approach we used at the time was really focusing on protecting the portfolio three standard deviations out. With the market moving so much a correlation to a normal move of two standard deviations actually proved to be quite painful. We lost about 600 basis points from the market directionality. If you combine the two it is nearly 9% so we were down 6% in 2008 from the stock selection. Frankly, it was in the summer pre the Beijing Olympics where we had a very strong cyclical orientation where we proved to be dramatically wrong. We went from a complete risk aversion situation to Lehman going bust. It was very painful. At the end of 2008 we had a couple of months when we revisited where we went wrong. We had a couple of strategies that were doing very well in 2008, including the UK side, the tech fund and some of the trading books. Because there are a couple of big engines in the fund that did well in 2008 we increased capital allocations to the portfolio managers in those areas and fixed parts of the fund that didn’t do well, in particular, event driven. That meant in 2009 we put a larger part of the capital deployed into those strategies that had done well. In 2010, we were basically flat. But now we are really making good money.

Q: During 2004-05 changes were made to improve the gross exposure of the fund? What did that entail?

A: It comprised two things. First, at GLG we try to run like an Olympic team. We found that we had people running races where they weren’t the strongest competitor. Applying this to the fund it meant that someone might be very good at stock selection but not very good at leveraging it. And vice versa. We felt that what we should do was to take the leverage away from the portfolio managers and run it at the risk management level. Instead of allocating capital plus leverage so managers could leverage themselves, we allocated a risk budget to each of the risk takers. That risk budget with each individual style and risk pattern is translated to a nominal gross exposure that is assigned to each manager. Therefore instead of people seeing themselves as two or three or four times leveraged managers thought of themselves as utilising, say, 85% of their risk budget. The whole idea is to manage that and improve on the utilisation of the risk budget. It started as moving the leverage away from the stock pickers and giving it to the risk managers.

What we saw later in 2006-07 is a quirk in the story. We were still holding the winners but we found that after taking the leverage away the performance was not high enough. That’s when we began to search how to improve the return on capital employed. We tried to weed out the strategy and the people who might make 0.5% times 10, for a 5% return, and really focus more on those strategies where we can do 3-3.5% times 1.5. That produces better employment of capital with lower leverage and thus lower risk. Even though it is producing the same return, it is an improvement in the quality of the return. So we embarked on improving the quality of the return by focusing on the return on capital employed. Each manager focuses on the return on capital employed rather than the return on capital, which is what I focus on with the risk management at the top of the fund. It is really pushing people to focus and take a decision where they are strong. That’s helped improve the risk/return of the fund. There are still areas where we think we can improve. That is another reason why we feel we can improve returns.

Q: Do you consider yourself an investor or a trader, or a bit of both? And how do you balance these and other approaches in how you manage the fund?

A: I consider myself as both an investor and a trader. By nature I would be more of an investor, but I do complement that with being a trader. Both help to give you an all around picture. Take our energy portfolio manager. From our internal chat system you can see that his analysis of a stock in which we have a very large position was at the beginning of the story probably better than that of the company itself. When a month later the stock goes down 30% in the morning for some obscure reasons, he immediately got the traders to buy stock. It shows how it works here as the traders acted because the fundamental guy really got the picture and brought it down to the stock level.

Our approach is to invest in stocks, not in companies. We have to focus not only on the value but on the price which is a second derivative of the value. At the end of the day that is what we own or that is what we short. Therefore you can’t say I’m going to be a trader and not an investor because you will get shafted as the fundamentals do matter. But you can’t be an investor and ignore the trading volatility because it generates such risk that you have to be on top of it. You need to combine the two skills so traders feel very good working with the fundamentals and vice versa. That’s how you get the best of both worlds.

Q: What are some of your key long exposures and why?

A: Three of our four largest names, each between 3-5% of the fund, are in the energy sector. It is one of the dullest performing sectors of the year to date but that is where we have extracted a substantial part of the return. It shows there are opportunities hidden underneath this flat water of the market not doing much.

Q: And on the short side of the book?

A: Shorts are much more macro driven. This is one thing we have done quite well. We are using shorts to express a macro view. We have shorts as baskets or sectorsor futures so there is a lot of risk management involved to make sure that the inventory of shorts in the good names we’ve got is very specific. We don’t want them there as shorts just to go market neutral. One of the big thematic long/shorts we’ve got right now is in technology around the iPad phenomena. The idea is to short the whole food chain of companies who aren’t involved with Apple and to be long the companies that are involved with Apple. We’ve got a couple of stocks on the long side and five to 10 stocks on the short side to express that view. It is a view we expect to have for the next 12-18 months.

Q: The European Long/Short Fund is said to operate more like a fund of funds or a bank proprietary trading desk than a long/short equity hedge fund; explain this.

A: The fund has two objectives. One is to get a lot of different investment styles in order to diversify how we make money in the fund. We’ve got all kinds of strategies: value, growth, momentum, trading, long term, activist, event, credit oriented and macro. For all of this you need quite a few different people. I am not as an individual able to be good at all these different styles. We need the right people on the team to take care of this and also the right people to combine all of them, do the risk management and do the portfolio optimisation. I’ve always felt that the right way to get the right people is to give them a huge amount of discretion on a risk managed basis. All of us as individuals aspire to freedom and flexibility in decision making. With my fiduciary responsibility I want to make sure that someone doesn’t bet the farm and give me a risk issue so it is in a very strong risk framework. But it does mean there is a massive empowerment of the portfolio managers in the fund. And that is translated into giving people individual allotments of capital. The idea is that this is going to help me get the best out of people. It is very transparent and aspirational for everyone and it is fantastic from a management point of view as there is nowhere to hide. It is tough because the numbers are the numbers.

How it works is that within an envelope individual portfolio managers have full discretion. It is based on the quality of the risk adjusted return that they get more or less capital following the periodic reviews I undertake with risk management to review allocations. It works a bit like a fund of funds because we look at the ‘x’ potential of one strategy and the ‘y’ potential of another strategy. It is not an incubation. There is a lot of synergy as everyone works in the same room. It is more like a collection of individual funds that have access to a common resource. We try not to have too much replication of style. Each of the books has a raison d’etre. It is there because it is special either from an industry, style or geography standpoint.

Q: How did the Société Générale Asset Management acquisition help the evolution of GLG’s equities business?

A: It was a great addition as there were a lot of complementary parts to the business. It brought us a Japan equities business that was among the best there over the past 20 years. This was a fantastic addition. It also brought a couple of other products as well as a fantastic distribution team in the UK. We also had a European team that was strengthened by some joiners from SGAM particularly in the utilities sector. A good indicator for our merger with Man is that we integrated SGAM earlier than expected and on better financial terms. There was also better asset retention and less disruption to the investment management than expected. It was very positive. The integration with Man is a totally different story but it was very good that we could experiment with that a year and a half ago and deliver a good outcome.

Q: GLG offers numerous products in the equities area, including 130/30 funds. How does a move into the UCITS space complement both the hedge fund and long only funds that you are operating?

A: Between the risk management and the managed account platform we have run for quite a long time it doesn’t matter where we extract the alpha. We can package it however a client requires. Most hedge fund strategies fit in the UCITS guidelines. For us it was just a question of opening the vehicle as we didn’t have to change any of the basic strategies to fit in with the UCITS guidelines. We are able to say to clients that we can tailor make the alpha extraction in any way they want it to contribute to their portfolio. This can be portable alpha, 130/30, UCITS funds, plain hedge funds or long only.

For instance we are looking at a new product that has very strong alpha. The question is what do clients prefer that we offer: a long product or a long/short product. It’s the same alpha and with the risk management we can organise it so we don’t dilute the return too much by neutralising the market impact on it. It is a question of whether they prefer the allocation to a long only product in that sector or do they want to have an absolute return. Depending on the client’s answer we can package the product accordingly. The alpha generation is the same and my investment managers don’t necessarily need to know the underlying product. They do their stock picking for the portfolio against a return target. How it is packaged into a product is a job for others.

Q: GLG has launched a global trading fund to cater to investors who want more trading oriented strategies. How does it operate and how has it fared?

A: It has not been as good as we wanted because one of the strategies – trading volatility – proved very difficult. We have since adjusted it and focused on cash equity trading which is working quite well. It is invested in securities and in strategies that are run in parallel with strategies traded in other GLG funds. One trading strategy is run in common with the European Opportunities Fund. Another one is run in common with the UCITS Pure Alpha Fund. And a third one is run in common with a strategy traded in the Global Financials Fund.

What it offers is a trading vehicle. This is something investors were keen to have a year or a year and a half ago when they feared it wasn’t an investors’ market but a purely trading market. But it will have cyclical appeal, too. There are very few people who know how to trade. The product is on the shelf and will be available when these sorts of strategies are attractive again.

Q: On UCITS, what are the upsides and downsides of the phenomenal growth we are seeing?

A: I think we have to be extremely careful as an industry to have what’s in the box described accurately on the cover of the box. We have taken immense care to make sure that the essence of the UCITS III regulation is respected: that these offer low leverage and that you don’t give something to clients that they don’t fully comprehend. It is a retail distribution and one can’t be cavalier with the risk management. What’s important is that people really do the work to see what’s inside the UCITS III fund they are buying.

We have actually been careful and kept our offering very pure. It is very important strategies in UCITS are based on strategies in hedge funds that use the same leverage as will be used in the UCITS. Otherwise investors are going to be disappointed. We have only offered strategies in UCITS where we can get the same returns without changing the leverage from what we use in the hedge fund. Otherwise you are going to deflate the strategy from the hedge fund to work in the UCITS III format and investors won’t get the returns they expect in a deleveraged version. It is very important that people are candid with investors. On that basis it is a fantastic way for people to get absolute returns in something they weren’t able to get before. It should be good for private clients to be able to get less leverage and more absolute return, and be de-correlated from the equity market.

Q:Your record of 11% annualised returns over a decade when the market has returned nothing is a solid vindication for the equity long/short funds. Is this the way equities investing is going to survive and will long/short strategies become an increasingly more mainstream activity in the investment arena?

A: We all know the danger of over reacting when we have periods of underperformance. Asset allocation now is very challenging as it is tempting to reduce equities because they have done so badly. Because of the nature of equities investment it is going to continue to be cyclical. There will be periods when the reward will be alpha exclusively and there will be periods when the rewards are beta and alpha. So returns will remain cyclical and be very macro driven. And because of that there is going to be continued volatility and not of the short term intraday type but really more of cycles with greater amplitude. That will offer profitable investment opportunities.

With equities the barbell approach is going to continue. Investors will do indexation for as much as they can and really focus on the active management and those managers who can generate the excess return. For this there will be more and more non-benchmarked equity investing backed by strong fundamental work and trading expertise that can deliver excess return against benchmarks because of the ability to focus on what stocks should be in the portfolio versus the stocks that are in the benchmark. Consultants are getting more and more interested in people like us that have high tracking and high information ratios. There are some changes that are in the interest of investors.

Q: How will a mainly equities shop like GLG be complementary to Man Group? And what opportunities does the deal offer?

A: The fact that we are going to be part of the Man Group basically means that we can all spend much more time in just managing money as opposed to managing money and running a company like we have been doing for the last 15 years. There is an immense sense of being able to do even more work and be focused on performance. Man Group is a beautiful distribution business with a global footprint. It has products that aren’t equity products but which complement equity products very strongly.

It is a question of making sure we understand the needs of the Man clients for what we do well. From the early work we have done with them there is a very strong need for what we do. We have an extraordinary opportunity but, of course, with a lot of integration work. It is a very exciting thing and such great architecture can really liberate the investment management team. The aim is to continue to get people to focus on where they are strongest. It could be that capex, instead of being spent on distribution, could be put back into investment management. That’s how one plus one could really end up being four.