Returns to Conviction

Thematic investing is key to Lesley Kaye of GAM

Originally published in the February 2007 issue

When looking at neophyte managers, investors in hedge funds can be wary of those that have come from the sell-side. The attitude is much stronger for those coming into money management from having been a salesperson in brokerage, decision-making being a different skill from the ability to encourage and close a sale. This attitude is not universal because there are those who have made the switch successfully from stock-jockey to an adept at portfolio management, but they are rare. One who has 'crossed the street' and has acclimatised well is Lesley Kaye, the Investment Director responsible for Global Asset Management's (GAM's) Japan funds and co-manager of GAM's Asia-Pacific funds.

"I was feeling as though I had had enough of the brokerage business after the violent swings of 19992000," says the GAM Investment Director, "and after a complete break I had a few options. Three different organisations offered me roles on the buy-side. GAM had always been among my favourite clients so it was natural for me to join Mike Bunker, who was head of Pacific investments for GAM at the time. The type of organisation was important to me as I was making the decision. I didn't want to join a start-up. That would have been too much for me: being deeply involved in a business that was itself finding its way." So Kaye joined GAM in May 2001.

The fit between the portfolio manager and the company is a good one. GAM has very good processes in risk, operations and in client servicing. Individual money managers at GAM are unconstrained in their investment decisions and run their portfolios according to their own investment style and philosophy. Historically, GAM funds tend to be fully hedged for currency exposures. Whilst managers at GAM have the ability to take currency bets if they wish, it is uncommon as they tend to focus primarily on stock selection. So the $4bn-plus in GAM's Japanese equity funds managed by Kaye do not often take active exposures to the Yen, except in the Yen-denominated Fund Class. Kaye has assumed a hedge fund style within the risk/return spectrum that is not unusual within GAM – in the medium-to-low part of the risk spectrum (see Fig.1).


The attitude of GAM's senior management is that their in-house managers can run hedge funds if they want to. Paul Kirkby, former Investment Director of Japanese Equities at GAM, had long been interested in running a hedge fund, and started managing GAM's Japan product in June 1998. Kaye took over the management of the fund in October 2002.

"One of the advantages of having been a broker is that I have had exposure to various approaches to markets amongst my clients," she says. "I take the view that an overly rigid approach to the Japanese market limits the insights you can get. So I knew I wanted to use a flexible approach to idea generation. We draw on top-down views, quantitative insights and bottom-up research to generate ideas. From the outset I knew the type of portfolio manager I was going to be."

Two products, two tools

Kaye's remit includes three mandates: long-only (the traditional product), institutional long-only (reflecting where GAM is moving its business footprint), and long/short equity hedge fund,all in Japanese equity. In addition Kaye carriesjoint management responsibility for the Pacific Team along with Michael Lai, who looks after Asia ex-Japan.

Some portfolio managers prefer to concentrate on running a hedge fund. For Kaye, who inherited funds in both formats, the two product types offer investors different choices. "I see myself as providing two different tools," she says. "When investors want full exposure to a market (when they see it as being in a bull phase), they can access the long-only fund as some investors do not want the hedging of the long/short then." This is important.

The GAM Japan Equity Hedge Fund under Kaye is never going to try to match those that style rotate and change hedge fund shape to chase returns in all phases of the market. When a manager runs only a hedge fund they may feel compelled to get into small cap stocks and lever up the balance sheet for a bull run. That is not going to happen in Japanese equities at GAM under Kaye.

There are consequences of this stance of giving investors the choice of playing full exposure to market or hedged exposure in different funds. Kaye's hedge fund is run with a conservative balance sheet compared to others in the peer group. As Japan was seen to mature as a destination for hedge fund capital, it became normal for investors in hedge funds to have allocations there. After she had been running the fund for more than a year, and with a decent 2003 return of 14.5%, it became feasible for external investors to commit, and they did. Assets under management doubled in the course of 2004 to more than $450m by the end of that year.

Around this time funds-of-hedge-funds were making allocations to Japan as a strategy, so they would be allocating to a range of styles within the Japanese equity long/short category. More aggressive funds got money, and conservative funds got money.

In the middle of 2005 all seasoned allocators recognised the bull conditions in Japan and returns and flows to Japanese hedge funds took off in the second half of the year. Assets under management in GAM Japan Equity Hedge went up 70% in 9 months (see Fig.2).


By late 2005 Kaye had a three year track-record with the hedge fund. In 2003 she ran the hedge fund with a low exposure (see Fig.3). This demonstrated that returns were coming from stock selection alpha rather than balance sheet utilisation (beta).Having shown this, gross and net exposures were built through 2004 and good returns were delivered to investors for a low net and gross style of management (see Fig.4). In 2005 individual investors fully participated in the Japanese equity market – "it was a reminder that the Japanese market can act like an emerging market at times. It is more like Thailand than a Western market when it does," says Kaye.

The contrast between 2005 and 2006 in Japanese equities

In a blow-out year for returns like 2005, Kaye's hedge fund was never going to be top of the performance rankings. Blue Sky Japan was up 142.9% in 2005; Melchior Japan was up 52.9%, and Boyer Allan Japan was up 44.8% in that year. In 2005 a typical exposure for GAM Japan Equity Hedge was net long of 50% on a gross of 150%, without much exposure to small cap stocks. The return of 21% was outstanding within that style, and comparable to the typical Japan long/short fund. Kaye knew that 2006 would present different challenges. "I believed that the 2005 returns were the next three years returns brought forward," she says. "I knew 2006 would be difficult. If I had known how difficult I would have taken 2006 off altogether," she laughs.

The TOPIX return given in Fig.4 is not even half the story of the year just gone in Japan. All the stock favourites of internet stock punters in Japan, many speculative plays, and some event-driven story stocks backed by new-wave entrepreneurs were smashed in the first half of the year. Small cap and illiquid plays were creamed. Many hedge fund managers learned the lessons of illiquid holdings and index hedging of non-TOPIX stocks. Blue Sky Japan was down 28% for 2006, Melchior Japan down 23% and Boyer Allan Japan down 17% for the year.


Kaye is disappointed that GAM Japan Equity Hedge was flat for the year. A return that putsher fund 3% ahead of the typical Japan hedge fund and in the top quartile of hedge fund returns for her speciality. "We recognised the top in commodity plays in May. We had started taking chips off the table, but they fell away from us. We should have done more sooner," she says self-critically, "because we ended up selling into weakness. For a lot of 2006 I had planned to add more specific stock shorts (as opposed to index shorts) but the results we got made that difficult for us to implement."


One view that did come right was in the steel industry. "A lot of investors have a view of the Japanese steel industry based on experiences in the 1970s and '80s. Then it was a price-sensitive commoditised play. When margins got to 10-12% most investors saw that as peak level. But the competitive environment has changed. There have been mergers in the steel industry, and there may be more. We looked back further to the 1960s. Then you could observe peak operating margins of 16-17%, in conditions not the same as today, but more like today in some ways than the 1970s or '80s. So we took a different view from the market and have done well on a re-rating as investors came around to our perspective on the companies."

According to Kaye, long-term secular macroeconomics shifts are the primary drivers of long-term portfolio performance. So she constructs and manages her portfolio accordingly. Multi-year themes are identified and exploited in stock/industry selection. For some years a Chinese influence was evident in commodities and their imports of capital goods and other industrial materials more than doubled over the last few years. The GAM Japan Equity Hedge Fund has reflected this theme, as well as the rolling financial restructurings that have washed through the Japanese financial system.

A current theme under development ("it's a work-in-progress," says Kaye) is the concept of new high-end tech plays. Kaye's team is researching hand-held devices in their various forms to find out to what uses the 2 billion web-enabled handsets that will be out there in 34 years time will be put. Quite in which sector the leverage to the theme will appear is difficult to say at this juncture – content, nandflash or even high-end lithography are among the areas that could be exploited. "We have to get to a position of a deeper understanding before we can take a view on a company that may benefit," she explains.

Dynamics of position sizing

Having identified themes to exploit, capital has to be put to work on a timely basis and in sufficient size. This is, perhaps, the key skill of money management and is where art meets science, that is in portfolio construction. In particular what separates the others from the best hedge fund managers (and great traders) is managing the size and closing of positions. The style indicators in Fig.1 do not capture this dynamic element.

The portfolio and approach to markets is thematic. So risk in the portfolio can be more concentrated than the limits on individual positions or even sectors show, as positions are related in concept. But the thematic risk exposures are built up over time, and even what may become very significant sources of return and risk typically start on a small scale. The first exposure taken by Kaye to a theme may be as small as 25 to 50 basis points.

The next stage of development is a crucial differentiating factor amongst hedge fund managers. Having taken a position, however small, the managers are effectively implementing an investment hypothesis. How this investment hypothesis is tested and demonstrated to be right, wrong or needing amendment is a differentiating style point amongst those running capital in this format. What Kaye is doing is making sure that in the very first cycle of hypothesis-testing her fund cannot be too badly damaged if she is wrong. The flip-side is that fund returns cannot benefit much from the first exposure taken.

There is only one way to determine whether an investment concept is right in conception and timing, and that is to own a position. The feedback on the investment concept is the P&L on the position. There are several ways to interpret the feedback. For a small position with a positive P&L the concept may be right and timing in markets to implement it accurate. However, the position may be profitable from a price reversal within a trend going the other way, or there may be a luck factor and exposure to random movements in securities prices (noise). The best managers try to own stocks for specific reasons and analyse the outcomes as they arise to ensure they are getting the factor or company specific payoff they are seeking. This ultimately enables controlled risk assumption across the fund.

Of course positions can go against managers, and for a variety of reasons. So again it could be random noise; it could be technical factors related to flow; it could be a co-movement with a related security; it could be something event-specific such as company news or the emergence of a new seller of the stock. Amongst the difficulties for managers of hedge funds is the time-frame of their processes. Here a loss could accrue even if the investment concept (big picture and medium to long term) is correct but the timing is wrong. "You pay so much as an investor for timing errors," discloses Kaye. And this is the differentiating factor – what the manager goes back to review on a position reflects the core style of the manager. So those implementing a short-term trading philosophy may check the RSIs or Bollinger Bands or price/volume characteristics, but they are unlikely to argue with markets very much if at all. A long-term value investor may argue with markets in both the short, medium and long term and simply add to positions where value is better (price gone against). Equity hedge funds tend to be in the middle and exhibit a range of first checks.

In Kaye's case she checks to see whether the theme on which the stock was selected and bought (sold) is still valid. If the theme is assessed to be at play still then a negative current P&L may be a function of noise or technical (non-fundamental factors). In short, the timing of taking the position was wrong, but the underlying case may be in tact. This means the manager can come back to the stock even if the timing is out and the position has had to be closed for the sake of keeping exposure discipline.

Kaye says she is not very religious about specific stop-loss levels. "I always look at stops on the basis of how much pain we are able to bear", she says. This is partly informed by spreadsheets maintained by her team that show review levels per stock. A loss of 25 basis points to NAV from a short position is a decision point in Kaye's process. Should a small position show it is working in the market (adding to the P&L) further research to reinforce conviction on the specific company or the informing theme will be conducted by Kaye's team. The small position will then be added to. Positions are thus built over time based on growing conviction within a diversified framework. This convention is universally applied so that the effect works in aggregate – thus implementing one of Kaye's investment philosophies that portfolio construction should be driven by conviction not benchmarks.

Glass half full in 2007

At the start of 2006 Kaye expanded her team to six members by two hires, one of whom is in Japan. Like his boss, Rowan Ewart-White has joined GAM as an Investment Manager from the sell side, in his case from Macquarie Securities in London. The other hire last year came from the hedge fund industry: Kaye had been trying to hire Comino Tamura from FM Capital Management for the previous two years, and the Research Manager finally joined in January 2006. Kaye speaks to her Tokyo-based team members 2 or 3 times a week, particularly getting feedback on company meetings they attend. All the team members also feed written reports into the team's information system to keep everyone abreast of developments from the bottom up.

As we enter 2007 Kaye is optimistic about Japanese equities. "From a longer term economic perspective we are entering a period of economic normality after parts of Japan Inc. have been dysfunctional," she suggests. "GDP per capita is going up at last, so the environment is good. Part of my positive take is definitely driven by de-regulation. For example you can see the impact of falling utility and mobile phone prices in Japan. Plus the gap between return on assets and funding costs is the highest ever in Japan at 5%. So I see a phase of expansion ahead with the lessons of the last decade applied to capital expenditure plans. In this environment corporate Japan does all the due diligence necessary before speculating with shareholders' funds. Having been cautious for 2006 the glass is definitely half full for this year. Perhaps the one significant risk for the market is the Bank of Japan making a monetary policy mistake."

The net exposure of the hedge fund under Kaye's stewardship has tended to be between 0 and 50% of the NAV. The positive take for 2007 has already been partially reflected in a current net of 65% and she sees potential for it to be 10% higher yet.

Kaye has succeeded where many fail in switching from a sales capacity in brokerage to being the ultimate decision-maker in the hedge fund format of money management. It has helped that she has enjoyed the support of her more experienced colleagues at GAM, and has around her the team that she has built and moulded, but the success is hers. There is a very good fit between her edge in research (identifying long-term macro drivers) and the money management process she employs. That she has employed more stock shorts recently gives her additional tools to deploy for varying market conditions.

In theory additional research capacity enables the team to generate more ideas or carry out research in more depth on a similar number of companies/ stocks. If the first, then Kaye and her team could run more positions (so a bigger gross) to achieve larger returns. Or, if the second, then Kaye could run positions with more conviction and size and offer a larger range of risk/return profiles. Of course Kaye could just carry on doing what she has been doing but selecting the best of an increased range of investment ideas. At this point, with $700m in hedge fund assets, she has created the chance to make choices. Get bigger with an increased range and/or get better? What is not in doubt is her abiding interest in what she is doing. "On Christmas morning I leapt out of bed to check the Japanese market on the screen," she discloses. "After 20 years markets are still absolutely fascinating."