Thematic & Concentrated

Ben Melkman’s Light Sky Macro

Originally published in the October 2017 issue

Discretionary macro strategy Light Sky Macro (‘Light Sky’) has rapidly raised assets, surpassing USD 1.5 billion within six months of launching in 2017. Its founder, Ben Melkman, had always wanted to set up his own business – an entrepreneurial streak that is in his blood as his family ran small businesses. “I want to create a culture, build a long-term team, and develop independent research and structuring expertise,” he says.

Although Melkman is the CIO and sole PM, this does not mean that the firm is a one-man band. In pursuing a concentrated and high conviction strategy, Melkman is supported by a team of seasoned executives and a robust research department dedicated to enhancing the entire investment process and business management.

Unconstrained and opportunistic
Melkman has always had an open investment style and his mandate at Light Sky is no different. He takes exception to the view that there have been limited opportunities in the macro space over the last 5-7 years: "Sure, if you define macro as the Fed funds rate, opportunities have been limited. But if you define macro as the ability to invest across regions, products and asset classes – there is always something to do."

Independent research
Melkman is now the architect of a firm that can leverage its resources to pursue broad but finely targeted opportunities, ranging from the sequencing of the ECB exit to the fair value of the Egyptian pound. Fundamental research is led by Alberto Ades who was previously Head of Global Emerging Markets Fixed Income and FX Strategy, and Co-head of Global Economics, at Bank of America Merrill Lynch (‘BAML’) and earlier at Citi and Goldman Sachs.

Light Sky relies more on independent rather than sell side research, but nonetheless Melkman finds “it is important to keep abreast of the street – and ahead of consensus.” Light Sky likes to stay close to the ground with numerous field trips, and attends events such as the Davos World Economic Forum, held in January each year, and the IMF meetings, held in April and October, as well as bespoke smaller gatherings with policy makers, academics and private sector thought leaders.

Melkman “wants to share intellectual capital with investors,” who are invited to Light Sky-sponsored roundtables, events and conferences. These include a Latin America dinner that hosted two leading thinkers from the region: Harvard Professor Riccardo Hausman, and IMF Americas Chief, Alejandro Werner. Melkman has no position in Venezuela today, but “could get involved if the market overshoots to the downside upon any default that prompts forced selling.”

Asymmetric themes and expressions
Key to the investment process at Light Sky is the identification of themes and the use of derivatives to create asymmetric trade structures. “Execution, trading, liquidity optimisation, and analysis, are key parts of the process,” he says.

While some macro traders primarily use ‘delta-one’ or linear, pay-off instruments, for Melkman, the nuances of how ideas are expressed are critical for both returns and risk management.

The team seeks out themes that are inherently asymmetric in the first place, where the range of outcomes are skewed toward a positive outcome. Next, he aims to add another layer of convexity through structuring (with a third level coming from risk management).

Derivatives are a critical component of Melkman's investment style. The types of option structures used are tailored to the market climate. “In a low volatility environment, we use more outright long volatility structures as there is less need to reduce the costs. For instance, in high carry EM currencies it is often possible to build an option portfolio that is both long gamma and has positive carry. Whereas in a high volatility environment we can use more sophisticated structures to cut costs,” Melkman explains. More exotic option structures that can reduce option premium costs by as much as 50-70% (in return for reduced upside or potentially earlier expiration), can include one touches, knockouts, reverse knockouts and spreads.

Trading, structuring, execution and counter party relationships all fall under Head of Markets, Joseph Mauro, who was previously a partner of Goldman Sachs, where he was responsible for European hedge fund coverage across macro asset classes. Of the three Light Sky partners, Mauro has known Melkman the longest, establishing a coverage relationship from Goldman when Melkman first made the move to the buy-side in 2009. Investor relations is another area that falls under the responsibility of Mauro. Given his role on the investment team and position on the Risk Committee, he is well situated to interact with Light Sky's investor base. "We believe investor partners should know what risk we have in the portfolio, why we have it and how we are running it," Melkman says.

Risk management
The risk management function is led by partner Barry Schachter, who has more than 15 years’ experience heading the risk function in hedge funds, including Moore Capital Management and Caxton Associates. He chairs the Risk Committee, which is responsible for allocating and managing the risk budgets given to investment themes. He, jointly with Melkman, developed the fund’s risk management governance structure and risk control processes.

Diverse capital base
Light Sky’s investor base is rather more diversified, as perhaps befits a global macro strategy. Investors come from Singapore, Hong Kong, Japan, the Middle East, UK and Switzerland, and less than half of the capital comes from the US, according to Melkman. Investor types include sovereign wealth funds, institutional funds of funds, bank treasuries, private banks, endowments and foundations.

Collection of themes
Light Sky’s risk is organised as a collection of investment themes and Mauro shared with us some insights into the firm’s perspectives on macro policy and markets.

Core opportunities
“One of Ben's strongest views is currently centred on monetary and fiscal policy themes that he thinks will take years to play out. After nearly a decade of quantitative easing and low rates, Ben believes monetary policy has reached its limits of effectiveness, shifting the burden of growth to fiscal stimulus. The current portfolio is constructed to capture the trends and dislocations associated with this evolution,” Mauro points out.

Core opportunities – US policy
Soon after launch, Light Sky Macro established a US policy focused theme to capture the interplay between economic data, progress on fiscal reform and the reaction function of the Federal Reserve. Light Sky’s core view, that the combination of a tight labour market and potential fiscal stimulus package would force the Fed to normalise more quickly, was initially implemented with a range of expressions across rates, FX and equities. “As the year progressed, economic data, particularly inflation, began to moderate and political turmoil created uncertainty around the entire Trump agenda. We were able to mitigate the impact of the retracement in rates with more nuanced expressions focused on the shape of the yield curve and dollar weakness,” Mauro says.

“Heading into Q4 2017, we believe that a combination of factors, including a sense of urgency in Washington on tax reform, hurricane relief spending, a nascent bounce in inflation data and continued strong growth could lead to a resurgence in the ‘animal spirit’ type trades that many believed would drive the market in early 2017.”

Core opportunities – EU Normalisation
Light Sky also has a constructive view on Europe’s economy: EU Normalisation was another early theme launched by Light Sky as their confidence increased that an economic and political revival was underway across the European continent.

“Our initial core view was that a robust discussion within the ECB related to both the timing and the sequence of normalisation would quickly lead to higher rates from ultra-low levels. As the difficult European election calendar began to clear and activity began to improve, we pressed bets on higher rates and a stronger EUR,” says Mauro.

The Q4 outlook is: “Heading into October, as data continues to surprise to the upside and Europe outperforms on both an outright and relative basis, we are confident that, despite the recent strength of the EUR, the ECB will reluctantly normalise, leading to higher rates,” he says.

Peripheral opportunities
A theme that Light Sky calls ‘peripheral shifts’ was introduced to benefit from the challenges facing policy makers of second tier central banks as they attempt to navigate the turbulence created by the exit policies of the Fed and the ECB. “Our view was that the new narrative coming out of the BIS, one that de-emphasised weak inflation measures and encouraged accelerated normalisation, would particularly apply to periphery central banks such as Australia, Norway, Sweden, Canada and the UK,” explains Mauro.

“In mid-June, as investors continued to question global policy makers’ commitment to normalisation, the BIS (known as the ‘central bank of central banks’), released their annual report. We were surprised by the hawkish tone and urgent nature of the recommendations,” Mauro goes on. Light Sky’s focus on the BIS message proved well-placed as a gauntlet of policy speeches took a sharp hawkish turn, ultimately leading to a hike by the Bank of Canada and strong signals pointing to a move in November by the Bank of England.

A paradigm shift in economic policy could lie ahead. It is Light Sky’s belief that, even though coordinated monetary policy was much easier to achieve as rates were falling, the exit will also be synchronised to an extent. “Following a decade of artificial support by the official sector, volatility has been depressed and asset prices distorted. Given full employment has now largely been achieved, policy makers have decided it is time to address these financial stability concerns,” Mauro details.

Emerging market opportunities
Light Sky keeps abreast of the links between developed and emerging markets. Earlier this year, as French election trepidation turned to jubilation and the calendar flipped from April to May, it also became clear to Light Sky that with US data moderating and political worries now focused on the US rather than Europe, the USD was heading into a weaker environment. Recognising that such an environment could lead to continued emerging market outperformance, (a reversal of 2014 – 2016 USD-induced stress) Light Sky screened for opportunities that would balance the more hawkish tilt to the portfolio.

“In mid-June, as it became clear that global central banks were determined to press ahead with the pace of normalisation, despite questionable inflation data, we decided to minimise high beta emerging market exposure. That said, a range of emerging market themes remain on our radar screen and we would not hesitate to pivot back into the asset class should conditions warrant,” Mauro explains.

Idiosyncratic opportunities
While some of the strongest Light Sky views centre on reflation and the exit from quantitative easing, Melkman realises this will not happen in a straight line. As a result, the Light Sky team is always searching for idiosyncratic themes to add to the portfolio.

Idiosyncratic opportunities – Egypt
Mauro reveals that one such theme where Light Sky has high conviction is centred on the profound political and economic transformation taking place in Egypt. “Supported by the IMF, Egypt is taking critical steps necessary to redevelop capital markets and attract much needed foreign direct investment,” says Mauro.

Light Sky’s Egypt stability theme was launched on the back of a rapidly improving economic and political picture as the country recovers from the aftermath of the Arab Spring. Following the November 2016 devaluation of the Egyptian Pound (‘EGP’), Light Sky believes the currency to be undervalued. The Central Bank of Egypt (‘CBE’) is pursuing a policy of high rates to stabilise expectations and prevent the inflation pass through effects of the weak currency. “Our view is based on three key pillars: (i) the government will remain committed to the IMF sponsored adjustment program; (ii) the CBE will continue to prioritise disinflation in the near-term, but eventually this policy backdrop will foster economic growth and investment; (iii) strong portfolio inflows, political stability and IMF support will allow the currency to gradually appreciate, neutralising inflation and allowing rates to continue to adjust lower,” Mauro says.

As usual, trade expression is important. Light Sky utilises the CBE ‘Repatriation Facility’, the mechanism created to establish confidence and attract foreign investment. “The liquidity benefit of the repatriation mechanism is key given our overall view of tighter global financial conditions ahead,” Mauro says.

Looking forward, Egypt continues to be one of Light Sky’s highest conviction views. Melkman recently visited Cairo, meeting with a range of government officials, business leaders and the banking community. His key takeaway was that the current government is committed to reform and the praise of the IMF is genuine and well deserved.

“Egypt represents a strong idiosyncratic story that sits well in our investment portfolio, insulated from the policy paralysis and political noise driving many other macro markets,” Mauro adds.

“We believe that the market focus over the last 12 months has been largely based on speculation,” Mauro sums up. “Speculation related to the sequence, pace and timing of normalisation, the willingness and ability of the government to provide the fiscal support necessary to bridge the transition and the ability of risk assets to withstand tightening financial conditions.”

“While the Q4 2017 pipeline is full of potential catalysts, volatility in core rates markets is close to historical lows, mirroring equity volatility and compressed global risk premium.” Light Sky anticipates realised volatility to recover as the market shifts from expected to actual liquidity reduction.

While Light Sky believes there are always opportunities in global macro, they believe the final stretch of 2017 into 2018 represents a particularly rich vein of catalysts and opportunities in core markets as the policy environment finally moves forward.

The team believes its approach of macro investing, combined with next generation portfolio structuring, will differentiate Light Sky from its peers.