Theorema Asset Management

Consistent Theorema looks to thrive on its corporate change

Originally published in the February 2008 issue

When a founder leaves a business it is usually a time of sweet sorrow. When a founder leaves a hedge fund business it is often taken as something much more serious. At the least there will be many questions from existing investors, but nearly as numerous can be the completed redemption forms. The departure of a founder can leave a hedge fund business commercially endangered. At the least, it is typical for the fund to change strategy, as at Egerton when Bill Bollinger retired. Over the course of the last year quite a different commercial future is suggested from events at Theorema Asset Management after Emanuele Antonaci came to an agreement with co-owner Giovanni Govi to leave the business.

The two had been brought together in 2000 by Gabelli Asset Management to run Gabelli European Partners, then a newly launched long/short equity hedge fund run in the Gabelli house style of GARP-with-a-catalyst. Govi says that his experience with Gabelli European Partners brought several lessons that he applied when the pair started Theorema Asset Management.

"One lesson was that you can't run a small hedge fund company without fully controlling a significant part of your business, whether that means back office, trading or accounting. This is critical because at the beginning we spent a lot of time trying to reconcile our performance data to the administrators, and making sure our trades got across accurately. Second, it is worth investing in several critical areas of the business. For example you need efficient front and back office systems. Thirdly you need to be able to produce reliable estimates for attribution. You need to know from which specific sectors your profits and losses are coming. You need to know if you are doing well on the short side. We had to answer the question "Were we making superior returns in the sectors we specialised in?"

Antonaci had been the telecom, media and cyclicals and utilities analyst at Fidelity (Europe) and Govi had been a financials analyst at Goldman Sachs. They were to divide up their portfolio along these sectoral lines – this has been a template used ever since, and a cause of both strength and division.

The Theorema Group is now owned by Govi and ten other partners. The firm manages approximately $1 billion across 4 products. The fund line-up consists of the flagship Theorema Europe Fund (long/short equity (TEF)), a double-levered version of TEF (called TEF+), Theorema Focus Fund (concentrated fund reflecting the top longs and shorts from TEF), and the long only product – the Axioma Fund. The investment process that focuses on fundamental stock picking is common to all the funds. I believe we should emphasise that our volatility is very low. This is a major differentiating point and goes well with our 10-15% target returns. Historically the net exposure at the fund level was a combination of the two books run independently by the founders and would go to 70-80% net long. After a critical review of performance of the fund during May 2006 it was decided that the net exposure at the fund level would be a controlled variable, and it is now capped at 50%. This has been easier to review and implement under a sole CIO, Giovanni Govi. "This level of net exposure makes it a scarce resource so it compels us to implement our best ideas as well as actively looking for shorts – it is a good discipline," says Govi.

Sectoral responsibilities

Theorema Asset Management has seventeen staff in London, including eight investment professionals, and two in Bermuda. Within the investment team the trader Francesco Masoni is the exception in not having analytical responsibility beyond special situations- he concentrates on hedging for all the funds and is the named PM for the Focus Fund. Frederic Gautier is PM for the Axioma Fund and he selects stocks for the funds in Capital Goods, Chemicals, Construction, Pharma, Telecoms, Utilities and Energy.

Paolo Mortarotti re-joined Theorema in August 2007 after the change in involvement of Antonaci. Mortarotti's portfolio management responsibilities across the funds are in Consumers, Media and Retail. CIO Govi is PM on TEF and has specialised in financials for 15 years. In addition to the portfolio managers there are four analysts who specialise by a sector split similar to the managers they support. The preference is for the analysts to be tenured in their specific sectors like the financials analyst, Pedro Furtado Reis, who has been covering the banks for ten years. Similarly Jelena Olman has covered telecoms companies for seven years. This continuity and depth of experience gives an edge according to Govi. He explains: "We have very good access to the companies we want to meet. By now we have been meeting them for over a decade, and know the most senior management from when they were running divisions rather than the whole company. We have deep relationships with some management teams and individuals."

The Theorema method involves seeing a lot of companies in the same sector. "We find meeting company managements to be a significant source of ideas," says Govi. "You can get fantastic comments from them about where they are doing well, or where they have big issues. Of course it is time consuming meeting company managements, and sometimes you go to a meeting when youknow full well that you won't invest in the company hosting the meeting. However, meeting a small regional bank may give you insights into part of a larger bank's business. Maybe they can say which bank it was that tapped the ECB? They might let slip who they wouldn't lend to on the inter-bank market. Is there anyone on their corporate black list, and if so why?" So company meetings can give insights into wider business conditions, and the current trading of other companies in the same sector.

The investment process is decidedly bottom up. "I have no idea what will happen in 2008. Every year is a different type of market," states Govi. "I don't have a crystal ball to see what is going to happen in the markets, so I believe that it is easier for us to adapt to whatever the markets are going to throw at us. The markets will always surprise you, so we think it best not to anticipate. During the six-year life of the Theorema Europe Fund we have seen every type of market." And the consistent track-record reflected in Table 1 suggests that the Theorema approach works, and being less directional than most equity long/short funds is a significant factor.

Many funds in the European equity long/short strategy target higher returns than TEF, but experienced investors in hedge funds have liked the fact that Theorema Europe Fund always carries shorts. Above that investors have appreciated the persistence of return achieved, a characteristic that academics deny exists in individual hedge fund performance.

The consistency of returns and downside risk control at the portfolio level has made the TEF a suitable fund to leverage, and the leveraged version, TEF+, was launched in September 2004. According to by the end of last year TEF+ had produced a compounded annual return of 29.4%, and had gathered assets of $200 million. It turns out that consistency is a pivotal word for Theorema management too.

Explains CIO Govi, "We try to be consistent at all levels. We are very consistent in our process compared to other managers. We have proprietary valuation models for each company we cover (over 500 now), and our valuation and analytical approach for each sector has been refined over a long time, constantly evolving. We follow the same companies through time – we don't drop coverage of a company just because it goes out of our portfolio as the same company could become interesting again with time. We also put a premium on consistency of ideas. That does not mean uniformity of thinking. Our portfolio managers will debate with an analyst, and sometimes it's the analyst telling the PM "there is no way we should get involved in that company." That is a key part of our company's culture, and derives from the experience of our people."

It is a key concept at Theorema to have several centres of excellence at work – varied sources of alpha within the team. So just as investment risk is reduced by the range of sector specialisations and associated exposures, so business risk (specifically key-man risk) is reduced by the increasing prominence given to Gautier, Masoni and Mortarotti, Govi's fellow portfolio managers (and partners). Govi himself, as CIO, has the key task of deciding on a month-by-month basis where the capital should go. He stresses that PMs don't compete for capital, as there is only one P&L across the firm. There is no link between the size of book run by a portfolio manager and his compensation.

"Capital goes where the best opportunities are," states Govi emphatically. "So in 2007 we benefited particularly from having actively allocated to telecoms chemicals and other cyclical sectors with Frederic Gautier and also to consumer stocks after Paolo (Mortarotti) came back. We took the opportunity to allocate more capital there because he saw a lot of opportunities – there were cheap companies available and we made capital available to build big positions in tobacco stocks and Swedish Match."

Rational allocation of capital

At some funds (like Horseman or Odey) the emergence of macro evidence for investment themes will drive capital allocations. At Theorema the allocation of capital is done on as rational a basis as their own analysis allows. The upside and downside of all existing positions and ideas waiting on the bench are collated in a firm wide database called "Target Prices", and the potential risk/reward ranking drives changes to capital allocations. "We normally like a 3:1 ratio of upside to downside for long positions," explains Govi.

"When we look at out-performance trades, where we are long one stock versus a sector short (ETF), we might have a lower expected return. For these positions we still expect a decent ROE, though admittedly a lower return on assets. We have upside and downside expectations for sectors, and when a specific company in the sector is an outlier on the same basis then it suggests an out-performance trade."

An average position size for Theorema is 3%, and a couple of times a year the managers find outstanding opportunities to justify 7% positions. "We borrow and lend capital between sectors," expands Govi. "Some sectors may do badly, and we can make money if a sector collapses, but timing can be difficult, and we prefer both longs and shorts in a sector. Sometimes it can be difficult to make money in a sector, and in that case we will allocate capital elsewhere." It seems the capital is drawn to sectors by the quality of ideas generated from the bottom up.

Theorema has a good record on the short side, and inevitably there are differences in tactics in managing short positions in contrast to longs. Govi advises that it is hard to hold onto short positions when the market is going up, but sometimes fund managers have to. Given market conditions of the last six months Theorema has put more emphasis on valuation in its approach. According to the CIO you need to grab opportunities based on valuation anomalies by the markets and not wait for a catalyst to appear. "We do not absolutely require a hard catalyst in the next few months any more for longs. We use catalysts more on the short side, where we prefer a hard catalyst. And if it doesn't work in our favour we review then. We are less 'sell-and-hold' these days. In practise we look at how a short position is behaving in the market much more than we do with a long. So we don't wait until the 15 or 20% review level is hit before we get out, we are more pro-active than that."

Information and knowledge sharing

As hedge fund investment advisory companies mature one of the issues that has to be dealt with is sharing of investment data and sharing of insights. This is important for multi-strategy organisations, for organisations running a series of funds, and for any company that seeks to grow beyond the founder(s). An investment ethos has to be developed and acquired by those joining, and there are physical constraints in only placing staff near the most experienced team members. So hedge fund companies have to develop routines and use technologies that facilitate this knowledge sharing. Consultants call this capturing expert knowledge when it is done via technology, but it can be achieved through other means.

Theorema has developed several strands to facilitate information flow and sharing of insights. All investment organisations have unstructured intercourse between team members as part of normal office life – the swapping of ideas and market developments as stock prices move. Nearly all investment managers have morning meetings – typically they recap the previous day's activities and cover the scheduled events of the day ahead.

"We have a formal morning meeting which is a perfect environment for sharing insights and discuss investment ideas," says CIO Govi. "We also use a 'chat' system – to record quick comments after company meetings or similar. Then when we want to go beyond a five-line analysis, the instant response, we put more structured thoughts into writing. We still use the chat system to disseminate the material, but in a properly structured write-up you can be more thoughtful, less emotional. You can support your thesis with numbers, and you can go beyond the immediate emotional reaction to the meeting or news. So it facilitates a genuine reflection, and it can be reviewed and when we look back we can see where we have come from on a company," he explains.

The final strand is not done quite so often in other firms, though it is a key part of building distributed expertise. Often money managers are so involved in the daily round of activity and keeping pace with information and data flow they do not commit to reviewing activity regularly enough. CIO Govi says it is very important to conduct a post mortem analysis – looking at the investment case that was made before committing capital, and how that might have changed after investment.

"I don't mean that we just look at the losers, you have to ask yourself what you learnt from each position taken," he advises. "Every time we have a good success or a failure I send out e-mail saying what I think we did right and what we did wrong, and considering what is the lesson for us from this investment." This gives substance to the investment aphorism that it is okay to make mistakes in investing or trading, but you must learn from them.

In looking to grow the business Giovanni Govi has gone down the route of offering different risk profiles to investors based on a common research process and active idea sub-set. So the same stock ideas are implemented in the long-only Axioma Fund, the long/short Theorema Europe Fund (and leveraged version), and in the latest fund variation, the Focus Fund. All the funds have in common that by design the returns are driven by stock specific risk – even in the long only fund (which has only 20 5% positions) – and the three long/short vehicles take limited net exposure to markets.

The Focus Fund

The Focus Fund is the latest addition to the product line, being launched to external investors in February this year. The concept was driven by one investor offering to seed the product, and back-testing strongly supported the idea. Focus Fund manager Masoni says that they don't take big macro views in any fund. In order to achieve the target returns of 20-25% of the Focus Fund he is looking to implement high-conviction medium-term bets on the long side by selecting ten of the top 15 longs held in TEF as 10% positions.

On the short side, where there are structural as well as tactical positions, his universe is the top 25 short positions of TEF, and he uses 15 of those in 5-7% sized positions. "Your biggest positions are where your conviction is, and you make your money in investing by running your biggest conviction positions. We are just doing that structurally in the Focus Fund," proposes Masoni.

For those that would hesitate over 10% position sizes Masoni comforts "on the long side we know these are good companies, though you still need to take a portfolio approach. And you need to create some pillars in the portfolio – an example elsewhere is that we have held Intesa San Paolo in a fund since 2003! We won't be adjusting these kinds of positions by 1 or 2%. So turnover is low on that side. On the short side, turnover inevitably is medium to high, and for this fund shorts are all in or all out – there is no phasing in or out."

On the short side Masoni is opportunistic and can take advantage of both short-term price action and what he describes as structural trend changes. The short book criteria also include assessing the market consensus and market positioning on stocks. He contends "our added value is to find longs and shorts. Investing in some sectors is just a cyclical call, but our biggest bets are not on an industry or cycle but on specific companies. After all our edge is serious bottom-up research, but we are also good at portfolio construction, and that is largely a matter of risk management. That means that I won't treat every position independently like a proprietary trader would. I could take large falls in specific long positions in November because the short book was doing its job."

On the short side Masoni is opportunistic and can take advantage of both short-term price action and what he describes as structural trend changes. The short book criteria also include assessing the market consensus and market positioning on stocks. He contends "our added value is to find longs and shorts. Investing in some sectors is just a cyclical call, but our biggest bets are not on an industry or cycle but on specific companies. After all our edge is serious bottom-up research, but we are also good at portfolio construction, and that is largely a matter of risk management. That means that I won't treat every position independently like a proprietary trader would. I could take large falls in specific long positions in November because the short book was doing its job."

Masoni's work is different from other investment professionals at Theorema, coming from a trading background rather than being an analyst before. He says that half of a portfolio manager's job is finding investment ideas, and half is in implementing them. "My role," he says, "is to help with the implementation. Sometimes it is easy, even on the short side. Sometimes a whole sector falls when the market takes on board one simple idea. The timing of the application of our capital to markets is what I spend my time on – the tactical side. It may be captured in one descriptive statistic – the performance of a stock relative to the sector, and the sector relative to the market is something we have found very useful." According to Masoni, if portfolio management is beginning to sound too easy then the markets soon evolve. Says Masoni, "If the investment case for a position changes then you must look at the position afresh. Similarly, we often look for a catalyst, and where the catalyst changes you have to close a position!"

At the moment founding partner Govi is more concerned with the soft assets of Theorema than the hard assets. "My goal for Theorema is less about assets under management than with our staff. It's a people business so you must have good people. The concept is to implement a disciplined approach to markets with the right people, where there are a lot of systematic elements. The AUM growth simply allows us to pay our people, and in that way we can get the quality of people we want. I believe we already have one of the best research teams around, and the new start we have had for the business has kicked everyone on – the investment team has never been so creative and enthusiastic for investment ideas. My aim is to grow people in their jobs and increase the richness of their work."

The inter-play between the Theorema staff is reflected away from the dealing desks and administration team in the storage area. Here an in-house tournament has recently taken place on the fussball table, epitomising that Theorema should be a good place to work as well as one that produces good results.

Hedge fund companies where there have been changes in the ownership structure become subject to review by external investors. The due diligence teams of institutional investors come a-calling again with a focused agenda. The review period will be over a couple of quarters, and Theorema marketer Silje Augustson is confident that the company has come through it well.

"We stabilised assets quite early on in the year and have seen significant asset growth since, however this has recently been accelerating rapidly," she says. "People are coming to us, rather than us going out to them to market the funds. We have even had investors apologise to us that they have not been able to commit yet."

The Theorema investment approach has been consistent through time so is reasonably well understood by investors, but now it is available in different fund styles. And crucially there are track records for each. "Investors can choose the risk profile that suits them from across our range, all products offering exposure to our in-house research ideas" suggests an expectant Augustson.

There are relatively few successful European equity hedge funds with a low net exposure to markets that are run by people that know how to short and do so structurally. According to prime brokerage sources in London maybe a dozen managers are adept at using single name shorts. As one of these, Theorema has achieved its performance targets across its range, and the flagship fund has done so across very different market conditions over its six-year life.

The flatter management structure introduced at Theorema, plus the extension of equity ownership has reinvigorated the firm. Whilst it was true that the firm's edge in "serious bottom-up research" was recognised by investors, the return objectives for the flagship fund were insufficiently attractive for some of the last few years when investors got higher absolute returns elsewhere in bull market conditions. This meant that the AUM of Theorema did not reflect the quality of analysis.

However, more recently Theorema returns have looked outstanding as bull conditions melted away. Now that the firm has demonstrated that they are also good at portfolio construction by harnessing the idea generation capability in different risk/return funds the commercial prospects of the firm look very good indeed. The departure of a founder has not so much endangered the firm as empowered it.