From sovereign wealth funds that jumped in too early, to shareholders spurning the rights issues of UK banks, financial stocks are currently a dirty word with long only investors. But the advantage of hedge fund investing is the opportunity to generate returns across the cycle. The Hedge Fund Journal spoke with the investment team at TT International's Financials Long/Short Fund, who have proved that market turmoil is no obstacle to performance.

TT International was founded in 1988 by its senior partner Tim Tacchi to manage European equities and now has US$3 billion assets under management in hedge funds, as well as a further US$19.9 billion AUM in high alpha actively managed long only funds. Mark Eady joined TT in 2002 from Deutsche Bank, where he had been Co-Head of European Bank Research, to be a stock picker in the long only side of the business. His impressive track record at TT in this role prompted the company to launch a hedge fund product, with Eady as the portfolio manager. The strategy was launched in August 2005, utilising US$50 million of capital "carved out" from two of TT International's managed accounts. The strategy's immediate success prompted a doubling of the capital commitment at the start of 2006 and TT launched a separate fund, the Financials Long/Short Fund in March 2006. Strategy AUM is currently US$240 million and fund AUM is US$84 million.

Small but perfectly formed

While still relatively small, TT International believes there is considerable scope to grow the fund. "We think capacity for the fund is US$1 billion," says Roddy Boulton, Executive Director Investor Relations at TT International. "A lot of our peers are considerably larger, but we want to remain nimble, unconstrained by liquidity issues when managing the portfolio and, with more than US$1 billion under management, we would need more people which would alter the chemistry of an investment team that works very well." In addition to Eady, the TT Financials' team comprises Simon Price, who was formerly a bank analyst with JP Morgan and Ben Steele, whose background is in proprietary trading in financial equities at Deutsche Bank.

Boulton also expects the fund's recent performance, with net returns of 17.5% in 2007 and a 12.1% gain in 2008 through the end of August, will provide a catalyst for increasing the Fund's AUM (see Table 1).

To a certain extent, there is a need to educate potential investors on the differentiating factors between a financials long/short fund and other sector funds. "In contrast to many other sector funds, which tend to be run by natural buyers of the sector, a financials fund can be run both long and short without this long bias," says Eady, Partner at TT International and Portfolio Manager TT Financials. "Take, for example, a specialist pharmaceuticals fund manager. He, not unnaturally, tends to spend his time accumulating specialist pharma stocks from the long side. But if you look at how we have run the financials fund you can see that we have been both long and short at the fund level."

Timing considerations, in Eady's opinion, are also currently favourable for a financials fund. "Every sector fund has a sweet spot in terms of timing. For banks, insurers and financials in general that sweet spot tends to be at the point when the economy moves into recession and the point when it comes out. That reflects the fact that by their nature financials are very highly geared, so that when you get those movements in GDP they are reflected in bank balance sheets with a multiplier effect. The position we have been in since August 2007, and probably will be in until late 2009 or early 2010, I think is a sweet spot for a financials fund, when hopefully you will make exceptional returns because of the volatility in stock prices." Or as Price sums up the situation: "A disproportionate amount of the alpha in equities is available in financials."

Scale and diversity add to the sector's appeal. Financials is one of the biggest sectors in the market, which, until recently, accounted for 25% of global equity market capitalisation, although the share price fallout from the credit crisis has reduced that proportion to about 18%. This large scale offers considerable geographic and product diversity, with business models ranging from highly leveraged investment banks to more stable non-life insurers. TT believes that this diversity can be utilised to make non-correlated bets in the sector.

At its heart, TT Financials' investment approach is based on stock picking. "We construct the portfolio from a bottom-up individual stock basis, with focus provided by a strong top-down view" explains Eady. "Obviously, at different points in the cycle you get different themes that work well across the different parts of the sector. For example, if deleveraging is a big theme the portfolio might reflect this with short positions in investment banks and if the underwriting cycle was seen as more robust you might be long nonlife insurers against it. But we don't deliberately construct the portfolio on thematic lines. The building blocks are the stocks themselves, the thematics help to identify where to go looking for the best stocks."

Geographical allocation is similarly the result of the search for attractive individual stock opportunities within a thematic framework, rather than the mechanistic outcome of prospectus stipulations. For example, for periods last year the fund ran long positions in the Middle East, which was attractive because of oil price strength, but the emphasis was on finding stocks that were attractively priced. Equally, the fund has tended to be short in the UK, Ireland, Spain and the US over the last year, because of the overheating of property markets in those countries and the potential for credit problems. But there have been occasions in the past when a promising theme has been identified, but it has not proved possible to find attractively priced stocks to populate the portfolio.

TT is prudent about becoming overly concentrated in any one area. The Middle East long position, for example, did not account for more than 15% of NAV. But equally, with an aim to make absolute returns of 20% net per annum, TT does not shy away from taking significant risk and running relatively concentrated portfolios. TT's investment style is not a pairs trading approach and the investment team wants to avoid diluting their ideas by over-hedging. "At times you have to take, not uncomfortable, but sufficient risk to make the type of returns we are targeting," says Steele. "To an extent the level of capital that we allocate to different areas is determined by the bottom-up work that we carry out and how much investment upside exists there."

Navigating through the bear market

Recent market volatility has required some modification of the team's approach to risk management. "We took the view that the world changed quite significantly last August," explains Eady. "Before then, we were running what I would call typical through the cycle levels for a financials fund, namely gross exposure of about 200% of NAV, net long exposure of 30-40% and a stock portfolio with about 40 names in it."

Last summer TT decided that financials were entering a bear market, which is characterised by higher volatility and "absolutely excruciating" countertrend rallies, requiring a very high conviction level for positions. Gross exposure, therefore, was reduced to between 100 and 120% of NAV and the fund has been broadly net short in developed markets sincelast August. (The net long position shown in Fig.1 for last autumn is accounted for by specific positions in the Middle East). Turnover in the last 7-8 months has also gone up significantly, because the violence of bear market rallies requires a more nimble tactical trading approach. Interestingly, because of the greater volatility, the fund's VaR exposure has been at similar levels with a net exposure near to 100% as it was when exposure was 200%, and the returns have been as good.

This change in the fund's net position is a good illustration of how it is differentiated from sector funds with a natural long bias. "We never thought that 30% net long was the new net short," says Eady. "We felt that given our view of the sector it was right to have an outright short position." That negative sector outlook is based on the belief that, in broad outline, the credit crisis is unfolding in a three-stage process. The first stage is the write-down of securitised assets on the balance sheets of financial institutions. Second is a rise in mainstream bad debts as financial system deleveraging induces a credit crunch and a downturn in major economies. The third stage is the completion of balance sheet renewal via recapitalisation and the emergence of a new more regulated, less-geared business model.

"There is still a bit more of stage one to go," says Eady. "The process of deleveraging has been more painful than people anticipated and the clearing price of those (securitised) assets has fallen to a lower level. Another way to look at it, is to say that banks' funding costs have continued to go up even though interest rates have come down, so the break-even price for banks, or anyone else, to hold or buy those assets has fallen. That means the pain in terms of writedowns has lasted longer and been greater than consensus expectations."

Eady does not believe there will be a debt default by the government-sponsored entities, Fannie Mae and Freddie Mac, as the US government has little choice but to support their debt. He does, however, have reservations about the value of the GSE's equity (see Anatomy of a Short). "We are most of the way through the writedown of securitised assets, but one can't take a great deal of comfort from that as clearly the impact of the crisis is now switching from Wall Street to Main Street."

Anatomy of a short

The TT Financials Long/Short Fund has held a short position in the equity of US government sponsored mortgage underwriters Fannie Mae and Freddie Mac since early summer 2007, when it became clear to the investment team that the problems in US housing were no longer isolated to sub-prime. With the problem widening into a broad fall in house price indices and contagion from sub-prime spreading through Alt-A and into prime mortgages, the two GSEs, which between them underwrite almost half of the US mortgage stock, looked vulnerable.

"Fannie and Freddie have a large exposure to housing credit, currently US$5.3 trillion in a US$12 trillion market, and by July last year it was clear that this exposure was about to generate significant losses," explains Price. "Most importantly, they were both around 100 times levered on an equity to assets ratio and so were extraordinarily geared. But nobody looked at the capital ratios of the GSEs because of the implicit government guarantee. In my opinion there is no such thing as an implicit guarantee, either it is guaranteed or it isn't and we believed that at some point the debt markets would test the government's resolve."

In March, the Office of Federal Housing Enterprise Oversight (Ofheo) reduced the capital requirements of Freddie Mac and Fannie Mae, to allow them to add up to US$200 billion to the mortgage markets, which strengthened the rationale for the short position and provided an opportunity to add to it. "The mantra from US brokers was thatthe GSEs were 'part of the solution, not the problem,'" continues Price. "But, in our view, the GSEs are in fact right at the very heart of the current problems." Two key aspects of the crisis have been, firstly, the overleveraging at financial institutions, among whom the GSEs are two of the most highly leveraged and, secondly, the falling value of the world's largest asset class, US residential housing, on which the GSEs are dependent.

TT still holds the short position, although not in the belief that there will be a debt default. "The government has to stand behind the debt otherwise US mortgage lending will come to a halt and that's the cancellation of the American dream," says Price. "But protecting debtholders doesn't necessarily provide any guarantee for the equity."

The catalysts to close out the position will be a recapitalisation of the GSEs, which TT believes will involve a massive dilution of existing shareholders (and in Fannie Mae's case, for example, requires raising US$75-US$90 billion), or a stabilisation in their asset base ie. a recovery in the housing market.

Banks taking the hit from bad debts

Stage two is unfolding as bad debts on mainstream on-balance sheet lending are starting to rise. Credit has been contracting in the US in absolute terms since the end of May and loan growth is decelerating quite significantly in Europe. Financial institutions are faced with a combination of credit contraction or tighter credit supply around the world, virtually no pass through of interest rate cuts and a consumer who is significantly overleveraged in the US and Anglo Saxon economies.

"We would expect bad debts to remain a problem for the banks until we can see some kind of bottom in asset prices. The trigger for an improvement in bank operating profits is the trough in asset prices and, as yet, it feels as if we are some way away from that," suggests Eady. Backing up this argument, he points to the US where there is still a significant inventory of housing, mortgage supply is tightening given the problems of the GSEs and the velocity of default on mortgages is rising as negative equity increases. "You are also starting to see areas that historically had held up very well, such as Manhattan, reflecting the downturn in Wall Street and the uptick in unemployment," says Steele. "That will provide the next leg down in housing price indices, such as the Case Shiller index."

The third stage of the unfolding crisis requires bank recapitalisations, but, as with the writedowns of securitised assets, that process is proving more prolonged and painful than anticipated. "The costs of raising equity have increased because of the carnage wreaked on banks' share prices," says Eady, who believes that bank managements will now be reluctant to raise equity capital without substantial support from external investors, (which was how Barclays approached the problem). Regulators for their part, who had been hawkish in pushing banks towards recapitalisation, may now feel inclined to allow the banks more breathing space, given that their efforts to raise capital have created as many problems as they have solved. The outcome, in Eady's opinion, is that the deleveraging process in the financial sector will continue to be acute and may even become more so.

The end result will be a less geared sector, in which existing shareholders will probably be more diluted than today, and which will be less profitable too. Research by Deutsche Bank, for example, has highlighted how the growth in bank profits over the last decade outstripped growth in nominal GDP, which was a function of the increasing leverage applied in the sector. Once this leverage is pared back, growth in bank profitability will be lower than in the boom years. "I think the thrust ofthat argument, that the world has changed and that you need to find a new equilibrium level of bank profitability and leverage that is lower than it was, is correct," says Eady. TT is not arguing that lower leverage will mean the end of securitisation. "We're not saying we have seen the death of some of these products forever," says Steele. "More that the volume of these products that are originated and sold and the yields at which they are originated and sold will be materially different." Eady continues, "If you run a bank with less leverage and a higher equity to assets ratio, it's not intuitively obvious that you will sustain the same returns on equity that you saw in the previous ten years. Our overriding sense is that the dynamics of the industry over the cycle will be less profitable."

Time for banks to pay the price

The bail out of distressed institutions and the wider underwriting of the financial system by the monetary authorities will come at a price, both in terms of profitability and oversight. "If in one form or another you are accepting taxpayers' money, a priori, you are accepting a lower ROE or will be unable to move as far out on the risk curve," says Steele. Regulation, too, is set to increase. "The academic consensus on the crisis is that it is not that different from previous crises. It was driven by excessive monetary growth and speculation fuelled by leverage and at the top of the cycle the system is not self-correcting," says Eady. "From a regulatory viewpoint, thinking will swing round to 'how can we stop the dysfunctionality as the bubble grows?' I don't believe that regulation will go mad, but it will try and take some of the cyclicality out of the business, which means carrying more capital in the good years. Profits may be smoother as well as lower."

The cycle, however, is unlikely to become so muted, that investment opportunities are impinged. "There's volatility and then there's volatility," says Eady, referring to the extreme price swings of recent months. "We like some volatility and given the highly geared nature of the companies, you are always going to get that in the financials sector."

Biographies

MARK EADY

Mark Eady joined TT in 2002 from Deutsche Bank, where, as Co-Head of European Bank Research, he was consistently highly rated in Institutional Investor surveys. From 1998-99 Eady was head of European Bank Research at Bankers Trust after spending 1990-98 as a UK bank analyst at NatWest Securities. He started his career as a bank analyst with Nikko Securities in 1985 after attaining an MA from Oxford University.

SIMON PRICE

Simon Price joined TT International in 2005 from JPMorgan, where he had spent 5 years as a bank analyst. He worked in a similar capacity at Schroder Securities from 1998-2000 and from 1996-98 at Merrill Lynch. He started his career at Newton Investment Management in 1994 as a financials analyst. He holds an MLitt Philosophy from St Andrews University and an MA from Oxford University.

BEN STEELE

Ben Steele joined TT International in 2005 at the inception of the Financials Long/Short strategy. From 1999-2005 he was at Deutsche Bank as a proprietary trader in financial equities becoming Head of Pan European Financials. He started his career in 1998 with Ernst and Young. He holds a BA Hons degree from Durham University.