WestSpring Advisors

Recovery phase in credit still offers many opportunities

Originally published in the November 2010 issue

Amongst the Hedge Fund Journal’s “Tomorrow’s Titans” was WestSpring Advisor’s Ralph Nacey, one of 20 US based managers in the survey sponsored by Ernst and Young earlier this year. WestSpring can be seen as a progeny of US military academy West Point, some 50 miles up the Hudson river from New York City, where Nacey and Brian Cox, his chief operating officer, started studying together back in 1991.

The oldest military training institute in the US was recently rated as the best university in the country by Forbes magazine. Another principal, Eric Philipps, has been working with Nacey for nearly a decade at investment banks before they founded Brigadier, their previous fund, in 2006. The longevity of the team’s shared work history has contributed to a consensual decision making process in an industry renowned for acrimonious separations and disputes. Disagreements are frequent and healthy, but agreement is needed before a thesis enters the portfolio.

Eclectic backgrounds
The academic backgrounds of the team span the gamut from Nacey’s physics specialism to “renaissance man” Eric Philips whose studies straddled economics, psychology and philosophy while COO Cox did economics and systems engineering before an MBA. Nacey is grateful for how the team’s background in the sciences has taught them how to do “deep data dives” cleaning and interpreting large volumes of data that may contain both “noise” (irrelevant patterns or details) as well as outright errors.

The New York office near Central Park contains art including a collage of multi-coloured bank notes from more than 100 countries, but WestSpring is firmly focused on US credits and the US economy. Nacey maintains that their understanding of the US consumer is a core part of the investment process, and identifying incipient problems in 2006 allowed them to start positioning the Brigadier portfolio to profit from the subsequent downturn. Data analysis at WestSpring takes advantage of the wealth of US Government statistics ranging from the Population Census to Department of Labor statistics as well as the filings that municipal and other government entities are required to make. Home prices, delinquency rates (late payments on loans), incomes, employment and demographics all feed into the microeconomic forecasting process which is regularly revised. By the summer of 2007 Brigadier was short biased, and by the end of 2008 profits from shorting credit had been monetised.

Macro view: an elongated recovery

Does subdued performance so far in 2010 mean they are sceptical about the latest leg of the credit rally? “The reasons for the rally are not only economically based,” says Nacey, “but that doesn’t make it any less legitimate.” Besides economics, WestSpring pragmatically looks at asset flows, and tactical positioning: some people have been caught on the short side this year. The nature of a post recessionary market, with an elongated recovery period, is a delicately balanced macro backdrop – where even slightly surprising economic news can have big impacts in both directions. “Exogenous events like Europe added more uncertainty earlier this year,” says Nacey.

Right now WestSpring does not fear a double dip recession, because the latest economic news has not indicated a further contraction, contrary to fears earlier this summer. Nevertheless conditions may still feel recessionary in some sectors, because the economy is far from entering an expansionary period. Their base case is a slow recovery, yet market sentiment could continue to alternate between over-pessimism in the form of recessionary fears, and over-optimism projecting a straightforward V shaped recovery. This could result in a range-bound oscillating market environment, with good opportunities for trading the range.

Quantitative easing (QE) is clearly having a dramatic effect on the markets, they insist. “It increases all asset prices – bonds, equities, gold and currencies (that serve as a) reserve currency,” says Nacey. “It has a dramatic effect and it will stay that way for a long period of time.” They do not like to speculate too much on the future shape of QE, and do not predicate positions on speculating on changes in QE. Therefore, interest rate duration risk is hedged out, costing around 1% a year if rates stay static. WestSpring likes to take bottom up views of companies and sectors.

Realistic return targets
Brigadier delivered an impressive Sharpe ratio of 2.5. Whether or not this might be sustainable through the cycle is not a topic WestSpring debate, because they do not target a Sharpe ratio. Instead they target returns, and the risk management framework has a range of position and sub-strategy level controls besides volatility. They also aim to maintain Brigadier’s very independent minded return profile in the new fund: the fund showed no meaningful correlation to equities, bonds, or the average credit long short fund.

Lower yields are not tempting WestSpring into employing more leverage. They take the straightforward view that if the risk free component of returns is 4-5% lower than historic levels over the past couple of decades, then realistic return expectations are also correspondingly 4-5% lower. The manager points out that fixed rate bond yields cannot avoid being compressed by risk free rates approaching zero. Once record low interest rates are removed from the equation, it becomes clear that credit spreads are far from historical tights.

Witness the investment grade index, sitting well above the tights of 35 basis points seen in 2005 and 2006, and also well below the wides of late 2008. Being in the middle of the historical range is a good environment for credit investing. What’s more, it is likely to persist because the recovery is also an extended one. “In an expansionary environment it’s clear equity wins, and in a contractionary one the fulcrum security wins,” claims Nacey. But in the current recovery phase, there are still credit stories – default, call, maturity, insolvency, and sustainability – meaning the fate of plenty of companies hangs in the balance. There is scope for widening and tightening at the single name level, and although the Treasury yield curve is steeper than ever, the term structure of credit spreads remains very much name specific: for instance weaker names with a dire credit outlook may exhibit an inverted credit spread forward curve.

Trade types, diversification
The core investment universe is investment grade credit, high yield credit, using credit default swaps and on occasion equity options for hedging purposes. Trades are broadly categorised into one of four groups. “Ballast positions” are low volatility holdings with positive carry. Relative value includes curve trades such as roll downs, intra-sector trades and negative basis trades. “Cheap optionality” can involve buying a cash bond well below par, or indeed buying credit default insurance on a corporate to express a view on the short side. The long and short books are each intended to be independent profit centres as opposed to being composed of pair trades, hence the name Directional Alpha for this bucket.

Risk management
COO Cox takes a holistic view of risk management: it is an integral part of portfolio construction and management, not a separate function. Processes are implemented from the moment a trade is placed through to reconciliation, shadow accounting, and many other double, triple and quadruple checking “comfort” routines usually done on a daily basis. The seed capital provider FRM Capital Advisers insists on robust operational controls, but in fact the team have been running their own risk systems for years since they were at Merrill Lynch. They like to maintain strong ownership of processes, so chose Sungard for its ease of customisation; analytics director and particle physics PhD Tom Hu has also worked at Sungard. Reconciliations between the prime broker (UBS), custodian (JP Morgan), administrator (Hedgeserv) and WestSpring ensure they are all on the same page. HedgeOp advise on compliance, and are likely to assist with a filing for registration with the Securities and Exchange Commission next year.

Market, credit and liquidity risks are continuously recalculated for each trade and the whole book: blending the bottom up approach with top down. Market stress tests are based on proprietary probability distributions. In other words, WestSpring want to limit their vulnerability to spikes in volatility. The statistical methods used are nuanced in placing greater weightings on some historical periods. In contrast to the continuous distributions applied to market risk, credit risk is more about assessing the potential severity of discrete and binary events: will a company default or not? Will it call back its debt at a certain date or not? Will it refinance or retire debt on maturity? On top of market and credit risk, liquidity risk is an often overlooked area where WestSpring has demonstrated a real edge.

Liquidity prioritised
The team’s former fund, Brigadier, returned capital to investors in 2008 and early 2009: US Army parachutist Nacey successfully parachuted cash back to investors. As such it was a victim of its virtuous liquidity criteria: investors used Brigadier as a much needed ATM because so many other funds could not meet redemption requests. Nacey believes that gating was so widespread they could easily have been forgiven for invoking the gate provision (WestSpring has a 20% monthly gate as well). Such was the commitment to liquidity provision that Brigadier took the unusual step of selling its Lehman exposure in late 2008. In spite of the consequent hit to NAV, that fund still delivered robust returns of 15.5% in 2008. They believe the Lehman claim is still only trading at 40-50 cents on the dollar two years later, and took the view that their duty to provide liquidity was the overriding consideration.
The approach has certainly not changed with WestSpring. The process of gauging liquidity goes beyond the usual multiples or fractions of average daily volumes to encompass a suite of proprietary liquidity indicators back tested over varying historical conditions and also constrained to allow for widening of bid offer spreads. Nacey is often asked if he expects regulatory moves to migrate credit derivatives onto exchanges will narrow bid offer spreads.

“Theoretically it should reduce spreads, as ultimate buyers and sellers are being brought closer together,” he says, “but the broker dealer community are not keen on it – they are not sure they can compensate margin pressure with extra volumes.” This means it may take longer before investors see any benefit. Talking to all eight of the main players in the CDS market means they know where it should be priced.

Diverse investor base
Ownership of the management company rests entirely with Nacey and Philipps at present, although over time other staff members will be rewarded with ownership of both the management company and the fund, subject to vesting periods. The day one money has been augmented with inflows from other investors, taking the asset base to just under $100 million in the first year. There is a diverse investor base, including two pension funds, family offices, and private banks, with funds of funds making up less than 10% of assets.

WestSpring can be accessed via the Hedge Fund Research platform although the same monthly liquidity terms are offered to both fund and platform investors. The onshore and offshore feeders are also run on a pari passu basis. The team gained experience of operating managed accounts for platforms at Brigadier. Portfolio transparency is offered to investors with varying time lags. Under current market conditions, capacity is estimated at $1 billion, although the manager admits that position sizes and numbers would be different with a larger asset pool. Would capacity be lower if markets returned to the conditions seen in 2008? Nacey argues that the opportunity set presented by the turmoil of 2008 would in fact warrant a higher capacity ceiling, once again illustrating the contrarian streak that lay behind the all weather returns generated by the team.

Hamlin Lovell was co-portfolio manager of a fund of hedge funds at Millennium Global Investments between 2005 and 2009. He is currently consulting on manager research and due diligence projects.