Hedge Funds Review European Single Manager Awards 2016
For Bill Lipschutz, a training programme at Salomon Brothers ended with him becoming part of a newly formed department. The idea was to create a team from the traders within the firm and learn currency trading.
That was in 1982. By 1985, Lipschutz was the star foreign exchange trader at Salomon Brothers, eventually becoming the managing director and global head of foreign exchange.
In 1991 he founded Hathersage Capital Management, a global macro fund specialising in G10 currencies. The strategy has consistently produced risk-adjusted returns uncorrelated to traditional or alternative asset classes. In 2015, the dbSelect Hathersage Long Term Currency Strategy returned a staggering 48.56% for investors.
Hathersage is what one might almost call a traditional hedge fund, except it does not hedge. It is focused purely on absolute returns, generating what Lipschutz calls pure alpha, not on portfolio hedging.
Lipschutz says leveraging the skill and experience of more than 30 years of forex trading is at the heart of Hathersage. The firm takes directional market views in G10 currency pairs, using interbank spot, forwards and options.
The strategy offered by Hathersage, much like a global macro manager developing global macro themes, is expressed through trade ideas based on drivers such as momentum, a fundamental analysis of economic relationships, political events and financial market expectations.
Because the foreign exchange market is the most liquid global market, it provides continuous execution capability for the strategy. Hathersage trades only G10 currency via interbank spot, forwards and plain vanilla options. However, it mixes up spreads, maturities and the types of instruments to express a trade idea.
The portfolio management team systematically gathers, filters and analyses macro and micro market information from a wide variety of sources in order to generate the directional view that is reflected in its strategy and trade decisions. It uses plain-vanilla options of varying strike and maturity, such as net long gamma and vega, for example, as the foundation of the trade. Cash is used as a modifier or delta adjustment, depending on the price action.
There will be between two and five trade ideas in the portfolio. The trading approach is discretionary, maintaining a nimble operation so that it is positioned to capture opportunities and manage drawdowns. The portfolio construction and risk management takes a positive skew, with high upside capture and limited downside. This has resulted in particularly outstanding performance in periods of extreme market dislocation.
"We are an FX specialist. All our themes are expressed from foreign exchange and specifically through G10 currencies. It is no more complicated than that," he says.
The skill is in how these themes are played out in the portfolio. Certainly the major theme over the last couple of years has been the divergence between central bank policy as the US begins tapering and raising interest rates, most likely to be followed by the UK, while other major central banks such as the European Central Bank (ECB) and Bank of Japan continue quantitative easing.
All of the central banks have implemented what Lipschutz calls extraordinary monetary policies, but pursuing slightly different timings with different results.
The US Fed is likely to continue to remove these extraordinary policies and return to more normal traditional monetary policies. This move is having a tremendous impact on foreign exchange rates. That is the driver for his trades, Lipschutz says.
However, how markets react, assigning value to assets: the push and pull interplay between perception and reality is what Lipschutz is really playing. "When it comes to financial markets, perception is reality. This may sound trite, but the collective market perception is what drives price action, which ultimately becomes the market reality," he says.
Discretionary managers such as Hathersage use systematic tools to sift through the tremendous amount of information needed to analyse before making an actual trade decision. The discretion is really knowledge and experience expressed in trade ideas that are generally active over a six- to 12-month period.
"Knowledge increases the longer you are in the game. Knowledge and experience lead to better judgement," says Lipschutz.
Discretionary traders are no better at understanding markets based on actual price patterns or actions of the past than systematic managers. But discretionary managers such as Lipschutz and his team do have the experience of making judgements when confronted by new situations.
Since the financial crisis, markets are moving in ways and on policies that are new for them. Many studies have been done looking at the portion of existing positions, crowded trades, and what people expect the ECB to do versus what it actually delivers. Sometimes market expectations can become wholly unrealistic.
"Post-2008, there is a new paradigm. In developed markets, central bank activism, increased regulation, fewer market participants and less short-term market participation has resulted in price action that is different from the past," he says.
"This is one big reason many managers have had to close. Systematic managers have found that variable relationships based on historic data no longer hold. Discretionary managers have found they are not able to make the right decisions within this new context. There is little room for error; markets are merciless," he adds.
He believes true forex specialists – not multi-strategy or big alpha houses specialising in long/short equity offering a currency product – are doing well in the fast-changing environment. "Post the financial crisis, there is a greater investor demand for managers who are specialists in a particular market sector," he says.
As a result of the various ways in which monetary policy is implemented by the central banks, the individual markets are very idiosyncratic. There is a premium on the knowledge that specialists have in all sectors. The foreign exchange specialists can do well in the sector, but managers trying to monitor several sectors at once will fail to understand the granularity and complexity of the market.
"Global themes are fundamental to investment success, but if you can't execute and manage them at a granular level, profits can be hard to nail down. The devil is always in the detail," he notes.
This is where Lipschutz goes back to "proving" alpha. How he defines it is important. "What you want as an investor is a manager who has a high probability of providing consistent returns. This is called persistence. High, non-beta return components are an empirical prerequisite to persistence."
One of the ways Hathersage has differentiated itself is by managing the risk of loss. "In managing our risk, we like to look at deconstructed metrics, rather than average metrics, for example, the ratio of upside return versus downside return, or of upside volatility versus downside volatility. We are most comfortable when our portfolio maintains a ratio of two or three to one on these measures. It naturally follows that, historically when we have up performance periods we are generally up a lot, while our drawdowns tend to be minimal," says Lipschutz.
While every manager says they have great risk management and manage downside well, the proof is in the track record. Two things that contribute to Hathersage's management of the downside is the usual "superior risk management". There are tight stop/losses on trade. The fund goes into trade with a clear idea of both profit targets versus losses. These losses can be caused by unforeseen events but, whatever the trigger, there needs to be a mechanism to exit the trade. Even in such liquid markets, there are times when foreign exchange is less liquid.
The risk management element that perhaps sets Hathersage apart is its use of portfolio construction techniques. The global macro theme expressed through a G10 currency becomes more and more granular.
While most managers will have an idea and take a position by going long or short in cash or futures, Hathersage uses cash as an instrument to modify underlying options positions.
"The way we build out a trade idea is the opposite to most managers. As our initial idea is usually broad in terms of price objective and timeframe, rather than start with a cash underlying position we start with an array of low delta options and use cash later to manage the net delta."
As the trade unfolds, the team can see if the idea resonates or is shown through price action to give a clear idea of the horizon. Then the team can concentrate on particular strikes. Or if it thinks the idea is not going to work, it sells its options and exits the trade.
"This way if a trade idea fails to take hold, the potential loss is limited. You exit and that's it. It becomes more interesting if the idea begins to resonate. In this case, level and horizon become clearer and we can begin to concentrate our exposure in particular strikes and maturities. Of course, there is a great deal of nuance in the selection of the specific options and forwards, which make up the trade idea expression. This is one of our core competencies," he explains.
The portfolio, which at any given time is the sum of three to five such trade idea expressions, performs like a series of straddles that show profit with movement either up or down, but not if the price remains unchanged. "The team continuously sculpts the portfolio through incremental trading to reflect our view on how much of a loss we are willing to take before optionality kicks in," he says. "This method of portfolio construction essentially builds an embedded drawdown circuit breaker into the portfolio."
The team is primarily concerned with downside variance. It views this top-down at the portfolio level. "We don't spend too much time thinking about how much we might make. That's good variance. We spend a lot of time thinking about how much we could lose. That's bad variance," says Lipschutz.
Top-down risk management makes sense in a portfolio of G10 forex ideas, as G10 correlations are unstable and historically tend towards one during periods of market stress. "You think you have built a diversified portfolio and all of a sudden, when you most need it, that diversification disappears as the correlations move towards one. This is why we focus simply on drawdown as a percentage of equity at the portfolio level," he adds.
As to the future, Lipschutz concedes the strategy is unlikely to have a sudden influx of assets to manage. Not a lot of institutional money is looking to add pure foreign exchange to a portfolio. Only a handful look at the strategy under the umbrella of a liquid alternative as a diversifier. So Hathersage seems likely to stay under the $1 billion mark unless more institutional investors become interested.
"Our focus has been and will continue to be as a return generator and not as an asset gatherer," confirms Lipschutz.
Hathersage Capital Management's dbSelect Hathersage Long Term Currency Strategy was also named best foreign exchange hedge fund in the Hedge Funds Review European Single Manager Awards 2016.