Paul O’Reilly describes the extensive knowledge of convertible markets, which feeds into IIU Asset Strategies’ consistently strong results.
Paul O’Reilly describes the extensive knowledge of convertible markets, which feeds into IIU Asset Strategies’ consistently strong results.
Paul O’Reilly is managing director of IIU Asset Strategies and has a career dedicated to trading global convertible bonds spanning over eighteen years. He has been trading the highly successful IIU Convertible Fund for the last nine years and his trading is one of deep fundamental analysis on a macro level, coupled with a strong emphasis on intrinsic value inherent in convertible issues. Prior to joining IIU he was head of the convertible bond desk at Schroders Securities, London. Having graduated with a degree in business studies from Trinity College, Dublin, Paul went on to receive a first class Masters in Banking and Finance.
HW: What is the background to the fund?
PO’R: The IIU Convertible Fund was initially launched in March 1997. Today, with over USD 146 million in assets under management the fund has an annualized return of over 18% and a max peak to valley drawdown of just 4.56%. The fund is a USD denominated investment company domiciled in Ireland and listed on the Irish Stock Exchange.
HW: How and where do you distribute the fund? What is your current and targeted client base?
PO’R: The internal marketing department of IIU Asset Strategies is the main means of distribution. The fund reports to all of the main hedge fund reporting databases including Albourne Village, Altvest, Eurohedge etc. We also have two independent marketers for the fund and we utilize the capital introduction team of our prime broker to assist with the asset raising. Our client base is made up of both European and North America investors with Switzerland being a main source of capital for the fund. Our clients are mostly fund of funds and institutional investors and we would anticipate that this will not change going forward.
HW: What is the investment process of your fund?
PO’R: The IIU Convertible Fund is an actively traded global convertible fund. A fundamentally driven bottom-up style is used to identify trading opportunities. This approach is founded on the team’s extensive knowledge of convertible markets combined with their excellent research and trading skills. Having identified equity opportunities that have a convertible alternative the fund invests in liquid at-the-money convertibles which are neither resting on their bond floor nor trading as equity substitutes. Almost like having a call on equity markets the fund trades in a very risk averse manner.
The fund’s trading strategies can be summarised as follows:
- Long term value trading
- Short term opportunistic trading
Our Long Term Value Trading involves buying balanced CBs that convert into interesting underlying stocks. A balanced CB is a fairly valued CB that isn’t too far from its bond floor with reasonable equity participation. Typically the delta would be in the 30% – 60% range.
Short Term Opportunistic Trading will often be in companies of lower credit rating or where we think there may be some short term catalyst and an opportunity to generate a positive return.
HW: How do you generate ideas for your fund?
PO’R: Idea generation comes from me with some additional input from my colleague, Dara Marnell manager of the IIU Convertible Arbitrage Fund. Between us we have over thirty four years experience trading convertible bonds and in that time we have developed an extensive knowledge of the sector. In order to identify suitable equity opportunities we study research received from the main finance houses -for example Goldman Sachs, Morgan Stanley, UBS and Nomura. An ‘interesting underlying stock’ could be a stock attracting rumours of M&A activity or our own perceptions of value. We study earnings growth, cash flow, gearing levels and the general financial health of the company. More importantly, however, we look for a catalyst that will shift the focus of the market to the stock causing it to move. A catalyst can come in many different forms, such as a restructuring, consolidation, de-mergers or spin-offs. These can occur to the company itself or to a company or companies in the same sector. Even a restructuring in the same sector in a different country can spark a big move in a stock. We would also look at the company’s balance sheet to ensure there are no inherent dangers there.
Another source of ideas is the new issue market. New issues provide an opportunity for the fund for various reasons. A convertible is usually issued at a discount to its theoretical value, which immediately gives a boost to the NAV of the fund, as the market values it closer or at a premium to that theoretical value. Usually during a convertible issue the company goes on a road-show to present themselves to investors which raises the profile of the company and will usually have a positive effect on the share price. Companies usually have a story to tell around this time which can have the effect of making the underlying share outperform over the short term. Even if a road-show is not embarked upon, the lead manager of the issue will usually organise investor conference calls in order for management to present their company and their reasons for buying the stock.
HW: What is your approach to managing risk?
PO’R: Active intraday position management has been the key to reducing portfolio risk and achieving superior risk-adjusted returns with very low drawdowns. A key element of our risk management is the highly disciplined approach that is taken to employing the stop-loss strategy. Initial stop loss limits are set at 2%-3% per position entered. These are maintained as trailing stops for the duration of the trade – with the stop moving upwards as the position moves into profit. The highly disciplined execution of the stops has kept losses in the fund to a minimum – the largest monthly drawdown was -2.96% in August 1998.
The risk manager independently monitors the portfolio to ensure that the stop loss limits have not been breached and that the portfolio remains within the preset fund guidelines.
- Average Leverage employed in the last 12 months : 1.23
- Max. position as a % of the total portfolio : 10%
- Max. position in any one sector : 20%
- At least 60% of portfolio in investment grade names
- Highly diversified portfolio in terms of geographic and sector allocations
HW: How/against what do you benchmark the performance of your fund?
PO’R: As the fund is quite a unique strategy in that it is not a traditional convertible arbitrage fund but a long biased strategy it is difficult to find a perfect benchmark. However, as an indicator we do use the S&P 500, the MSCI Global Index and the ML 300 Convertible Index. In addition we monitor the fund’s performance compared to convertible arbitrage indices.
HW: Has your performance been as per budget and expectations? Do you expect your performance or style to change going forward?
PO’R: In 2005 the performance of the fund more than exceeded expectations with a return of 10.99%. This is even more pleasing for us in a year which was a very difficult one for the convertible market. Year to date in 2006 the fund has returned 6% and going forward we hope to continue our performance of solid consistent returns with very low drawdowns.
HW: What opportunities are you looking at right now?
PO’R: We believe that the main opportunities in the convertible market are currently in Europe and Asia. In Europe we’re expecting a strong performance from equity markets and, with an average delta of 55%, convertibles will achieve a good level of participation. We’re expecting a strong year for M&A transactions which will help performance and encourage new issuance as will the turn in the investment cycle. We’re expecting Japanese convertibles to continue their recent good run on the back of their equity market making fresh highs. It’s been a long time coming in Japan, but the general view is that this is not yet another false dawn, and if its does continue then there will an abundance of money making opportunities.
HW: What events do you expect to see in your sector in the year ahead?
PO’R: I expect to see a return to inflows in the convertible arbitrage sector. We have raised new assets in 2006 and we are seeing further enquiries from investors considering turning around their negative stance on the sector. While it may not start immediately by the third quarter we should be seeing good inflows.
HW: How will these changes/future events impact on your own portfolio?
PO’R: Although we’re not convertible arbitrage we would benefit from a better outlook for the arbitrage community. Our trading is more dependent on the outlook for global equity markets and the forecast is good – in the short term at least. Increases in volatility will increase the value of the convertible universe which will have a positive impact on our strategy.
HW: What differentiates you from other managers in your sector?
PO’R: The competitive edge of the fund includes my eighteen years of trading experience in the convertible sector together with the backing of a strong proprietary valuation system and managed within a highly disciplined risk management framework. A robust company structure ensures that the trading team can concentrate on the investment process secure in the knowledge that they are backed up by a team of highly skilled individuals.
Other points to note are:
- A very strong track record dating back to March 1997- annualised return of 18% and a maximum peak to valley drawdown of just 4.56% in August / September 1998
- Commitment and backing of IIU’s Principal
- Dedicated risk manager and investor services personnel
- Top quality in-house technical support
- Proven highly disciplined risk management approach – max monthly drawdown of 2.96% in August 1998
The Fund won the 2005 Hedge Funds Review European Performance Award in the convertible category – this was the second nomination for the fund last year having been short-listed for the Eurohedge Hedge Fund Awards.
HW: Do you have any plans for similar/other product launches in the near future?
PO’R: We are currently developing a European long/short product which we are currently running with proprietary capital. It is envisaged that we will launch this as a separate fund in the near future.
(Paul O’Reilly was Interviewed on 20 February 2006; this interview was revised on16 May 2006)
