Fri, 23/05/2008 - 07:00
Paul Sloane, who researches and recommends global insurance and diversified financials stocks as co-manager of the Martin Currie Absolute Returns Fund - Global Financials, argues that the key to overall performance in the sector will be to what extent the real economy gets hit and how quickly mainstream credit - as opposed to exotic asset classes - deteriorates.
HW: What is the background to your fund?
PS: I have co-managed the fund since launch with Len Riddell, a chartered accountant and sector manager for banks. We launched the Absolute Return Global Financials fund, which is domiciled in Bermuda and listed on the Irish Stock Exchange, on June 1, 2006 and currently manage assets of USD6m. With a combined 25 years' financials experience, we invest in financials stocks across the globe on both a long and short book.
Our aim is to produce consistent returns with a low correlation to the MSCI ACWI Financials index using a bottom-up stock-picking approach, and seek to generate alpha on both the long and short book. The fund is genuinely global and has no market cap or sector limits. We limit drawdowns and - where necessary - look to contain volatility through active balance sheet management and disciplined risk management.
HW: Who are your service providers?
PS: All our hedge funds at Martin Currie have independent service providers. Our fund administrator is BNY Fund Services (Ireland), our prime broker is Morgan Stanley International. Ernst & Young is the fund's auditor, while its lawyers are Lovells in the UK, Ropes & Gray in the US and Mello Jones & Martin in Bermuda.
HW: What is the profile of your client base?
PS: Our hedge funds are available to both US and non-US investors. Our global client base includes institutions, family offices, high net worth individuals, private banks and funds of funds. Like all Martin Currie products Absolute Return Global Financials is currently run as a pooled fund, but we can offer the same strategy as a managed account subject to a minimum of USD50m.
HW: What is your investment process?
PS: Financials cover 30 per cent of the MSCI World universe, ensuring a great degree of liquidity, and a range of local and global drivers ensures that stocks are at different points in the economic cycle at any time. This has the combined effect of generating a number of potential opportunities for long and short investing.
Through running our winners and cutting our losers on both the long and short side, our high-conviction stock-picking approach provides investors with risk-adjusted exposure to global markets.
Targeted research using a combination of primary and secondary sources, and strong contacts with companies on an ongoing basis, is at the root of our investment process. Our bottom-up approach to stock-picking and unconstrained portfolio composition ensures there is no bias toward any country, region, sub-sector or market cap.
The investment framework seeks to identify holdings for the long book by focusing on undervalued, well-financed companies that are exhibiting evidence of positive change. We establish whether we see them as having super-normal earnings expectations and therefore enhanced growth potential. At present, for example, our long book has a strong tilt towards well-financed companies with a positive earnings outlook - an approach that is inverted in order to identify opportunities for shorting stocks.
HW: How do you generate ideas for your fund?
PS: In a nutshell, we believe the market finds it difficult to discount fully the impact and duration of change. We thus seek to identify processes of change that are material to share prices. We evaluate the investment opportunity using a framework of quality, value and growth versus market expectations, and apply a technical overlay before finalising an investment decision.
In order to identify change drivers we use a number of idea generators. Under a more traditional guise, Len and I attend around 300 company meetings per year, giving us direct contact with the management of companies within our universe. We also rely on our colleagues within the regional teams to come up with stock ideas and we meet regularly to discuss each party's recommendations.
An in-house numerical stock selection framework also generates potential investment ideas that are then examined and either validated or dismissed by further research and direct contact with companies. The Dynamic Stock Matrix acts as a screen to identify changes, both positive and negative, in the key variables that influence the direction of stock prices.
Significantly, it acts as a discipline, ensuring that the proven elements of the screening tool are adhered to as a principle and encourages us to be evidence-based rather than subjective in stock picking. Finally, it gives us a common vocabulary for assessing stocks globally.
Our research capabilities are further strengthened through the selective use of high-quality sell-side analysts and models, used to test our long ideas and enhance our short ideas.
We find the varied methods of research and analysis employed adds considerable value to the overall stock selection process. For example, 18 months ago company meetings would yield a significant amount of useful information, as the management were very open to questions.
In the current climate, however, it is more difficult to separate the noise from worthwhile answers, so the information flow from this particular source is limited. In these circumstances it is more appropriate to look at the strength of balance sheets rather than pay heed to management rhetoric - a tact that has served us well recently.
This detailed analysis is less daunting despite the fact we operate in a complex sector, as Len and I are financial sector specialists. Forming a view on the real capital strength of a company is less about management's version of events and more about pulling together credit market, regulatory and rating agency views and evidence.
Similarly on valuation, more complex metrics such as embedded values for insurance companies are genuinely useful and the metrics can be applied globally to exploit inefficiencies. Combining this specialist knowledge with our common language on stocks is the key to cutting through the noise on any individual stock idea.
HW: What is your approach to managing risk?
PS: The management of risk is integral to the investment process company-wide, and in essence our process can be described as being a bottom-up stock-picking approach with a risk overlay. For example, I have a risk analytics tool on my desktop so I can perform real time analysis of the portfolio's risk profile as and when I choose.
In conjunction with the risk team, we manage risk budgets, analyse investment ideas, discuss portfolio positioning and review the fund's beta-adjusted exposure. We have no sector limits on the fund, but to give us a realistic view of potential short-term downside risk, we analyse value at risk over a two-week period. Because we all work together on one floor in our Edinburgh office, we readily communicate face-to-face so any potential issues can be tackled head-on.
We also have an industry-leading risk model that lets us customise and decompose portfolio risk in numerous ways. Multiple stress-testing gives us the flexibility to analyse the potential impact of changes in macro factors and look at 'what if' scenarios for the fund over various time periods.
Of particular relevance is the way Len and I run the balance sheet on the fund, as we find this an effective way of managing downside risk. The fund has a gross exposure range of +60 per cent to +200 per cent, and a net exposure range of -50 per cent to +50 per cent, with maximum position sizes of 8 per cent on the long book and 6 per cent on the short book.
At the beginning of the third quarter of last year, we looked at how we could use the net band more effectively and have generally been running with lower net bands in the region of -10 per cent to +10 per cent.
Working closely with our risk team and making best use of the net band has helped us contain volatility of the fund through recent turbulence. For example, in the six months to the end of April, the fund was up 2.1 per cent while the MSCI ACWI Financials index was down 13.3 per cent.
HW: Has your performance met expectations? Do you expect your performance or style to change going forward?
PS: We have been pleased with the way the fund has performed since its launch 23 months ago and firmly believe we have shown the ability and skill-set to fulfil the fund's objective of consistent returns regardless of market conditions. For the 12-month period from launch to the end of May 2007, the fund returned 9.8 per cent compared with a return of 23.8 per cent for the MSCI ACWI Financials index.
For the remaining 11 months to the end of April, the index is down 16.4 per cent, but Len and I have effectively managed the downside and returned 2.1 per cent on the fund, with which we are extremely pleased.
It's important that we can demonstrate upside capture as well as protection in down markets, and these contrasting market conditions have allowed us to do just that. Looking back, the fund's realised non-correlation with market returns is particularly pleasing, as well as that alpha generation has been evenly distributed between long and short ideas.
The elements we believe drive stock picking have been shown to work and, despite the recent volatility, we kept faith with this process and it has paid dividends for our investors. One of the greatest challenges for us was to identify which factors have the greatest impact on the market, and to do this we changed our focus to put the emphasis firmly on balance sheet strength.
The financials universe clearly turned on its axis as investors refocused on financial strength and assessing balance sheet quality. We don't expect this to change any time soon, and a clear focus on balance sheet metrics should enable us to make consistent returns regardless of market conditions.
HW: What opportunities are you looking at right now?
PS: We are revisiting Japanese financials given a more helpful inflationary environment and the fact that they generally are locked into a very different credit cycle.
We continue to see potential for long ideas in global insurance sectors, especially in non-life, where we see low capital market risks, strong over-reserved balance sheets and increasing M&A potential. In some cases the pricing cycle suggests negative change, but other non-life stocks look like a combination of positive change (earnings outlook), cheap valuations and quality balance sheets. This combination defines a potential long idea for us.
On the short side we see ongoing negative change from earnings disappointments and necessary balance sheet rebuilding in many large cap developed market financials. European bank balance sheets remain vulnerable, whereas in the US a negative credit trend is more clearly established but balance sheets are generally less stressed and here the risk/reward on potential shorts is different. There is clear evidence of short alpha potential within financials given that credit cycles tend to involve multi-year trends that represent negative change.
HW: What developments do you expect to see in your sector in the year ahead?
PS: We anticipate lots more capital raising and/or dividend cuts in the banking sector, and ongoing deleveraging from developed market banks. The key to overall performance will be to what extent the real economy gets hit and how quickly mainstream credit - as opposed to exotic asset classes - deteriorates. We expect few developed market banks to show non-correlated credit trends - they may play catch-up with the current US experience as the issues broaden further across asset classes.
Pure capital markets stocks such as investment banks may become more interesting as the exotic asset classes stop falling in value and these institutions have a history of reinvention and recovery. Counterparty risk will remain very high and this ever-present risk will mean many financial stocks will trade below normal valuation bands.
There will be M&A activity in financials, which is likely to be dominated by distressed assets changing hands. Correlation of stocks is likely to be less precise than in recent quarters unless there is a very aggressive move in overall markets.
HW: How will these changes affect your own portfolio?
PS: On a stock-specific basis, if balance sheets are decisively repaired we will look to become more positive in these instances. We do expect to buy into recovery stocks and have done this with the likes of SocGen.
At some point the emphasis will shift for the wider sector from balance sheet risks to earnings upgrade potential and growth. This generalises a little, as we think the global financials sector contains uncorrelated sectors and geographical regions, and thus these shifts are constantly occurring. This gives us long/short potential regardless of overall markets moves.
The potential recovery in investment banks needs monitoring, as it is likely to be very powerful. More M&A activity will make it tough to generate alpha as strong short ideas can go wrong in this environment. Near-term lower correlation of stocks will help us generate alpha.
HW: What differentiates you from other managers in your sector?
PS: An objective stock-picking approach based on firm criteria, which also give us a common language on stocks. We also enjoy global access to companies given that many of our global colleagues are located in a single venue, promoting short lines of communication. Finally we rely on alpha generation, both long and short, rather than beta to deliver returns, so we largely avoid the difficult task of calling market direction.
HW: Do you have any plans for other product launches?
PS: Martin Currie currently manages eight equity long/short funds. These include regional equity funds investing in Japan, Asia, China and Europe, along with sector specialist funds investing globally in the resources, energy and, of course, financial sectors. We also manage a market-neutral UK equity fund.
Our most recent launch was the Martin Currie Omnium Fund, a fund of hedge funds that gives investors blended access to the entire range of Martin Currie hedge funds with no additional layer of fees.
We manage the growth of our hedge fund range in a controlled way, launching new funds only where our internal skills intersect with proven client demand. We always run model funds internally before taking them to market - our investment team is currently running five model funds.
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