Julius Baer Investments Ltd is preparing to roll out a third fixed income hedge fund in November this year. Tim Haywood and Stephen Lucas trace the progress of the London-based fixed income hedge funds unit at Julius Baer and share their investment thinking.
HW: What is the background to the fixed income business at Julius Baer.
TH: Julius Baer Investments Limited has just celebrated its 20th birthday. It was formed in the early 80s to act in fixed income principally for US state pension plans and associated ERISA money.
That's grown from the international bond mandates to being global bond mandates - again long only - for central banks and supranational investors etc and is now a business with USD 5 billion in assets under management.
This model has been successful for 20 years. The problem is that potential returns from international fixed income are fairly constrained. Imagine that your benchmark is 40% in JGBs and last summer when 10 year JGBs were yielding 0.4, a significant part of your benchmark is mathematically constrained. So nearly three years ago we began to look at developing solutions to these constraints.
HW: How did you solve the problem of these constraints?
TH: We had skills - we managed to make money for our customers in the fixed income and currency markets - but we wanted to know if could turn those skills to a product that made money in all markets - a hedge fund - and delivered LIBOR plus 10% after costs, with four times gearing.
We then considered what extra skills we would have to learn to execute these strategies. I had been running absolute return money in Asia for four years and my colleague, Tom O'Shea was a derivatives strategist and trader from Commerzbank, so it became quickly apparent that we had all the bases covered expect for repo, a skill which we learned.
HW: Who are the key players on the hedge fund team?
TH: Tom O'Shea and I look after the Julius Baer Diversified Fixed Income strategy, Tom's particular expertise is on interest rates and G13 and my expertise is focused on the junior markets, although we also have experience of dealing in each other's areas.
It's really a five-man team, which we expanded to six this week. The other person on G13 interest rates is Adrian Owens, we are assisted on FX by Andrew Snowball, and on emerging markets by Paul McNamara and the new man on the team is Darren Reece, previously with ING, who will look after the credit aspect.
These six people contribute ideas across all aspects of the business, from long only to hedge funds, a separate team does the execution for the long only accounts.
We don't do mortgages and we are not volatility traders, so we don't have those skills here.
HW: When did you launch your hedge funds?
TH: In January 2002 we launched the Julius Baer Diversified Fixed Income Hedge Fund. It is backed by Julius Baer - in terms of both reputation and capital - it is principally a relative value offering so it is not as capital intensive as many of the arbitrage strategies but it is meant to be non-directional in terms of interest rates, with a duration of +/-3 years or normally +/- 1 year.
At the beginning of this year we launched a second strategy called the Julius Baer Global Rates Hedge Fund. This concentrates on FX and interest rates, and is directional with a duration of +/- 8 years.
None of our funds are allowed - by prospectus rules - to handle equities, commodities or real estate.
HW: Why do you focus on fixed income hedge funds?
TH: Although we do have equity skill sets in our New York and Zurich offices, we are predominantly fixed income-driven in London, this continues to be our core area of expertise.
If any bond and currency is fair game, there is plenty of alpha to be found in these areas. By one measure there are 60,000 bonds that you could reasonably trade so, unlike European long short equities, this is a genuinely large universe to trade.
HW: Would you call the Diversified Fixed Income strategy your flagship product?
SL: I suppose it is our flagship - that strategy has raised USD 1.2 billion so far in assets under management and is our first and most successful (to date) hedge fund. It has offshore and onshore strands and although it is technically soft closed there is still capacity within the onshore fund to cater to the appetite of US investors. The onshore fund is at c. USD 50 million and we would like to take this to c. USD 150 million.
That's not to take away from the second strategy, the Global Rates Hedge Fund, which is just under USD100 million (including USD 20 million of Bank Julius Baer 'seed' capital) and is just five months old (launched 2 January 2004). Because it is based on a one-legged strategy rather than a two-legged or multi-legged strategy, it has more capacity; its risk profile is also greater.
HW: What is the strategy behind the Diversified Fixed Income Hedge Fund?
TH: The principal trading areas of the fund are within the G13, the government bond and swaps markets and derivatives based around those of the US, Canada, Australia and New Zealand, Euro, Sterling, Scandinavia and Japan.
Common themes across those countries is that default is extremely remote, this is where 90% of our assets and 80% of our risk is. We also look at inflation-linked securities in those countries, and we look at FX between those countries.
10% of the assets and 20% of the risk is in the junior markets, where there is a chance of a big default - here our attitude is arbitrage, we trade Ford against Ford, Brazil against Brazil. This area has traditionally made good money for us -we didn't make as money as many did in 2003 because of our arbitrage bias rather than a naked long carry bias in junior markets. Our philosophy is to avoid long carry trades in junior markets because naked longs are a problem when you have an event such as Enron or Parmalat.
HW: How is your performance to date in 2004?
TH: The year-to-date numbers are approximately 5% for the Global Rates strategy and +1% for the Diversified strategy. This is disappointing after a tough second quarter. The good news is that the funds are out-performing the traditional long only benchmarks, are flat to cash, outperforming the equities indices. The peer group is also having a tough time in the main.
HW: It's been a tough second quarter for the industry, how do you feel about your performance in Q2 2004?
TH: We are disappointed with ourselves, because like all hedge fund managers we have the tools to make money in every market if we are right, and also to call it wrong and exit. What's annoying is that we predicted a fall in bond prices and a rise in yields, but they went further and faster than we expected.
HW: What is your outlook going forward?
TH: The problems of Q2 seem to be based around the position of liquidation. There has not been a truly dramatic change in the outlook for certain markets.
In the US, this is probably the most highly anticipated monetary tightening of all time and broadly as expected. There has been a slowdown in China but I don't think Chinese growth is going to stop and I don't subscribe to a 'hard landing' in China. I think they are fairly efficient at micro management and we are probably looking at 50 years of built-up consumer demand.
HW: What trends are you seeing currently?
TH: We do believe that risk appetite is coming back. The financial architecture is in good shape and I am not hearing of any major redemptions or any major margin calls, and money is still flowing into the asset class.
We are seeing a series of record positions, record underweight in US treasuries by speculators and record longs by commercials, who can hold their breath longer than speculators.
We are also seeing record underweights in currencies such as the Mexican peso and the Australian dollar which indicate that speculators have been involved there.
Taking Mexico as a case in point, we think the outlook there is very positive. Oil is high, which definitely helps Pemex, growth north of the Rio Grande is strong, growth in Mexico is also quite robust yet the Mexican peso has weakened to 10.70, an all-time low against the dollar.
We see similar dynamics in Australia where the CTA community seems to be very short on the basis of declining cosmopolitan house prices and one weak GDP announcement.
However, we definitely subscribe to a growth rather than an inflationary view of the world. We do believe that growth will be reasonably strong but that global capacity utilisation is still not at truly inflationary levels.
In that scenario, the Mexicos and Australias of this world should do well.
HW: What about Europe?
TH: European growth continues to be relatively disappointing. The Euro itself is relatively expensive and it's one of our chief funding currencies at the moment.
There are no dramatic problems in Europe but credit spreads are fairly tight and without growth the Euro cannot show the rewards that the currency markets give to other growth markets.
HW: What are the sources of your assets under management?
SL:. Our mandates are split roughly as follows: 20% private banking from Julius Baer; 80% institutional from FoHFs, Banks and Family Offices etc. We have a very limited amount from institutional pension funds/plan sponsors but that is an area we want to grow significantly within the second fund and potentially the third fund.
HW: How do you currently distribute your products?
SL: Julius Baer has a limited distribution capability compared with the larger banking/asset management houses so we maximise distribution through our private banking offices in locations such as (but not limited to) Lausanne, Basel, Geneva, Lugano, London, Zurich and New York. We also distribute through our institutional sales force based in London, New York and Zurich.
We are also going beyond these internal channels to building selected distribution relationships outside the bank. For example, we have worked with Dexion Capital targeting UK, other (Middle East, European, US) institutions and in the US we work with a placement agent called QMC targeting private clients. In addition we engage in considerable direct marketing to private banks, institutional FoFs and family offices which are not covered directly by Julius Baer offices, Dexion and/or QMC.
HW: What new products are you planning to launch this year?
TH: We plan to launch a fund with the working title of the Julius Baer Junior Markets Hedge Fund. The idea is that any asset that can have a 70% move is included, emerging market, both local and hard, credit of all categories, convertibles and some equities - under 10% of the fund - to allow us to accommodate arbitrage.
We are pretty much doing all of this at the moment, the idea is that it will be put into a separate fund managed by Paul McNamara and Darren Reece, and to a lesser extent myself. This fund will become the focus for all our junior markets activity.
It will have a master-feeder structure, Cayman domicile and a listing in Dublin and is scheduled for launch on 1 November.
The new fund will allow us to market our junior market capability. I think there is a demand for junior market product as we've seen from managers such as Crescendo.
It also extends our portfolio of fixed income products within Julius Baer - over the next 1-2 years long only fixed income managers are going to find it pretty hard to make big returns whereas we have the real capability to do so with our fixed income hedge funds.