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Opalesque Futures Intelligence

Founders Q&A: Lessons from the dramatic rise, fall and revival of Bayswater, a global macro fund originally seeded by Man Group.

Thursday, February 04, 2010

Lessons from Tough Times

Our guest, Eva Xu, provides insight about macro investing in turbulent markets. Her understanding of this topic evolved during the dramatic rise, fall and revival of Bayswater Asset Management LLC.

Dr. Xu and Daniel Schuessler founded the firm in May 2004 with $25 million from Man Global Strategies, part of Man Group. Man’s investment grew to over $900 million and Bayswater’s total assets reached a peak of $1.14 billion in August of 2007.

Returns were strong and the business appeared to be an exceptional success story. In May 2007, Man introduced a new capital-guaranteed product that combined its AHL, Bayswater and four Man Global hedge fund portfolios. The combination was attractive because Man’s AHL and Bayswater had low correlation with each other. Bayswater’s longer-term macro approach complemented AHL’s short- and medium-term trading.

Then came the quant meltdown of 2007, which in retrospect appears to have presaged worse to come in 2008. Bayswater did not lose as much as some hedge funds, but nevertheless its loss was in the double digits. The partners returned money to investors and rethought their system, as Dr. Xu explains.

Bayswater launched a new global macro fund in July 2009, backed by former Man Group chief Harvey McGrath’s Revere Capital Advisors. Some of the founders of Revere knew the Bayswater team from the association with Man. They’re taking an equity stake in the firm.

Prior to starting Bayswater, Ms. Xu and Mr. Schuessler were directors at Mellon Capital Management, where they worked together for seven years. By the time they left, she was a director of research and he director of hedge funds.

Subsequently she became vice president at Aetos Capital’s fund of hedge funds division, responsible for portfolio construction. She has a PhD in economics and has served as a consultant for the World Bank.

For more about risk control takeaways, see Futures Lab, the next section.

“From a risk/return tradeoff perspective, it is much better if you can make money from cross-sectional trades with market neutral bets.”

Opalesque Futures Intelligence: How did you get into futures trading?
Eva Xu: My partner, Daniel Schuessler, and I were part of the original team that developed Mellon’s Global Tactical Asset Allocation business, which I joined in July 1995 and he joined some months later. We revamped the system there so as to add countries, currencies and asset classes. This was a big business, with over around $20 billion in the GTAA fund, managed accounts, hedge fund, currency overlay and other investments when we left.

OFI: What is Bayswater’s strategy?
EXu: Our strategy is bottom-up fundamental, with relatively long-term, big-picture, economic fundamentals-driven bets. It is not trend following and has low correlation to a trend-following program like Man’s AHL, so Man Global Strategies originally seeded us as a way to diversify their offerings. We trade global equity indexes, global government bond indexes, currencies and commodities, with a focus on developed countries.

OFI: Have you changed your strategy in recent years?
EXu: It is the same basic strategy that we previously traded for Man Global Strategies, but we added a lot of downside risk management in the past two years.

OFI: Does that mean you have become more discretionary?
EXu: Our core strategy remains systematic. For instance, to trade stock indexes, we collect all earnings information for the companies in the indexes. That data and country-level inflation and GDP growth forecasts all go into a valuation model that gives us expected returns at company level. Those are aggregated at index level and combined with risk and correlation measures for countries. This systematic process led us to go long Europe and short Japan in 2009.

OFI: Why short Japan when there’s a recession in Europe as well?
EXu: Earnings are down in very country because of the recession and analysts have downgraded earnings prospects across the world. But in Japan the downgrade was much larger. Our model indicated a great opportunity.

OFI: How do you factor in expectations of future earnings?
EXu: We use analysts’ consensus earnings growth forecasts for next year and beyond. That is forward looking data and under normal conditions that’s what the market prices. What’s interesting is when bottom-up and top-down forecasts diverge significantly, as happened in late 2007. Top-down analysts priced in recession, but that did not show up in the forecasts of bottom-up analysts, whose skill set is to look at individual companies, not whole economies.

OFI: What happened then?
EXu: This is the hazard we came up against. Going into the recession, analysts’ forecasts were behind the curve. If the input going into a model pretty is bad, so is the output. It leads you to double down and double down again. After that experience, we added a risk overlay that kicks in when top-down and bottom-up disagree widely.

OFI: What do you mean by risk overlay?
EXu: The overlay is not an input for the regular model but an indication that things are going wrong. It indicates the probability of recession and/or crisis. There are times when analysts miss the boat, so we need another indicator that will move us to a different model. We don’t expect this to happen frequently, only once every several years, depending on business cycles. It took work to construct this indicator because data services’ top-down coverage is very thin. Top-down forecasts were popular for a while after the 2002 recession but afterwards people lost interest. Continuous series on top-down consensus don’t exist and we have to collect the data ourselves.

OFI: Is the overlay itself computer-driven?
EXu: We have not turned into a discretionary manager. When the computer indicates that the overlay is needed, we switch to a model that can deal with the different environment. What we may do manually is to clean the data. We have a lot of experience with that. We run all the models every day at the end of US market closing. Any data that comes out in the previous 24 hours is collected by the end of day. A lot of data collection is automated, but you have to make sure the integrity of data is maintained at all times. We keep in mind the adage, “Garbage in, Garbage out”!

OFI: What other risk indicators did you add since 2007?
EXu: We use long-term credit measurement as a signal of the equity market cycle. This is not to be confused with the business cycle— the equity market cycle leads the business cycle by six to eight months. The data we use – high-yield spread – is easy to get. In 2009, the spread was dropping like a stone, which told us to move into equities. Timing is very difficult in recovery. Our new model performed well. We launched the fund in July and through Nov were up 11.5%.

OFI: Have you made other significant changes?
EXu: We have made our trades faster. This is something we realized we can do to improve the return distribution on a daily basis. In cross-sectional equity trading, for instance, we added short term mean-reversion components to the valuation-based strategy. That shortened the half-life of cross-sectional trades. But we’re not a short term trader. Our equity cross-sectional positions average six to eight months. Directional bets take longer, because they’re tied to the market cycle.

OFI: Would you give an example of a cross-sectional trade?
EXu: A cross-sectional is a relative bet. For instance, in part of 2009 we were long equity, short bonds. After the 60% stock rally, this bet has run its course, so we’ve dramatically reduced the position. Once it is off, we may put on commodities. In most of 2009 we did not trade commodities. A lot of the time we do not make directional bets, because cross-sectional strategies are more reliable. They have higher Sharpe ratios and lower risk than directional bets. From a risk/return tradeoff perspective, it is much better if you can make money from cross-sectional trades with market neutral bets. We were long the Australian dollar, the yen and the euro, while being short the US dollar, during most of 2009. We got out of the AUD briefly because the valuation became too extreme.

OFI: Is this a carry trade?
EXu: It is similar to a carry trade but not exactly because we adjust the picture for expected inflation. For instance, many traders were perplexed by the yen going up. But that was due to fact that Japan has deflation, so even with zero nominal rates, it has positive real interest rates! By contrast, the US is subject to inflation, so it has zero or negative real interest rates. That theme made money for us in ‘09.

OFI: Did you run into bottlenecks when your AUM went over $1 billion in 2007?
EXu: We don’t have the same capacity constraints that can affect CTAs. We’re not a high-frequency trader and we do not trade single names. Anything we do is a little drop in the market bucket.

What do you see in the future?
EXu: There will be downturns again, you have to be prepared. We want to diversify within our own portfolio and are adding more volatility-loving components, in particular commodity strategies.

This article was published in Opalesque Futures Intelligence.
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