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Interview with Jessica McCarroll, co-founder of Lynx Arbitrage Volatility Arbitrage Fund
Eurekahedge

February 2004

Lynx Arbitrage is an Asia Pacific, relative value volatility arbitrage fund with a stated focus of delivering optimal, consistent "risk-adjusted" investment returns uncorrelated to general market movements and trends by exploiting pricing anomalies between Asian Pacific stocks and related exchange traded derivative contracts.

Interview with Jessica McCarroll

  1. You are due to launch your fund in February 2004. Why did you choose to launch an arbitrage hedge fund? What experience do you have in this field?

    In short, we believe there is a very real opportunity to make money with a pure volatility arbitrage strategy in Asia, and we are uniquely qualified to execute such a strategy. We have been investing our own money in this exact strategy over the last 12 months in a pilot fund and have delivered 27.5% returns for the year, which we believe justifies our conviction. We also believe the timing is perfect for launching the fund.
    Nobody else is doing what we do in Asia and most hedge funds are not set up or able to execute our much focused trading strategy. Asia is dominated by long/short hedge funds, which do apply hedging techniques but typically hedge apples with oranges. At Lynx, we hedge apples with apples and are looking for pricing anomalies, not studying/screening balance sheets to look for absolute or relative stock out-performance. We are capturing Alpha, not creating it and there is no one else in Asia adopting this trading strategy or possibly even with the experience to execute it.
    Between the Lynx Arbitrage principals we have a combined 35 years of experience in the Asian and global derivative markets, and including VivianTing, our head dealer, we have 42 years of directly relevant experience to offer to investors. This experience spans from Lesley-Ann's many years running Exchange Traded Derivative Desks at Morgan Stanley and UBS Warburg, to my many years as an O'Connor trader, fund manager and hedge fund manager with extensive experience in managing derivatives arbitrage strategies, and Vivian's years both on the floor at the Hong Kong Futures Exchange and as a dealer at UBS Warburg. Lesley-Ann was also one of only two foreign nationals invited to sit on the Migration Committee when the Hong Kong Futures Exchange migrated to screen-based trading. So we feel our credentials are pretty strong for running this fund.
    In addition, Lesley-Ann and I are licensed Commodities Trading Advisors and Investment Advisors under the Hong Kong Securities and Futures Commission (SFC), while Vivian is a Dealer's Representative, Member Representative under the Hong Kong Exchange and Hong Kong SFC. The Investment Advisor is SFC-licensed and the Fund and Investment Manager are BVI-licensed.

  2. Who are the other key members of the team and what do they do?

    At present there are the three of us, Lesley-Ann, Vivian and myself, an all-girls team but more by accident than design. Lesley-Ann and I have known each other for nearly ten years, both professionally and socially, and developed the Lynx Strategy between us over a number of years of discussions. Vivian was Lesley-Ann's head dealer at UBS and jumped at the chance of joining us when we approached her.

    We have intentionally kept costs and headcount low for the past year while we have been running our own fund, and have called in a lot of favours and outsourced when it has made sense to do so. We intend to continue to keep costs to a minimum; however, we have identified two more individuals to bring on board as AUM rises, one in risk management and one in office management and administration. They are both very experienced in what they do and will make for a very well-rounded, experienced and happy team.

  3. Are there plenty of opportunities for arbitrage in Asia and which markets present the best?

    Our strategy is perfect for today's Asian markets as short-term liquidity is high, due to the issuance of covered warrants in Hong Kong, and the large and increasing retail activity generally across the Asian markets. In addition dividend yields are high and dividend growth is strong and above average in many blue chip companies in Hong Kong and Australia. As institutional and retail interest continues to return to the Asian markets, we expect the opportunities for our strategy to continue to increase.
    As I mentioned, our strategy is designed to take advantage of relative value differences in implied volatilities between say an index and a basket of component stocks. This strategy is uncorrelated to the markets' direction and more a function of retail liquidity. If retail/general liquidity increases it is more favourable for our strategy, even if, or especially if this means high levels of market volatility.
    Our strategy performs best in the markets of Hong Kong, Australia, Korea and Japan where liquidity is high in derivative markets. Our strategy would perform worst in say India or other Asian markets where derivative liquidity is currently limited.

  4. How extensively have you back-tested your ideas? What models did you use?

    Back-testing has been important for some parts of our strategies, particularly with respect to fine tuning of different strikes or expiries in certain specific market conditions or events like SARS, and also with respect to market depth. The best 'test', however, of our ideas is our performance running an identical fund over the past 12 months. We were up 27.5% for the year with little market correlation, and our numbers are all independently verified by Fortis, our clearers.

    With respect to models we have really had to develop our own proprietary models to deliver what we need, and these obviously dovetail into our risk management models.

  5. Which of the following strategies do you use: Index Arbitrage, Warrant Arbitrage, Stock Class Arbitrage, Convertible Bond Arbitrage, Option Arbitrage, Dispersion? Any others and to what extent?

    Our strategy can best be described as a hedged strategy designed to take advantage of relative value differences in implied volatilities between for example an index and a basket of component stocks or between different strikes on a particular index. We stick strictly to Market Neutral Volatility Arbitrage Strategies and are committed to allowing no style drift into other areas.

  6. What do you see as the main pitfalls in trading Asian markets?

    The main pitfalls to trading any market are 1) not understanding risk exposure, or 2) not quantifying risk exposure correctly.

    Even with our 42 years' experience at Lynx, we still have "Risk Measurement and Risk Management" as our Mantra. You can't make returns for investors without taking some risk, but it is all too easy, especially in Asia, to underestimate the level of risk being taken to achieve any given "unit" of return.

    At Lynx we are totally focused firstly on minimising our risk exposure and secondly on quantifying the residual risk we do take. For example, we keep our corporate risk exposure to an absolute minimum and we minimise our liquidity risk by investing only in the most liquid instruments and markets and only investing in Exchange Traded Derivatives (no OTC transactions).

    One of the virtues of our strategy is that it is inherently "risk-minimising" in that it is non-directional and we are hedging apples with apples to lock in Alpha generated by mispricing. If you like, our strategy happily gives away the "top-slice" of potential returns in exchange for the significant reduction in risk associated with those potential returns. We then lock in and maximise a lower risk return for investors.

    Another pitfall very specific to our type of strategy is the potential cost involved in setting up and executing derivative-based strategies in Asia. I am not going to give away all our secrets, but our combined experience has been extremely valuable in structuring the Lynx model and keeping our costs to an absolute minimum, which we believe will pay handsome dividends to our investors going forward.

  7. In your template you are very specific about the geographical split of your gross exposure. Under what circumstances do you envisage that ratio changing?

    Our strategy performs best in the markets of Hong Kong, Australia, Korea and Japan where liquidity is high in derivative markets and where opportunities exist to capture Alpha. We select the markets we operate in for the opportunities they offer, not for any diversification purposes, so should liquidity collapse in any one of the markets we would reduce our positions accordingly.

  8. What are your risk management measures? How is risk measured?

    We have three principal risk management processes: our in-house system; our outsourced subscription system; and our clearer's risk management system. The outputs from these three systems are cross-referenced at the end of each trading day.
    I am in charge of our in-house risk management model as well as utilising a very high quality external subscription risk management system.
    Fortis Clearing (HK) independently runs a daily VAR on our portfolio since they are our clearing bank, and delivers the results of this to us at the end of each trading day. Fortis is also in regular contact during the trading day should any questions arise.
    We measure real-time risk by portfolio delta, gamma, theta (time decay) and vega (volatility risk). We also monitor tracking risk on a real-time basis.

  9. What is your edge?

    We are unique in Asia, nobody else is doing what we do and to be honest, the barriers to entry in terms of experience, qualifications, market knowledge in multiple markets, etc, are pretty high.

    This uniqueness enables us to offer something to investors which is not otherwise available to them and provides much sought after diversification away from existing strategies they are invested in. We also believe we are offering investors exposure to Asian markets in a
    "controlled-risk" strategy at a time when volatility, and hence standard measures of risk, are likely to be high.

    We also feel that our most recent 12 month performance and our commitment to investing our own capital to produce the track record for investors to see, send a clear message that we have a well thought out strategy - we believe in it, we have tested it, we know it works, and we are sticking to it.

  10. Will you be rolling the funds from the pilot fund into the new fund?

    Absolutely yes, it will all be rolled into the new fund. Interestingly enough, the initial application for this idea a few years ago was as a low-risk strategy for our own savings. Now it has become a licensed fund we fully intend to keep our own money invested in the strategy, because we believe in it.

  11. Where do you see more interest in your fund coming from geographically and the type of investors?

    Investing in an early stage hedge fund will always have a personal element to it and we are no exception. Our initial investors include everyone from family and friends to wealthy European and Asian private investors to global institutional funds, with the common theme being people who know us well as individuals.

    Going forward, the people who are closest to being the next round of investors are not from any one region or group of investors but are people who really understand our strategy and are looking for diversification away from the long/short or long-only funds which are otherwise available to them. Other investors not so familiar with volatility arbitrage will understandably take longer to get comfortable with what we do and will be later stage investors.

  12. How do you find Hong Kong as the base for your fund?

    Hong Kong is very much home for all of us at Lynx Arbitrage. Lesley-Ann and Vivian were both born here and I have been here for 12 years and we have all been SFC-licensed for many years, so it is natural for us to be based here. Having said that, Hong Kong was a great market for us to start our strategy given our experience and contacts in the market as well as the healthy derivative market liquidity and our ability to trade direct with the exchanges.

    In addition, Hong Kong is the head office for Fortis, our clearers and administrators, which has helped us develop a very good working relationship very quickly that has been important in the implementation of our strategy.

  13. We note that you are using Fortis Prime Fund Solutions as your prime broker what are the advantages to this kind of service?

    At Lynx we do not have many of the same needs as most start-up hedge funds because we trade direct with the exchanges in nearly all of our markets, don't tend to borrow stock, and have considerable front and back office experience in what we are doing.

    Given our "out of the ordinary" needs, Fortis has been extremely flexible in providing us exactly what we require at a competitive price without having to pay for all the extra things we don't need. This has enabled us to keep costs down and will contribute significantly to enhanced returns to investors going forward. So far this relationship has worked very well for all concerned.

Contact Details
Lynx Arbitrage Limited
Hong Kong
+852 2866 3831
lesleyann@lynxarbitrage.com


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