The Billion Dollar Interview:
Davide Basile, Partner/Head of Convertible Bonds of RWC Partners
Davide joined RWC Partners in January 2010. He was previously head of convertible bonds and lead portfolio manager at Morgan Stanley Investment Management where he managed a range of pooled and institutional convertible accounts including the Morgan Stanley Convertible Bond fund. Davide worked at Morgan Stanley for nine years, working in both the investment management and private wealth management divisions. Prior to this, Davide worked in the telecoms industry.
Eurekahedge: What were you doing before RWC and what were your motivations behind moving to RWC?
David Basile: Prior to joining RWC, I was with Morgan Stanley managing convertible funds at Morgan Stanley asset management. I had first joined Morgan Stanley in April 2001. I had been there quite a long time and was managing convertibles, or involved in the management of convertibles from around the beginning of 2003. Pretty much my whole career I have been involved with the convertible asset class. At the end of October 2005, I took over as head of the team at Morgan Stanley.
I decided to join RWC because it was a firm which was solely focused on the asset management part of the business whereas within an institution, as you are very well aware, there are different parts of the business. I wanted to focus just on the convertible asset class and the asset management side. RWC for me was a perfect fit because that’s the sole focus of the firm – looking at different strategies for asset management and being able to just focus on that for me was a great opportunity.
EH: Could you give an overview of the RWC convertible fund strategy? What sort of qualitative or quantitative research goes into your investment decisions?
Basile: The strategy itself is relatively simple in what we try to achieve. What we try to provide is a portfolio of convertibles which offers, in our view, a very attractive convexity, with an emphasis on capital preservation. So what we try and do is provide upside with equity markets with a certain level; a meaningful level of protection on the downside and we do this in a number of different ways. We have a lot of quantitative screens to look at individual convertibles in themselves but we also have a lot of technology that aggregates the portfolio and then aggregates the different components of risk.
The main criteria that we try and provide is a balanced delta profile, usually between 30 and 50. We feel that this is an attractive level because you have a good degree of participation but also you are not too far from the bond floor so your premium to bond floor is relatively low which is something, especially in these markets, for us is very attractive because as equity markets take a little bit of a breather and just concerns with growth, the convertible assets class naturally adjusts down in delta. That natural adjustment downwards is what we look at and what we measure in terms of convexity. In technical terms we call that the gamma of the portfolio which is how quickly the delta of our funds readjusts down or up. It is always positive so equity markets going down, your delta naturally goes lower, equity markets going up, your delta naturally goes higher.
That is what we try and provide from a profile exposure of the fund and we do that in the context of a very liquid portfolio. We have a daily liquidity fund. We try and focus on the better quality rated names so we always have more than an investment grade rating on the funds as an average. That does not mean we do not invest in some of the high yield bonds but on average we have an investment grade quality fund. Those are some of the technical dynamics we try and provide to the fund. We don’t invest in synthetics. That tends to reduce the liquidity and also tends to reduce the convexity of the portfolio. Any structural product is something we avoid completely. We hardly have any mandatories or preferreds, just because they tend to have a slightly different profile to what is our optimal. In that sense, it is a very vanilla product with regard to convertible bonds.
That is just the quantitative side; there is a lot of work as a long-only fund that however goes into the underlying names. So ultimately we are a fundamental product, we do a lot of research on the credit and on the equity of the individual names. So we tend to know a lot about the majority of the convertibles we invest in and I don’t mean the technical details of the convertible, I mean the actual company.
There is a significant amount of fundamental work that goes into the individual names and we also have a macro overlay that we try and put to the fund. So for example we can target delta levels and sectors and regions and we can just aggregate that risk. So for example if we feel that Asia is going to outperform, we can have a slightly higher risk budget to delta in Asia as opposed to Europe or as opposed to the US. And so, we do that constantly and actually we’re very transparent in our information and we provide that data on a monthly basis.
In essence it is a very simple strategy, there’s a lot of work that goes into the fundamental names and into the aggregation of the risk. But ultimately what we try and do is we provide a very balanced portfolio that fits very well within a multi-asset class mandate and it gives a lot of our clients a very good level of diversification because we target the 30 to 50 delta range, we have a good exposure to implied volatility which has to have a diversifying benefit within our multi-asset class portfolio.
EH: Does the fundamental analysis take precedence over the quantitative model i.e. do you strike out the companies that you don’t want to invest in and run the quantitative model on that or do you have a model that generates names and you decide from them based on your fundamental research?
Basile: It is a combination of both. I would say the most important dynamic is the fundamental analysis of the underlying companies. To give an example, we would buy an expensive convertible if we like the credit or the equity - but we would not buy a cheap convertible if we were not comfortable with the equity’s credit. Obviously we want cheap and fundamentally attractive but you cannot always find that. If we have to choose an aspect that we have to forgo, it is the cheapness of the convertible because the technical dynamic, although it is important, is not what really provides the capital preservation or the long term upside. I can have 3 points of cheapness in a convertible but what’s going to make the 20 to 30% return on the name is if we get the credit and the equity right.
So ultimately it really comes down to the fundamentals of the underlying names. But there are situations where the technicals might tell us to sell a bond. For example, there are some names in the US and Europe which we actually find attractive from an equity and credit perspective but the convertible is way too expensive. Even if we may be right on our view of the equity going higher, or the convertible credit spread tightening, our viable activity may already be reflecting that and the convertible is trading - so expensively that there will be no returns to be made. So, ultimately, it is the whole package but if you were to ask me which one of the two is more important, it would have to be the fundamental. I suppose that’s kind of the difference between a long-only kind of outlook to convertibles as opposed to a hedge fund approach.
EH: You have delivered some admirable returns over the last couple of years. What were some of the key themes that enabled you to deliver this performance?
Basile: It is a combination of what we mentioned. The emphasis on capital preservation and the fact that we really do focus on that convexity component. What that means is if equity markets rally, we do participate but by also focusing on the convexity obviously you never go up in a straight line. When you do have the bit of a drawdown or pause on the markets, you tend to protect a lot of that capital. When markets stop recovering again, you’re starting from a much higher base. It is the ultimate diversification tool.
I think it is this combination of providing the adequate profile for a convertible fund combined with a fundamental analysis of the names that we have to try and avoid some of the big credit blowups that we’ve seen in recent years or try and capture some of the very attractive returns that some individual equities have been able to generate. We do not always get them all but hopefully with the work that we do we can participate with a good portion, while avoiding a good amount of some of those names which don’t perform as planned.
EH: Although the 2008 return of RWC global convertibles fund was negative, it was relatively better as opposed to other absolute return funds and the markets. Most absolute return funds lost significant value during the financial crisis, which managers do you think were better positioned to handle the situation?
Basile: One of the things that was important in 2008 was liquidity more than anything else. Managers who have an ability or had been managing daily liquidity products for a long period of time have a bit of an edge over managers who are either weekly liquidity or monthly liquidity or have products or investments which were not easily realisable. Some funds, although they were negative, were better during the crisis than others. Those are the funds that were able to maintain liquidity and able to deal with the aggressive redemptions that most managers were facing.
That was ultimately the crux of it because whatever performance number or index you were comparing to, it was not a proper comparison because the difference between the bid and the offer on bonds was 10, 15, 20 points. You could pretty much name any kind of level you wanted. When you are going to the market and say “Can I have a price on this?” and you hear someone who replies between 50 and 70, how do you mark that bond? What is the correct price to mark it? The index takes 60 and then you have to sell at 50? That is already 10 points difference. So I think 2008 was a very difficult time to compare managers, it was a very difficult time to look at index performances because the index valuation on any given day was not a true reflection of what could be sold or bought for that matter.
EH: What kinds of risks are involved in investing in convertible industries and what sort of risk management tools do you have in place to minimise the risk of your portfolio?
Basile: When you try and quantify risk, with any investment there is obviously risk of default in the asset class on any individual name in corporate investment. It is the same risk you will have in any corporate bond portfolio whether it is investment grade or high yield which will obviously lower down the yield terms, the bigger the risk. But if you look at historically, the defaults and converts, it is not any significant additional risk to a normal asset class.
If you look at the performance of convertibles and consider 2008, as probably the worst year for asset class, we are significantly above those levels whereas equity markets are not. What you see is you have the asset class which is essentially doing what it is saying otherwise it provides capital preservation on the way down even with a year which was considered by many as the worst year for the asset class and valuations which really did not represent reality and we saw how quickly the returns to normality in 2009. So if you look at the performance of the asset class within this period of significant financial distress in the market, you see the volatility of the asset class.
Those are some of the risks you have, that are now more so than some of the other products. One of the risks that I think is probably the more relevant is that funds or asset classes tend to be smaller in general. The market cap of our products is about $450 billion dollars. You compare that to listed equities or bonds, we’re talking probably 15% of that market for equities or bonds. The asset class is smaller. So the risk is in liquidity, which is what happened in 2008, whereas if you have a significant portion of your investment in convertibles, if you go through a period of liquidity stress you might have to take a valuation discount to exit the position. If you have a longer term view in your investments, you can mitigate that risk a little bit because if you invested in 2007 and kept it through 2008 to 2009, right now you would still be profitable. It is more of a liquidity issue given the asset class size compared to some of the other products. It is also a relative risk.
If you are investing from convertibles, this is a question that I get, “Where do I place it? For example I have a portfolio of bonds and equities, should I sell bonds to invest in convertibles?” You are introducing a different kind of risk or a market dynamic whereas you have more exposure to the equity markets but not from the same degree so if you are looking at it from a cash basis and I say well I would rather invest and convert, so I invest in cash then you have some mark to mark risk because you could go negative. At the same time if you are looking at it from the point of view of an equity investor, say “well should I sell some equities and buy convertibles?”, then you could have an opportunity cost in the sense that equities rise and you’re not participating as much.
Usually convertibles are a relative risk to something else. Ultimately the theory we subscribe to is, because we have convexity, ultimately you will beat a balanced portfolio if you go through more than one market cycle. Convertibles are always in second place as an asset class, when you compare it to equities or bonds. That’s a good thing. On the way up, convertibles are never going to beat your equity but they will beat your bond portfolio. Then on the way down, you’re not going to beat the bond portfolio but you will beat an equity portfolio.
EH: To what extent do you think your fund will be affected by changes in government policies and new regulations that are being put into place in the wake of the financial crisis?
CBasile: Changes in regulation are more of an issue for hedge funds. Regulations will impact on how convertibles can trade, there’s no doubt about that, but ultimately we stick to what our fundamental views are. It might change our timing to sell a convertible, or it might change marginally what convertibles we will buy but ultimately our profits are more fundamentally driven.
EH: How much interaction is there between the different RWC funds and how do you drive synergy?
Basile: That goes back to the original question of why I joined RWC. One of the attractive things is the calibre of some of the other investment managers that we have within RWC. Every manager here is a partner in the firm. What that means is there’s a real incentive for every manager to try and help everyone else. For example, if there is a really attractive convertible deal which is coming to market, I have an incentive to talk about it with the other managers that potentially invest in convertibles. That opens a dialogue for sharing models on companies that we build or sharing information from company business that we do. Because there’s no centralised process or investment decisions, each team retains their independence which actually assures survivability of the firm ultimately because if we all have the same view and it goes wrong, it puts into question, do we really need so many teams if they’re all doing the same thing.
Independence is vital from a business perspective for RWC and also for each team to develop their track record and their style and whatever we are trying to achieve with our long term return objectives. At the same time, this partnership that we all are in, it is an incentive and for me as a shareholder of the firm and for all the other teams to increase their assets.
We do a lot of note sharing. There’s no formal asset allocation committee that decides where we invest or what risks we do. We do have a meeting every two weeks, but it is not a manager meeting as such - it is one that we all go to and we talk about individual names, or if there’s any particular asset which has caught our attention. We just talk about markets and sectors and strategies; a general dialogue. It is actually very helpful to get some ideas from investors which have all been successful in their previous roles and have decided to become more independent and come into a firm which is solely focused on asset management. There’s no hardcoded decision but there’s a lot of open discussion between managers.
EH: You mentioned earlier that the RWC Global Convertibles Fund is a UCITS fund. Did you start off on a UCITS platform or was this more of a recent thing?
Basile: We launched the fund as a UCITS fund. We were quite early to launching UCITS; we launched our first UCITS at the end of 2006.
EH: Is there a particular class of investors within UCITS that you’re targeting like institutes or specific type of investors?
Basile: We tend to find proper institution investors like pension funds and endowments, like strategy and as do global private banks.
EH: How has the asset-raising environment been over the last year? Have you gained a lot of assets recently from capital inflows and do you see a lot investor interest in your fund in particular and in UCITS funds in general?
Basile: The asset inflows were very good actually. Since I joined last year we are up 50%. We were at 500+ million euros during January of 2010. We were then at 700 million+ euros during January of 2011. We are about 880 million euros right now. It has been constant and we have seen a lot of inflows beginning of this year and last year. We saw stable flows during the period to the summer months of last year with a pickup towards the tail end of last year. Our flow has been very good and the team is very stable, we have been here for a number of months now, so I think investors look at that. The track record has been good, performance has been good, flow has been very steady and we have had periods of markets up and down and that’s good for investors because they can see how the fund behaves not only in good times but also in not so good times. I think that’s something investors should focus on when they’re selecting a fund. It is great to have great returns but are you really investing in convertibles, do you have that capital preservation side or are you just like a quasi-equity product?
EH: Could you give us your short to medium term outlook of the global convertibles market?
Basile: We think that the asset class was very cheap in 2009 and 2010. I think 2011 with the exception of certain regions is closer to fair value. It is still cheap if you look at long term trends but broadly it is closer to fair value. Asia is cheaper than the US, which is cheaper than Europe; we are looking at those discrepancies from a regional perspective. Issuance is going to be better than the last three years but it is not going to be phenomenal. We have seen Asia becoming the dominant region from an issuance perspective which we kind of like. When you start having rates increase in the developed world a little bit more, that’s when you’re going to start to see a bit more of an issuance pickup.
Broadly I think what the convertible market offers is a good level of convexity right now, the participants in the market are still skewed to the long only space, so you don’t have the dynamics that you had in 2008 where you had a lot of hedge funds leveraging up and causing problems of liquidity.
This is an environment which we like because we think it is picking up and all the markets are probably going to correct a little bit and we think the valuations are attractive.