Interview with Richard Hollington, Managing Director of 36South Investment Managers Ltd
Research into the New Zealand market indicated that investors were well served in terms of traditional market products but not alternative investments, especially hedge funds. As a result, 36South Investment Managers was incorporated in March 2001 to develop locally managed hedge funds investing in global markets.
After a period of analysis centred on LEAPS (Long Dated Equity Anticipatory Securities), 36 South Investment Managers launched their first fund in December 2001. That fund is called the Kohinoor Series One Fund (named after a famous diamond in the Crown Jewels), and invests in a combination of money market assets and highly leveraged long-dated out-of-the-money options. The Kohinoor Series Two Fund was launched in August 2005 to allow offshore investors to benefit from the same strategy applied to the Kohinoor Series One Fund.
To begin with, could you outline the key features of the Kohinoor Series Two Fund such as, say, terms of liquidity and redemption, incentive fees charged etc?
The Kohinoor Series Two Fund operates on a monthly cycle of issues and redemptions. There is an initial lock-up period of six months which we think is reasonable considering the average length of the instruments we trade is three years. The fund is based in the Caymans and is set up as an exempted company with limited liability. The fund’s administrator is HSBC Hong Kong, auditor is Rothstein Kass and solicitor is Walkers. The fees charged on the fund are 1.75% management fee paid monthly in arrears and a 20% performance fee which is paid quarterly in arrears and is subject to a high water mark.
Is Kohinoor’s strategy markedly different from a conventional market neutral strategy? For instance, the Eurekahedge Arbitrage Hedge Fund Index, like the fund, is also up 140% over the last 4 ½ years, and has a positive/negative month pattern similar to the fund’s, suggesting a high correlation.
I would say that the strategy is markedly different and the correlation is spurious. The Kohinoor Series Two Fund is a bottom-up strategy which selects the best option opportunities available in the universe of assets which we monitor. This could at times create a market neutral type position but it is certainly unlikely to be market neutral over time. Depending on the quality of the opportunity the fund could conceivably be heavily biased in favour of bullish or bearish market moves.
On a related note, could you give us a brief overview of the niche that the Kohinoor Series Two Fund pursues, and the edge it has in that playing field?
The Kohinoor Series One Fund is a global-macro absolute-return fund.
Our investment process is two fold – firstly identifying global macro opportunities and secondly, picking the right instrument to garner the most profit for the least risk on the opportunities discovered.
We use the feedback approach to macro trading. The underlying philosophy is that markets are rational most of the time but 5% of the time rationality gets thrown out of the window, whether because people have made money too easily and become complacent or have lost money too quickly and are so distressed that they are off-loading assets below their intrinsic worth. The emphasis of this approach is market psychology. We search for fear, greed, hysteria and mania. We sell into a bubble about to burst and buy into a post-crash recovery. Bubbles as we know, can take time to play themselves out over an extended period of time and their turning points are normally associated with high volatility. This makes the method of investing in an opportunity critical. Normally it is better to wait until the bubble is bursting as the markets tend to go a lot higher or lower than one thinks. The downside to this is that the move might be over in a short period of time. Happily there is way to have one’s cake and eat it too!
We use an investing methodology that allows us to position ourselves before the bubbles burst with risk of getting “run over”. In fact we believe that we get very undervalued investments principally because of the sentiment in the market at the time.
Our investment methodology is to BUY ONLY long dated “out-of-the-money” options.
This methodology has some excellent features.
Firstly these options can return multiples of the original investment. We look for options that have the potential to return between 5 and 10 times the original investment. Because of their high reward characteristics, only 10-20% of the fund need be invested in these options to achieve our target returns of 15-25%. Our worst case loss is thus known, being the amount invested in options.
Secondly because they are long dated (between two and five years), time decay is not a major feature. We do not hold options which have less than a year to run. The long time value allows us to wait for a situation to unfold without fear of getting whip-sawed. It also ensures that losses in any one year are minimised as options will always have time value regardless of whether the market has moved against them or not.
Thirdly, because we buy “out of the money” options, we normally can put on an initial nominal position in excess of what we would be able to if we were to put on a spot position, ie if we wanted to put on a US$100 million short position spot, we could buy nominal US$300 million out of the money options and risk LESS than the US$100 spot with a stop loss!
Fourthly, options are generally mis-valued during periods of irrationality giving great risk/reward possibilities.
In summary then, our methodology is aimed at increasing the odds in our favour by piecing together tell-tale signs in the market. So we search for what we think are “irrationally” priced markets and then search for mis-priced instruments within that market ie long dated options. We are looking for two diametrically opposed situations, one in which the market has become massively overbought through rampant speculation and greed and one where the markets are massively oversold because the investors have become disillusioned and fearful and do not want to be involved in the market. Piecing together information which is useful in improving the chances of a betting on a rare event comes from a multiplicity of sources and will vary from market to market.
The first step of our process is to identify our asset universe. That is, all assets where one can source long-dated OTM options. Next we further limit ourselves (and improve our probability of success) by ensuring we never buy “expensive” options. Our rationale here is that one can never get killed jumping out of a basement window!
Also in order for our macro view to be right timing wise, the options should seem inexpensive to an investor with perspective. The macro opportunity could be great but by implementing the strategy using expensive options, we are significantly reducing our reward potential and thus our probability of success.
We identify inexpensive options by looking at an option’s major price determinant, implied volatility and comparing it to its long-term average. This will quickly give us a good indication as to whether it is expensive or cheap historically. Having identified a list of assets which have reasonably priced options, we can then look for the high potential global macro situations. We zero in on these situations by using our in-house developed “Quadrivium” Methodology.
Quadrivium literally means where four rivers meet and a strategy which conforms to criteria required in each of the four circles in our approach will be selected to form a portion of our risk portfolio. The four criteria are used in conjunction with each other in order to “ensure that one reality respects all other realities” as Charlie Munger put it so well. These criteria are:
Volatility has already been covered. We ensure the option (using volatility as a proxy) is cheap enough to provide the leverage we require for the level of risk.
The next criterion is to look at the technical picture of the market to seek confirmation that there is potential for market movement to the extent and in the direction that we require to attain a multiple return on the option price.
The next criterion is fundamentals in that market/asset/option to corroborate our view. We have developed a framework of economic indicators that we monitor in each of the markets we have selected to trade. We are specifically looking for flaws in the structure of markets which are caused by government policy and supply demand imbalances.
The next step in the process is based on the sentiment prevailing in the market that we wish to trade. Sentiment often becomes deeply entrenched at market tops and bottoms to the extent that supporters of the status quo can become aggressive in defense of their beliefs. In order to gauge the prevailing sentiment in the market we use Internet searches for key words and couple this with feedback obtained from diverse media coverage. These media opinions can reflect ‘irrational exuberance’ or deep-seated pessimism on a particular stock, index, commodity or currency. These quotations from seasoned professionals in the financial markets encapsulate the essence of this driver of our trading philosophy.
“Everything I have experienced suggests that, at core, economic conditions and markets are grounded in the human psyche” ~ Robert Rubin
“What is so intriguing is that this type of behaviour has characterised human interaction with little appreciable difference over the generations. Whether Dutch tulip bulbs or Russian equities, the market price patterns remain the same.” ~ Alan Greenspan
The Kohinoor Fund is searching for opportunities where the payoffs are multiples of the original investment and therefore the majority of ideas that appear on the radar screen are never traded.
Once a strategy has run the gauntlet of the “Quadrivium” approach, we know that the strategy has a significantly enhanced probability of success and would look to include it in our risk portfolio.
What went right in your best month (+15.2% returns) and your longest winning period (six months)? Can you put an estimate on the alpha-component of these returns?
We ascribe the large gains in the fund to the excellent trading features which are inherent in long dated options. As markets move in the direction of the option strategy the options pick up leverage and volatility often increases. The option is acting like an automatic trader adding to winning positions and trimming its position when the market goes against it. Options allow you to stay in the market to capture the big moves when real money can be made. If we look at the global macro index for the last three years, our Kohinoor Funds have outperformed by a considerable margin and this is what we estimate as being the alpha added by 36South. This was by 30% in 2003, 11% in 2004 and 18% in 2005. For 2006 to end of May, we outperformed the global macro index by 1%.
It is stated that returns volatility (annualised standard deviation of returns since inception equals 15.8%) should dampen as the portfolio gets more diversified. In what direction would this diversification be?
As we attract more investors we will increase the research team and more markets will be analysed. This will unearth more opportunities (especially in individual stocks) and this will add to the diversification of the portfolio as they are included as risk assets.
What is the current breakdown of the fund’s portfolio? What are the typical holding period of an investment and turnover of the portfolio?
Kohinoor Series Two Fund as at 31 May 2006
Percentage of fund
USD swaption Deutsche
USD swaption RBS
AUS swaption RBS
SP 500 calls
Japanese interest rate swaption
Japanese yen puts
Funds under management
On average, options are held for one year and turnover is 30%.
What is the rationale behind such a cash-heavy portfolio?
It is a matter of targeting returns which are acceptable to the investing public. If we increased the amount of long dated options in the fund to 50 or 60 percent the returns could be considerably higher but the risk will also increase significantly. We target 15 to 25% per annum as a return which has been achieved on average with 20% of the portfolio at risk.
Does the fund have a specific geographic focus? While options expertise is portable across asset classes, is it equally portable across regional markets? Would this have any bearing on the capacity potential of your chosen niche?
We have not focused on any particular geographical area and this is due to the fact that we do not have the research capability to unearth the interesting options at individual stock level at the current time. As we have mentioned previously this will become a priority as we grow the research team. There is a case for designing a long/short options fund based on our selection methodology and focused on geographical areas.
Could you elaborate on your observation that “meltdown or absolute risk is known in advance”? What other risk management practices does the fund employ?
Since we know exactly what the current option portfolio is worth we can safely say that this is the absolute worst-case meltdown in the fund based on market risk. This would be an extremely unlikely scenario because long dated options always have some time value and it would mean all positions have moved against us in all asset markets and volatilities have collapsed at the same time. We manage each option on a stop-loss methodology. The stop-loss is based on the number of times the initial option premium multiplies. The first stop is instituted when the option premium has increased three fold. At this level a 60% stop on the option price is registered. As it moves to four times, the stop is tightened to 50% and so on until a maximum of eight times when the stop will be 10%. At this point in time the option has earned the right to discretionary stop-loss status as long as it does not hit the 10% in place. A profit target is then calculated which is based on a three standard deviation move above the 200-day moving average. We will also sell options which have only a year to run if they have not achieved the minimum 3-fold increase and are still worth something.
And lastly, what is your view of the current volatility in the global financial markets? What kind of opportunities do you foresee in the near term?
If we breakdown volatility into asset classes using our proprietary implied volatility index, the GIVIX, the following can be noted. Commodities are at multi-year volatility highs, equities are quite expensive, foreign exchange is just below the long-term average whilst bonds and interest rates are near multi-decade year lows. We see volatility picking up in currencies and bonds as the global imbalances in leverage, debt and trade flows work through the system.