The Billion Dollar Interview with Matthew Luckett, Partner and Co-Portfolio Manager at Balestra Capital, Ltd.
Balestra Capital was founded by James Melcher in 1979 as an investment advisor for high net worth clients. In 1999 Mr. Melcher and Norman Cerk, who joined the firm in 1997, co-founded the firm's global macro strategy. Matthew Luckett joined Balestra Capital in 2004 as a partner and co-portfolio manager. Prior to joining the firm Mr. Luckett was a venture capitalist and senior operating executive for three years, following the sale of his firm SoundView Technology Group where he was a Principal and Senior Research Analyst - to Wit Capital and subsequently to Charles Schwab. Balestra Capital is an SEC registered investment advisor since 1987 and, beginning in 2013, a CFTC registered commodity pool operator and member of the NFA.
Eurekahedge: Can you share with our readers a bit of history about Balestra Capital, Ltd. What investment strategy do you employ and how well does it fit with your overall investment objectives?
Balestra Capital was founded in 1979. The firm's global macro strategy has, since its inception, achieved significant annualised returns, uncorrelated to global equity markets, and with a history of strong performance in periods of market stress.
The firm employs a global macroeconomic investment strategy, seeking to capitalise on dislocations between asset pricing and underlying fundamental economics factors. As such mispricing can persist for long periods of time before correcting, the strategy is long term and thematic in nature and utilises options where appropriate. This fits with our core philosophy of creating an asymmetric risk and reward profile, preserving capital in complacent markets while generating outsized returns when dislocations correct. In addition, the broad range of macro instruments we employ, including futures, ETFs and currencies, are all highly liquid; we do not attempt to capture any form of illiquidity premium and therefore do not create any asset-liability mismatch for our investor base.
EH: Balestra Capital has returned an impressive compound annual rate of return since inception, please share with us the story behind your success.
The underlying basis for our success is the emphasis on capital preservation and creating optionality to generate outsized returns when positions move in our favour. This has been a staple of our history. In the late 1990's and early 2000's our portfolio was positioned to capture the equity bear market following the tech bubble and later the growth of emerging markets while retaining a fully hedged portfolio. Following the massive credit expansion of the early to mid 2000's we were able to take extremely low risk stakes in CDS on MBS-backed CDOs, which we carried at a small cost into 2007, where, along with short positions in credit indices, we had significant convexity and was able to generate substantial returns. Through 2008 and 2009 going into 2010 we positioned our portfolio for a drawn out global recession, with CDS on major financial institutions, European Sovereigns, and a significant long position in gold as a response to currency devaluation worldwide. For each of these positions we have managed to build an asymmetric risk and reward profile, embedding optionality into the portfolio to generate outsized performance during major market shifts.
EH: Please share with our readers some of your main winning and losing themes since last year vis-a-vis region and sector?
Our Japan theme has been the most significant winning theme in 2013. This is a long running theme, which has consisted of a short positioning in the Japanese yen against the US dollar, structured primarily through options, supplemented with long positioning in Japanese Equity Indices and Japanese mega-banks. Another winning theme for us in 2013 was our Quality Equity theme, which has consisted of a basket of high cash flowing and blue chip US and European equities with attractive valuations.
The firm has long maintained a conservative outlook on the global economic environment and has primarily expressed this view through shorts in emerging market and commodity currencies, which we expect to suffer from a continued softening of import demand globally, particularly as we expect the Chinese economy to underperform current expectations.
EH: In your opinion, what factors are responsible for the lacklustre performance of global macro funds over the past few years and what actions are being taken at your firm to decouple itself from this dismal trend?
Global macro hedge funds in general seek to take advantage of fundamental economic drivers of asset prices. Unfortunately, over the last several years fundamentals have just been less relevant as central bank liquidity injections drive markets and perpetuate rising asset prices. In addition, significantly reduced volatility, and wider spreads between implied and realised volatility have had a detrimental impact on long option positions. Given the current environment, we have made a concerted effort to find mispriced optionality where possible and build tail scenarios into the portfolio that will benefit as markets correct.
EH: Could you share with our readers the rough breakdown of your exposures across regional geographies, in particular emerging economies, and how this has evolved post the global financial crisis of 2008.
Our major exposure is to developed markets. Roughly 35% of our portfolio is invested in our Japan theme, short JPY and long Japanese equities. 25% of our exposure is in the United States, primarily through our Quality Equities theme and US fixed-income. An additional 25% of exposure is in Europe, both short FX and long rates.
Approximately 15% of exposure is directly related to emerging markets across various geographies, the majority of which is comprised of short exposure to currencies of commodity producing countries, the remainder being largely positioning in Chinese FX.
EH: How has your asset allocation changed across equities, commodities and currencies over the last three years? Do you feel the current allocations have worked in your favour?
Allocation across asset classes varies widely based on our view towards the optimal implementation of our portfolio themes. However, we have increased gross exposure across our portfolios in an attempt to maximise risk adjusted returns in the current environment. More broadly, we remain constructive on equities, particularly in the United States. We are generally bearish on commodities, and remain constructive on the US dollar relative to currencies globally.
EH: You have a robust risk management framework that places key emphasis on the liquidity of its positions. What safeguards have you put in place in order to ensure high liquidity levels and to what extent have they been successful during times of market freeze ups. Could you produce greater returns with lower liquidity?
The firm only invests in instruments that are highly liquid. At any point, any position could reasonably be liquidated within 1 to 3 days in normal conditions. While in a severe market seize-up, some positions may take as long as a week to liquidate based on our stress analysis, we have historically been long volatility, and are therefore a provider of liquidity in periods of market stress. Our investment strategy is based exclusively in liquid macro instruments; we do not see lower liquidity as a means of generating greater return, particularly on a risk-adjusted basis.
EH: With reference to your risk management philosophy, what changes have been incorporated into your models to guard against sudden market movements which are driven by news flow, such as the Fed’s taper scare in the earlier part of 2013?
Sudden market movements driven by news flow show us time and again that current asset price correlations are not reliable as the sole means of measuring risk across a portfolio. When thinking about risk, in addition to monitoring recent correlations, we conduct separate stress tests using correlations from historic scenarios and dismissing current correlations entirely. We are constantly looking at these various sets of scenarios in order to capture as many risks as possible. These ‘ad hoc’ scenarios are revised daily and reviewed with the entire investment time to determine not only what the current macroeconomic risks might be, but also what dislocations we may see in the future.
EH: Your long positions in credit default swaps were a major winning theme in the aftermath of the mortgage bubble in the US. If the Fed were to reduce its purchases of mortgage backed securities tomorrow (QE trimming), would you consider re-visiting your winning strategy in credit default swaps? If not, how successful do you feel the Fed’s QE policy has been in restoring confidence in the markets?
We no longer see CDS on mortgage backed securities as an attractive market as Wall Street is no longer providing the liquidity that was seen in that space in the mid 2000's. As such we have not been using those instruments in the current environment, but continue to monitor the space.
EH: Balestra Capital has actively traded in commodity futures since the inception of its global macro strategy; maintaining long positions in gold throughout most of the previous decade. Going forward, what are your expectations of the short-medium term trends in commodities and gold?
In general we expect commodity prices to decline as emerging market demand; which drove much of the commodity boom of the mid to late 2000's, remain weak. As China begins to transition from an industrial to a consumer economy, its import demand for raw materials in particular will decline. Further, the road to a consumer economy is unlikely to be an entirely smooth one, and hiccups in the Chinese economy will further dampen demand across emerging markets. Gold; unlike commodities more broadly, we see as having become somewhat unhinged. Post-2008, gold was an interesting instrument, acting as an effective barometer of market perceptions of QE in the United States and elsewhere. Recently, gold prices have not reacted to many of these ‘fundamental’ drivers. As such, while we have taken tactical short term views on gold, we do not see it as a core position in the current environment.
EH: We understand you trade actively in the FX markets and have realised recent gains from your short positions in the Japanese yen. Going ahead, what is your take on the key trend emanating in the global FX markets? Are emerging market currencies poised for another dive as the FOMC signals its intent to trim its QE program? Are you seeking exposure to the Chinese yuan as it treads on the path to its internationalisation and appreciates relative to the dollar? Where do your expectations stand on these issues?
One key trend we see in the FX market is relative currency devaluation, as central banks around the world reduce interest rates or renew quantitative easing in an attempt to stimulate growth. While this liquidity injection has been a major driver of our Japan theme, we expect central banks to be more accommodative globally. In the developed world we expect to see renewed easing out of the European Central Bank, and remain bearish on the euro, while in emerging markets, particularly commodity exporters such as Chile, Australia, and South Africa we expect central banks to target lower interest and exchange rates as a means of increasing exports. As such, we see the US Dollar as having significant potential to appreciate as stronger US economic data gives the Fed more room to taper.
We are currently positively inclined towards the Chinese yuan. As import demand wanes and China begins to transition to a more domestically driven economy, we expect the yuan to continue its managed appreciation against the US dollar, in response to both mounting political and economic appreciation pressure. We do not expect a radical appreciation in the yuan. The Chinese economy has some major hurdles to overcome and we believe appreciation will proceed somewhat below the long term average of 3% per year as a means of easing China's economic transition.
EH: Going forward, what are some of your high conviction themes for the near future?
Going forward, the Japan theme remains a high conviction theme in our portfolio. We also remain optimistic on the United States, and are positioned in US equities, long USD, and short US rates against European rates. In addition to that relative value trade, in which we expect US outperformance and European economic underperformance to drive a divergence in US and European interest rates, we are also long European rates outright, as we expect the ECB to renew its easing effort in the face of softening economic data across the Euro zone.
EH: Finally, as the year concludes on a positive note for equity markets globally, what is the future you envision and how does Asia feature into your grand strategy for the firm?
From an investment perspective, we continue to believe that there is no one way view for Asia. We remain bullish on demographics in Asia and expect Asia to continue driving emerging market growth globally. In Japan, we continue to expect a reinvigoration of the Japanese economy driven by both government and central bank policy. We continue to research opportunities in Asia and maintain an active Asian client base which we hope to grow going forward. We retain a high level of conviction in our core themes and expect asset prices to be increasingly driven by decidedly mixed global economic fundamentals in the medium term.