Q: What is the history of the fund and its management?
The fund was established in 1989 and had been managed by a third-party before the fund was brought back under the management of Oppenheimer Funds in 2005.
At that time, the investment mission shifted from moderate allocation to an alternative strategy with prime brokers so it could short equities. Although the portfolio had some individual stocks and opportunistic assets, it was mostly a long/short equity fund until a few years ago.
My tenure as portfolio manager began on April 1, 2012. Although still an alternative fund, the investment mandate was structured to employ multiple long/short strategies across different asset classes: equities, derivatives of credit, rates, currencies, and using more financial derivatives.
Currently, we manage in this fund $1.2 billion and in addition we manage approximately $100 million as a sleeve in a different vehicle using the same strategy. Moreover, my team also manages another fund with a different strategy and total assets of $2.5 billion.
Q: What is your investment philosophy?
We use both longs and shorts together to diversify traditional market exposure and manage drawdowns with low volatility. While in a sense the fund can go anywhere—it is not constrained by asset classes—its characteristics remain stable, and it uses a wide range of assets to find strong risk-reward and generate returns over a multi-year period.
Because it is impossible to know what the markets will bring, the fund does not have particular monthly or quarterly return targets. We are long-term investors seeking to capture upside year in and year out, as well as buffer risk in down markets. Even though our exposures change over time, they change slowly and align with our longer-term view.
The fund is quite unlevered relative to its restrictions; we do not borrow money and invest it. What leverage it does have comes through derivatives and inherently through the short positions.
Q: Could you describe your investment process?
The team continuously follows different industries and asset classes to find change, disruption, and ultimately opportunities. We do not use quantitative analysis to generate ideas. In some ways, our process is precisely the opposite: we are looking for fundamental factors that will change or break a trend, factors not yet reflected in the numbers.
Our investment process has four parts: idea generation, where we identify a change or disruption that might present opportunities; establishing a fundamental framework to monitor and track a change; scenario analysis, where we model key drivers affected by a change; and security selection, which uses those drivers as inputs to create bull and bear cases.
We use both a top-down overlay and a bottom-up approach which at times can inform each other to generate ideas.
An example of the top-down informing the bottom-up happened in late 2014, when oil was $95. At the time OPEC met and decided not to cut production, signaling it was going to target market share rather than price stability. We had seen something similar in 1997–1998, when the price went from $30 to $10.
In addition to OPEC’s decision, low-cost oil was coming in with new shale energy producers in the U.S., driving out high-cost producers.
Our top-down view suggested several things. Economics were shifting from oil producers to consumers, so consumers in oil-producing regions like Russia and the Middle East had been buying luxury goods—and the people we spoke with at luxury companies confirmed this. Luxury sellers and makers were trading at a high valuation in financial markets, and our thesis was the decreasing oil price would hurt that demand.
When our analysts began looking at luxury stocks to short, they found Compagnie Financiere Richemont SA, the Swiss watchmaker. Although 60% to 65% of the company’s costs had to remain in Switzerland, the watchmaker sold its watches around the world. But because the Swiss franc was high, Richemont would suffer from a currency mismatch, with its costs in a high currency and its sales in lower ones.
What is more, the watch market in general was being negatively affected by a number of factors, such as a corruption crackdown in China, a cultural shift toward using mobile devices instead of timepieces, and new competition from products like the Apple watch.
In a similar fashion, our bottom-up approach at times informs our top-down. For instance, if we were to speak with a number of companies and they all gave the same response, we would take a closer look.
One time this happened was around 2010-2011. I met with a group of natural gas exploration and production companies, and one after the other, each stated they would be producing much more natural gas liquids (NGLs), such as ethane and propane. This encouraged us to analyze that market, which eventually led to positions around chemicals that use NGLs as feedstock
Q: What is your research process and how do you look for opportunities?
We look for change, for improving fundamentals with reasonable valuations for our longs, for deteriorating fundamentals with high valuations for our shorts, and for idiosyncratic returns for our shorts that help diversify the fund.
Our research team includes four analysts who report to me. Some have multiple industry coverage and focus on the equity side, and one covers multiple asset classes, but everyone analyzes macro data and uses the same work, across all the fund’s assets. For example, both our multi-asset analyst and our consumer analyst examine the labor market, and they share their work with each other and our whole team.
Separately, we are part of a 25-member global multi-asset and alternative team, which runs quantitative analysis of global macro trends. Although we make decisions independently, we do find their work interesting because it often picks up early trends and changes.
Our decision-making process starts with an analyst’s pitch, which can take several weeks to formulate and is discussed thoroughly before a formal one-hour meeting. When the analyst is ready, they go through data on the industry and company, present their thesis, identify the change, and how it will be tracked. Additionally, the analyst will have done models for bull, base, and bear cases, and formulates targets for the security under each scenario.
During the pitch meeting, we pinpoint areas of concern and determine whether more information is needed. A key part of our process is identifying the second-order impact: what is the next step, and what are its implications?
For example, over the summer we were looking at China before its equity market went down. Its growth rate was decreasing dramatically, much faster than people realized. The conventional wisdom was its government would not devalue before November, when there was a review in for the strategic currency reserve.
We were not convinced. We believed the Chinese government would respond by devaluing the currency, and bought puts on the yuan before they devalued. The puts were inexpensive, and because the currency was pegged, volatility was low, and when China devalued, we made money.
Going forward, our view was it would eventually devalue even more. When China first started devaluing, we began looking at the second-order impact, specifically at Asian trading partners which would be disrupted by further devaluation.
Malaysia has significant trade with China. Since its national oil company, Petronas, had been providing 30% to 35% of its government revenue, this idea also came back to our other theme that oil will be low for longer. These decreasing oil prices would be challenging for government revenue and for the country’s credit profile, so we bought credit default swap protection on Malaysia, which we continue to hold.
Q: Does diversification play a role in your portfolio construction process?
Our mandate is to be an alternative fund. In our view, in order to serve as effective diversifiers, alternatives either need to be independent of traditional market exposure, or have low exposure to them.
Because idiosyncratic returns create diversity, having different drivers and returns is important in portfolio construction. We use three strategies—long and short equity, long and short credit, and long and short macro—which diversify each other because they are uncorrelated with each other.
At the portfolio level, having three uncorrelated strategies significantly reduces its overall volatility. We look at that from the bottom up, security by security, but we also look top down to determine how independent and correlated our strategies are.
We run stress tests on the portfolio to determine how it would have acted based on historical events. Additionally, when we add securities to the portfolio, look at risk and reward, on a bottom-up basis, and on an asset-class basis, looking for asymmetry—better upside than downside—and for independent or idiosyncratic returns.
Q: Does the portfolio have any restrictions?
On the equity side, we cannot short more than 40% of our total net assets by our prospectus, although in practice that is highly unlikely because this is not a bear market fund. We do not have limits on the long side. For some time the fund has been running 40% to 50% long and 20% to 25% short. In a protracted down market, we may choose to reduce longs or increase shorts on the equity side.
Derivative exposure also has limits, although we have not come close to hitting them. If we saw an opportunity, we could decide to implement more aggressively.
Volatility is limited to two times the HFRX Global Hedge Fund Index, the fund’s benchmark. This index includes hedge funds with alternative strategies—as opposed to alternative assets like gold or REITs—including long-short equities, market neutral, merger arbitrage, multi-strategy hedge funds, and macros.
In some scenarios, the fund’s volatility might be increased. For instance, should a shock cause the market to go down, it would give us the flexibility to buy if we saw falling valuation.
Q: How do you define and manage risk?
Since the hallmark of the fund is risk-adjusted return, we think about risk a lot and weave risk control into the portfolio construction process, asking what it would mean for a security and for the portfolio if we were wrong, or not sized appropriately.
One aspect of risk is drawdowns, and we consider how the fund would perform in a down market. Another is the need to keep a low volatility profile. As an alternative fund, we also have to take different considerations into account. After all, if we want to diversify effectively, the fund needs low sensitivity to traditional markets.
