I launched a new credit fund in Europe (and it's working)October 17, 2012: 11:32 AM ET
Where some see disaster, others see opportunity. Pictet Kosmos, a new London-based hedge fund, sees the latter.
By Cyrus Sanati
FORTUNE -- It's tough being a credit trader in Europe these days. Not only are the markets more volatile and unpredictable than ever, new rules and regulations have created an air of uncertainty that has forced investment banks to slash jobs and hedge funds to close shop. Complicating matters, new rules restricting the use of credit default swaps on certain trades are set to go into effect next month, creating the potential of more problems for the market.
Given all the uncertainty and regulation, it might seem odd to launch a new investment fund in Europe that focuses specifically on credit. But where some see disaster, others see opportunity. Pictet Kosmos, a London-based long/short credit fund that launched last year, has been able to buck the trend and deliver solid performance where others have fallen flat. The fund's transparent structure and nimble investment thesis may become a model for other credit funds as they look to get back into the deep end of the credit pool.
If the 2008 credit crunch taught the hedge fund community anything it was to simply avoid illiquid and hard-to-sell assets. Those pesky and complicated structural products and leveraged loans that defined the boom years ended up as toxic assets that no one wanted to buy, leading to a number of fantastic financial meltdowns.
Raymond Sagayam and Kazik Swiderski had front row seats to the credit meltdown of 2008 while running the credit book for a Swiss re-insurer. From their offices in the City of London, the two were able to minimize the collateral credit damage to their multi-billion dollar portfolio and haul it through the gauntlet relatively unscathed. Once the crisis abated, they decided to move to the asset management arm of Pictet & Cie, the Swiss private bank with $377 billion in assets under management, where they would be able to form a totally new fund appealing to clients who had just been burned by the crisis.
Sagayam and Swiderski decided early that this new kind of fund would be truly global in reach and would invest in liquid, primarily investment-grade bonds and credit default swaps (CDS). It would be kept at around 1 billion euros in assets, so they could manage the fund and deliver returns for their clients without compromising their investment thesis.
"The focus on our fund is on liquidity, transferability, and a lack of reliance," Sagayam told Fortune. "The last thing we want to do is buy some credit-linked note or a bespoke CDS where you are beholden to the original counterparty."
But as they were pitching the fund to potential investors another credit crisis flared up, this time in their own backyard. Across the Channel, the 17-member Eurozone was showing signs of trouble. Years of mismanagement, combined with an unrealistic linking of monetary policy across a disparate economic landscape, led to the bursting of a number of investment bubbles. Investments that were thought to be safe, most notably, sovereign bonds, were indeed not so safe at all even though they were some of the most liquid instruments one could hold.
Despite the turmoil, Kosmos was launched in 2011 just as Europe's slow-motion crisis had spilled over to Spain and Italy. Being a fund based in Europe, Kosmos again had a front row seat to the slow sovereign simmer in the eurozone. But unlike when they were managing proprietary capital at their old fund, the fund managers at Kosmos needed to raise capital from investors and convince them that the credit markets were more than just a few European sovereigns.
To do this, Sagayam first needed to explain to investors that while the fund was based in Europe, it had a multi-regional portfolio with an investment mandate that allowed it to seek out credit opportunities across both the developed and emerging markets. The fund also needed to convince potential investors that they had a structure that was safer and more transparent and liquid compared to funds in the past.
For example, despite the large gains that credit funds have had trading non-investment grade bonds in the last two years, Kosmos continues to stay away due to the pitfalls that accompany lower rated corporate securities. They also avoid investing in structured credits and asset-backed securities, which were among the first type of securities to blow up during the 2008 crisis.
The fund needed to hone its strategy for the realities of today's market. With interest rates volatile and low, Kosmos focused its investments on the credit spread of bonds, which is the difference between US Treasuries or Libor and different securities, while hedging out the interest rate risk. In addition, the fund does not use physical leverage and has a very liberal redemption policy, allowing investors to withdraw their funds on a weekly basis, instead of annually or bi-annually like a large majority of hedge funds.
Kosmos has, in part, been able to offer this level of liquidity because a good chunk of its portfolio is in credit default swaps. While a CDS is normally thought of as simply an "insurance contract" that protects investors from the possible default of an underlying credit product, it has grown well beyond its original mandate. Along with providing protection, it has also become a sort of liquid proxy to the underlying product. Funds like Kosmos can therefore maintain a more liquid portfolio by taking a long position on the CDS of an issuer where valuations and liquidity are more attractive than the underlying bond.
But the CDS market has its critics, most notably, the European Union. Last year, the EU voted to ban short positions on CDS contracts that were connected to the sovereign bonds of its 27-members. There was a concern at the time that speculators were somehow manipulating the CDS market to artificially drive up bond yields on certain countries. It is debatable as to whether or not CDS contracts were being used in such a sinister way. For example, in April 2010, it was believed that speculators were driving up yields in Greek sovereign bonds to such a degree that it caused the actual Greek bond to lose value.
"Since then both the European Commission and the Bundesbank concluded that in fact, both markets [the bond and CDS market in Greece] were simply responding to news events at the time," Sagayam said. "However, with the ongoing and protracted eurozone crisis, this restriction continued to gain momentum and will ultimately now become the law on November 1st."
But it should be noted that this isn't an all-out ban on European sovereign CDS contracts. It is still possible for a trader to buy CDS protection if they hold enough bonds in their portfolio that are significantly correlated to the underlying asset associated with the CDS contract. So, for example, a trader can still buy CDS on a German 10-year bond if they either actually own German 10-year bonds or something significantly correlated to those bonds, like German bank credits. This exemption therefore allows CDS to be used solely as a hedge against default risk but does not allow it to be used as a more liquid proxy of the underlying asset.
Critics of the ban believe that these restrictions could crush liquidity in the European debt markets, ultimately leading to higher, not lower yields. But it's not clear how much trading this ban will end up killing. Not only is there the hedging exemption, but there are also exceptions for market makers as they are expected to facilitate trading by taking the opposite side of their customers' orders. While Kosmos is a big proponent of CDS trading, it is not as concerned about the new rules as it relates to European sovereigns as they tend to use sovereign CDS more in the context of hedging emerging market sovereign risk than European sovereign debt.
"The target for this ban is therefore likely to be certain hedge funds which used CDS in a manner deemed inappropriate, which probably makes up just around 10-20% of overall volumes," Sagayam said. "While this means a decline in overall liquidity, the final effects as we are already witnessing are likely to be more subdued than originally feared."
So while Kosmos benefits from using CDS to enhance the liquidity of the fund, it is not concerned with losing this sliver of the market. Being one of only a handful of firms that can trade both domestic market credit and emerging market credits has given the firm the ability to essentially hedge regulatory risk from one jurisdiction to another.
Kosmos has managed to convince investors that their diversified and liquid strategy is not only a viable alternative to more traditional funds, but that it also can be very profitable. In the 14-months since the fund was launched, it has returned a strong 6.13% return net of fees to their investors with an extremely low 1% volatility. The three other main European long/short credit funds based in London that publically release their returns, Schroder GAIA CQS Fund, Henderson Credit Alpha Fund and Blackrock Strategic European Credit Strategies Fund, are up only 0.28%, 2.63%, and 4.53%, respectively, over the same time period.
Kosmos is now close to hitting its goal of raising 1 billion euros ($1.29 billion). As for the future, Sagayam says that he isn't concerned with any of the regulatory changes on the horizon. In fact, he actually welcomes some changes as part of the Dodd-Frank Act, such as the upcoming rule mandating that all CDS trades happen out in the open on a public exchange instead of behind closed doors in the opaque over-the-counter market.
"The hope is that Europe will follow America's lead in this regard," Sagayam said. "I believe putting CDS on an exchange will just add to the transparency and liquidity of the market, helping all investors."