While Paulson’s star was finally setting in 2011, that of mega macro fund Brevan Howard was rising, and has been rising for years by never posting a negative return since 2003. The $34.2 billion fund, now about double the size of John Paulson’s, returned 12.12% in a year marked by abysmal hedge fund performance. But how did it make money? Simple – by taking advantage of the same permabullish market myopia that marked the beginning of 2011, and that has gripped the market once again. « The Fund’s large gains during the third quarter were due predominantly to pressing the thematic view that markets were ignoring clear signs of economic slowdown and were not correctly pricing the probability of central bank accommodation, particularly the reversal of the ECB rate hikes in April and July. » Not to mention the €800 billion ECB liquidity accommodation that started in July and has continued since. So yes: those betting again that the market correction is overdue, will once again be proven right Why? Because « we are about to witness an unprecedented policy move. In the US, Eurozone and UK, fiscal austerity is being prescribed as the cure following the bursting of the credit bubble and to overcome the malaise following a balance-sheet recession. Unfortunately, there is no historical example of when this approach has been successful. » As for looking into the future « we continue to believe that markets remain at risk of substantial dislocation. »
Lastly, for all those who believe Europe is « priced in », the right thing to say it is not priced at all: « One risk that we are particularly careful to avoid is betting on the outcome of the Eurozone crisis. Its resolution will ultimately be a political decision and we have no real edge in understanding which way the politicians may go. For us, the better trade is to look to the macroeconomic picture and position around macroeconomic developments rather than try to second guess the politicians. » Alas, macroeconomic developments are now more defined by politicians than ever. We, unlike Brevan Howard, instead would bet on the stupidity of these politicians, and the certainty that as usual, they will screw things up, only to be bailed out by immense printing as the usual last ditch resort. Which means that stupidity hedging precious metals, are and continue to be since March 2009, our preferred « investment » category.
From the letter:
As we wrote in the Fund’s Annual Investment Manager Review this time last year, our strategy for 2011 was to strike a better balance between harvesting modest short-term profits and pressing large thematic trades. This strategy proved successful.
During the first half of the year, a balance between general optimism on the state of the global economy on the one hand and fear of possible large event risks on the other hand kept markets in a broad trading range; this allowed the Fund to make steady, modest gains by trading tactically. For example, the Fund held both long and short positions in European interest rates during this period, depending on the market’s probabilistic pricing of future ECB rate hikes at any one point in time.
The Fund’s long interest rate volatility positions also benefited from this environment, generating steady returns through gamma trading. Tactical opportunities in other areas including yield curves, bond versus swap spreads, commodities and credit also generated positive returns.
The Fund’s large gains during the third quarter were due predominantly to pressing the thematic view that markets were ignoring clear signs of economic slowdown and were not correctly pricing the probability of central bank accommodation, particularly the reversal of the ECB rate hikes in April and July. The Fund took significant long positions in G7 interest rates, with a concentration in European short-term and US medium-term rates.
As the economic data softened over the summer and the euro crisis escalated, forward interest rates fell sharply in G7 and the Fund’s positions made substantial profits. The Fund’s structural volatility positions also paid off from this move, as interest rate option deltas were allowed to expand, thereby increasing the size of the Fund’s positioning during the rally. The decision to position early and in size for a decline in interest rates was the primary driver of performance in 2011.
Apart from the basic long rates position, the Fund profited from gains made across several strategies during the third quarter including bond versus swap spreads, libor basis, foreign exchange, commodity and equity trading, while credit proved modestly unprofitable. The Fund’s general positioning, although reduced, was maintained into the fourth quarter, resulting in further gains in November which were partially offset by small losses in October and December as markets settled once again into a more mean-reverting, tactical environment, with interest rates and the euro initially rising before resuming their downward path.
I am particularly pleased to report that a meaningful part the Fund’s return was generated by newly recruited traders. At the end of 2010 and in the early part of 2011, the closure of bank prop activities caused by the introduction of the Volcker rules allowed Brevan Howard to add 13 new risk takers to our trading group and 3 new people to our research efforts. These additions made a material contribution to our results in 2011. Brevan Howard has never had a deeper, broader or more talented investment team.
In 2011, we took the unusual step of asking the Fund’s Board to return some capital to investors. This was done simply to alleviate ongoing investor concerns about the Fund‘s size and not because of liquidity issues or a poor opportunity set.
Following the Fund’s lacklustre performance in 2010, there was a degree of investor unease over the size of the Fund and whether it was an impediment to performance. It wasn’t. As we wrote in this letter last year, the reason 2010 was lacklustre was because the three major themes we positioned for in that year proved unprofitable.
Nonetheless, in order to assuage this investor concern, we undertook to return capital if the Fund got larger than $25bn. As a result of strong performance, the Fund exceeded the $25bn AUM level during the summer and, in line with our undertaking, we announced that we would return almost $2bn to investors. Having done so there are no plans at this time to return further capital. However, as always, we will monitor the size of the Fund, the opportunity set, our trading capacity and the market liquidity on an ongoing basis to ensure that we are comfortable with the size of the Fund. Looking forward, we continue to believe that markets remain at risk of substantial dislocation. The European sovereign and banking issues appear to be approaching a head and may result in extreme outcomes (in either direction). The US fiscal situation remains highly strained and large imbalances remain in emerging market economies. In short, the issues we raised in last year’s letter are still unresolved.
In light of the ongoing binary risks, we have taken decisive action to focus on liquid, uncomplicated strategies, to increase the Fund’s cash liquidity and to ensure that the exposure of the Fund to potentially vulnerable counterparties is kept to a minimum. One risk that we are particularly careful to avoid is betting on the outcome of the Eurozone crisis. Its resolution will ultimately be a political decision and we have no real edge in understanding which way the politicians may go. For us, the better trade is to look to the macroeconomic picture and position around macroeconomic developments rather than try to second guess the politicians.
As we start 2012 the Fund’s positioning is once again quite tactical, with the only structural position being long volatility across multiple asset classes, in particular interest rates.
I want to thank, as I do each year in this letter, all of our investors for their continued support and I assure you once again that all of us at Brevan Howard will do our utmost to deliver another profitable outcome in 2012.
In terms of market sentiment and the macroeconomic outlook, 2011 was a year of two halves for the US. In the first half of the year, markets and commentators expressed optimistic views about the future. Equities hit a high during the second quarter, with major indices up almost 10%. At the same time, buoyant forecasts were relying upon increasingly strained rationalisations in the face of worse-than-expected data. In the third quarter, another EU summit failed to deliver the measures required to resolve the European sovereign debt crisis and the normally pro forma vote to increase the US debt ceiling turned into a fiasco that cost the US its AAA credit rating. In response to these developments, investor and consumer sentiment collapsed, equities swung to 10% losses on the year, and the economy barely avoided a recession. Investors fled to the traditional safe havens of US Treasuries, German Bunds, the US dollar, and the Japanese yen.
By the end of the year, the US economy regained its footing, led by brisk business capital expenditure, improved consumer spending, and moderate gains in payroll employment. In addition, inflationary pressures eased, as total and core consumer inflation fell below an annualised rate of 1% in the fourth quarter, import and producer prices declined, and longer-term inflation expectations drifted into the lower end of their range for the last decade.
Additional monetary policy easing by the Federal Reserve (« Fed ») and European Central Bank (« ECB ») played a role in stabilising the economy in the second half of the year. In September, the Fed rolled out a Treasury duration extension programme and renewed its purchases of mortgage-backed securities. As a result, the Fed committed to buying virtually all of the net issuance of longer-term Treasury duration through to the middle of 2012, a move that, if nothing else, signalled that monetary policy would be utilised if the economy threatened to rollover. Despite the rollercoaster ride, equity markets were largely unchanged in 2011, Treasury interest rates ended at historic lows and economic growth registered somewhere near its long-term trend.
Looking to 2012, investors appear to be expecting moderate growth, inflation and financial market returns. At Brevan Howard, we expect the continuation of enormous uncertainty. On the one hand, policymakers appear to have a much-improved grasp of the dangers posed by the banking and sovereign debt crisis in Europe. Furthermore, we are one year further along the long road of deleveraging household balance sheets and repairing the housing market. On the other hand, we are about to witness an unprecedented policy move. In the US, Eurozone and UK, fiscal austerity is being prescribed as the cure following the bursting of the credit bubble and to overcome the malaise following a balance-sheet recession. Unfortunately, there is no historical example of when this approach has been successful. In the Great Depression, economies grew to the extent they pursued Keynesian stimulus and sizable depreciations in the exchange rate of their currencies. Presently, enthusiasm for additional stimulus appears to have come to an end and the room for competitive devaluation appears limited given that the largest economies are in a liquidity trap and emerging markets are slowing markedly. Financial markets and the economy are at the mercy of the convergence of these positive and negative forces in 2012. As such, developments in 2012 look set to mirror the ups and downs of 2011.