Perspectives from ISB

This article was first published in ISB Insight, Volume 10, Issue 4, 2013, pp48-50

Vilas Gadkari, founder of the Nilgai group of companies, was formerly the Managing Director and Chief Investment Officer of Salomon Brothers Asset Management from 1992-1999, a co-founder of Rubicon Hedge Fund and Partner at Brevan Howard Asset Mgt LLP from 2008-2011 He is currently the non-executive Chairman of Pratham Institute for Literacy, Education and Vocational Training. During a visit to the ISB in January 2013, Gadkari shared his thoughts on identifying global macro imbalances, managing risk and his predictions for the coming years.

Following is an excerpt of the interview between Nupur Pavan Bang, Senior Researcher, Centre for Investment with the fund manager who has more than 30 years of experience in global markets.

Tell us about your journey from a degree in operations research to becoming a hedge fund manager.

After graduating from IIT-Powai, I went to the US to earn a Master’s Degree in Operations Research. In the late 70s, US investment banks were starting to use a lot of quantitative techniques and this attracted many analysts. For example, Salomon Brothers had a number of nuclear physicists and PhDs in mathematics on board. Like many others, I also turned my attention to Wall Street and joined Salomon Brothers. I was initially in the systems development department developing quantitative models. I quickly realised that the heart of the firm was on the trading floor, but I had never studied either finance or economics. I decided to return to university and learn as much as possible about these subjects. I became a PhD student at Columbia University and my thesis topic was “Foreign Currency Option Pricing.” While I was doing my PhD, I continued to work part-time in the economics research department of Salomon Brothers, which was headed by the legendary Henry Kaufman. My years at Salomon Brothers were a tremendous learning experience.

In 1998, the firm was bought by Smith Barney and then merged with Citibank. It went from being a 6,000-people company to a 160,000-people global conglomerate. It was such a large cultural change that five of us left Salomon and started our own hedge fund called Rubicon.

What is the thought process behind your global macro strategy?

Global macro strategy is principally about macroeconomics. There are always imbalances in global economies. The idea is to try and locate if there is a macroeconomic dislocation or imbalance somewhere. Economic policies are often designed to achieve certain political goals. European integration is a classic example where the idea of a single currency has very strong political desires supporting what is arguably an imperfect economic policy. This situation has turned Europe into a classic global macro trade that many types of global macro fund managers have taken advantage of for the last two decades.

The existing global financial crisis that started in 2008 is another example of global macro imbalances that resulted in very large dislocations in the financial markets. This crisis is still playing out and may continue to play out for another five or ten years.

The investment strategy then focusses on instruments and positions in the financial markets that would benefit from further evolution of the crisis.

How do you identify imbalances?

To begin with, we monitor several macroeconomic variables such as GDP growth, inflation, trade and current accounts, etc. In-depth research and analysis can usually point to sectors and countries that are moving away from sustainable trends. The key is always to find countries that are moving away from sustainable equilibriums.

There are three main financial markets that we track: one is the equity market, the other is the interest rate or the bond markets, and the third is the foreign exchange market. They all tend to react to a given crisis at different times. The pricing or valuations in these markets allow us to take positions to benefit from the evolution of the expected crisis.

Interest rates, if you watch the monetary authority, are relatively easy to predict. Monetary authorities are focused on fewer variables, so they are easier to identify and they are usually transparent. In fact, they are more and more transparent these days. Monetary authorities try to tell you what are they looking at and how they make their decisions. Even if this still doesn’t make it very easy, at least you have a lot of information to work with.

Equity markets and currency markets are very difficult because there are many different players in these markets who buy and sell for very different reasons. If you take the foreign exchange markets, there are short-term speculators, investors making medium-term investment decisions and importers and exporters. Thus, it is much harder to identify which flows are occurring and which flow is dominant.

Similarly, business cycles across countries create opportunities. If the cycles in major economies are desynchronised, it can create disruptions in certain sectors, whereas if they are synchronised, some sectors will get a tremendous boost. Once again, we turn to in-depth macroeconomic research to understand these economic developments.

Movements in capital flows, changes in interest rates, economic cycles ¾ many of these variables would depend on social, economic and political policy making, would they not?

Yes. Policy framework is very important for us. As macro managers, we look to identify an imbalance in the policy framework. As fund managers, we want asymmetry. For instance, if there is a recession and policy makers have responded to it, then the chances are that the economy is going to start emerging from recession. On the other hand, the asymmetry would suggest that the chances of the economy plunging into deeper recession are lower. As a result, taking positions with that view has a higher probability of success.

How do you identify whether the policy framework supports or reduces the imbalance?

A typical business cycle (you can start anywhere in the cycle) is where the economy is in recession or going into recession. The monetary authority will then start cutting interest rates and provide some stimulus. Often, the fiscal authorities will also take some form of action. Sometimes, there are automatic stabilisers. As unemployment starts rising, governments start providing unemployment benefits. That means the government is infusing more money into the economy. What you have to do as a global macro player is to follow the capital flows and price actions to look for the signs of change and predict when that is going to happen.

Can you give us a few examples of the sort of imbalances that you have seen in the past?

The last 10 years have been the favourite of global macro fund managers in this respect ¾ where imbalances were created by economic policies that were put in place for political reasons. There is no shortage of such examples. China, for instance, has a mercantilist policy where they intentionally encouraged investment in the export sectors and subsidized those investments so that Chinese exports became cheap and Americans would buy them. That created significant trade and current account imbalances. Cheap Chinese goods kept US inflation under control. It tempered US inflation. US interest rates were lower than they should have been; US bond yields through the nineties remained very low.

European integration, specifically German unification, is another fantastic example.

Let’s take the case of the European integration. What were the imbalances and how would you take positions?

European exchange rates were pegged between the countries in the European Union, within a band, in order to achieve greater economic integration in the region. It followed that German and French interest rates were very similar. In 1990, when East and West Germany unified, capital flooded into Germany in search of opportunities, such as cheap labour and cheap assets.

In order to cool the economy, Germany needed to raise rates. France, however, needed to cut rates as they were experiencing a slowdown at that time due to the global environment, but they were locked into pegged exchange rate regimes. Hence, neither could Germany raise their interest rates nor could the other countries cut rates. This put a lot of pressure on the exchange rates. The central banks initially said that they would not change things and that the exchange rates would remain same. However, they slowly started to intervene in order to try to stabilize exchange rates. The imbalance here was really in the exchange rates. The actual exchange rates were increasingly getting out of line with the fundamentals.

This was a great opportunity for macro managers. Because of the pegged exchange rates, the Deutsche Mark was grossly undervalued and the French Franc was overvalued, so we bought Deutsche Mark-Dollar Calls and sold French Franc-Dollar Calls as the currencies were free against the dollar.

Hedge funds are highly leveraged. Risk management becomes very important as margin calls could quickly go out of hand. How do you ensure the safety of your principal along with being leveraged?

Options offer a good tool for risk management. Buying calls is a safe bet as the initial investment is lower. If the bet goes wrong, you only lose the premium. And if you both buy and sell options, as we did in the case of Deutsche Marks and French Francs, the initial investment becomes even lower. The probability of losses are lower when taking positions in long calls. The gain could be considerable if the bet pays off and the situation starts to turn. We often also use covered positions and stop losses to manage our risks. It is also important to realise that there are no free lunches. There is a cost associated with each alternative. These are tools for risk management.

You had a dream run at Rubicon for five years and then a couple of difficult years. When there is an imbalance, and you are correct in identifying it, how can you go wrong?

We were fortunate that after the NASDAQ crashed in 2000 and 2001, our strategy, “global macro,” became quite fashionable and we significantly grew our assets under management. By 2005 we were up to about US$3.5billion.

The problem with global macro is that while it may be relatively easy to identify the macro imbalances, it may be a long time before those imbalances begin to reduce. You first have to decide whether you want to bet on the imbalances continuing to grow, or on the likelihood that something will soon happen to reduce these imbalances since they cannot be sustained forever. It sometimes takes a very long time before the imbalances and the markets turn. Therefore, when we start taking positions with a view that the turn will come soon, we need to be patient and also take positions in such a way that we do not lose a lot of money while we wait for the markets to do the right thing ¾ or what we think is the right thing. In the mid-2000s, the US housing market was booming. By 2005, we were convinced that it had gone too far; thus, we started shorting the US housing market in late 2005 ¾ a little bit too early. It wasn’t until the middle of 2007 that it really started to turn. We had a couple of difficult years. It is a part of the ups and downs of the business.

What is your outlook for the coming years?

The US economy is starting to grow, but slowly. The risk of a fiscal cliff continues to hang over their heads. Emerging markets have relatively more healthy fundamentals, but the risk of a Chinese hard landing remains. Europe continues to be in recession and will continue to have very low growth for many years. The global monetary policy will remain loose to stimulate developing economies for several years as well. I feel that there are opportunities in fixed income instruments of countries with lower default probabilities and in a sub-set of emerging markets. In equities, one ought to look at companies with resilient earnings, low leverage and high dividends.