Gold, the Yen, Upside in Equities and Petroleum Week With Archbridge Capital

In this article Simon Kerr, Publisher of Hedge Fund Insight, has a Q&A session with global macro manager  Hakan  Kocayusufpasaoglu, CIO of Archbridge Capital.


Hedge Fund Insight: You had a good year in 2013, with your macro fund up over 19%. In which asset classes did you make the most money, and how much leverage did you have to carry to get those returns?


Hakan  Kocayusufpasaoglu: Even though our instruments are leveraged since they are exchange traded futures etc., we do not utilise leverage for our portfolio, and we manage our risk very carefully. In fact risk management is the most important part of trading for us and this culture is imprinted into all Archbridge Capital personnel. In terms of asset classes we tend to have differing strategies: Macro trades in one camp and Relative Value trades in the other. Last year 70% of our profits came from Macro trades, like short Treasuries or short the yen vs. different currencies (as discussed in this previous article), including the US$. But in other years Relative Value trades dominate. The mix of both allows us to have a higher return for a given risk level and has helped to keep our Sharpe ratio above 2.3. In terms of asset classes, we have seen last year a proportional allocation between bonds, FX and commodities and equities. By a tiny margin FX and commodities contributed most to our p&l last year.


Hedge Fund Insight: Many macro managers made little from commodities last year. Did you have one dominant view or trade? Which commodities did you make money in?


Hakan 4Hakan  Kocayusufpasaoglu: We did have a few prevalent views about commodities last year. The first had to do with gold: Most people look at gold as an inflation or recession hedge but the main driver of gold according to our research of the gold price over last 100 years is real interest rate levels. When real rates turn negative and are expected to remain there for long periods of time it usually creates a gold rally, while the opposite causes the gold price to fall. As we have stated in the media, we believed that QE reduction is in effect a reduction of negative real interest rates and that the gold price would be falling from the highly elevated prices of US$1900/oz. This materialised as we got closer and closer to the Fed’s tapering efforts.


Additional to the gold trade argument was also that tail risks in the world were being priced out which supported downward pressure on gold. We also generated revenues from relative value trades in commodities, like the WTI-Brent trade, where a similar quality crude was trading substantially below the other European crude. The price differential was substantially higher than transportation costs and was caused by logistical issues which over time should be alleviated. The rule is that all logistical issues typically get solved when a large profit potential is involved and so it was with this trade.


Hedge Fund Insight: China is key to world growth yet official GDP data does not tell you much except the level central government would like it to be. How do you assess what the underlying growth or real growth rate is in China?


Hakan  Kocayusufpasaoglu: Statistics in China, as you say are not always the best indicator of Chinese economic growth, one has to go a little deeper in order to get the full story for China. We pay attention to things like electricity usage, port activity and lumber usage. Overall we have been of the view that China’s shift from being a foreign investment driven economy to a consumption economy will slow down their overall growth performance and that view seems to bear fruit via the overall statistics and the other proxy indicators for Chinese economic growth going forward.


Hedge Fund Insight: We have just had the Chinese GDP for 4Q 2013. Officially it was at 7.7% y-o-y. What do your measures tell you underlying growth was?


Hakan  Kocayusufpasaoglu: Our measures tell us that GDP will be slowing down over the next quarters due to a clear disorientation from investment driven to a consumption driven economy. Our research also informs us that the credit limitations put into place are having an effect on the housing market, which I see finally slowing without a collapse, which so many had feared.


Hedge Fund Insight: There is a debate going on about whether emerging markets are going to return to generating the growth and equity performance that  they used to. What are you going to look for to get involved in emerging markets equities in the short or medium term?


Hakan  Kocayusufpasaoglu:We have analysed the probabilities of EMs entering a crisis, ie the contagion risk. There are two major issues at work. At first glance when one compares the situation of EMs to those in the previous EM crisis of ’99 for instance, we see that EMs are in a much better position than they were then. They are larger, more powerful and have a stronger underlying economy. EMs are now around 40% of world GDP and will exceed 50% in a few decades. Their GDP per capita is rising steadily and so is their standard of living.However, there is a second worrying issue that is at play this time that is different than in the past. A huge number of US$ has entered into EMs from the developed countries since the 2008/09 crisis, around 4 trillion US$. This money has entered into the EMs taking their credit risk and currency risk. In the past foreign funds entered EMs only taking credit risk, as they invested in $s or hedged their FX risk; whereas now they have entered into the EMs in their local currency making them more sensitive to FX movements in EMS than ever before. Local currency government bonds went from around 600bn$ in 2008 to 2.5tr$ of foreign funds in 2013. The key danger is that foreign investors have big EM FX risk and may run to the exit doors at the same time, finding that the door is too small.

Evaluating both the above points one positive, one negative we have reached the conclusion that some EMs will suffer, but that an overall crisis will probably be avoided this year. That is that EM central banks will realize (some already have) that they have to raise rates more and by doing so have to keep their FX stable at higher levels, so that any depreciation of their currency happens in an orderly fashion. The EMs experiencing strain and difficulty are to our calculations around 10% of world GDP and hence probably too small to affect the path of developed markets in any grave way this year.

Despite our relatively benign outlook we are, however, making investments which should be successful in either scenario. For instance we are bullish the US$ especially when we get closer to short term interest rates rising in the USA at the start or middle of 2015. Any EM crisis will assist this view as the US$ is the main safe haven currency of the world. We also believe that Eurodollar contracts (3-month interest rate contracts in the US) are pricing in rate rises when none will happen. Again an EM crisis will assist this trade.


Hedge Fund Insight:Is there more money to be made being short the Yen this year? Which currency would you take for the long side, and why? If there is money to be made short the Yen, what do you want to see from the markets as a set-up?

Hakan  Kocayusufpasaoglu: Please see above for the long US$. The yen will weaken to the 120-125 levels over the next years, but it is the EM contagion risk that is keeping the yen anchored at the moment. If as we believe that gets priced out in the next few months, then the yen will enter another weakening leg. We are still waiting for that moment and watching the yen carefully.


Hedge Fund Insight: Gold seems to be in the process of bottoming. What is your view, and if it is can you make any money from an instrument bottoming rather than going up in price?

Hakan  Kocayusufpasaoglu: Gold, like the yen will strengthen if the EM risk talked above materialises, but we are being prudent in limiting ourselves to trades in both macro and relative value that are not binomially dependent on these two scenarios (as described two questions above).


Hedge Fund Insight: In which case, what trades have you got on that will benefit from scenarios other than the ones described above. These trades must be diversifiers relative to the long $/short Yen trade described above. How do you size them in an absolute sense, or relative to the existing positions in your portfolio?


Hakan  Kocayusufpasaoglu: We have a number of RV positions that are insulated from the scenarios described. In fact the scenarios above and the resulting trades fall into the Macro trade category. We have for instance some gasoline spread postions and some spread positions in crude (Brent-WTI). These RV trades benefit from very different outcomes and are for the most part insulated from the above mentioned macro scenarios. For instant in gasoline we have seen the US winter gasoline spread widen. Since winter gasoline is easier to produce and can be imported easily, and since we are not seeing very strong demand improvements and refinery utilization is nowhere close to maximum, we expect these winter gasoline spreads to come back into line. Since they are only one or two months apart their volatility is limited and the trade is nicely insulated from other macro events like the ones discussed above.


Hedge Fund Insight: Some developed equity markets may be running into overhead supply. Do you see them that way?


Hakan  Kocayusufpasaoglu: We still see upside in the equities markets especially in the US. We believe that on relative valuations, on macro economic projections and on money flow data that the US equity market is still relatively well positioned for further upside. Most people are worried that equities will dive since higher interest rates may mean that equity valuations will be lowered. Though this is ultimately true it is not so at the start of an interest rate rising cycle. In fact during the first 6-9months of a rate cycle equities perform quite well. If we see tapering (i.e. the reduction of easy money by the Fed) as real interest rises, and we use the Taylor Theorem to translate the 10bn$ per month of tapering into interest rate rises then we see that the Fed in effect is raising rates by around 0.7% each month. Tapering can hence be viewed as the start of an interest rate cycle. In effect at the start of this cycle we expect US equities to perform quite well. But as we get closer to the end of the year and tapering is taking its toll on the economy, and people begin to focus on the Fed funds rate rises on the horizon, then equities will begin to correct in our view.

That said, we see each major correction as a longer term opportunity in equities. The reason for this bigger picture view is that we see the 2008-09 crisis as significant as the Great Depression in the 1930s and believe that it was pro-active central bank action that has helped to avert a similar outcome. If the central banks of the world had not reacted in unison (with the Fed as the leader) then we believe we would have had a replay of the 30′s and instead of being called the ‘Great Recession’ the last crises would have probably been called the second ‘Great Depression’. With this background in mind we do expect equities to show strong performances for years to come. Of course they will have corrections and big ones especially when we get closer to the end of tapering and Fed funds rate rises, but in the larger scheme of things we believe we will see a multi-year rally in equities from today.


Hedge Fund Insight: You regularly attend Petroleum Week and indeed went to the last one. What did you get out of it?


Hakan  Kocayusufpasaoglu: I have been going to the IP week for nearly two decades and used to go for most of the week and various functions. But these days I go to one or two functions a year and not the entire week. This year I flew in on the Wednesday and left on Thursday. There are a number of functions which bring together a vast array of people from the industry and assist in the exchange of ideas. Since it occurs only once a year it is probably not much of a contributor to our trading nor our strategy formation but does assist in confirming views or raise question marks. Also it assists in seeing old friends, colleagues and working partners whom you may not have seen in a long while, since we are all busy people and often nowadays in different countries.


Hedge Fund Insight: How much of your portfolio could energy trades be? What is the largest they have been?


Hakan  Kocayusufpasaoglu: Although we have multiple decades worth of energy trading experience within the company, the vital point for us is not the size of exposure we have to an asset class but the correlation it has to other trades. For instance we may have 3-4 RV trades within energy that are not dependent on the direction of the market at all and completely uncorrelated to any other trades we have in our portfolio. In short it is not the asset class per se, but the correlation of each trade to others that is very important to us.


Typically we will risk between 1-3% of our AUM on any given trade. In other words if we are risking 3% on one trade and have another idea about another trade, but it turns out that the two are correlated quite strongly then we would not take the second trade. All our trades have to fulfill stringent criteria before we engage and one of them is that they are uncorrelated to other trading positions within our portfolio.


Hedge Fund Insight:  Can you talk about the Brent-WTI spread trade you have had on?


Hakan  Kocayusufpasaoglu: Both Brent and WTI are similar quality crude oils, produced in different locations. WTI is deliverable into Cushing, Oklahoma and is locally produced. Over the last decades WTI used to trade at a premium to Brent by about the transportation costs that it took to move crude from Europe to the USA. However, over the last few years we have seen that due to infrastructure problems the oil stored in Cushing was not able to move to the Guldf Coast nor to the refineries within the US that needed the product. Hence there was a logistical bottleneck which made a large amount of crude oil being accumulated in Cushing and hence drove the price of WTI below Brent. Substantially below Brent; at times more than 20$ below Brent. However, such logistical issues tend to be overcome given time, since a 20$ profit per barrel is an amazingly strong motivator. In fact, oil was delivered on the back of trucks, trains and any transportation that could be procured in order to lock in this vast profit potential. We expect WTI to strengthen towards 4.5$ below Brent, which is roughly the cost of transport of WTI from Cushing to the Gulf Coast.


Hedge Fund Insight: Is the Brent-WTI trade what you would classify as a relative value trade? How do you think of the portfolio construction in terms of relative positions and absolute  directional positions?


Hakan  Kocayusufpasaoglu: Yes, Brent-WTI would be classified as a relative value trade, since it is in effect the same product in differing geographic areas and the trade is to purchase one while selling the other. Other relative value trades can be across products or across time (time spreads), where one buys one product and sells the other due to some demand-supply disruption that is expected to last only for a small period of time.

When it comes to portfolio construction we are much more concerned with correlation risk, rather than RV trade vs Macro trade risk. Both strategies generate a decent return over time and we are as eager to take advantage of one type as we are of taking the other. It is the market environment that determines which trades are more prevalent at any given moment in time. However, it is vital to us that our trades are not correlated to each other, since then we are in effect putting on the same trade in just larger size. As long as our trades are uncorrelated and fit our risk parameters we are willing to take them whether they are RV trades or Macro trades.


Hedge Fund Insight: Thank you Hakan. I’m beginning to understand how you did so well last year.
Hakan  Kocayusufpasaoglu: Thank you for the questions.