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A Hedge Fund Chronology

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Part one of a three part series.

My partners and I started our fund two years ago to manage private (and then public money) on a hedge fund basis. Over this time we have built a particular infrastructure and methodology that we feel maximizes the effects of asset allocation.

I am responsible for the volatility portfolio and overall risk. We manage our money on an opportunistic basis, moving capital quickly to where we believe the best return for risk exists. These opportunities focus on volatility and consist of wider than normal discrepancies in the relative prices of things like convertible bonds, options, and other derivatives. In order to effectively trade and build a volatility portfolio, we generate opinions on nebulous factors like the macro-economic environment and market technicals and fundamentals. These opinions also allow us to make diminutive volatility bets between correlated assets within it.

Once we offensively construct our portfolio from the top down through a series of opportunities, we analyze it for risk from the bottom up. This means that we take the whole portfolio and stress test it under various market conditions, changing variables like price, time, volatility and interest rates. If we find that we are uncomfortable with the overall risk or even a particular risk, we will take action to hedge that risk away.

An example of this process occurred around two to three months ago. As I talked about in a few pieces, the convertible bond market was in a shambles then. Credit spreads were still fairly wide and bond managers were at the same time hit with the prospect of companies raising dividends as a result of new tax legislation. They were forced to sell many older issues at risk of suffering from this phenomenon, but as a consequence they also became less aggressive in bidding for new issues that were coming out that subsequently had protective covenants put in place.

We were basically out of this market before this period, not because of any special prescience, but simply because prices several months ago were simply too high for our liking. We had plenty of room to become more aggressive in buying new issues that were cheap. But we were unlikely to become overly aggressive (buying on leverage) unless we could find an effective way to hedge the risk in this trade that we were concerned about. As I have explained in other pieces, setting up a convertible bond trade has several risks, the most costly to hedge away being credit risk. In my mind, being exposed to credit is like being short an option: it may never be a problem, but if credit begins to deteriorate, the trade can be disastrous if too much leverage is used.

The offensive opportunity was there, but when we looked at overall risk we were uncomfortable with using too much leverage without a good defense. The defense was provided by relatively cheap options. The risk of the trade was that credit spreads widened dramatically. We understand that there is a very high likelihood that if this occurred, volatility would pick up, especially in certain sectors of financial companies that provide credit and credit hedges that would also suffer from a general rise in rates that could occur as well. The implied volatility of the options of these companies was cheap enough, not perhaps for an offensive trade, but certainly to provide a correlated hedge that allowed us to play offense with the extremely cheap convertible bonds.

So we levered up about three to one and bought cheap convertibles (as everyone else was either selling or not buying) and at the same time used the volatility portfolio as a defense: we bought straddles (long volatility) in many names.

It gets complex when going into details, but you get the picture. Suffice it to say that as liquidity continued to flood the market, the equity market picked up, credit spreads narrowed, and convertible bonds had one of the best months in years last month. Of course volatility continued to come in and our defensive trade cost us money, but the convertible bond positions made three times the losses in our volatility hedge; net the overall portfolio was up 1.75% last month. As I write this, we have now liquidated half of our convertible bonds and will likely continue to sell at these prices. We are keeping on our volatility positions as they now are at prices that make sense offensively: our gamma/theta relationship is very good.

Some might say, "Well, you could have made more money just by buying the convertible bonds". This misses the point entirely: we would not have done the trade, at least not to the magnitude that we did (although I guess some managers would have), because of the risk. And there lies the primary driver of our fund: risk control.

NOTE: Please understand that this is not a solicitation of any kind. We share the process with you for the sole purpose of education. Stayed tuned for parts 2 and 3.

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No positions in stocks mentioned.

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