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The Billion Dollar Interview with Jeppe Laderkarl, Partner at First Quadrant Tactical Currency Allocation Long/Short USD

Eurekahedge

October 2013

Established in 1988, First Quadrant (FQ) is an innovative investment management firm specialising in dynamic asset allocation and equity strategies. Our client base consists of institutional investors around the globe. Headquartered in Pasadena, California, we actively manage approximately US$16.8 billion as of June 30, 20131.

First Quadrant’s goal is to provide clients with risk-managed products that deliver consistent performance using strategies that are intuitive and transparent. Our investment approach is theory-based and systematic; we rely on fundamental insights into markets and economies as the source of investment ideas and implement them using a systematic and risk-controlled process, while remaining adaptive to market events. Our firm’s largest investment is in a team of in-house investment professionals whose sole responsibility is to maintain and improve our ability to deliver high risk-adjusted returns.

Jeppe Ladekarl joined First Quadrant as a member of the investment team in November 2009. Before joining First Quadrant, Jeppe Ladekarl was the Principal Portfolio Manager for the currency and global tactical asset allocation portfolios managed by the World Bank Pension and Endowments Department. Before joining the World Bank, Mr. Ladekarl was a Special Advisor at the Danish Central Bank holding various positions in the Monetary Policy and Capital Markets Departments.

Eurekahedge: The currency markets have witnessed some swings over recent months and Eurekahedge research shows that currency-investing hedge funds are up 4.21% on average July year-to-date. How do the returns of your funds compare against the industry average?

Our comparable performance net of fees was 6.40% for July 2013 year-to-date.

EH: Tell us a little about your investment philosophy and your strategy – do you aim to exploit short-term directional trends in the currency markets, or are you a long-term player? Could you walk us through an example of the kind of trades that have worked well for you over recent months?

FQ believes that changes in the relative attractiveness of an economy drive changes in the value of its currency. While the fundamental underlying macroeconomic outcomes matter for that measure of attractiveness, we also believe that investor perception, interpretation and sentiment also matter in the short to medium-term. This top-down macroeconomic approach to currency investment, which in a systematic process blends economic fundamentals with behavioural biases, leads us to express views that have been played out from over a matter of weeks for our shortest-running ideas, to up to 16 months for our longest-running ideas.

For example, we entered Q2 of 2013 with a bullish US dollar position against smaller G10 currencies. Our models signalled that the US was in a much better economic state than the rest of the world in general, and the minor currencies in particular. While this position did not bear fruit initially, developments in May and June resulted in the portfolio achieving substantial gains during a period where most markets and other active strategies suffered.

EH: How did your fund perform in 2008 when most hedge funds delivered negative returns? What were some of the trades that worked for you during the crisis?

Unlike most hedge funds, our strategy profited nicely in 2008, primarily in the second half of the year. The period leading up to 2008 had seen investors seeking yield and returns in markets with shaky fundamentals, driving prices of low quality assets higher. The relative valuation part of our process increasingly found those moves to be excessive, and we positioned the portfolio to be short high-carry currencies and long low-carry currencies. As the crisis unfolded and investors around the world sought safety and quality, that defensive positioning profited. In addition, the large and rapid changes in relative interest rates during the year created significant shorter-term opportunities and profits. As for specific positions, only one currency let us down in 2008 -- we suffered a mild loss from our euro position. All other currencies were profitable for us in 2008. Our Japanese yen, Swiss franc and US dollar positions were long throughout the year and all provided strong returns.

EH: There are over 300 pure-currency-investing funds within the hedge fund space. What competitive advantage would investors in your funds have over those investing in other funds having a similar focus?

Our approach has historically been different from other currency funds because of what we do – but also what we don’t do. We do seek to uncover the underlying motivations or ‘drivers’ of the participants in the currency markets, and profit from the inefficiencies created by those drivers. While many use the word ‘fundamental’ to mean exclusively macroeconomic when speaking of those drivers, we believe that any underlying driver of behaviour and by implication markets is, by definition, fundamental.

While macroeconomic factors do play an important role in our approach, we also believe that currency markets can exhibit considerable noise in the short run that has little to do with developments in the relative attractiveness of economies. For us, that creates opportunities to enter into fundamentally based trades while risk-managing through the short-term noise. Additionally, we believe in providing a currency product that is truly liquid, uncorrelated and diversifying for our investors. This means we do not trade the typical currency strategies often found in currency investing funds. Specifically, we do not have any exposure to carry or momentum strategies, and we do not have any persistent bias to be either long or short any currency – including the US dollar – in our process. If you look at our historic returns, we believe you will find that we indeed have lived up to the aim of providing a return stream that is uncorrelated to whatever market or factor against which you wish to compare us.

EH: Could you tell us about the qualitative and/or quantitative research that you perform on the broad markets or the economy before taking positions in the currency markets? Do you rely on any electronic models for your research or analysis?

We use a systematic approach in investing. Although this means we build models to trade currencies, this does not mean that we start with data. Instead, we start with a fundamental idea or hypothesis -- why, for example, a change in inflation will lead a particular market participant to change the assessment of the relative strength of an economy. Data is then used to validate that idea or hypothesis. In other words, the use of data in our process comes second, never first.

This approach means we are not a black box. We can, at all times, lead our clients through our process, explaining exactly which ideas are driving a position in a particular currency at any  given point in time. This also means we have a better sense for what we don’t know. The investment team is tasked with continuously following developments in markets and economic circumstances in the countries in which we invest, and assessing if those developments are appropriate for the investment insights we seek to apply. If the investment team believes circumstances exist which may make the models less effective than normal, we will, as necessary, reduce or remove risk.

EH: Could you shed some light on the risk management principles that you have in place, in order to safeguard your funds’ investments?

We believe in taking risk to achieve return -- but not in taking uncompensated risks. If possible, our goal is to proactively identify and mitigate uncompensated risk, rather than react to risks as they occur, when it is often too late. With that goal of risk mitigation in mind, we start risk management at the research stage. In our opinion, finding ideas that are uncorrelated to each other, that do not rely on exposure to risk factors, that do not have undesirable distributional characteristics such as left tails and that work over different time horizons is an important step in building a proactively risk-managed investment process.

When investments are made, we seek to optimise the positions in the portfolio to reach the highest expected return for the risk level of the fund. We will adjust the level of risk in the portfolio to take into account unintended factor exposures or undesirable distributional characteristics. For example, if we see a set of concentrated positions that historically have given returns that are more negative than positive in the extreme (the distribution has a large left tail), we would reduce risk in the portfolio. We also monitor for event risk that our risk models do not know about, adjusting the portfolio as necessary to avoid exposure to the types of event risk our views are not intended to capture.

As a final point, we believe in checks and balances when it comes to risk. We have a risk department that, independently of the investment team, provides analysis and oversight of the risk in all our portfolios. This department reports directly to our firm’s Managing Partner.

EH: How do the research and risk management of your fund drive synergy with the broader resources of First Quadrant? Are there some central investment themes that each fund must adhere to or is each fund run more or less independently?

As a firm, First Quadrant is focused on asset allocation strategies. As such, both research and risk management of the currency strategy is part and parcel of the firm as a whole. All of FQ’s strategies that either fully or partially provide active currency exposure use the exact same process. We do not have different funds with different currency ideas. All clients participate fully in our best ideas.

EH: Which classes of investors, according to you, is your fund ideal for? And, what are the types of investors that have shown interest in your funds so far?

Our currency strategy has been used by many different types of investors over the years, including domestic and international corporate and public pension plans, foundations and endowments, sovereign wealth funds, sub-advised mutual funds and high net worth individuals/family offices. Because we target a low correlation to markets and other strategies, our marginal contribution to the risk-adjusted returns of existing portfolios have been for the most part attractive to investors. We seek to manage the strategy in such a way that the end product would be a truly liquid, diversified and diversifying alternative investment. Recently, we have seen investor interest in using our currency product as a proxy hedge for equity tail risk. This particular use of our strategy is relatively new and has us being used on a standalone basis by investors that have the expectation that we will provide returns when others have a hard time.

EH: Given the current global themes of a sell-off in emerging markets, a ‘recovery’ in China, fears of further US intervention in the Middle East and QE-tapering by the US Federal Reserve – how are you positioned going forward in the short term?

Broadly speaking, we believe we are positioned for a positive change in the perception of the attractiveness of the largest economies in the developed world against the smaller developed market economics. In practice, this means we hold bullish positions in the currency of large countries like the US, UK and the euro area against bearish positions in New Zealand and Canada. Our views are driven by different factors for the specific countries, but in general we believe the recovery in China will not lift growth in the commodity-exporting countries high enough to compete with the growth and monetary policy trajectory in the larger economies.

EH: How do you see the currency markets trending over the medium to long-term?

Our currency process does not rely on trends to work. We rely on major market participants to react to changes in the macroeconomic or market environments in a particular manner. We increasingly see normalisation when it comes to behaviours of various buyers and sellers of currencies, which, we believe, bodes well for our process regardless of whether this will result in mean-reverting or trending markets.

AUM and performance quoted for the most recent period may be preliminary. Past or simulated performance is no guarantee of future results. Potential for profit is accompanied by possibility of loss

Footnote

1The historical AUM presented for any particular period of time reflects the preliminary AUM figure calculated at the end of the period. Includes market values for fully funded portfolios and the notional values for margin funded portfolios, all actively managed by First Quadrant and non-discretionary portfolios managed by joint venture partners using First Quadrant, L.P. investment signals. First Quadrant is defined in this context as the combination of all discretionary portfolios of First Quadrant, L.P. and its joint venture partners, but only wherein FQ has full investment discretion over the portfolios.

 

 

Contact Details
Cassie Williams
First Quadrant, LP
+1 (626) 683 4171
cwilliams@firstquadrant.com
www.firstquadrant.com

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