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 subsidised
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 stabilise 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.
The issue of the relationship between development of financial systems
(including currency markets) and economic fundamentals has been a much studied
topic. The numerous studies on the topic confirm a positive and significant
relationship between them. Successful financial sector reforms should translate
into higher GDP for a country.
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