What led you to found Haven Cove?
Myself and Ashley Hudd (CEO) have worked together in financial markets in different guises since 2008, and we had always shared an entrepreneurial spirit & ambition to set up our own investment management firm & fund.
The key driver for taking that step in January 2018 was the opportunity we believe there is in the Credit Derivatives market. The sector is approximately 20 years old and has undergone dramatic change since its arrival into mainstream financial markets in the early 2000s. We currently see a confluence of two factors:
- Continued high barriers to entry into the market & lack of crowding on the risk-demand side (due to a number of factors including inability for investment banks to hold this risk since regulatory change post-GFC).
- Significant progress & developments in the last 10 years in terms of depth & consistency of liquidity (across single names, index, tranche & options), standardisation of contracts & instruments across the industry, plus major progress in trading and clearing architecture. This means the “left-tail” or negative skew risks that many market participants failed to manage during the GFC can now be controlled very robustly.
Combining these two features gives an asset class which has significant and persistent pricing dislocations (value, technical, term, capital structure, volatility), but also a market infrastructure in which these can be capitalised upon (with the correct expertise) to produce extremely attractive risk-adjusted returns.
How has the fund performed?
The Haven Cove Absolute Return Fund was set up with a target of producing attractive, consistent returns through all market conditions with low volatility and low drawdowns.
In numerical terms, one could define this in many ways. For simplicity, we label this as a net annualised average return of 10% and an annualised Sharpe ratio of 2. We have other more nuanced risk-adjusted and correlation measures that we track, but we find the above to be a useful and simple objective.
Since inception the Fund has averaged 7.1% p.a. with an annualised Sharpe of 2.25, (in addition the max drawdown since inception is -3.6% from monthly NAVs, which occurred during March 2020). So we have slightly underperformed in terms of returns and slightly over-performed in terms of volatility and drawdown control.
The simple practical reasons for this are two-fold:
- New funds and emerging managers rarely get a 2nd chance after drawdowns! For the first few years of the Fund we concentrated first and foremost on volatility and drawdown control, and I think it is fair to reflect we did not use our full risk envelope at times, preferring to concentrate on absolute consistency, building up trust from our clients.
- A genuinely robust CDS trading infrastructure takes a long time to set up (getting sufficient CDS ISDAs in place, risk management tools, clearing etc) – far longer than the set-up required for e.g. a long/short equity fund.
The set-up we have now after 4 years of work is mature, robust and road-tested, and has everything we need to utilise our risk envelope to the full. On this basis we are very confident of achieving our targets going forward.
What is your approach to managing risk?
Our Credit Derivatives portfolio is a systematically constructed relative-value strategy, so risk management is very much built into the investment process.
We do not have an investment side constructing profit-generating ideas, which then get analysed by a separate risk function to assess whether they fit into the portfolio. The risk management framework is built into the systematic construction by the portfolio managers.
We then have an independent risk oversight function conducted by the non-investment side of the business.
There are 4 key risk pillars that we focus on:
- Unencumbered Cash (current live & stressed)
- CS01 (current live & stressed)
- Default risk
- Liquidity risk
Credit Derivatives as a pure long risk asset class does have negative skew properties and the key job of any CDS manager is to manage these unremittingly. This is why the stressed version of 1) and 2) above are so important, and is why Quantifi is so useful as an analytics tool for running CDS portfolios.
As well as knowing at all times the current live (i.e. “at-the-money”) risk on the portfolio, it is also necessary to continually measure how the portfolio would look in a stress scenario (roughly defined as: on-the-run spreads double & whole term structure moves in a parallel shift). Credit Derivatives have quite a useful feature in respect of unencumbered cash in a stress scenario: when trading CDS bilaterally (i.e. under ISDA) the initial margin % on any position is agreed on Day 1 and cannot change during the life of the trade. So unlike long/short equity strategies which are subject to a “portfolio” margining method that can change in market stress at the discretion of the prime broker, the initial margin on bilateral CDS is fixed. This means cash modelling in stress scenarios can be done accurately.
What, if any, are lessons learnt from the COVID-19 pandemic?
Expect the unexpected!
In all seriousness, the Fund fared relatively well during the height of the COVID-19 crisis in Feb/March 2020. In the months prior our time-series risk allocation signals were flashing overbought conditions in the Credit Derivatives sector so our Long book was relatively under-powered. Added to this, implied volatility had been relatively cheap so our Short book had a powerful set of tail hedges and very strong positive convexity coming into the market volatility.
We believe it was a good road-test of the risk framework and processes we have put in place to manage risks in the CDS market. We also believe the CDS market itself came through the crisis with distinction, showing strong liquidity throughout (greatly superior to its physical credit cousin), despite the unprecedented conditions.
What trends do you foresee in the short/medium term?
Credit Derivatives is such a rich area of opportunity with so many idiosyncratic dislocations that will continue to present themselves over the coming years. We believe the sector will continue to develop in terms of liquidity & infrastructure, attracting more participants as understanding improves and the opportunity set becomes more widely recognised.
We believe the next few years will be very challenging for the more “traditional” risk assets based on current valuations and the inevitable difficulties the markets will face in the next phase of the economic cycle, especially coming into it with inflation where it currently stands.
On this basis we believe alternative assets should form part of any active investor’s portfolio. However, we also believe the crowding present in some typical hedge fund strategies (L/S Equity in particular) means this should be a good time to seek something a little different.
We believe our relative-value Credit Derivative strategy will continue to produce consistent & attractive absolute returns in whatever market conditions lie in store.