THE EDGEOctober 2015

Q4: Women & Investing

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The Biology of Trading 3

The Rooster vs. The Hen: Who Delivers The Goods? 5

Co-founding a hedge fund 8

Where next for China? 14

The Most Common Operational Breaches Investors Fail To Spot During Due Diligence 18

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s the summer turmoil reminds us of the fragility of the financial system, we examine

the matter of gender diversity in the markets as a possible moderating influence. With the increasing breadth of research undertaken on how gender affects investment styles, preferred time horizons and performance, we’ve invited three guests for this quarter’s publication to discuss ‘Women & Investing’. They will take on three perspectives - neuroscientist, industry researcher and hedge fund co-founder.

As Dr John Coates, neuroscientist and former Wall Street trader (Goldman Sachs, Deutsche Bank) explains, it seems that men experience an enormous "winner's effect" (where winning can feed on itself to lead to more wins). At a certain point, they go over the top of this inverted U-shaped dose response curve and there, any further increases in testosterone decreases the returns. However, this is not something that women experience, who often outperform men over long-term investing.

So why is it that when Meredith Jones, author and renowned researcher, prompts you to name

a famous investment manager, there would be few, if any women, in the first 10, 20 or even 50 names that spring to mind? Read on for the six factors that lead men and women to different approaches in investing.

Wonderfully exemplifying the intersection between research on the benefits of investing with female investment managers and the entrepreneurial spirit typified in Silicon Valley culture is Nadine Terman, co-founder of hedge fund Solstein Capital. The featured article for this edition, we discuss at length her approach to investment and her drive to increase capital allocation to women-owned and -led investment firms.

As always, our staple sections see guests comment on topical market outlook and operational concerns. BlueBay Asset Management's Head of Credit Strategy David Riley outlines key points of note for China in the upcoming quarter and Laven Partners' CEO Jerome Lussan notes the most commonly overlooked due diligence red flags accompanied by case studies.

From the Editor

Maggie Yang

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We would like to thank each of our contributors - Nadine Terman, Meredith Jones, Dr. John Coates, David Riley and Jerome Lussan - as well as Edgefolio's advisor, Aude Thibaut de Maisieres, and designer, Michael Worley, for giving so generously of their time. and efforts.

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Dr. John Coates

Meredith Jones

Nadine Terman

BlueBay Asset Management

Laven Partners

The Biology of TradingN your book, you describe the “winner effect” as it applies to

traders: an upward spiral of confidence, fuelled by increasing levels of testosterone in the body, which inevitably tips into overconfidence and pathological risk-taking, leading to cycles of boom and bust. Are women susceptible to the “winner effect” in the same way?

Dr Coates: It should be noted that it wasn't the win itself that was raising the testosterone levels of male traders, it had to be an above-average win. At some point, they go over the top of this inverted U-shaped dose response curve and there, any further increases in testosterone decreased the returns. It looks like that doesn't happen to women. The consensus used to be among psychologists, led by Amos Tversky, that there is no such thing as a “hot hand” in sports, that a “winner effect” is a cognitive illusion, just like streaks of luck in dice. To me that belief is a complete denial of our biology. The “winner effect”, as fuelled by rising testosterone in the body, has been robustly tested in animal behaviour and replicated in sport; and it demonstrates that winning can feed on itself in humans because of the physiological processes in the body. In men, we found an enormous winner effect. And none in women, who have only 10-20% of the testosterone of men. As a result they don’t tend to expand their risk to the point of owing up.

Although women on average, for their long-term stress response, have same levels of cortisol as men, research suggests that their stress response is triggered by slightly different events and that they may be less hormonally reactive than men. You yourself actually advocate that greater numbers of women among risk-takers in the financial world would help dampen volatility in the markets. Do you think women actually have a competitive advantage in risk taking?

Dr Coates: The trouble with doing these kinds of experiments in markets is that it's hard to get a big enough sample of women traders, who make up at the most 5% of a trading floor. What we know is that, in opposition to the belief that women had lower risk appetites than men, our research shows no difference in risk preferences between men and women. However women show a preference for longer holding periods, which could explain their relatively larger numbers in asset management. It would seem that men are good in the high-frequency space, whereas women often outperform over the long haul.

So how could trading floors increase gender diversity to benefit from this different skill set and diversification effect? Dr Coates: If women have an advantage over longer holding periods and men in high-frequency space, the answer is to have a trading floor with both men and women and to encourage longer holding periods than current reporting periods;

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R John Coates, Research Fellow, University of Cambridge, researches the biology of risk taking and stress. He previously traded derivatives for Goldman

Sachs and ran a trading desk for Deutsche Bank. He developed techniques for valuing and arbitraging the tails of probability distributions, and for trading low probability events such as financial crises. He is the author of The Hour Between Dog and Wolf: How Risk Taking Transforms Us, Body and Mind.

THE EDGE �3

by EDGEFOLIO Thursday, 1 October 2015

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and for compensation schemes and risk management to allow that. It's a problem if you have someone who's really good with a one-year holding period, but they're judged quarterly. Ideally, the judging period, would take into account an entire business cycle. As long-term out-performers, you would find that the markets naturally select for more women portfolio managers and traders without need for affirmative action.

You left trading and the markets to pursue research. Do you miss it?

Dr Coates: Yes, I miss the markets. I continued trading after I left Wall Street and found out that I was better than I thought (without the resources of the bank behind me). I probably did some of the best trading of my life after I left Wall Street, but then the science I was doing just swallowed me. Science is 16 hours a day, 24/7. I used to put on positions and then I'd be in a lab meeting and suddenly recall that I'm long on USD-YEN - I had just completely forgotten I had a position on! After the meeting, I'd run out and check the markets and realise that I'd had the position on for two weeks. So I had to stop. But lately the markets have been so interesting that I have made time to put on some vol arbs. I am also involved with wearable technology to access the biological markers such as rising cortisol levels (in one experiment, 68% rise across the trading floor over two-week period significantly affected traders' risk preferences).

A number of cutting-edge hedge funds see this human optimisation as the next thing that will give them an edge.

N this startling book, physiologist and former Wall Street trader John Coates

graphically illustrates what happens to your body when you place a bet in the financial markets. He tells a gripping story of a group of traders caught in a bull market and then a crash. As the excitement builds he takes us inside the traders’ bodies to see the biology of risk taking at work, a biology shared by athletes, politicians, soldiers – anyone venturing beyond their safety zone. Coates then discusses how men and women excel at different types of risks; the stress of failure; and how we can train our bodies so that they help rather than hinder our risk taking.

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Further reading:

— Coates, J. “From molecule to market: steroid hormones and financial risk-taking.”

— Coates, J. “Endogenous steroids and financial risk taking on a London trading floor.” 

— Barber, B., and Odean, T. "Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment." 

THE EDGE �4NEUROSCIENTIST

by EDGEFOLIO Thursday, 1 October 2015

Many thanks to Aude for leading this interview.

The Rooster vs. The Hen: Who Delivers The Goods?Quick! Name a famous investor!

HAT names came to mind? I bet you immediately thought of Julian

Robertson. Or George Soros. Or Warren Buffet. I would be willing to bet that if you scrolled through the first 10, 20 or even 50 names that sprang to mind, there would be few, if any women, in your list.

Part of the reason has to do with supply. The number of women in the financial industry has been and remains remarkably low. In private equity and venture capital, roughly 10% of female executives are women. In the hedge fund universe, there is roughly an 80:1 male to female ratio. Morningstar recently determined that women comprise less than 2% of the mutual fund world. Even in the relatively “popular” female roles like Registered Investment Advisors and Certified Financial Planners, the numbers are still abysmal. Less than 30% of RIAs and less than 23% of CFPs are women.

In an effort to quantify gender inequality at the highest ranks of society, in 2015 the New York Times created a “Glass Ceiling Index” that examined the ratio of men to women in high-powered positions. They discovered that there are four CEOs named John, James, William or Robert to every one female CEO. There are 2.17 Senate Republicans with those monikers for every one female Senator. There are 1.12 men of those names for every one female economics professor. But if you think those numbers are low, they aren’t anything compared to the ratio of John-James-William-Roberts to female fund managers. My research shows there are 11 male hedge fund managers with those names for every one female hedge fund manager. This lack of women is not just unsettling, it could be decreasing returns and increasing market volatility. As the old saying goes, “the rooster may crow, but the hen delivers the goods,” and new research is showing that wisdom may also apply to investment returns.

My 2012 & 2013 research for Rothstein Kass showed that women-run hedge funds and private equity funds outperformed the hedge universe at large by a margin of six percentage points over six-and-a-half years. A 2015 study by Kyria Capital highlighted that women-run hedge funds are more likely to produce top-quartile performance. Although a June 2015 Morningstar study was less conclusive, it did reveal a slight edge for mixed gender teams. However, by examining the entire (and growing) body of performance research on female retail and professional investors, it is easy to see a consistent and compelling trend towards outperformance by female money managers.

And while it’s tempting to write off these statistics with arguments of “best and

EREDITH Jones is an alternative investment consultant and the author

of The Women on the Street: Why Female Money Managers Generate Higher Returns and How You Can Too. She created the first Women In Alternative Investments Hedge Fund Index at the professional services firm Rothstein Kass. She writes a weekly alternative investment blog here.

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THE EDGE �5INDUSTRY RESEARCHER

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by EDGEFOLIO Thursday, 1 October 2015

brightest bias,” I urge investors to take a closer look at the data. Yes, the women that have attained portfolio manager roles have had to run a significant Wall Street gauntlet, one which some would argue weeded out any weak performers and left only the strongest female portfolio managers standing. However, the literature on outperformance goes beyond the relatively small sample of professional money managers to explore the female retail investor mindset. In that research, which has been conducted on thousands and thousands of men and women investors, we see similar behaviours and similar outperformance. It seems highly unlikely that women retail investors would have investment characteristics and performance that wouldn’t be present, and perhaps amplified, in female professional investors.

At the very least, research shows that women and men approach investing differently. While researching my book “Women of The Street: Why Female Money Managers Generate Higher Returns (And How You Can Too)” I determined that the following factors led men and women to different approaches to investing:

Biology – Even though women are often stereotyped as “more emotional” when it comes to investing, that may not be the case. Brain structure and hormones impact how men and women interact with the markets, and can influence everything from probability weighting to risk-taking to market bubbles.

Overconfidence – There have been a number of studies that

show men have a higher tendency to be overconfident investors.

Overconfidence can manifest in a myriad of poor investment practices, including over-concentration in a single stock, not taking money off the table, riding a stock too far down (“It will come back to me”) and overtrading.

Better trading hygiene – One very crucial side effect of

overconfidence is overtrading. Overconfident investors tend to act (buy or sell) on more of their ideas, which can lead to overtrading. Over time, overtrading can significantly erode investment performance.

Differentiated approach to risk – Although women are often

stereotyped as being more “risk adverse,” the truth of the matter is a bit more nuanced. Men and women weigh probabilities differently, with women generally having a flatter probability weighting scale. This means they tend to not to inflate expected gains as much as their male counterparts, which can be beneficial in risk management and in minimising overall market bubbles.

Avoiding the herd – Women may be more likely to look at

under-followed companies, sectors, geographies or deal flow in order to obtain an investment edge.

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THE EDGE �6INDUSTRY RESEARCHER

by EDGEFOLIO Thursday, 1 October 2015

Maintaining conviction – Female investors may be better at

differentiating market noise from bad investments. Women tend to be less likely to sell underperforming investments simply because of broad market declines.

I think most investors will agree that behaviour impacts investment performance. Billionaire Seth Klarman once said that “Investing is the intersection of economics and psychology,” and it seems increasingly undeniable that that statement is true. Whether it’s the behaviour of the individual investor, the investment advisor with whom they work, the money managers to whom they allocate or even the broad market, macro-economic behaviour (like the “January effect” or market bubbles such as the tech wreck).

Even the market turbulence in late August can, in some ways, be blamed on behaviour. While some would blame the sell-off on a single source (China), others argue that the accumulation of bad news caused under-reaction (as news started to trickle in in July) followed by overreaction as the flood

of bad news (oil prices, China, etc.) continued to come. You simply can’t escape the fact that behaviour matters when it comes to investing. Let’s think of it this way: There are a growing number of studies that show that cortisol, the stress hormone, and testosterone interact in interesting ways when it comes to investing. One study that I highlighted in my book looked at men and women’s trading behaviour as cortisol levels rose. They put the subjects’ hands in ice water to simulate stress and increase cortisol levels. The study showed that men, as cortisol levels increased, had a tendency to make riskier trades. Women did not have a similar reaction. So during a stressful event such as a market sell-off, an all-male investment management team has their hand in the same bucket of ice water. They may increase their risk-taking, creating correlated behaviour among money managers. And we all know correlation is not our friend during market sell-offs.

So my question is this: If we diversify portfolios by geography, liquidity, number of investments, asset classes and other factors, why don’t we also consider diversification from a behavioural and gender point of view?

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Women of the Street: Why Female Money Managers Generate Higher Returns

OMEN of The Street looks at behavioural and biological investment research to explore how women think about investing,

and to determine why women may have a money management edge. The book then identifies and interviews 11 top female “market wizards” in hedge funds, private equity, venture capital, and other asset classes to see how women’s innate investing characteristics translate in different strategies and markets into significant profits. From less overconfidence, overtrading, and testosterone to a greater tolerance for market noise and more consistent application of investment strategy, there are a number reasons why women approach investing in a unique way. Women create both cognitive and behavioural "alpha" with their investment style, which contributes over the long-run to outsized investment returns.

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THE EDGE �7INDUSTRY RESEARCHER

by EDGEFOLIO Thursday, 1 October 2015

Co-founding a hedge fund N 2010, Ms. Terman co-founded Solstein Capital, LLC with J.C. Torres. At

Solstein, she oversees investments and operations of the fundamental value, global manager. Previously, she was a Partner with Blum Capital Partners and served on its Investment Committee. Nadine has a B.A. with Honors and with Distinction from Stanford University and was recognised with the Firestone Medal for Excellence in Research and as Phi Beta Kappa. In addition, she earned an M.B.A from the Stanford Graduate School of Business, where she was an Arjay Miller Scholar.

One of Nadine's key personal initiatives is to increase the capital allocation to female fund managers. In 2013, along with another San Francisco manager, she created a fully sponsored conference for the group 100 Women in Hedge Funds that joins leading asset allocators with woman-owned or -managed hedge funds. Starting in San Francisco, this conference is poised to expand to the East Coast and to Europe. In 2015, she was named as one of Institutional Investor's Hedge Fund Rising Stars.

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Nadine Terman Solstein Capital

CEO, Co-founder and Managing Member

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THE EDGE �8HEDGE FUND CO-FOUNDER

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Click here to visit Solstein's webpage

In line with the theme for the publication, do you agree with

Meredith Jones (above) that women create both cognitive and behavioural “alpha” with their investment style, contributing to outsized investment returns in the long run? Do you feel your gender has given you an edge in investing?

UR style at Solstein is much more opportunistic in long-term, high-

conviction investments. When I consider gender on the investment side, I first think about it in broader terms of diversity research (whether at Stanford or other major institutions), which shows there's significant, identifiable benefits to diverse teams – to name a few, it improves decision-making, breaks up groupthink and improves effectiveness. At our firm, the key aspect of our edge is a team-based approach, so having diversity through gender (myself and Sandra), nationality (across the board in our team), professional experience or other areas definitely contributes an edge. So I wouldn't say it's only the woman aspect to it, but diversity across the board. As an example of how the advantages of diversity are highlighted in our investments, when we're performing due diligence and we want to access key individuals within an industry ecosystem, it should be obvious to anyone that you want your collective network to be as broad as possible in order to find and access those key individuals who are going to help you with due diligence. So rather than considering whether has gender helped me, I think about how diversity as a whole has helped our team.

In relation to Meredith’s research, I'd say that our investment style of high-conviction, long-term investing is very in

line with the behaviours that have been analysed in women investors. From her and others’ research, women trade positions less – all else equal, men traded stocks nearly 45% more often than women and therefore, their net returns were reduced by almost a full percentage point compared to women. At our firm, our turnover statistic has been around two years, clearly exemplifying the characteristics and benefits of female investing.

The second characteristic was that in periods of major market downturns, women tend to act differently – they maintain their convictions and can benefit from holding positions out of the downturn. When I look at our strategy, whether it's because I'm a woman or just it's the way we invest, we actually like periods of confusion and dislocation as providing attractive entry points so we can find businesses on sale. Then, we monitor positions and perform due diligence to ensure the return drivers are coming to fruition. So again, that's a behaviour aligned to the universe of research on female investment behaviours.

Another characteristic that, again, we exemplify particularly well at Solstein, is how gender relates to level of confidence and how women relate to risk-assessing and risk-taking – how you view risk and, when you're acting, how you take risk. At Solstein, from the type of businesses we target, to the management teams we back, to the securities we own, we're actually looking to minimise mistakes – not that anybody else isn't – but it forms a very specific focus in our investment process. To this end, our team has managed losses in dollar numbers fairly well by maintaining that focus on that capital preservation. This strategy enables the rest of our portfolio to compound over time much more easily.

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THE EDGE �9HEDGE FUND CO-FOUNDER

by EDGEFOLIO Thursday, 1 October 2015

If you don't lose a lot and don't lose very often, when you do win, it's going to impact the portfolio more.

So it's several elements, when I was looking at Meredith's and others’ research, that we are data point supportive of their research of the impact of gender on investing.

Hedge Funds are definitely very entrepreneurial in nature – what

prompted you to co-found one?

OU know, when I saw the question I laughed because living in Silicon

Valley, it doesn't seem very heroic or unique to start your own business. But at the same time, it's probably not as daunting either. Starting our firm was a destiny in many ways. Our founding team, we'd worked together for so many years at a well-known activist firm before launching our own fund in August 2011. Throughout all the years working together, we shared a

set of personal and professional values that became the foundation of our firm. Most notably, our team-based approach across investments and operations is key to Solstein’s identity and strong foundation. Also, we designed the firm with the intent of alignment and longevity. Building an investment firm requires alignment across many elements-- culture, capital base, investment philosophy, incentives, processes—just to name a few. We were mindful in how we designed Solstein and sought to build a firm that would be aligned with and invested in our clients’ long term financial success, across these various elements.

Being based in Silicon Valley, was the building of your company

culture very deliberate and very much influenced by the start-up and tech world?

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THE EDGE �10HEDGE FUND CO-FOUNDER

by EDGEFOLIO Thursday, 1 October 2015

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N some ways yes, and in some ways, no. We don't have free food, no one

does our laundry (laughs), and some of the perks you might get at Google and Uber, we don't have. But I would say that entrepreneurial aspect of it is definitely ingrained in our culture –I think since day one, everyone's always been ready to pitch in and help. That's representative of that startup-type culture that you need to have when you're building a tech company, or any type of company.

It was definitely a conscious choice when we built the culture at Solstein. We had a long history of working together, but something we did quite deliberate is that my co-founder and I went out and interviewed various investment managers that we thought really highly of and asked them to look back 20, 30, 40 years ago, as they built had built their firm. What were the challenges that they faced and why, what might they have done differently, what were the things that they did well or think that they do well now, what kind of advice would they give a new manager? So for ten months before we launched our fund, we actually used a blank slate and worked to design culture and processes. I’d say the diverse nature of our team was not a conscious decision – we were picking the best for the positions. But I think when you have an open mind, it naturally leads to a diverse group of people.

With regards your experiences in the United States investment

industry, do you feel there is still a significant promotion gap between top male and female investment managers?

think there's an entire lifecycle gap, not even with the promotion, but with the

whole lifecycle – from the number of women entering the business, to being promoted, to leading and managing the business, to starting their own firms, to raising capital. Meredith [Jones] quotes a roughly 80-1 ratio in hedge funds, so I really think you have to look at the entire professional lifecycle to understand why that is the case. I prefer to think about change and what can be and how I play a role in that future.

It starts with capital allocation. Linking fund managers to capital allocators is one example where I think I can make a difference specifically. If you can get money to women, more women will start funds, hire diverse teams. I believe change can occur faster through capital allocation than at the start of the pipeline. Let’s create more firms who are open to developing diverse teams.

At the end of the day, investing continues to be a very data-

driven process. As a long-term, value-oriented investor, how has data played a role in your investment processes?

N many respects, we’re playing a different end game than most other

investors – our edge doesn’t come from paying for satellite data to get images of

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THE EDGE �11HEDGE FUND CO-FOUNDER

by EDGEFOLIO Thursday, 1 October 2015

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parking lots so we can count cars outside a retailer to get an edge on next quarter’s results. We're trying to understand and capitalise on multi-year trends within an ecosystem. Therefore, we collect and use data in a much different way than other investors in the marketplace. At Solstein, when we identify a potential investment, we also identify a very specific due diligence process over the short, medium and long term. Then the team performs immersive due diligence across the lifespan of the investment in order to confirm or disprove the investment thesis. Of course, our team’s initiatives often include data collection and interpretation. So there's a bit of an art and science when it comes to collection and interpretation, given the element of time.

Allocators don't want the same names across their managers’ portfolios, so even if you have good returns and you manage risk appropriately according to your stated targets, you have to be bringing something different to the table. So it’s the independent collection and interpretation of data that lets us reach that differentiated view as a team and create a differentiated concentrated portfolio.

With your focus on predominantly developing and

select emerging markets, your eye must be on China. Where do you see the fundamental drivers?

EGARDING China, obviously it’s a big question. Our take for the long-term

is that, as has been the case with other major economies of the world, the path to increased economic development in China is going to be dynamic. So the US, for example, went through periods of great expansion and contraction, but over the

course of time, it's been a wonderful source of opportunity. So rather than trying to forecast short-term market swings in China, we focus on long-term, secular trends and how they affect businesses at their fundamental level.

China plays a key role on both the supply and demand sides of the equation for a whole host of businesses around the world, regardless of local stock market gyrations. So we think about China as it relates to these businesses, but we also consider the effect of Chinese political influence on security prices, which may present a short run volatility challenge. To put it in perspective, when there's that choppiness, we don't really need to call a bottom, we just need to understand the long-term drivers more and then understand where an attractive entry price is.

What key markets will you be focusing on over the next

quarter?

HE team is highly focused on building an investment in Spain with specific

value drivers that are identifiable and – if I can make up a word – “due diligenceable”. Our targeted business has strong cash flows, long term contracts, an experienced management team, and multiple ways to increase value for shareholders that are not dependent on the economy. That said, Spain’s economy has been improving, which can be seen in various published data points. Continued improvement would act as a free call option for our investment. Also, the business underlying our investment should be unaffected by regulation or the upcoming elections, from a risk perspective, which we care deeply about.

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THE EDGE �12HEDGE FUND CO-FOUNDER

by EDGEFOLIO Thursday, 1 October 2015

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We also have six businesses on deck at the moment, headquartered in Europe, Asia and Latin America. They span very different industries, including financial services, healthcare services, telecom infrastructure and media, and our priority pipeline is now focused on that list, but it does change every few weeks as we complete due diligence. Our goal is to be prepared so the incremental work we have to do on an investment before execution is quite small. We're trying to be very ahead of the curve while doing work on a few

things so that we're ready if a dislocation arises.

Finally, what do you believe has been the most challenging part of

your career and what advice would you have given yourself 10 years ago?

HERE were different challenges at different stages, so perhaps the key

challenge is actually to embrace that fact. Especially as an entrepreneur and an investor in the public markets, you can't expect to be in control of your destiny each day. So it's about having the right mindset and being prepared for those unexpected challenges that change over time.

Looking back 10 years ago, I would advise myself that just because you haven't seen many others like you forge your intended path, it doesn't mean it's overly difficult to do. My husband and I try to instil the same message with our three children. Not seeing a long list of other trailblazers before you shouldn’t delay you or stop you from forging ahead.

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THE EDGE �13HEDGE FUND CO-FOUNDER

by EDGEFOLIO Thursday, 1 October 2015

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Where next for China?

With the impact of developments in China having global ramifications, how can investors position themselves to avoid the fallout?

Key points

China’s surprise currency

devaluation and manufacturing

downturn was the catalyst for the

sell-off across global financial

markets to become a key source of

global macro and market instability

Chill deflationary winds from

China and decreasing commodity

prices are intensifying and will keep

global inflation and interest rates

lower for longer

Click here to visit BlueBay's webpage

OUNDED in 2001, BlueBay Asset Management LLP

provides investment management services primarily to institutions and manages a combination of long-only and alternative strategies across the sub-asset classes of investment grade corporate debt, convertible bonds, high yield debt, distressed debt, loans and emerging market debt. BlueBay also manages a number of segregated mandates on behalf of large institutional clients globally. Based in London with offices in the USA, Japan, Hong Kong, Switzerland and Luxembourg, BlueBay Asset Management LLP is one of the largest independent managers of fixed income debt funds and strategies in Europe with over US$61.1 billion of assets under management (as at 30 June 2015). BlueBay's overall aim is to provide a broad range of credit products to modern institutional investors which offer attractive risk-adjusted returns.

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THE EDGE �14MARKET OUTLOOK: CHINA

by EDGEFOLIO Thursday, 1 October 2015

Fears of a China-led global

economic slowdown prompted

the US Federal Reserve to delay its

first rate rise in almost decade,

further adding to recent market

volatility

In our opinion, markets’ have

become too pessimistic on the

outlook for global growth and the

correction and volatility in asset

prices has broadened the opportunity

set for active investors

Pressures are mounting on Chinese policy

makers

ROM China’s perspective, the

potential for mistakes as policy

makers seek to rebalance the economy to a

‘new normal’ i.e. one less reliant on credit-

intensive heavy industries while sustaining

growth and employment, are rising. If

monetary policy is too tight, it could

precipitate a hard landing. However, much

easier credit conditions could prompt a

further unsustainable debt splurge and

increase risks to financial stability. The flow

of weaker-than-expected indicators of

activity and the boom and bust in Chinese

equity markets underline the challenges

facing Beijing.

China’s shift towards a more flexible

exchange rate regime is a significant policy

change motivated by the weaknesses of

the Chinese economy, as well as being a

necessary reform for the International

Monetary Fund to confer global reserve

currency status on the renminbi. China has

now become an aggressive participant in

the global “currency war” and is no longer

an innocent bystander.

Concerns over China are also exacerbated

by weaknesses in the official data and

arguably a more accurate picture of the

current state of the economy is derived

from tracking other measures, such as

purchasing managers’ surveys, trade data

and rail traffic volumes. These indicators

suggest the economy did slow in the first

half of the year even though the official

GDP statistics suggest growth was stable

at 7%. Weaknesses in China’s economic

statistics and opaque policy-making means

China will remain a source of global macro

uncertainty and market volatility.

Moreover, the Chinese government’s

response to the recent equity market

volatility and the unexpected shift in the

exchange rate regime has shaken

confidence in the ability of Beijing to

effectively manage the necessary re-

balancing of the economy and avoid a more

severe ‘hard landing’. Nonetheless, there is

scope for further policy stimulus – real

interest rates remain high in China despite

recent cuts and easing of liquidity

conditions – and the government’s balance

sheet is strong, including some US$3.7

trillion of foreign exchange reserves.

China’s debt problem is domestic and

funded by domestic savings and

consequently the risk of a financial crash is

greatly diminished.

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THE EDGE �15MARKET OUTLOOK: CHINA

by EDGEFOLIO Thursday, 1 October 2015

Moreover, employment and household

incomes remain robust and the consumer

and service sectors that are not accurately

reflected in the official statistics are

expanding even as the state-dominated

heavy industry sector stagnates. Managing

the re-balancing of the economy between

the two, including restructuring of the

banking sector and financial sector

reforms, is the key challenge facing the

authorities. But we do believe that markets

have incorrectly extrapolated recent falls

in the oil price and the stock market bubble

bursting as well as weak industry data to

indicate an economic crash rather than an

economy that we think is still growing at

around 5% and will likely stabilise at this

level.

As the world’s second-largest economy

(and largest trading nation), the

deflationary forces in the Chinese

economy are being felt around the world.

China consumes more than 40% of the

world’s production of iron, steel, copper

and coal as well as being a significant

importer of ‘soft’ commodities such as rice

and wheat. But China only consumes about

10% of world oil production and the

decline in oil prices primarily reflects

excess global supply rather than a sharp

drop in Chinese demand.

Key challenges for investors

The recent fall in commodity prices, the

Chinese equity market crash and mini-

devaluation of the renminbi sparked fears

of an imminent China-led global economic

downturn and led to significant volatility

across global markets. In our opinion, the

Chinese and global economy is fragile but

THE EDGE �16MARKET OUTLOOK: CHINA

by EDGEFOLIO Thursday, 1 October 2015

not on the brink of a deflationary

downturn.

Emerging market assets have been

buffeted by a perfect storm of China-led

global growth fears, falling commodity

prices and the prospect of a Fed interest

rate hike. In our view, these risks to

emerging markets are fully-priced at

current valuations and if, as we believe, the

Chinese and global economy will avoid a

hard-landing, valuations offer attractive

entry points for investors.

Lower commodity prices and China

manufacturing prices imply that global

inflation and interest rates will stay lower

for longer, complicating the Fed’s planned

‘lift-off’ from near-zero interest rates

demonstrated by its decision not to raise

interest rates at its meeting in September.

Even if the Fed raise interest rates later

this year, the impact will likely be

cushioned by the Fed clearly signalling an

even more gradual path for subsequent

interest rate increases. In Europe and

Japan, further policy easing to offset the

deflationary pressures is likely in our

opinion.

Divergent and complex global cross-

currents imply greater cross-asset market

volatility and dispersion that present

opportunities as well as risks for investors.

Exploiting volatility in currency and

interest rate markets as well as the greater

dispersion in returns within asset classes

such as corporate credit offer a much

broader opportunity set for globally active

investors than has been the case in recent

years.

Investors should remain focused on capital

preservation and active management of

the investment risks they face, but also be

ready to exploit the opportunities and

rewards that increased volatility will

present.

David Riley Head of Credit Strategy

David assesses the implications for fixed-income and credit asset classes of market, economic and political developments. He is also a member of BlueBay's investment and asset allocation committees reporting to the co-CIOs. Prior to joining BlueBay, David led the global Sovereign & Supranational rating team at Fitch and was its most high-profile senior analyst. During his tenure as Head of the team, the sovereign and supranational rating coverage grew significantly and the ratings were recognised in major benchmark indices and investment mandates, firmly establishing Fitch as a leading provider of sovereign rating opinion and research. As an economic policy advisor in the International Finance Directorate of HM Treasury and the UK Export Credit Guarantee Department, David was involved in sovereign debt restructuring negotiations at the Paris Club of Official Creditors, as well as providing advice and briefing to Ministers on G7 and IMF policy issues.

THE EDGE �17MARKET OUTLOOK: CHINA

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by EDGEFOLIO Thursday, 1 October 2015

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The Most Common Operational Breaches Investors Fail To Spot During Due Diligence

ITH constantly evolving regulations,

changing tax laws and growing best

practice standards, operational due

diligence has never been so relevant and

hard to do. It is burdensome, operationally

heavy, expensive to staff properly, yet

crucial to get right.

Anyone hoping to achieve

reliable operational due diligence (ODD) in

a cost efficient manner faces a big

challenge. A proper ODD requires

expertise in global regulations, compliance

and fiscal reporting, as well as operational

systems and controls but also specific risk

management know-how over a wide range

of areas.

Negligent practices or short-cuts may

result in financial loss or reputational harm.

The cost of getting it wrong is inestimable.

For this article, therefore, we have

aggregated some of the most common

ODD mistakes picked up from the

thousands of ODDs we have performed

over the last decade, as well as selected top

breaches that should always be spotted

(illustrated with examples).

Weak or poor corporate governance

Prominent examples of where governance

is poor and decisions are made in an

informal and unprofessional manner,

usually linked to a strong overall control

arranged around one key personality or

Jérôme de Lavenère Lussan CEO, Laven group

érôme de Lavenère Lussan is the CEO and founder of Laven. His background includes acting as a COO of a hedge

fund and as a financial lawyer at Jones Day. Jérôme has a broad degree of expertise in the hedge fund and fund management industry and is an advisor to many international financial services firms specialising in regulatory, legal, operational and risk matters. He is a member of the Law Society of England and Wales, the International Tax Planning Association and of the CFA Society of the UK. Jérôme holds an LLB from University of Edinburgh. In 2010 and 2011, Jérôme was named by Financial News as one of its 100 Rising Stars, and in 2011 and 2012 one of its 40 under 40 Rising Stars in Hedge Funds. He is the author of the FT Guide to Investing in Funds, published in June 2012.

J

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THE EDGE �18DUE DILIGENCE RED FLAGS

£££HI££££HI£

by EDGEFOLIO Thursday, 1 October 2015

related family ties include Stanford

Financial Group, Weavering Capital and

Bernard L. Madoff Investment Securities.

This form of governance is conducive to

persons being conflicted and could reduce

independence. This could hurt investors’

best interests. The lack of an established

process to support the functioning of a

proper board of directors for example is a

clear concern. The opposite should help

directors provide independent oversight.

As a ‘factorial’ check point we find that the

absence of minutes or even notes of

meetings is a good indicator of a poor

process, which should lead to further

verification, e.g. if minutes are even signed,

or which points are followed up at

subsequent board meetings.

Lack of restrictions on leverage or

borrowing

The use of high amounts of leverage in the

case of Long Term Capital Management led

to a large loss, due to the Asian and Russian

financial crises. As a result the fund later

needed to be rescued by the US Federal

Reserve which in conjunction with other

banks injected $3.6 billion. It is obvious

that if there are no limits on leverage or

borrowing in any legal documentation such

as a prospectus, then the risk is higher for

investors. This was also the case for

Peloton Partners LLP. Although there are

no laws breached we suggest that this is

treated as below best practice. Short of

doing investment due diligence and stress

testing various portfolio exposures, which

is even harder to do usually because of

limited access to data, the next best thing is

to look for the absence of controls. If there

is nothing specified between the investors

and the fund, then the investor has no

recourse. In conjunction with a review of

the internal risk management culture that

pertains to the controls of any leverage

levels, one can start forming a pretty

precise picture. Today a fund that wishes to

abide by new AIFMD European rules must

justify a level of leverage, which should

make life better for investors.

Click here to visit Laven Partners

stablished in 2005, Laven is a global integrated consultancy servicing

the financial industry, with offices in London, Luxembourg, Geneva, Singapore, New York and Barbados. Laven’s vision is to empower banks, brokers and managers by offering robust regulatory solutions that improve their operational processes and structures. Laven’s expertise, experience and perspectives are driven to sustain that vision. Delivering solutions in Global Regulatory Compliance, Operational and Investment Due Diligence and Operations Consulting such as Risk and Strategic Product Advisory, Laven positively impacts the success, strength and reputation of its clients.

THE EDGE �19DUE DILIGENCE RED FLAGS

E

by EDGEFOLIO Thursday, 1 October 2015

Lack of independence of service providers

The appointment of independent service

providers is deemed to reflect an

engagement by the manager to be

objective when dealing with the affairs of

the fund. The opposite is a concern.

Presently this is rare as there is either a

new regulatory framework that demands

it, or a strong investor preference for it.

Nonetheless it is still valid to check this

through ODD and make sure the

appointment is supported by a contract. If

the fund’s administrator is not an

independent entity, this poses a risk

including inaccurate NAV calculations, as

the manager would have influence and a

clear conflict of interest. The more illiquid

the investments, the more this is likely to

be a risk. Examples of investors being

misled by managers include, Stanford

Financial Group and Market Neutral

Trading LLC. Both used unheard of auditors

to falsely verify their exaggerated financial

performance, with Stanford bribing a small

audit firm, C.A.S. Hewlett in Antigua, and

James Murray of MNT, even going as far as

creating the fictitious firm Jones, Moore &

Associates. Requesting to review the

service providers’ agreements, verifying

the information by sending questionnaires

to the appointed auditor, administrator and

other parties, are compulsory steps for a

proper ODD process.

Low or no insurance coverage

Sufficient insurance coverage is important

as it could protect investors in the case of a

claim which the manager may not be able

to pay for. There are no clear standards on

this, and cynics may point out that few

claims were paid out by insurers.

Nonetheless the absence of insurance

again is evidence of a disregard of the

potential benefit to investors. Further

Laven believes that it is sufficiently

affordable that both Professional

Indemnity and Directors & Officers

insurance should be in place. Coverage

amounts according to best practice

standards should represent a minimum of

1% of the assets under management.

Insurance can make up for certain losses. In

the mid 90’s, AT&T Pension Fund was left

with costs of $150 million due to rogue

trading by the asset management firm.

Those costs could have been covered had

the manager, Rhumb-Line Advisers, had a

reasonable policy in place.

Lack of separation of responsibilities

between front and back office

In 1994, Barings Trust lost millions through

trading activities because there was no or

little segregation between front and back

THE EDGE �20DUE DILIGENCE RED FLAGS

by EDGEFOLIO Thursday, 1 October 2015

office activities. The trader, Mr Leeson, did

not just hold a manager position on the

trading floor, but was also in charge of

settlement operations which meant he was

able to book fraudulent trades. Due to the

lack of separation between the front office

and the back office, his activities went

undetected until a massive loss was

realised. Investors can protect themselves

from such cases by gathering information

on the segregation of duties and verifying

that during the on-site visit with the

manager. Evidence of strong processes

reflect a better risk management culture.

Lack of effective Risk Management

A manager should have an independent

risk function in order to make credible

decisions to limit risks on investments. If

this is not independent from the front

office, there will be a conflict of interest,

which can prevent the risk function from

performing its duties and may lead to

potentially greater losses. Some traditional

managers prefer to talk of risk as being

part of the controls and know-how of the

front office, but even if this is true it does

not replace the role of an independent risk

management function. This has been

embedded in the regulatory framework in

Europe now, but should be checked from

an ODD perspective everywhere. The lack

of such a control has led to losses in recent

cases where some hedge funds were

caught out by the Swiss move early in

2015. The absence of independent risk

management was also a factor in

Weavering Capital. Evidence that this

control is in place not just by name but also

as evidenced through minutes and other

verifiable tools is essential to the well-

being of investors. Whether the same

applies in a more illiquid context such as

private equity funds is a moot point, but

some independence has never hurt an

investor.

Poor application of Anti Money

Laundering (AML) checks

It is a requirement for managers to carry

out AML checks on their clients. Two things

can be caught through ODD that reveal a

weak risk management understanding.

Either the manager does no AML as the

administrator of the fund is paid to do it, or

the manager does all the AML checks on

investors. In both cases this is wrong. If the

administrator does all the checks on

investors in the fund, this does not alleviate

the manager from doing AML checks on

the fund (a separate entity which it must

treat as a client) or indeed any managed

account clients. This may never lead to a

prosecution but it is nonetheless a mistake

in a field that includes criminal liability. The

second point relates to this criminal

liability, the more the manager does AML

checks the more it starts incurring liability

on investors being wrongly assessed when

it could have left this to the administrator.

These are complex legal technicalities, but

ones which a professional in financial

services should understand. While Ponzi

schemes such as Black Diamond Capital

Solutions have revealed that sometimes

managers seek to participate in money

laundering, any weakness on this subject is

perilous and another factor that there

could be inappropriate behaviour taking

place.

THE EDGE �21DUE DILIGENCE RED FLAGS

by EDGEFOLIO Thursday, 1 October 2015

Lack of thorough background checks on

key individuals

Between 1997 and 2002, investors of

Bayou Hedge Fund Group were defrauded

as funds were misappropriated for

personal use. A simple background check

would have revealed that the CEO, Samuel

Israel, had lied to investors about his

previous work experience and had a

criminal record. This would have given

reasons enough to avoid his management

company. Similarly, a simple internet

search on Kazuhiko Matsuki, who ran AIJ

Investment Advisors’ Ponzi scheme, would

have revealed that he had been charged in

1997 for making illegal payoffs to a

racketeer. Background checks are not

expensive, they just take time. They should

be part of the ODD process at all times. In

our book the FT Guide to Investing in

Funds we listed all the sources that are

available for free to conduct various news,

but also AML and court checks.

Key Conclusions for investors and

managers, wishing to avoid operational

failures

Assess the entire operations of a

manager including internal

operations as well as relationships

with external service providers. This

factorial approach is the only way to

acquire an understanding of the

overall risk management culture of

the manager.

Trust the information received

but always verify. Verification is a

process of corroboration. In an

opaque world, this form of

verification is the only way to protect

your investment.

Perform an on-site visit to

validate information and

particularly to interview staff to

assess that their work corroborates

what the manager is marketing itself

as doing. Anything that cannot be

explained clearly or disclosed

reasonably must be a concern if not a

red flag.

Remain focused on lurking

conflicts of interest and the

independence of service providers,

directors and other parties that may

be tempted to put their interests

ahead of those of investors. This is

true especially where the investment

strategy is not subject to investment

restrictions or pricing policies

designed to protect investors. 1

2

3

4

THE EDGE �22DUE DILIGENCE RED FLAGS

by EDGEFOLIO Thursday, 1 October 2015

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