Hedge Fund of the Year - Stark Investments

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In 2007, investors in the US credit markets were rudely awakened from a consensual hallucination. A seemingly insatiable demand for structured credit from banks, hedge funds and institutional investors had driven spreads tighter and tighter, forcing them to record lows in the early part of the year. That all changed in July, after soaring delinquencies in the US subprime mortgage market caused the rating agencies to downgrade hundreds of residential mortgage-backed securities and collateralised debt obligation (CDO) tranches. Investors that had gone long credit racked up hefty mark-to-market losses as valuations fell. But those who had paid attention to the warning signs in 2006 - high loan-to-value ratios, an increase in mortgages based on undocumented incomes and rising instances of fraud - profited handsomely.

One firm to have capitalised on its deep understanding of the credit markets is Stark Investments. Two of the $15 billion Wisconsin-based hedge fund's winning trades, executed in the fourth quarter of 2006, involved going short both bonds associated with merger and acquisition (M&A) deals and subprime mortgages, which led to double-digit returns in 2007.

The thought process behind the trades was simple: investor demand for these products would dry up given that prices did not accurately reflect the risks. For example, Stark Investments was quick to note that the strength of the high-yield bond market partially depended on the demand for structured credit - specifically, collateralised loan obligations (CLOs) and CDOs. Both markets were highly leveraged, with investors grasping for yield.

"The M&A market was bristling with activity in the beginning of last year. But a lot of the transactions that were going on weren't very attractive if you were a credit investor," says Mehul Desai, chief risk officer at Stark. "As CLO and CDO machines came to a grinding halt, going short investment-grade and high-yield credit was a great opportunity, because it didn't seem like the market would have the appetite for the placement of these high-yield bonds."

It should come as little surprise that the firm has had success in the credit space, given that founders Brian Stark and Mike Roth cut their teeth in the convertible arbitrage market, and were among a small group of traders to notice arbitrage opportunities in the Japanese warrant market in the late 1980s. Stark and Roth went long convertible securities and shorted the common stock, while hedging the changes in the price of the warrants - in the process, racking up sizeable profits.

Their achievements in 2007 were no less impressive - even more so given the sizeable losses at some of the largest US investment banks, largely due to leveraged loan warehouses and exposure to subprime securities. For instance, two hedge funds managed by Bear Stearns Asset Management - the High-Grade Structured Credit Strategies Fund and the High-Grade Structured Credit Strategies Enhanced Leverage Fund - could not meet margin calls in June following losses on structured credit positions. By the end of July, both funds had filed for bankruptcy.

A handful of hedge funds and proprietary trading desks also made hefty profits by taking a contrary view. But unlike some of these funds, whose profits were largely derived from mammoth short positions in the subprime space, Stark stuck to its portfolio limits and also benefited from its shrewd insight elsewhere. In particular, the firm was also able to accurately foresee oncoming troubles in the quantitative equity market.

In early July, the firm started to notice that its quant equity models weren't behaving as they should based on their historical performance. As a result, the fund conducted multiple macro analyses, which showed other funds were unwinding these trades. "It had the implication of a liquidity crisis in the market," explains Desai.

By mid-July, Stark had reduced the assets in its quant portfolio by 25%. With the models continuing to misbehave, it reduced its exposure further. By August 6, it had cut its positions by over 50%. Just two days later, this had increased to 90% - meaning the firm avoided the majority of the losses that hit statistical arbitrage funds in the first two weeks of August, when equity volatility and correlation spiked and equity prices began moving erratically. Those funds to be hit included AQR, DE Shaw, Goldman Sachs Asset Management, Highbridge Capital, Renaissance Technologies and Tykhe Capital (Risk October 2007, pages 22-25).

Many of these funds made up losses later that month as the markets recovered. As equities bounced back, Stark put a small amount of capital back into the portfolio to be able to monitor the strategy. "But what has really given us concern was the explanation for the liquidity event. The explanation was overcrowding, and you can't just tweak your model and fix overcrowding," says Roth. The firm will wait for a more prolonged period of stability and performance in that market before it allocates more capital, he adds.

Roth argues that all multi-strategies should ideally work this way: in situations where there is uncertainty in a specific strategy, the firm should quickly reallocate: "We could have ridden through it, but the feeling is that we have better trades to put the capital into," Roth adds.

The ability to manoeuvre with agility has taken some time to develop. Starting in 2003, the firm began developing a proprietary method to measure liquidity - a project that was completed in 2006. The fund claims it is one of the areas that distinguishes it from its competitors, and was critical during the turmoil in the quant space.

"We've put a lot of work in trying to put up a rigorous way of measuring liquidity. And with whatever liquidity picture you think you are in, you have to haircut that in stressful situations. In those situations, you want to be a provider of liquidity and not a seeker of liquidity," explains Roth. "Mehul's group has done a lot of work around that and developed a system that gives a very accurate picture of what the liquidity of the fund looks like, and therefore becomes an invaluable tool for us to manage our portfolio."

The risk management group, led by Desai, comprises 20 individuals, supported by six on the quantitative and technology systems side. The team is divided into market risk, credit risk and tail risk. Stark also has a separate risk policy group.

Elsewhere, the firm's foray into the Asian markets paid off in a big way in 2007. "Everyone has ideas about opportunities there, but how do you monetise that and how do you make money?" says Roth. Stark Investments has found one answer to that question: participation in collateralised lending deals that have an equity upside to them.

Four years ago, Stew Wilson, a partner at the firm, moved to Hong Kong to develop Stark's financing capabilities. Since then, the company has participated in a number of transactions, including a large port and a mining deal, which has resulted in double-digit growth in revenues. Staff in the region has grown to 28 people - around 6% of its total employees. Two years ago, it also expanded into Singapore.

Desai says the firm has spent a huge amount of time understanding the risk around these investments. The firm's commodities trading business, which has been in place for five years, has provided a lot of information. But one of the areas currently being analysed is whether the troubles in US credit will spill over to the Chinese markets, and then to commodities, and how that scenario might unfold.

"At the end of the day, with the number of investments we carry on our books, we have to have some method of simplification. This amounts to reducing our investments to a limited number of risk factors, and then stressing those factors. But if you rely on the past, you will never be prepared for stress events in the future," says Desai.

This year, the firm believes that, along with its opportunities in Asia, another bright spot will be its environmental financing division. Stark has spent more than three years trading carbon in Europe and has begun to trade on the Chicago Climate Exchange, says Roth. It has also made investments globally in biodiesel, oil sands and solar power. One of its most publicised has been in Wisconsin-based Virent Energy Systems, which has developed biofuels with the same fundamental characteristics as petroleum and is compatible with existing engines. In its second round of venture capital financing, partly led by Stark, the start-up raised $21 million.

The firm is hopeful these investments will pay off given the presidential elections and an energy bill signed by President Bush on December 19. The bill has far-reaching consequences: it increases the average fuel efficiency of new cars from its current 25 miles a gallon to 35 miles a gallon by 2020; provides greater subsidies for farmers growing corn for ethanol production; and requires 36 billion gallons of renewable fuels a year be used as motor fuel by 2022.

In essence, Sark's recent achievements reflect its ability to accurately capture and capitalise on forward-looking trends with impeccable timing. And so long as it continues to innovate its risk management techniques while not falling into a deep money-hungry trance, its success looks likely to continue.

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