Ken Griffin is a hard man to please. The founder and chief executive of Chicago-based Citadel saw his investment teams expertly navigate the macro headwinds that blew many hedge funds off course in 2015 – escaping losses when the Swiss National Bank (SNB) scrapped its exchange rate peg and generating positive returns during the Greek debt crisis and the devaluation of the Chinese yuan.
Citadel's performance – its main multi-strategy funds were up around 13% through early December, with low annualised standard deviation of under 1.2%, according to several sources – places it "at the top of its class", says one long-time investor. Another client praises the firm for "significantly outperforming its peers" in 2015.
But Griffin is not so easily moved. "People give us a pat on the back for not losing money when the Swiss franc peg broke," he says. "We should have made money on that event."
As 2014 drew to a close, Citadel's fixed income and foreign exchange team was beginning to think selling puts on the EUR/CHF and USD/CHF pairs had become a crowded trade. "We reduced risk to those trades because the risk/reward didn't seem appropriate," says Rich Mazzella, chief operating officer for global fixed income at Citadel. "The likelihood of the SNB abandoning the peg wasn't high, but it wasn't zero either, and as people kept putting this trade on, it was driving implied volatility lower and lower, diminishing the returns."
Citadel began thinking about taking the other side. The challenge was getting the timing right. The firm's portfolio managers debated the trade internally. All the while, the SNB was making public statements about its resolve to maintain the peg. Then – on January 10 – Ernst Baltensperger, an academic and former SNB adviser, told a Swiss newspaper that the central bank should consider removing the peg. "This only added to our conviction to further reposition our portfolios," says Mazzella.
There is a common fallacy that we're in the risk minimisation business. We are in the risk-taking business
Ken Griffin, Citadel
On January 15 – four days after Baltensperger made his comments – the SNB announced it would scrap the peg. The franc surged 30% against the euro on the news.
The mood inside Citadel was mixed. The firm avoided losses, but it had not built a big enough long position in the franc to fully capitalise on the rally.
"We went from being long the carry associated with the peg in 2014 to almost flat going into early 2015, and we were waiting for the tipping point to go the other way," says Griffin.
Nearly 12 months later, Griffin is still frustrated at missing out on arguably the year's biggest trade. "You see a move like that in a major currency a few times in your career. We didn't hit it, and that's a big ongoing conversation within our four walls," he says.
Much of the criticism levelled at hedge funds in recent years has focused on their failure to anticipate and hedge tail risks, such as the removal of the Swiss franc peg.
This cannot be said of Citadel. The firm places a strong emphasis on portfolio construction and risk management, employing cutting-edge technology and a team of around 30 dedicated risk managers to monitor and manage exposures across its hedge fund portfolios in real time.
Risk management also feeds into portfolio construction. The firm uses various tools to decompose its portfolios into systematic and idiosyncratic components, and surgically eliminate undesirable exposures. As a result, the bulk of Citadel's portfolios tend to be market-neutral, focusing on idiosyncratic risks
Still, Griffin insists managing risk and hedging tails is only half the battle. "There is a common fallacy that we're in the risk minimisation business. We are in the risk-taking business," he says. "I want everyone to keep in mind that both sides of the equation drive our performance. Our expected return, on one side, is about our offensive stance, balanced, on the other side, with the necessity to preserve our capital from catastrophic losses."
Citadel's portfolio managers took that message to heart, trading more aggressively as the year wore on to maximise returns during periods of market stress.
For instance, Citadel had a strong view going into the second quarter that the US economy would outperform the European economy. As a result, it was long the dollar against the euro and short US rates relative to European rates.
The emerging Greek debt crisis threatened to throw a spanner in the works. "We had a set of views that were all subject to huge volatility due to the situation in Greece," says Mazzella (pictured). "We felt the eurozone would muddle through, but there were a wide variety of possible outcomes, and the tail risks were quite high."
Rather than bow out, Citadel turned to scenario analysis to further assess the risks. The firm's risk team had created a number of forward-looking stress scenarios in 2011 that analysed the implications of Greece leaving the eurozone – or, alternatively, of Greece, Italy and Spain exiting together.
As the crisis in Greece began to heat up last spring, Citadel's risk team created additional versions of those core exit scenarios.
Still, Mazzella felt these scenarios did not capture all the possible outcomes as events were quickly changing. "Our risk team created a flexible scenario tool that enabled us to start with the original scenarios and dynamically alter components of them, so we could see how new developments could change the outcomes, almost as they occurred," he says.
Citadel's risk systems were also able to identify the firm's exposure to various risks associated with a Greek default in real time. "Those tools allowed us to actively trade and maintain our core views, while managing the various Greek risks that were constantly evolving," says Mazzella.
Citadel maintained a significant amount of exposure to European fixed income and currencies through the height of the Greek debt crisis – hedging some of this risk with swap spreads – which contributed to the firm's positive performance through the early summer months, according to sources familiar with its performance.
"We kept the big picture view in mind and didn't let the day-in-and-day-out P&L swings that were caused by extraneous events dominate our thinking and our risk-taking," says Griffin.
The Greek debt crisis illustrates how Citadel's risk management process is meant to work. "There is a careful risk management process, run by the central risk team, which creates scenarios for the whole firm. They provide uniform analysis, so our management teams can understand the risks to the business as a whole with immediacy and be responsible and accountable for them," he says. "But fixed income, which has the largest exposure to events in Greece, will also run its own independent stress and scenario analysis. They must go deeper and have a higher level of insight into specific problems as they rapidly emerge."
Those tools allowed us to actively trade and maintain our core views, while managing the various Greek risks that were constantly evolving
Rich Mazzella, Citadel
The fixed-income and currency team was not alone in generating strong performance. Citadel's commodities team also had a stellar second quarter, capitalising on the ongoing weakness in oil prices by trading gasoline crack spreads, which track the relationship between crude and refined products, such as gasoline and heating oil.
"In late 2014, we identified a number of factors that were structurally positive for US gasoline crack spreads," says Mark Stainton, Citadel's head of commodities. "The price of oil had fallen dramatically, but we felt it was still too high versus gasoline and other refined products. In particular, gasoline demand was increasing due to consumers driving more in response to lower prices."
Citadel scaled into the trade at the end of 2014 – going short crude oil and long gasoline futures – and held on to the position through the first half of 2015 as the spread widened. "As we reached the end of June, gasoline prices had rallied significantly due to growing global demand and supply tightness," says Stainton.
For Citadel, it was a cue to exit the trade.
Gasoline crack spreads peaked in July and have narrowed significantly since. Citadel went short gasoline cracks in late July and into August, catching a good portion of the reversal, too.
The fixed-income and currency team also had a chance to erase the memory of the Swiss franc trade that got away when the People's Bank of China (PBoC) devalued the renminbi in August. Going into the third quarter, the team had "a sense" the Chinese currency would underperform the US dollar.
"We may have low confidence in a given macro call, but we have a particular skill in using options to express certain of our macro views, especially in foreign exchange," says Mazzella. "As we looked at potential ways to express our view on the Chinese currency, we saw an effective way to do it with options."
Implied volatility in USD/CNY had cheapened to around 2% in May and early June – a side-effect of Chinese exporters' hedging strategies.
Citadel began buying straddles in USD/CNY in June and into July. "The downside was limited as we were able to buy volatility relatively cheaply," says Mazzella.
Implied volatility began creeping higher in July and exploded to more than 5% in August, when the PBoC devalued the currency.
By any measure, 2015 was a strong year for Citadel's hedge funds, with the commodities, equities and fixed-income and currencies teams all generating positive performance.
Griffin, however, continues to chew over the firm's hits and misses, determined to do even better in 2016. "Markets give you an endless opportunity to learn and improve. If we're going to put up solid returns year in and year out, we have to be at the forefront of thinking about what drives asset prices, how we construct robust portfolios, how we manage risk, how we maximise returns, and how we can improve continuously in all those areas," he says.