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October 2015



Q4: Women & Investing


The Biology of Trading Dr. John Coates


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

Co-founding a hedge fund Nadine Terman


Where next for China? BlueBay Asset Management


The Most Common Operational Breaches Investors Fail To Spot

During Due Diligence Laven Partners


Maggie Yang




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.

From the Editor


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


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.




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 Biology of Trading


N 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 risktaking,

leadings 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

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


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;

by EDGEFOLIO Thursday, 1 October 2015



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 outperformers,

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 twoweek

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



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.

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


Many thanks to Aude for leading this interview.

by EDGEFOLIO Thursday, 1 October 2015




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.

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

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


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



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



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



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.

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, macroeconomic

behaviour (like the “January

effect” or market bubbles such as the tech


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 underreaction

(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


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?

Women of the Street: Why Female Money Managers Generate Higher



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


by EDGEFOLIO Thursday, 1 October 2015





Nadine Terman

Solstein Capital

CEO, Co-founder and Managing Member



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 womanowned

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


Click here to visit Solstein's webpage

by EDGEFOLIO Thursday, 1 October 2015




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, highconviction

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 highconviction,

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.

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



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?

by EDGEFOLIO Thursday, 1 October 2015




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


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 datadriven

process. As a long-term,

value-oriented investor, how has

data played a role in your investment


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

by EDGEFOLIO Thursday, 1 October 2015



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



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


by EDGEFOLIO Thursday, 1 October 2015



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



Finally, what do you believe has

been the most challenging part of

your career and what advice would

you have given yourself 10 years



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.

by EDGEFOLIO Thursday, 1 October 2015



Where next for China?

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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


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

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



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



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 creditintensive

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 rebalancing

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.

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


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 minidevaluation

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

by EDGEFOLIO Thursday, 1 October 2015



not on the brink of a deflationary


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

David Riley

Head of Credit Strategy


££HI££ £££££

David assesses the implications for fixedincome

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.

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


Divergent and complex global crosscurrents

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


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


by EDGEFOLIO Thursday, 1 October 2015



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.

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.

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

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


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

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stablished in 2005, Laven is a global

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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

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positively impacts the success, strength

and reputation of its clients.

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.

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

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 wellbeing

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


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


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



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.

by EDGEFOLIO Thursday, 1 October 2015








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