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HOME >Sorina Zahan Discusses Core Capital’s Approach to Changing Markets at Opalesque Round Table – Chicago

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At Opalesque’s Round Table 2013 event in Chicago, Sorina Zahan joined a select number of panelists in a discussion of pressing topics in finance. What follows are excerpts from the roundtable wherein Sorina spoke on her thoughts and research regarding myriad topics, including specific points from her series of talks entitled “Sophisticated Bad Habits in Portfolio Construction”.

Sorina Zahan: Sorina Zahan, I am the CIO of Core Capital Management. We are an asset manager and financial research firm in Chicago. On the research side we do structural research, what I like to call financial de-engineering, and we look at things from portfolio construction to structural analysis of pension plans. My background is in Math and my PhD is in artificial intelligence, so I have a bias towards optimization and modeling.

We apply our research into our asset management side of the business, where we have managed for the past eight years specialty funds of funds. These are mono-asset class, multi-strategy concentrated portfolios. The three asset classes that we cover are equity, credit, and volatility.

Mark Melin: What do you see as the investment opportunities going forward, and how does that relate to how your fund or your investment strategy has operated in the past? Have you changed your approach to cope with the changing markets?

Sorina Zahan: We look at three major asset classes; credit and everything that’s related to credit, including credit derivatives and credit linked securities; equities and equity derivatives; and then volatility. Our volatility portfolio is biased long, we don’t sell necessarily volatility. These portfolios are fund of funds; we tend not to invest directly although we manage portfolio overlays.

The credit space has been very interesting for the past one year-and-a-half with a good environment for short term or more trading oriented opportunities. For example yield curve and rates trading can be very profitable, if they are well-traded.

There are also long-term opportunities in credit, for example by providing liquidity through direct lending, especially in Europe in the middle market segment. This is really a three to five year opportunity, if you think about liquidity of the asset. However, in between short term and long term opportunities, i.e. in the medium holding time horizon, I think credit is expensive. It is very, very hard to make money there on an unlevered basis.

In equities we see a bit of the opposite going on. The recent disruptions that for example the recession in Europe has caused are providing good opportunities for old style fundamental stock picking, both on the long and short side. The recession has created a scenario where you find winners and losers. High-cost producers are likely to lose market share, while strong companies are trying to expand in other markets. You can also find strong U.S. companies that can expand or buy in Europe.

For a number of years into the crisis and even afterwards it was quite a challenge to pick winners and losers, because everything was so correlated, everything tended to work well, which made it difficult for stock pickers to show real skill. We believe that now the environment has changed and stock picking is actually rewarding. We believe that withstanding some volatility and being willing to ride a good stock will pay off.

And lastly, in volatility trading, it has been very hard to make money being long, but the price level is so depressed that now you can use your balance sheet very efficiently. Per each dollar invested you get now a lot of upside, if you want, when the volatility picks up. So, in general, I think volatility is a space that is cheap, but I don’t know how long it will take to actually be very profitable.

Mark Melin: These are great points, what else do you see changing in the future? What other opportunities will unfold?

Sorina Zahan: The 40 Act funds space is quite interesting, but I am, well, I wouldn’t say skeptical, I am just curious how it will actually evolve. The way I see it, there are only few strategies like equity long/short or CTAs that are truly suitable for offering the sort of liquidity that is needed in a 40 Act fund. Given this limitation, it will be a challenge to launch products that are truly differentiated, and there may be a big impetus to launch funds where the liquidity will not be true liquidity. These funds will be offered with daily liquidity, but the underlying liquidity of the assets will not actually fully match that.

And at one point players will be pushed into taking on illiquidity in liquid format. We have seen this in past cycles and know how it ends up. I am sure there will be excellent funds in this format, but I am a little bit skeptical of the impact these other funds with riskier liquidity situations will have on the space.

We looked at the space and think that through structural analysis and financial de-engineering, as I like to say, a different breed of products can potentially be offered to a broader audience. Nevertheless, I believe that once the space becomes crowded and extremely competitive, there is a significant threat that some players will actually start blowing up for liquidity reasons.

Mark Melin: What are your observations regarding asset flows?

Sorina Zahan: I think assets should flow from asset classes or securities that are expensive into those that are cheap. The cheap ones will become expensive because of those flows and then experience outflows, so we should get this type of rational cyclicality. I am not sure though that in practice we observe this predictive power of asset flows. If you look historically, Emil is probably right. Sometimes flows go exactly into the expensive asset classes.

Notwithstanding this observation, I think credit is expensive, at least the US credit. Moreover, the more liquid it is, the more expensive it is. There have been some outflows from this asset class, and it will be interesting to see if this will continue. It’s easy to say yes and expect to see a big correction there, but we also have to remember that players with very different risk appetite and very different return objectives are acting in this market. If the return objective is low enough, we might not see such pronounced outflows from the credit marketplaces. I was tempted to say that we will probably see outflows from credit and inflows into equities, but I don’t think there’s a guarantee for that. I do think that we will probably see more flows into equities, especially into developed markets equities.

Mark Melin: Let’s look at risks and challenges you see in the market right now. Is there anything that worries you?

Sorina Zahan: I am not so much concerned about the regulation itself, but the cost of the regulation – the cost that’s imposed on every single player down the chain. This cost will ultimately be borne by the investor and will erode returns. We already discussed how the returns are not easy to make and are not outsized anyway. I don’t see a good solution to minimize those added regulatory costs. We try to minimize every cost, and I am still struggling with this.

A second challenge that I also see developing is related to volatility. Volatility has been going down across all asset classes. In equities, volatility has been going down for over three years now. I don’t even want to talk about credit. It’s ridiculous, credit probably has 30% of the volatility that it should have normally. You also see that phenomenon in FX and in rates for sure.

As I said, this trend has been going on for three years or more now. Now, a lot of risk models in this industry work with 100 day VaR or a few years, and many investors, both more sophisticated and less sophisticated, started allocating based on this completely under-appreciated risk. In our work we often see portfolios we believe are riskier than the true appetite of the holder.

Hopefully this will not happen, but I am afraid that we will get to a point where these holders can get very scared, because all of a sudden the risk is back to its normal values. As a consequence we might see irrational behavior, which actually is rational behavior, but based on the wrong cause. So that is something that worries me.

On the positive side, I am actually happy with the trends in our industry, the fund of funds industry, in my case. I think the most important trend is the search for alpha. This is really a good trend. It will make our industry much better. I don’t think there should be room in this industry for index funds, i.e. for hedge funds or fund of funds that actually provide you the index. For that there is passive investment. You don’t have to pay an active manager for that.

A second trend I consider positive is that we are seeing more emphasis on risk management in this industry. Scott has mentioned it; it is very necessary.

30 years ago we had good hedge funds that were very holistic – they knew very well the securities they owned, but they really had no idea how much systematic risk they had in their books. Now things are far from being perfect, but investors are more preoccupied by measuring more dimensions of risk, and they should do so. As long as they understand the limits of what they know, this is a very positive trend and can potentially counteract the second challenge, the one of taking under-appreciated risk.

Our clients rarely ask for particular risk metrics, because we do provide them a large range of those metrics. I have a series of talks, which is called “Sophisticated Bad Habits in Portfolio Construction”, in which I fight some of the habits I personally used to have for years. One example is looking at rolling beta.

Paul MacGregor: That means your clients were sophisticated?

Sorina Zahan: We and they were sophisticated, but there was a problem. People would ask for rolling beta to understand systemic risk, but through rolling beta you really looked at the noise of the market.

I think what people want now is at least to understand the exposure of the portfolio. They also try to risk adjust performance as opposed to just look at performance in a vacuum. There are people that understand that Sharpe Ratio should not be applied to many of the hedge fund strategies. Sharpe is OK for very liquid CTAs that tend to run normal distributions, but if you have a less liquid hedge fund, there is no way you can use Sharpe Ratio as a measure of your risk-adjusted returns.

There are people that have started understanding the limitations of VaR, and they are starting to understand that VaR is the minimum amount of loss as opposed to the maximum amount of loss. Ten years ago I met a lot of people who thought that VAR is the maximum amount of loss with 1% or 5% probability.

So these are more subtle changes, but I think a decade ago if I tried to speak to an investor about running risk budgets, and running simulations, forward looking simulations, I would get a completely blank stare. So it was a no go. I think now at least I can try. Moreover, and this is something of great interest to me, the hedge fund managers are starting to look at their portfolios in a more sophisticated way.

And what’s very important is for them to understand the limitations of the tools they have, because I am very afraid of a dogmatic approach to risk management. I think that’s worse than no risk management.


Complete event coverage and discussion transcripts can be found here.

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