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Third Wave Global Investors

TradeLink and DigiLog Capital

Concordia Advisors

2007 TOC

Larry Smith, Founder and Chief Investment Officer, Third Wave Global Investors (Greenwich, Conn.)

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Personal Background
Fund Background
Technology and Algos
Big Picture

Description of Firm:

Third Wave Global just finished the third anniversary of our global macro hedge fund. Our fund has a unique approach to investing in stocks, bonds and currencies around the world. Over our first three years, we've achieved all of our objectives, ranging from solid performance with a net Sharpe ratio over 1.0, to doing it with an alpha stream that is virtually uncorrelated to the competition (in fact, our correlation to some of the major indices is literally zero) and in growing assets in an orderly way.

Assets Under Management:

Approximately $400 million.

Asset Mix:

Third Wave Global focuses on 13 equity markets (all equity indexes), seven government bond markets (all 10-year government bonds) as well as seven different currency markets. The firm implements trades with futures wherever possible. Sometimes we trade exchange-traded funds or options.

Structure of Trading Operations:

We have separate quantitative and qualitative areas. On the quantitative side, we have a couple of people who do nothing but run the model and research the model to try and push it forward. On the discretionary side, we've got a couple of people who look around the world and have a more traditional perspective in trying to figure out what the drivers are for different markets and which markets are mispriced at particular points in time. We sit right next to each other -- there's a lot of communication here, providing ample opportunities to profit from the insights because they're happening so fluidly.

Products Offered:

We have a global macro fund that has two share classes -- Class A targets 8 percent to 10 percent volatility, and Class B is targeting 16 percent to 20 percent volatility with twice the alpha. We're also close to launching a quantitative equity fund.

Trading Style:

Our trading style is to leave no stone unturned. We start with a really solid quantitative core. We also have a complementary discretionary process that looks at all the markets around the world much more directly and, as a result, has a slightly different perspective from the quantitative model. I'm the architect of both of these processes. On a day-to-day basis, my job is to combine those insights into the best possible portfolio that we can put together. Risk management is something that's everywhere you turn here. In fact, the name Third Wave comes from the fact that the first wave of hedge fund management was 40 years ago, when the Alfred P. Jones' of the world figured out that by shorting stocks you could reduce portfolio risk -- the focus was on the risk side. Twenty years ago, with George Soros doing what he did, the focus was very much on the return side, as people realized that if you had good ideas, you had many different ways of implementing those ideas with a lot of flexibility and ample leverage. The third wave of hedge fund management, we believe, lies in integrating the risk and the return sides toward generating very consistent returns. In fact, when I ask myself what my objective is as a hedge fund manager, it really is to maximize the Sharpe ratio at a predictable level of risk and to allow the unique nature of our process to generate a very low correlation to the markets and to the competition. I know if I do that consistently, then a majority of hedge fund investors out there will want to use me as part of their portfolios.

INTERNATIONAL TRADING

Does the firm trade internationally?

When you take a look at the global macro world, one of the challenges is that the markets don't all overlap in terms of time as much as you'd like. So, as opposed to a U.S. equity investor, we've got the challenge of trying to figure out what to do in Asia, Europe and North America. We tend to have a roundup early each morning, reviewing the output of the quantitative model with the latest thoughts from our discretionary process and then spend some time thinking about how best to integrate these insights.

What are the challenges of trading globally?

The first challenge is knowing what's going on around the world. We focus on the drivers of markets that are generally longer in time horizon -- three, six, 12 months -- on the discretionary side. We rely on the quantitative side to give us an edge on what's likely to happen shorter term. Instead of staying up 24 hours and trading each market individually, we view the world as one integrated portfolio, leveraging all the return and diversification opportunities. And when we come up with trades, we tend to arrive at decisions at a given point in time and then spend the rest of the day executing those trades -- as opposed to other firms that constantly try to figure out whether to buy or sell based upon what a particular market might be doing.

Professional Background:

Prior to launching Third Wave in September 2004, I served as global chief investment officer of Credit Suisse Asset Management from 1999 to 2003. I also served as CEO of CSAM Americas. CSAM was the 15th largest asset manager in the world, with around $300 billion under management. In addition to overseeing the firm's investment processes worldwide, including CSAM's hedge fund offerings, I was chairman of the firm's U.S. mutual funds, and chairman and CEO of a number of closed-end funds. Prior to CSAM, I worked for JPMorgan Investment Management from 1981 to 1999. There I was the global head of asset allocation and balanced account management worldwide from 1994 to 1999, responsible for creating and executing the investment processes behind the firm's macro decisions. In that role I had direct responsibility for a $6 billion book of global balanced business from institutional clients in the U.S. Before that, I spent a decade in the firm's fixed-income group, ultimately serving as its cohead.

Day-to-Day Responsibilities:

I'm responsible for all investment activities of the firm. Robert Birnbaum, who cofounded the firm with me, is responsible for all the firm's business activities, so I'm free to retain my focus on investment issues.

Education:

I hold a B.S. in business administration from the University of Florida and an M.B.A. in finance and international business from the University of California at Berkeley.

Fun Fact

You have to give back to society as well as take. Everybody has to realize that we are all part of the best industry that you could possibly be in, and as we reap the rewards we have to give something back. So I spend as much time as possible on the charitable side. I've been on the board of directors of White Plains Hospital for three and a half years, and I'm cochair of the finance committee. I spend as much time supporting that organization as I can. In addition, I have coached virtually every sport in which my children have participated, and I'll continue to do that as long as the opportunity presents itself.

TECHNOLOGY

Technology Environment

Our differentiating technology is our investment model. Most people look at each market and ask the very direct and simple question of what drives that market. Then they try to find factors that will be helpful in trying to come up with an outlook for that particular market. We take a different direction in order to isolate the effect of signals on the markets more directly and eliminate as much extraneous noise as possible. Instead of focusing directly on markets, we focus on decisions and have adopted a pairwise approach within that. We break down the world in two different directions. The first is what we'll call local trades -- trades within a locality that are across asset classes. So we'll take a look at U.S. stocks versus bonds, for example, or U.S. bonds versus cash. By looking at these decisions locally, we get more reliable signals because we're analyzing decisions within the context of a common economic and monetary policy framework. When we're done with analyzing all the local pairwise trades, we slice the world in the other direction -- what we like to call global trades. Those are pairwise trades within an asset class -- intercountry equity trades, intercountry bond trades and currency trades. We end up with a large number of pairwise trades -- currently 147. And that allows us to infuse the law of large numbers into a macro process, allowing us to diversify decision risk in a unique way. One of the great problems most managers have in macro funds is that they tend to be too focused on one, two or three themes -- and, as I'm fond of saying, he who lives by the sword, dies by the sword. What we have chosen to do is, in effect, have a number of smaller bets in place that diversify each other because that's the only way you can achieve the consistency of returns that we desire.

Buy vs. Build Strategy

I learned a long time ago that the world of information technology needs to be divided in half. There are IT issues that relate to network infrastructure that are fairly common to all firms. There's no need to recreate the wheel there, so we've outsourced all network infrastructure to a firm in Greenwich whose job is to support hedge funds, and they've been phenomenal. There are also many commercially available applications that serve the operations end of an investment firm. But when it comes to applications that impact our investment process, we do our own programming, with the caveat that if there's something that needs to be done on a higher level, we'll bring in that resource on a consulting basis. But the applications code, for the most part, is done by people at Third Wave Global. By separating the different needs of different functions, we think we get the best of both worlds.

Who ultimately is responsible for the firm's technology?

Daniel Lam, the head of our quantitative area, has done the vast majority of the programming that supports the research and the daily running of our model.

Use of Crossing Networks and Dark Pools

We don't need to use them because we're trading on centralize futures marketplaces.

ALGORITHMS & BROKERAGE SERVICES

Use of Algorithms

We haven't done anything there at all. We're moving down the path toward opening an equity long-short fund, and this is the type of area that we would consider in that process.

Prime and Executing Brokers

Citi is our main prime broker, and we also trade futures with Fimat. Plus, we have a growing relationship with Bear Stearns.

How do you determine which brokers receive your order flow?

We've got a pretty simple world here. Most of our trading is done within the futures markets, and there it's generally split pretty evenly between Citi and Fimat. And since it's a centralized marketplace, both of those firms are acting as agents. So the idea that you're getting better execution from one dealer or another doesn't really hold water.

BIG PICTURE

Biggest trading opportunities for the firm?

There have been many market events over time, such as October 1987 or any of the emerging market-driven events of the 1990s. While all different, they all had two things in common: Volatility spiked upward, and the correlation of risky assets went to one (i.e., they all moved down together). Relying on traditional means of diversification consistently failed during these turbulent periods. We think we have a better approach, which involves focusing on the relative bets across markets as opposed to grandiose pronouncements about the direction of asset classes. These relative bets are not nearly as affected by market events because rising correlations actually mean lower overall risk since the short side of our book will track the long side of our book better than expected. The bottom line is a higher degree of consistency in returns with fewer surprises.
So where are our big bets? Very long Swiss stocks and very short U.K. stocks, which is the result of a number of quantitative signals, all pointing in the direction of Switzerland being a favored market over the U.K. at this time. At the same time, when we take a look at the markets from a discretionary standpoint, we think that the Bank of England has made a pretty major policy error by being as vigilant as they've been, and now that we've had a catalyst to turn the monetary policy -- the credit problems in the U.S. -- we don't think that the U.K. is very far behind the U.S. in reversing the course of their monetary policy. We also like the Asian equity markets, such as Taiwan and Hong Kong, and are funding a lot of the long positions that we have in Asia and the emerging markets with the lower beta equity markets such Australia and the U.S.

In addition, if you look at the carry trade in currency, while it has worked over time, the trick is to find some type of signal that will give you advance notice that the carry trade is about to go in the other direction. What we've found is that credit spreads generally give us the best advance notice. So we were very long in the carry trade in the spring as credit spreads were narrowing, and had just about a maximum short position in the yen at that point in time. We started reversing that dramatically in June and went quite long with the yen in July. And now with credit spreads starting to narrow again, having reversed a significant portion of their prior widening, we've gone back the other way. Adjusted for volatility, credit spreads widened almost as much this summer as they did in 1998, and it had a profound effect on our positions. Of course, the flip side of the yen was our position in the Australian dollar in which we went from a very long position to a sizeable short position and are now back to a long position. It's interesting to note that while the carry signal has had a profound impact on our positions, there are other signals that are now leading us in the direction of putting on the carry trade more so than the carry signal itself. The diversification of our signals can, at times, reinforce the position that another signal also might be indicating is appropriate, and that only strengthens our conviction in the trade.

Difference between trading for an alternative investment firm vs. trading for a traditional asset manager?

The focus on performance is more acute at an alternative firm. The time horizon in generating performance tends to be shorter. People may say they're long-term investors, but the reality is they're looking at monthly returns -- you have a couple of bad months and they're already starting to get jittery. What that means in practical terms is that you have to have much more disciplined risk-management practices in the alternative world. On the relationship-management front, I think historically there had been a big difference. But if you look at the alternative firms that have been successful in growing their business, they've done a very good job on the relationship-management front, so that's no longer as different as it was 10 years ago.

What is the most challenging aspect of your job?

Being global means the world's my oyster, and it also means I have to keep on top of changes all over the world on a real-time basis. So I never stop thinking about the markets, and finding enough hours in the day to do that can be a challenge.

Major Industry Trend

Growing up at JPMorgan, I learned what it meant to be a fiduciary at a very young age. So when we started managing a hedge fund, we had that same fiduciary mind-set. As a result, we registered with the SEC from Day One. And while the pressure is off now for hedge funds to do that, I think the pressure is still on for them to give their clients a better idea of how they manage money and where their risks lie. Our perspective is to be as transparent as we can possibly be with our clients, so we let our clients know what our portfolio is at each point in time. We have enough liquidity so that we have no concerns about doing that, and we've got enough intellectual capital here that we're perfectly willing to share any and all thoughts of what we've done and what we see going on in the market on a real-time basis with all of our clients. Getting close to your clients is growing in importance. People who think all they have to do is put up great numbers and they're off to the races. Well, there have been a lot of disappointing stories on that front, and that's likely to continue. You've got to hit the client confidence side hard, although obviously this is still a business that's based on generating good investment performance.

Interview Conducted by Randall Devere, Contributing Writer

Phil Simotas

Walt Weissman