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2007 TOC

Michael Cagney, Managing Partner, Cabezon Capital (San Francisco)

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Personal Background
Fund Background
Technology and Algos
Big Picture

Description of Firm:

Cabezon Capital is the general partner to the Bretton Woods II Fund, which was launched in July last year -- originally with about $60 million in assets. We currently manage about $180 million in assets in both an onshore vehicle and an offshore vehicle, as well as a separate account. We're a global macro discretionary fund. We trade across fixed income, equity, commodity and currency.

Daily Trading Volume:

Approximately $5 million to $10 million in equities, $3 million to $5 million in fixed income and $3 million to $5 million in futures.

Trading Style:

We leverage what we call a Bretton Woods II framework to identify tradable macroeconomic imbalances, particularly as they relate to central bank or other policy behavior. We tend to concentrate our trades around four to six themes, generally within a six- to 12-month time horizon. We try to emphasize idiosyncratic risk over systemic risk in our themes and generally invest in liquid, local debt, equity and currency. Within those themes, we tend to trade a decent amount, rotating and taking a more tactical view in terms of current market situations.

Structure of Trading Operations:

It's myself and two other traders. Effectively, we cover markets from Tokyo open to New York close, so we're running against a 20-hour clock across all the primary asset classes. I make all the portfolio decisions; the other traders manage execution and risk and have some discretion for intraday trading.

INTERNATIONAL TRADING

Does the firm trade internationally?

There really aren't a lot of markets in which we don't trade, and we tend to trade locally. So we're registered in places such as Vietnam, Russia and Turkey to trade and hold securities. One of the benefits of a global macro approach is that you can move to whichever market you feel offers you the best opportunity and the best risk/reward profile. Conversely, one of the challenges is that you've got a 20-hour clock against which to trade.

What are the challenges of trading globally?

One of the benefits of being in San Francisco is that you can readily trade the New York and Latin American open and close, and then Asia comes on at a reasonable hour. The challenge is emerging Europe-Russia in particular, but developed Europe as well. It's very hard to trade that open, but you do get the tail end of that at New York open, where you basically have the Europe close. So emerging Europe is sort of the "lucky shift" through which we rotate, but it's doable.

TECHNOLOGY

Technology Environment

From a portfolio-management standpoint, we use a customized product from a firm called CapEdge -- a small start-up here in San Francisco -- that allows us to model, book, mark and run risk against the fixed-income, equity, commodity and currency components of our book. We've established loose integration of that into our execution platforms, which are primarily Bloomberg, Goldman's REDI, and Morgan Stanley's Passport and Passport Express. There's a significant amount of execution that we have to do in our markets via phone, as many of them don't have any electronic capacity. In those circumstances we have some checks and balances to ensure timely and accurate trade capture back into our portfolio management (PM) system.

The portfolio management system has some proprietary components to it. In particular, we like to look at our book specific to these thematic views, and the PM system does a pretty effective job of consolidating and showing target allocations of individual securities in terms of how those composite a theme, as well as the ability to substitute securities and see that handling within the overall blotter.

Buy vs. Build Strategy

Global macro trading covers so many instruments that it's hard to find a one-size-fits-all solution. For example, I was looking at things this morning, and I'm laughing at the idea of a system trying to book an Argentine bond with a Euro-Hoff binary option with an Indonesian total return swap. Unfortunately, most systems will fall down pretty quickly in that context. We need to be able to book, mark and run risk in real time across those kinds of securities. So it necessitated a little bit of customization on our part. We were starting with a pretty good foundation with some of the PM technology we got from CapEdge and our general understanding of these markets. We try not to do a lot of customized work, but inevitably there's some that we have to do because it's difficult to get the large commercial products to have that kind of scope.

Who ultimately is responsible for the firm's technology?

Our COO, John Gardner, ultimately is responsible for all technology decisions, implementation and management.

Use of Crossing Networks and Dark Pools

Working within the context of a global macro strategy, a lot of the securities that we trade don't even trade through an electronic medium. So we're as far away from dark pools or gray pools as you can be. But, obviously, there are some securities -- such as ADRs (American Depositary Receipts) or GDRs (Global Depositary Receipts) on New York or London -- where we can take advantage of that liquidity, as well as some of the dealer algorithms that we use. For example, TradingSort from Morgan Stanley has a default option to show into a dark pool. But by and large, our size and our volume haven't really necessitated that as a liquidity source. We've been fine getting the liquidity that we need in the DMA markets in which we have access.

ALGORITHMS & BROKERAGE SERVICES

Use of Algorithms

In general, we don't use them. We do tend to trade in relatively algo-heavy markets (for example, Hong Kong) where sensitivity on algos is dialed up pretty high. So we tend to trade more of the old-school way -- by hand. A lot of times we have to push the algos a little bit to actually make a market because with the sensitivity dialed so high, if you're trying to trade certain names in Hong Kong, for example, and you go to lift offers, they'll immediately begin to fade and you can't get liquidity. So you sometimes have to play both sides to essentially trick enough volume on the other side of a market to get your deals done. So we don't tend to use them very often and, in fact, generally find ourselves working against them in terms of execution.

When you do use algorithms, are they primarily dealer-provided?

Yes.

Prime and Executing Brokers

Morgan Stanley is our prime broker. But we do a decent amount of execution via Goldman, Morgan Stanley, Deutsche Bank, Bear Stearns, JPMorgan and, to a lesser extent, Citigroup. We've got a relatively diverse coverage universe.

How do you determine which brokers receive your order flow?

We try to be fair in allocating across the dealers. We're at a point now where, even considering Morgan Stanley to be our prime, on a net basis the prices are roughly equivalent across the board. We're relatively low-maintenance, so we don't really demand a lot in terms of coverage. We certainly appreciate dealer color, but we also like to get our own inferences on the market. We do try to reward dealers' work to accommodate some of our more esoteric markets and trades. So, for example, as we were getting set up to trade in Vietnam, we got help from some dealers that we rewarded with flow.

BIG PICTURE

Biggest trading opportunities for the firm?

There are a few things that we see as opportunities. One is just getting better electronic access across global markets -- equity markets in particular. It's a huge difference having DMA access to a market such as Singapore versus being restricted to voice only in a market such as Indonesia. To the extent that we get broader adoption of technology in those markets, it obviously helps us and would probably facilitate more volume. On the futures side, there are a lot of highly traded contracts that aren't Commodities Futures Trading Commission (CFTC)-approved and force the use of a swap. To the extent that we can get more approval, it reduces our cost and, again, would probably facilitate more execution. And in terms of price discovery, getting a process analogous to Trace [FINRA's Trade Reporting and Compliance Engine to which all U.S. OTC bonds traded must be reported] that we have here in the U.S. for emerging market sovereign debt would be a huge boon to people on the buy side like us. Obviously, it wouldn't be great for the sell side in terms of giving up that price discovery. But overall, it would actually help facilitate more volume.

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

When I was at Wells, I was in the fortunate position of not having any security or asset-class restrictions, and so I did trade across a broad variety of security types, asset classes and geographies. And in a macro fund, that's what you need to be able to do. You can think of returns as coming from three themes: You've got your idiosyncratic aspect of risk and return, where you've got a particular view and you take it; a systemic aspect, which is just, "Does the market go up or down?" and "Are you long or short?"; and then there's a tactical aspect, which is where you try to extract as much value from the trade as possible. And to do that effectively, you've got to be comfortable with a broad variety of asset classes [and] a broad variety of geographies. And, more important, you need to really understand the local markets in which you trade -- in particular, who participates in those markets and what it means to see a particular entity buying or selling -- so that you can take advantage of what I would often consider inefficient flows in these markets that, from a technical standpoint, can help facilitate excess returns.

What is the most challenging aspect of your job?

The biggest challenge is just staying on top of all the markets in which we trade and the markets in which we might want to trade. That's hard to do, and when you're trading across a broad variety of security types and asset classes, you put a lot of strain on your infrastructure. Fortunately, we've got some extremely talented people in the front and back offices. But it can get a little stressful at times, especially when we're in fast markets.

What new technology would solve your biggest trading problems?

Everybody would love a single platform from which they could seamlessly book and execute their securities. It just seems highly unlikely that we're going to see that anytime soon. We've come a long way on the portfolio management side in being able to consolidate securities and represent a very timely view of the market and risk, but there's still more to be done. And then, as I mentioned, many of these markets in which we trade don't trade electronically. So, inevitably, you're still picking up the phone, doing voice execution and manually loading information back in. It's a long way from true straight-through processing, and I don't see any movement in the market to change that.

Major Industry Trend

There are two big issues out there: One is risk and the other is fees, and they are both problems that people have had with the alternatives community for some time. On the risk side, we're getting to a point in time, with technology and expertise and the development of markets, when we should be able to provide fairly decent market and risk at high frequency. By high frequency I mean, at a minimum, daily. And in doing so, we can mitigate some of the operational and market risk that funds face when they don't have that kind of price transparency. That's an important trend that the hedge fund community, in particular, needs to pursue, although there's some digging of the heels on that. Ironically, a lot of that is coming from the administrator community.

On the fee side, completely separate from risk, there's this constant debate about alpha vs. beta and whether you're paying for alpha or paying for beta, and even if you're paying for alpha, whether the fees are warranted. We've seen the advent of products such as clones, hedge fund replication strategies and so forth. And as a result of the combination of that and a relatively large pool of hedge funds that, quite frankly, haven't been knocking the ball out of the park from a performance standpoint, we're going to see fees come under pressure, especially for new or underperforming funds. We've seen this happen already -- we've seen some funds adopting reduced fee structures -- we've been fortunate enough not to have to do that. I'm actually a big fan of a performance-only fee structure, as I think it directly aligns the interests of the fund with the investor. I'd love to see the market move in that direction, but I don't think the large funds, in particular, have a lot of incentive to do it. Earning 2 percent on a huge volume basically transitions them from risk takers to asset gatherers, and I think that's bad for the industry. But I don't see that reversing anytime soon.

Interview Conducted by Randall Devere, Contributing Writer