Quant Hedge Fund Strategy Explained & Why GBP Is Outperforming The EUR

Hey, hello and welcome to the podcast series on global markets where I'm joined by co-founder Piers Curran. As a reminder, if you're new to the podcast channel, there are two episodes per week. One when I speak to Piers on all things breaking down the major themes in markets, and the other is more focused on all things corporate finance. Only you will be able to decide which one you prefer most. Steven and Piers are slightly competitive, um, but in this episode we're going to look at two stories, predominantly going to focus on the first, which is unpacking a quant trading hedge fund strategy. We're going to look at what is their trade, how does it work, featuring a view on a macro level about US rates and US debt, how they use products like futures for leverage and then the overarching strategy of being market neutral. And what does that mean and how does that work? Then the second story, why the British pound might surprise you because you're probably thinking we are in for a general election, got announced, and it's not looking good for Rishi because the Conservative members are leaving by the busload. But the pound has risen to a 21-month high against the euro. So How does that make sense when there's a lot of domestic political disruption potentially on the horizon or not? And then more importantly, from an economic point of view, why is the pound strengthening against the euro? Because there is a quite clear answer when you know what that is. Before we begin, Piers, two things. One, I might sound a little different because I'm using a headset rather than my normal podcast mic, and the reason why is there is a finance accelerator going on right now.

Ah, very good.

100 keen students on the call with Sam at the moment, and 6 of those come from the University of Chihuahua. Ever been to Chihuahua?

Chihuahua? I'm ashamed to say I only know Chihuahua with reference to a type of dog. Tell me, is it a place? I have no idea. Where is it?

It's actually one of the 31 states which form the 32 federal entities of Mexico. It is in fact the largest of the Mexican states.

Is that right?

And that state in fact is larger than the UK.

Wow. So there you go.

There you go.

That's a lot of dogs.

But yeah, just pointing that, I mean, the, the reach of that is incre— it always surprises me. But yeah, anyone who hasn't done one yet, just go in the show notes. You need no prior experience, but do check out our Markets Finance Accelerator experience. It is in partnership with Morgan Stanley and UBS. And if you perform particularly well, irrespective of background, you could be fast-tracked to either one of those investment banks. So definitely, an opportunity worth investigating. And secondly, shout out quickly to Sophie Cases, who dropped me a lovely message, and she said she loves the podcast. In fact, she thinks you're quite a funny guy, Piers.

Ah, she sounds like she knows what she's talking about.

Okay, so with all of that out of the way, let's dive in. And this Top performing quant fund is the headline in Bloomberg, or on Bloomberg, is shorting 5 to 10-year US Treasuries on expectations that interest rates will stay on hold this year as prices remain elevated. So that's part of the summary, but perhaps you can unpack then this hedge fund and their trade that they've initiated.

Yeah, I love this. It's kind of, I mean, it's, it's a great trade to use as an example of Yeah, yeah, you know, a complex— well, I'll talk about structured products a bit later, maybe, as you— how you execute this thing. But it, like, it's a, it's a trade that's got many multifaceted sort of elements to it, um, and this is kind of gives you— showcases, you know, a more complex, uh, way of investing and what the hedge funds tend to, to do to be creative, to generate ultimately as much return as they can, but with as little risk as possible. So yeah, they are— well, so this is a fund called Catalyst teaming up with Milburn, and they've come up with this strategy where they're basically shorting the US Treasury bonds. So that's when we talk about bond, this is a fixed income trade. So we're talking about US fixed income, US bonds. And the part of it where they're going short is then the, what we call the longer duration, is the longer end of the curve. So they're selling 5 and 10-year US government bonds, and they're hedging that. And it's a market-neutral trade because they're basically buying an equal and opposite amount of short-term Treasuries. So this is either, well, US government bonds again, but with a shorter duration of, let's say, 12 months. So they, they're called T-bills, or maybe 2-year government bonds. And they're also maybe buying some corporate bonds in there as well. So this is a hedged trade. Now, their main thesis ultimately is a macro one, and that is that they don't believe that the Fed are going to be able to cut rates, number one. And they believe that actually the inflation pressures will remain elevated, preventing the Fed from cutting rates. And this then feeds also into the idea that the US government, as debt costs remain high, because don't forget, the US government bond yield is effectively the cost of borrowing for the US government. So if those yields stay elevated because inflation stays high, then the cost of borrowing for the US government is going to stay high. And because they got a really wide deficit, because Biden basically spent all the money on stimulus and so needs to borrow a ton, they're going to need to borrow a load more money at higher interest rates. And so ultimately we've got a debt ticking time bomb, some alarmists might call it. But ultimately, in the short term, we think about demand and supply, then we think there's going to be more supply of US government bonds on the longer duration. Coming down the pipe as the US needs to borrow more money. So more supply means prices go down. So anyway, there's quite a few elements to this, but ultimately, how does this work? Well, if you think inflation is going to remain high, then it's actually longer duration bonds that are more sensitive to inflation expectations. Okay? And if inflation expectations are going up or staying high, then in, then the yield on— let's just use the 10-year government bond— the yield goes up. Okay, now if the yield goes up, price goes down. So they are short US 10-year government bonds. They're shorting because they think the price is going to drop and they want to profit from that price movement to the downside.

And just to add a layer of what's happened this week. In fact, in the last 24 hours of us recording this, I don't know if you saw yesterday, but one of the Federal Reserve members, Neel Kashkari, came out and said, do you know what, we shouldn't entirely rule out rate hikes here. So what, is he on the book for this hedge fund, or is, um, what's going on here? One thing I would note, and something to, I guess, as a learning point here, is that Kashkari is a non-voting member of the FOMC. So there's two layers to that, just to kind of summarize. One is he leans on the hawkish side in recent commentary, so less surprising to make a comment like that. And secondly, I don't think he's a voter this year or next. So you're properly out on the fringe where you can make some pretty bold statements because you're not actually centered to the discussion and from a voting power perspective.

True. Pop quiz. What? So Kashkari is a Fed president, but which Federal Reserve District?

Minneapolis.

Nice. Full marks. So look, hawkish comments from the Fed there, obviously helping with this trade because, I mean, we just mentioned the Fed not being able to cut. Well, here you've got Kashkari, a member of the Fed itself, saying, well, maybe we might have to hike. So Again, that kind of all plays in here. But so that's their main central trade, right? Is we want to short the long end of the curve because we think inflation is going to stay high. Rates are going to have to stay high. We expect more supply, so prices will drop as well. So we want to get short that long end. Okay, great. That's their primary trade. Now, what happens if they're wrong? And ultimately, can they do this in a clever way where they can hedge it? To kind of lower the overall risk profile of this trade? And actually, can they generate any yield and income in the meantime? And so this is the clever part of the trade, right? So they're shorting the long end, the 10-year. Now they're going to offset that by buying short-duration government bonds, so T-bills, okay? And they're also going to be buying US corporate, like investment grade corporate government bonds. Um, I think particularly it was Apple and Microsoft, I believe, were the kind of two. So like top end of the kind of investment grade spectrum here.

I was just having a quick look at the sort of coupon size on one of those. So going out to 2039, 41, Microsoft, you're banking about 5.2%.

Okay. Yeah, but that's a long duration though. Yeah, they're buying short. What have we got on a— do you know what we got on a 2-year?

2035 comes in at 3.5. Let me have a look.

Okay, well, you can fact-check that whilst I, um, carry on here. So basically they're selling the long end and they're buying the short end. So basically this is what we call market neutral, where you ultimately from a top level, you are neutral because you've bought as much as you've sold, right? All right, they're different durations and you're anticipating them to obviously move by different amounts, but this market neutrality play means you're immune to any kind of unexpected shocks. Because look, as an investor, there's obviously the known unknowns. So for example, when will the Fed cut rates, right? That is a known unknown. Now there's then what you call the unknown unknowns, which is ultimately anything can happen at any time. And, and, and that stuff you cannot prepare for, um, specifically, but you can prepare for generally. So this is kind of what this market neutral play is. If there's a big shock which all of a sudden sends markets massively up or massively down, then ultimately they're protected from that because they're long and short at the same time. Okay. So this is much less risky. They're hedged against unknowns lurking out there. And in the meantime, their play is that they expect the prices of the longer duration bonds to move down by more than the prices of the shorter duration bonds. Now, the final part is, right, how have they put this trade on? Because they're actually using a leveraged futures position to short the 10-year US government bonds. So they're selling 10-year US government bond futures. And they're buying on the short end, they're actually buying the actual physical bonds. So why are they doing that?

So just quickly, that bond maturity March 25, Microsoft is 3.1.

Okay, 3.1. Right, okay, so that's actually lower than the US government 2-year.

So the payment of the coupon though takes place twice. Okay, so would equal—

yeah, okay, all right, so that makes better sense. Yeah, like more like just over 6. Okay, so, so with the with the long end, right? So they're selling US 10-year government bond futures. Why are they doing that? They're doing that because they can leverage up the trade. Basically, they can use less money through leverage to get a much bigger market exposure. So for example, and this is kind of a, a simple example of what we call leverage, if you wanted to, um, sell $100,000 worth of US government bonds, okay, then you would actually have to sell the nominal value of $100,000. Okay. If you're dealing in the physical bonds, all right, you'd need to put up $100,000 and then you're selling that amount. Okay. Now you can get the same amount of market exposure, as in equivalent to $100,000 worth of nominal value. You can get the same amount of market exposure by just putting up $2,000 via the futures markets. So you're getting 50 times leverage, and that's because to trade futures, well, you're not buying the physical bonds or selling the physical bonds. So you don't need $100,000. You're actually buying a derivative of that product. Now, to trade that, you trade it, you, you provide margin, right? So you deposit margin into your trading account, and then the exchange or the investment banker you're trading through will ultimately determine determine, right, how much margin do you need per futures contract? And one futures contract is equivalent to $100,000 worth of underlying nominal value.

So just for context, the reason why not every person on the street is leveraged up in the futures market— so I'm assuming the margin is significant.

Well, it's $2,000 per contract, right?

But at least—

well, hang on, the point is about your average dude on the street. You cannot trade futures unless you are either— you've got to pass several checks. So such as you're an industry professional who has experience and knowledge of these products, therefore you're able to trade them. Or I think you can just get away with just being a straight-up high net worth individual who has a certain minimum amount of liquid assets, um, or you've passed some exams to again demonstrate that you've got knowledge and awareness of the risks that are involved with these assets. So you can't just— an average punter can't trade this stuff, it's too risky. So it's normally the finance industry professionals, right? So they're able to make a much, much, much bigger bet with the same amount of money by leveraging it up. Okay, this is a very typical hedge fund play. It's using leverage. Okay, now that's on the long end, right? They're selling US 10-year government bond futures. On the short end, they're actually buying the physical bonds. They're not using futures. Why? Because they want to benefit from the very high yields that the short duration bonds are currently giving. as we've just said, like 6% for a 2-year Microsoft, right? So they're, they're basically funding the trade, or part of the trade at least, through the yield and income that they're generating from the long part of their trade. So it's actually quite a genius play where you've got market neutral, fine, your macro idea makes sense, you don't think the Fed are going to cut, You think there's going to be more supply because the US have got a huge deficit, price is going to drop, let's get short futures. And then we'll fund that by buying the actual high-yielding shorter duration bonds at the same time.

And to give context to the fund in itself, I think it was $7 billion that I saw. Correct me if I'm wrong. So that's the sort of hedge fund size that we're talking about in terms of assets under management.

I don't know, that might sound like a lot of money to people, 7 billion. I mean, don't get me wrong, it is a lot of money, but in hedge fund world, it's not that big. I mean, that's, that's like a medium-sized fund. I mean, it's not a small fund, but it's, it's not a big one either. Um, I wouldn't say So, but yeah, they've got a good track record for sure, and they've been outperforming. And, you know, it's these kind of trades which, you know, ultimately you're trying to basically generate return on investment irrespective of market conditions. So this is again a kind of feature of a hedge fund, kind of selling point. It's, look, doesn't matter what's happening out there, doesn't matter what part of the economic cycle we're in, doesn't matter what's happening with exchange rates or yields or interest rates or geopolitics or natural disasters or pandemics. It doesn't matter because we've got a play that can generate returns irrespective of what's happening. And so it's these kind of market-neutral strategies that are designed to, um, deliver those returns.

So assets under management, $7 billion would put them just inside the top 200.

Okay, yeah, all right, that's probably higher up than I thought on the list, but yeah, still not— obviously not nowhere near the big boys.

So my final thing before we, we move on to the, to the pound is, in order to factor then the type of positions that you need when you have these contrasting products to structure this trade, Yeah. Is this where the quants come in to calculate that, but also the calculated risk of this position under different scenarios that may impact the neutrality of the trade?

Yeah, absolutely. For sure. These are the— and look, these quant hedge funds, I mean, because they're running these massive models, they're basically able to assess the the statistical anomalies between, you know, they're comparing like hundreds of thousands of financial assets, right? And they, they can compare such a vast volume of assets with each other. And then within this giant, giant model, they're picking out these kind of statistical anomalies where prices relative to each other are out of line, and they're expecting that, that divergence isn't sustainable. And there is kind of a mean reversion strategy, but you've got to find these products that are— that have diverged, right? And then you use your skill and judgment. Maybe this is where the human being part comes in. You say, okay, the model spits out however many divergent kind of asset pairs, and then you as the human can go through and say, all right, well, you know, these 5 I think look the most promising because in our judgment and in our experience from decades sat in front of these screens and going through economic cycles, we would expect those to be temporary divergences that you'd expect to revert back to the mean.

Yeah, it's interesting. It's like when I used to work on the desk aggregating news, it's a similar process. You use the technology to filter the large data set. In this case, for us, it was Twitter. Yeah. And then the the machine, the algorithm you designed would then sift through certain signals. And in the end, the pilot makes the judgment call on whether I would say it or if it has value from my expertise. It's just, I'm, I'm now looking at, I don't know, a million things instead of 10,000 things.

Right. Exactly.

Yeah. Makes sense.

And then also, like, these hedge funds, I mean, if you go lower down that list, you said these guys were like 200th or top 200. Yeah, there's obviously thousands of hedge funds out there. And a lot of them, the smaller you go, or the less large the team, right, the less budget they've got to hire PhD quant students. And therefore, this is where more and more so the smaller hedge funds will rely on the services that the sell-side investment banks offer. And so this could be— and again, so within the sell-side investment bank, let's take Morgan Stanley. So if you're a small hedge fund and, you know, maybe you've come up with the top-level idea of the trade, but right, how can I just go about kind of executing this? And this is where the kind of investment bank might come in and basically facilitate the execution of the multiple parts of that trading strategy idea that you have. It's kind of— they're the one-stop shop that you can go to to kind of click the button and say, great, I, I want X amount of overall exposure in this multifaceted strategy, can you help me executing this trade?

So the Prime Broker guys then, I've always thought they're kind of good relationship managers in a sense of they could fix any, any problem sort of scenario, but they must be quite their breadth of knowledge then about— I suppose you have a specialism within prime brokerage, which is dealing with a subset of certain type of hedge fund strategy. Yeah, that you, you pretty much know these strategies inside out yourself, even though you sit on the sell side.

Yeah, that's right. And you know, you're providing market color and research, and you know, because don't forget, these smaller hedge funds, they don't have research teams, or, you know, so you're reliant on this, the prime brokerage firm, you know, your, your your, your contact at Morgan Stanley to be providing daily market color and insights, and then also coming up with trade ideas, right? And it could be that, it could be that a hedge fund has an idea of a trade, but they don't quite know how to, you know, even begin when it comes to actually executing it or building the different components that might be needed. And this is then getting more towards like structured products where you've got a you know, you've got a product expert on the investment bank side who's able to essentially build the product using your very top-level design trade idea and essentially come up with the building blocks for that product that you can then execute through the bank. So the smaller the hedge funds go, the less support services they've got in-house, and the more they rely on the investment banks to outsource that to.

Cool. All right. Ready to open my futures account and put on my structured trade. Well, let's talk, let's talk a little bit about the, the UK and specifically sterling currency, which has risen to a 21-month high against the euro. So tell me more.

Well, your, your summer holiday to Benidorm just got a whole lot cheaper. I mean, you might need to upgrade your hotel room here because you can now buy a lot more euros for your pound.

Oh, I've got the bar that's in the pool, you know, when they have that sunken bar in the middle of the pool.

Yeah.

And then I go to Benidorm, but I get the chicken nugget night and the pizza night, and I just don't even need to leave. It's all inclusive, Piers.

No, you need to upgrade to personal masseuse. You know, for, you know, 5-course dinners. That's what we're looking at here. So basically the pound's on the rise. And yeah, as you said at the start of this podcast, it might seem a bit odd when you look at the political state of affairs here in the UK. And we've got an election coming in whatever, 6 weeks or less. And yeah, if you read the press, you know, it's all doom and gloom and And so you might think, well, hang on, why is the pound appreciating? But look, it's got nothing to do with the election. Or you could spin it the other way and say, actually, maybe actually Labour coming in to take over from the Conservatives, you might view that as a positive thing. And actually, that's why the pound is appreciating. But you could spin that argument, but I wouldn't give it too much credence. That's because there's a much more powerful force at play. And it's multi-sided because, look, you've got two currencies here. And actually, it's all— it's probably worth reminding people, you know, when you're trading FX, um, in many ways it's, it's one step more complex because when you're trading the pound versus the euro, you're basically trading the relative difference between two different assets. You've got the pound and then you've got the euro, right? And the pound, well, there's lots of things, particularly obviously here in the UK, that are influencing the pound's value. And then entirely separate, there's a whole bunch of stuff out there in the Eurozone that's influencing the euro's value, and you've got these two separate things that have got their own forces moving up and down. And what, what's the relative value between the two at any moment in time? So it's a bit more of a juggling act here to kind of get the exchange rate play right. But what we have here is a break. If I talk, um, pound versus euro— so we're actually, we're trading right now at 1 spot 1757. And this has just broken up above the March high. And that's put it at the highest levels we've seen. You've got to go back 2 years now. So a 2-year high in the pound versus the euro. There's actually— we'll see if it continues to rise or not. But of note would be up at the 121 handle, which was a very key double top. It was the 2020 high and the 2022 double top up at 121. But we've got a bit of a way to go because we're at 117.5 here. But the reason for the direction is just purely it's a straight up interest rate differential play. As time has ticked on, and we talked about this a couple of weeks ago, the chances of the Bank of England cutting rates have decreased. We're delaying our Bank of England first rate cut now, and it's being pushed into maybe the autumn. Whereas, and so that's positive for the pound's value relative to other currencies, because if interest rates remain higher, that attracts inflows and the pound is strong relative. Now, if you switch over and go across the channel, then over in Euro land, we're expecting the ECB to cut rates in June, and that expectation has not changed. And so when you think about the US, the Bank of England, the ECB, then actually we've delayed the US and the Bank of England rate cut expectations. We have not delayed the eurozone and we think they're going to pull the trigger in a couple of weeks.

Yeah. And you mentioned within this 2-week window, even 1 week, we've had that inflation figure in the UK and this week in the FT thinking about when we mentioned Kashkari and the composition of who has influence within the committee of making policy decisions at a central bank, the chief economist of the European Central Bank, A chap called Philip Lane spoke to the FT this week and basically reinforced what you just described. And he said the central bank was ready to start lowering rates at its next meeting, quote, barring no major surprises.

Yeah.

One might add that we record this on Wednesday, it's going to go out Thursday, and EU inflation figures come out Friday. So you could have egg on his face at the end of the week. Yeah, but unlikely.

Unlikely.

All right, cool. Well, look, let's wrap it up there. And thanks for deconstructing, particularly on that hedge fund strategy. If there are any questions at all, I know for sure on Spotify, you can drop questions or comments in the Q&A box. But otherwise, wherever we share this, namely on LinkedIn, just drop a comment. Piers and I are more than happy to engage on any commentary, good or bad.

Especially comments about how funny I am. I like those. What did you say her name was? Sophie.

Sophie, yeah.

Thanks, Sophie.

Mate, that's made your week, isn't it? You can tell your wife that tonight over dinner. All right. Thanks for listening, everyone. And we will see you next week. Thanks, Piers.

Catch you later.