Thorp is chief investment officer and runs ILEX's European credit opportunities fund with James Sclater, senior portfolio manager. The London-based hedge fund has more than $100 million under management, up from $2 million at the time it was founded in June 2000. It focuses on bonds rated single-A through triple-C.
What is your portfolio strategy?
We take a top-down, macro-driven approach combined with a bottom-up overlay. This entails taking a macro view on the market, drilling down into sectors and then into specific credits. This perspective will determine the investment themes in the portfolio as well as the outright risk. Alongside this approach we monitor and analyze individual credits to enable us to establish both absolute and relative valuations. Turnover of the portfolio is fairly aggressive--typically around two times per month. Very important in this type of trading-oriented strategy is a very disciplined stop-loss policy; limits are set conservatively and are observed stringently.
How do you make money for your investors?
Our emphasis is always on capital preservation. If we can capture 50-70% on an upside move and avoid losing money in down moves, then we believe that over the credit cycle we will produce returns which are attractive to investors. Over the last three years we have successfully achieved this, with just one down month since December 2002 together with very low volatility of around 1.5%. As a total return fund, our task is to keep the correlation between returns and the direction of the market as low as possible.
As a result, our performance has been good in up markets, such as in 2003 and early 2004, and very good when the market has done poorly. We were net short of the market in the summer of 2002, and again in April and May of this year, when high-yield and crossover credits traded off on concerns interest rates would rise faster than expected, a heavy supply pipeline, deteriorating emerging market bond markets and rising oil prices. It was as much this call on the market as our individual credit selection which enabled us to remain in the top quartile.
How does ILEX differ from other hedge funds?
In the 1990s, a lot of funds sprang up that were highly leveraged vehicles generating extraordinary returns. Rightly, in our view, people's conception of what hedge funds should achieve has matured over the last few years. This shift is reflected in the way ILEX is run. We are not aiming for 20% annual returns, but rather prioritize the protection of investors' capital. Most of our peers tend to have more of a long-biased approach than we do. This was reflected in 2002 and the spring of 2004 when we were actually outright short of the market. While there will always be a tendency to run long in asset classes where the securities carry a high-paying coupon, risk in credit markets is asymmetric to the downside.
What themes do you see emerging among investors?
We've seen increased risk aversion among investors such as high-net worth individuals, pension funds and fund of funds. These investors are increasingly looking for consistent, low-volatility returns which have a low correlation with other investments--and this is exactly what ILEX provides. Investors seem more uncertain than usual about the future.
How do you see the high-yield markets performing for the rest of the year?
Since May the credit markets have made a strong comeback and this looks set to continue for the rest of the year. The shortage of supply, low default rates, investors' large cash positions, very strong demand from collateralized debt/collateralized loan obligations and the relative attractiveness of yield product in a world that does not appear to be under inflationary pressures are all still combining to provide a very strong bid to the market--in spite of spreads having already significantly tightened.
At the moment it is difficult to find trades with a three-to-one risk reward ratio, which is our usual guideline. Accordingly, the proportion of relative value trades in the portfolio has recently increased. These might be intra-sector trades such as France Telecom against Deutsche Telekom, or trades within the capital structure of the same company, where we might play the five-year bond against the 10-year, or dollar bonds versus euro bonds, or the credit-default swap/bond basis. Special situations have also provided excellent opportunities. For example, in the Invensys refinancing, we made four trades over a three week period in different parts of the capital structure and generated returns by correctly analyzing how the restructuring would take place and the market's valuation of its component parts.
Where is ILEX heading next?
After significant growth in the last 18 months, we're now looking to soft close the fund at $150 million by Christmas and then expect to hard close it at $300 million. Beyond this, we are considering opening further funds under the ILEX brand in fixed-income related strategies. Thus far we have had specific interest from existing investors in a long-only product. The strong asset allocation trend from equity to fixed income products clearly presents us with a number of very exciting potential avenues to explore.