The lesson bears repeating here and has a direct impact on everything Odey Asset Management now does. In 1994, when the company was in its infancy (before Hendry’s arrival), Odey took a large bet on UK government War Loan. War Loan is the most leveraged fixed income debt issued by the British government, and Crispin had charted a 17-year break-out.
Odey was gambling that disinflation, a slowdown in rising prices (inflation), would continue to assert itself in the 1990s, driving down interest rates. As rates fell the expectation was that bond prices would rise as investors tried to lock in higher rates paid by the bonds. The bond holders would enjoy tremendous capital appreciation in the assets they owned. The price broke out to a 13-year high which appeared to confirm Crispin Odey’s hunch, so he bought generously to the tune of hundreds of millions of dollars, eventually buying up 40% of the issuance.
It was the right trade, at the right price. But, says Hendry, when the market knows that you own such a large position, you are a target unless your pockets are very deep. There is an intellectual conviction that drives Hendry’s investment process, and that owes much to the guidance of Crispin Odey. At the time Odey was sure theWar bond was the right investment and, rewarded by the market with rising prices, loaded up heavily on the basis of a single trade.
At that point the market delivered an unwelcome surprise. The price checked back to its break-out level, leaving him stretched and needing to sell some of his holding. But, as he now owned 40% of the issuance he was at the mercy of the market makers who knew he needed to sell. Odey had no choice but to lighten his position to mitigate the risk of a more serious loss. The price did start to move back in Crispin Odey’s favour, but by then it was too late. His hedge fund had lost 43% of its value. By the end of 1994 those losses, and the withdrawals from spooked clients, saw assets under management fall from a billion dollars to just $40 million.
Hendry says that the experience has had a profound effect on the company’s risk control. A hedge fund company either goes out of business when something of that magnitude happens or it changes its business practices. The company has now changed the way it operates to allow it to accommodate mistakes and survive. Inevitably that means taking on smaller bets. On a company-wide level, because of the concern about
the current environment for financial markets, there is a focus on liquidating to cash at the sign of any serious sell-off.
Strategically, because of Hendry’s view on the bubble-like conditions that markets are still exhibiting, his aim is to take a lot of negative bets on European and American stocks while running faster long positions in Japan. He also hedges his portfolio by buying derivatives in the S&P 500. A significant part of his strategy through 2003 was to buy S&P 500 index Puts for his hedge fund. These are options contracts that give him the right to buy the index back at a lower price if it falls. The contracts are a basic insurance policy against downside risk, and while they do cost money to arrange, they earn their keep in declining markets. At any one time in 2003 the contracts may have cost him 3–4% of the fund’s net asset value.
Read More : Dealing With Risk
