Analysis - Man overrides machine to tackle low bond yield risk

LONDON Tue Aug 14, 2012 3:24pm BST

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LONDON (Reuters) - Man is overriding machine in the computer hedge fund industry, with some managers no longer ready to accept "black box" trading strategies blindly as government bond yields in the likes of the United States and Germany hit ultra low levels.

Man Group's AHL, one of the world's biggest funds, has built a new computer model to cap its exposure to bond futures for fear of big losses, should the market reverse abruptly, and others are likely to follow.

Since the euro zone crisis began, investors have shifted huge sums into the debt of governments they believe to be low-risk, sending the prices of bonds issued by the U.S., German and British governments soaring.

With the interest on government bonds fixed, yields have consequently tumbled and even turned negative, meaning investors effectively pay for the "safe" governments such as Germany's to look after their money.

Some believe this market trend cannot last much longer, so managers of computer hedge funds are reconsidering their strategies and AHL has become one of the first to act.

"We have adjusted our models," said Keith Balmer, a portfolio manager at AHL. "You have to be concerned about risk.

"There will be situations where markets change. We've very, very rarely seen negative yields (historically). Do we blindly accept that the model is going to work, even though there's no historical basis? No."

The new model at AHL's $16.7 billion (10.64 billion pounds) fund has stopped the "black box" buying more and more bond futures as yields fall.

AHL now thinks its existing algorithms - mathematical instructions to the computers - may not react fast enough to a sudden policy change, such as an official interest rate rise after years of central bank cuts to tackle the financial crisis.

The changes, which mark a rare intervention in a sector where firms are often reluctant to change their models when market conditions look intimidating, come from one of the funds that has struggled most to cope with the euro zone crisis.

The AHL fund has around 25 percent of its portfolio, as measured by risk, in bond futures including Japan, the United States, Germany and Britain - all countries perceived as safe havens in the global storm.

FEW RECENT PRECEDENTS

Industry insiders said other funds are also considering changing their computer models, which tend to analyse data over the last 30 years to deal with market conditions with few recent precedents.

Some go to even greater lengths in the search for historical information to help put price trends into context. Winton Capital's London offices display charts tracking the prices of commodities over hundreds of years. Its researchers have found prices of English wheat going back to 1209 and even those of barley and sesame in ancient Babylon.

CTAs (commodity trading advisers), which develop computer models that try to make money by following market trends, have made big profits in recent years from the long rise in "safe haven" government bond prices.

Now they are assessing the risk that the long run up, which has allowed the governments to fund their budget deficits and refinance their debt cheaply, may end or reverse.

"All the big CTAs will be looking at this," said one industry executive, who did not want to be named. "Bonds have been a really successful thing for many, many, many years."

Morten Spenner, chief executive of International Asset Management, said: "I've heard a few managers say 'perhaps we should tone down our allocations to fixed income as it approaches very low yields'." His firm runs a fund which invests in other funds, rather than directly in the market.

Earlier this year AHL's chief scientist told Reuters he wasn't sure if some of the fund's short-term codes would ever work again.

Analysts and shareholders see a pick-up in performance at AHL as crucial to a recovery at former FTSE 100 firm Man Group (EMG.L), whose share price has fallen more than 70 percent since the start of last year. The fund accounted for around 70 percent of Man's revenues last year.

However, after soaring 27.3 percent in 2008 AHL fell 6.4 percent last year. So far this year it is up 0.4 percent.

CONCERN

The move by AHL also reflects growing caution among both computer hedge funds and managers who take investment decisions over bond yields.

"The bond rally is close to its end, and at some point investors will be reassessing the risks of holding bonds," Philippe Gougenheim, chief executive and chief investment officer at Gougenheim Investments, said in a letter to clients.

"If you run a pension, endowment, sovereign or even mutual fund and you are holding bonds with such low yields, you might wonder what the rationale is."

German two-year yields, for instance, have dropped from around 1.9 percent last spring to minus 0.04 percent on Tuesday, while U.S. five-year yields are down from 2.3 percent last spring to 0.72 percent.

Even when positive the yields fall well short of inflation rates, meaning the value of the bonds is constantly eroding.

While funds, including AHL, can still profit from falling yields, many would normally keep increasing the size of their bets as yields continue to drop. This is because volatility, an important signal for many such hedge funds, has also fallen.

Typically, the smaller the short-term swings in the market, the more likely the current trend is likely to continue.

However, some managers fear the low yield volatility could be misleading, for instance if sudden action by a central bank, a credit ratings agency or a politician shocks the markets.

"As volatility heads towards zero your position gets bigger and bigger and bigger. When you're in normal market conditions then you don't worry," said AHL's Balmer.

"But if both forward and backward volatility are saying zero you don't want to hold an infinitely large position. Our positions have been capped more than if bond yields hadn't been close to zero."

Forward volatility is implied by the options market while backward volatility is that indicated by actual past trends.

CTAs are highly secretive about their money-making computer models, declining to reveal details that rivals could incorporate into their own systems.

However, they performed strongly in July after a tough start to the year, helped by the falling bond yields as well a drop in the euro, which many funds have been short selling, and jumps in commodity prices as a result of a U.S. drought.

The main fund of Winton Capital, a $29 billion rival to AHL, is down less than 1 percent so far this year after gaining 4.4 percent in July.

Cambridge-based Cantab Capital Partners gained 9 percent in July, taking year-to-date gains to 17 percent, said a source familiar with the matter, while the high-volatility IQS Performance fund rose 28.6 percent, according to an investor letter, bringing gains this year to 8.7 percent.

(Reporting by Laurence Fletcher; editing by Sinead Cruise and David Stamp)