Selling Nikkei vol hedged Phalanx’s long vega

Chris McGuire is chief investment officer of US-headquartered Phalanx Capital Management, which manages the $70 million Phalanx Japan Australasia Multi-Strategy Fund. The fund uses convertible arbitrage, volatility-related strategies, merger arbitrage and event-driven trading strategies.

How was your performance in 2009?
We finished up 42.7% for the year after being up 44.54% in 2008 and grew our AUM to $55 million. As of March 1, our fund was up to $70 million and, along with a managed account we took on in February, the firm manages $88 million, plus confirmed commitments for April 1. 

We moved offices in Hong Kong and in December hired another person to work in that office. We are currently at nine full-time staff, along with five consultants working within the Phalanx team.

What were the keys that drove 2009 performance?
2009 was the year of convertibles and, ultimately, improving credit. It was almost impossible for anyone with cash not to have made a substantial return while trading the CB product. 2008 was a year when convertibles lost money due to deleveraging and forced liquidation due to balance-sheet reduction. In that liquidation process, prices overshot to the downside. Last year rewarded those funds left standing and who had dry powder after the apocalypse of 2008.

Phalanx had relatively consistent performance attribution in both 2008 and 2009, in that roughly 70% of our profits came from CB trading. We remained risk-averse with credit and did not profit by purely buying beaten up CBs. We hedged our risks and were able to generate our returns as a true, relative-value-orientated fund. We took advantage of selling index vol on the Nikkei as it traded above 40%. 

This served as a blanket hedge on the long vega (implied vol) exposure we held within the portfolio. Thus, as the world 'normalised' and relative pricing reverted towards the mean or historical averages, we were able to benefit from implied vols moving back towards 20%. The Vix, for instance, started 2009 above 40% and finished at about 20%. In addition, credit tightening in a bull equity market provided a beneficial entry or re-entry point for investors into debt and convertibles, which pushed valuations up from historically all-time cheap levels.

How did investors react?
In 2008, we spoke with investors who said they were not allocating money to convertibles. Our only guess was that at the time they were scared and in panic mode while reducing risk and moving to cash. Last year we spoke with investors who said they felt convertibles were not where they wanted to put their money.

At the end of 2009, after the hedge fund CB indices were by far the best performing in the hedge fund universe, returning over 40% for the year, investors said they felt they would stay on the sidelines as they pondered how the product could produce more positive returns after having such a strong rally.

This confused us, as we profited from convertibles in 2008 and 2009, deriving 70% of profits in each of those years from our convertibles trading product. We wondered how investors were unable to see the merits of a product that was offering the best risk/reward profile in Q4 2008 and Q1 2009. 

But most importantly, we stress to investors that Phalanx does not invest like an index. We utilise convertibles in Japan and Asia to identify mispriced implied volatility, which can then be purchased to produce options protection that may not otherwise be available to investors in the market.

What do you predict for the future?
Looking ahead into 2010, we are unsure of what catalysts will occur in the first couple of quarters. There are still severe economic problems in the Western world at least, and we will spend years working through these economic difficulties. 

Although we do not necessarily expect to see Armageddon such as we saw at the end of 2008, we are quite confident that volatility is here to stay for several years and that a market-neutral approach in the CB and vol space will provide investors the ability to benefit from choppy, sideways and downward-moving markets. We are not bullish on equities and remain extremely cautious of downside risks.