By J. C. Lewis

Wall Street derivatives traders always dream of ditching the boss and starting a fund of their own. Here are some who have actually done it.

In most cases, they're taking the proprietary derivatives trading skills they learned on the sell side to the buy side. The ultimate inspiration for many is Long-Term Capital Management (LTCM). The superstar hedge fund run by former Salomon trader John Meriwether et al., was launched last year with an estimated $2 billion in capital - and is now rumored to be worth a billion or so more.

Like LTCM, many practice some version of relative value arbitrage, a highly quantitative technique designed to exploit low-risk trades in the cash and derivatives markets. Most can also teach their money management colleagues a thing or two about risk management and controls. They generally try to avoid directional plays and use their risk models before, during and after trades to probe how much and what type of risks are embedded in each trade and portfolio.

They Love Trouble

Fisbury Partners' Chris English and Peter Bernard profit from the world's calamities.

In February 1994, Chris English and Peter Bernard left their Wall Street jobs and set up shop as money managers in a stately old building on Boston's Congress Street. A few weeks later, the building started sinking into the sands of Boston Harbor.

They quickly moved to a more stable venue down the street, but somehow the whole incident seemed appropriate for Finsbury Partners, a firm designed to prosper from crisis situations. A chain of debacles involving the Mexican peso, European interest rates and Japanese equities have provided a rich proving ground for the firm's eclectic tactics.

"We refer to ourselves as a low volatility fund that engages in relative value fixed income trading," explains English. Finsbury resists all types of speculation on the direction of rates and tries to build a portfolio that is likewise immune to interest rate changes. Instead, the firm focuses on extracting value by combing the global markets for mispriced securities. In most cases, these opportunities are associated with financial breakdown, political instability or general investor confusion.

Dynamic Duo

English and Bernard met in 1984 when they formed JP Morgan's New York swap group. In 1988, English moved to Merrill Lynch, where he managed sales and trading groups in a variety of areas, including OTC debt options, commodity derivatives and emerging market derivatives. His last assignment before founding Finsbury was organizing emerging and developed market derivatives strategies for Merrill's hedge fund clients.

Bernard, meanwhile, built a 14-year career at Morgan. He ran the firm's OTC trading desk in US Treasury options and then served on the Brady Commission that examined the 1987 stock market crash. Later, he ran Morgan's London Eurobond syndicate desk and directed the firm's Latin American corporate finance and capital markets activities, a position that steeped him in the calculus of defaulted Latin bank loans. In 1992 he was appointed head of Morgan's New York swap business.

English says he wanted out of the sell side to immerse himself once again in the hands-on trading that had initially drawn him into the field. "As you move up the Wall Street corporate ladder, you end up doing things far removed from what attracted you in the first place," he says. He started the fund to secure more autonomy and a better working lifestyle - not in the sense of shorter hours, he says, "but in the overall control one can define for oneself. It's a higher risk/reward environment but paradoxically with a lot less stress."

Risk/return

The key to Finsbury's strategy is finding arbitrage opportunities with good return/volatility characteristics. The firm's risk management system scans the global markets looking for mispriced instruments, including swaps, futures and options. It also looks for anomalies in the term structure of interest rates and quirks in the volatility of different markets. Any potential arbitrage opportunity must meet the firm's capital-at-risk guidelines.

"We define the concept of risk as the loss one would suffer given a two standard deviation move over a one-month time frame," says English. "But that only describes 95 percent of the outcomes. These can be easily systematized. We spend our time looking at the last 5 percent, which can be up to six standard deviations. It is easy to predict 95 percent of the outcomes. The hard part is the last 5 percent."

Finsbury is especially active in the OTC derivatives markets. "Swaps are a particularly good tool for our brand of fixed income arbitrage because there is an infinitely expandable supply, which exempts them from short squeezes and market panics," English explains. A typical trade might involve holding a government bond (say Japanese governments, US Treasuries, German bunds or French OATs) hedged with a short interest rate swap of similar duration. In calm markets a government bond and a short position in an interest rate swap can be carried at no net cost.

Cheap protection

Bernard and English also use swap spread strategies to provide cheap put protection for their portfolios. Swap spreads typically represent the expected long-term average spread of the difference between short-term government borrowing rates and interbank borrowing rates. They find that swap spreads are reasonably tight in calm markets, but can widen considerably during financial crises. A long bond/short interest rate swap can act like a low-cost put option on the market.

Emerging markets is another happy hunting ground for mispriced securities. In 1994, when the sector took a big hit after a long bull run, many investors started running for the exits. In the resulting panic, several important gaps opened in the relative values between the myriad of complex debt securities created during the restructuring of the last decade.

Many of the firm's best trades involve options and long/short positions in Mexican Brady bonds, which were issued in 1989 in exchange for $35 billion of restructured bank debt. One recent opportunity involved an arbitrage between Mexican discount and par bonds. The issues mature on the same date in 2019, with principal components backed by US Treasury zero coupon bonds. The Mexican par bond carries a fixed coupon of 6.25 percent, while the discount bond carries a floating rate of Libor plus 0.8125 percent. As a result the two issues trade at different dollar prices.

In the month following the peso devaluation, panicky investors showed a markedly irrational preference for selling the "higher-priced" discount bonds. Finsbury purchased a number of these bonds and hedged away the floating rate risk with interest rate swaps, governments and futures. In mid-January, an opportunity arose to purchase the discount bonds as the long-term US Treasuries and sell the par bonds at a yield spread of 170 basis points. The trade was executed on a credit-neutral, rate-neutral basis. When the markets stabilized two days later, the trade was closed at almost even yield.

In their first year in business, assets have grown to $80 million. Most investors are financial institutions as well as US and European family groups. Although the firm does some marketing, they've got the best response from word of mouth. "Generally, we are introduced," says English. They believe they can manage up to $300 million in their defined strategy without materially changing portfolio composition.

Although first year returns have reached 15 percent, English says he is particularly proud that he has achieved these returns with extremely low levels of volatility - about 3 percent. Their goal is to return levels substantially above the return of the stock market with one-third the level of volatility. "Historically, the S&P returns about 9 percent with 15 percent volatility. We seek to return 16 percent with a 9 percent volatility."

VZB Partners tries to quantify third-world risks

Because gunslingers and greed-possessed money managers are so common in emerging markets, Alfredo Viegas and Michael Balboa expect to stand out from the herd, and, in time, outperform them. For the seven-month-old VZB Partners, the optimal strategy in this Wild West terrain is a keen focus on economic fundamentals and political events combined with prudent hedging. "Most funds have a seat-of-the-pants approach, wrapped in promises of ramped-up returns," says co-founder Balboa. "Our goal is to preserve capital within a strict risk-control approach and attain the high returns associated with emerging markets."

Until last year, the two worked together in the emerging markets research department at Salomon Brothers, advising both the firm's proprietary trading desk and clients. Viegas was a Latin America equity strategist and Balboa was a fixed-income specialist. They also shared the conviction that their fellow emerging market traders were not recognizing the magnitude of the risks they faced.

Then came last year's Mexican peso devaluation. It proved to be a defining moment for the pair since it revealed how little positions were hedged at some of the largest money management shops. According to Viegas, one major dealer was officially bullish about Mexican markets in its public statements, while its proprietary traders were bearish. "Managers who wanted to reduce exposure had to stay fully invested, so that clients on the buy side remained exposed," he says. At another major investment firm, he adds, "no manager could so much as buy a put on Telmex."

Total balance

Soon afterward, they decided to strike out as hedge fund managers under the rubric VZB Partners (the "Z" belongs to third partner Mustafa Zaidi, who has deep Mideast contacts). It has since displayed a knack for sniffing out special situations with low-risk characteristics. Once VZB identifies promising trades based on local events, market conditions or proprietary information sources, it tries to quantify its exposure and develop arbitrage, hedging or leveraging strategies to maximize returns within preset risk parameters. VZB's flagship Strategos Fund also claims to be the first balanced fund to combine global and local debt and equity. "Traditionally emerging markets have been either debt or equity related - either to a single country or region," says Balboa. "There is no other global fund that combines local debt and equity to external debt and equity across all of the emerging regions of the world."

The key to their strategy is understanding the myriad risks lurking in the exotic markets - and knowing how to hedge them. "Total return says that if you buy a Brady bond that yields 14 percent but the volatility is 40 percent, the price risk dwarfs the yield," says Viegas. "The bond price can drop dramatically and the yield does not compensate for that. In many countries, however, high-yield short-term government and corporate paper are issued at a discount to face. The only risk you have is the crisis risk, the risk that the country will default on its obligations."

In these situations, VZB buys the paper and hedges away the currency risk by purchasing a put or selling a forward. Doesn't the constant hedging lower returns? "Not by much," says Viegas. "In Ecuador, they sell $3 million at government auctions every other week, with no threat of default. The unhedged yield is in the high 30s, but hedged, the trade still returns 18 percent."

Day traders

The firm is also adept at picking up arb opportunities in hidden corners of the emerging market trading world. One arbitrage opportunity involves equity purchases in an obscure market that Viegas says generates a fully hedged fixed-income yield of 16 percent. "It's a day trade that happens automatically every day, but not that many people know it exists," he says cryptically. "The volume is about $5 million a day, but it's hard to do without someone on the ground. We do it in partnership with a local bank and split the net."

One of the firm's most successful recent trades, however, was based on basic fundamental analysis. VZB placed a big put play on Arakis Energy, a Vancouver company that reportedly held a concession to drill oil in the Sudan. The stock had run from 3 to 26 on the excitement over Arakis' claims to be developing a large pipeline, oil reserve and deep water port. But Mustafa Zaidi's research and contacts told them the idea of running a pipeline to the sea through an area torn by civil war was a pipedream. Then there was a certain Saudi prince purportedly backing the venture. VZB gumshoeing revealed that the mysterious prince didn't have adequate funding. When these facts became common knowledge, Arakis stock dropped more than 80 percent from its high.

The incident not only earned the firm profit, but credibility. "We shared our knowledge and talked to the biggest stock holders, hedge fund colleagues, fund-of-fund and money managers," recalls Viegas. "At first we were downright ignored. When we showed that the thing was a setup - based on information in the 10-Q and Bloomberg News screens - opinions started to change."

Illiquid markets, restrictions on foreign ownership, currency and market risks as well as byzantine firm-specific risks can make investing in emerging market equities a nightmarish experience. In some cases, the turn-around costs for investing in single stocks can be as high as 100-200 basis points per trade. To get around some of these issues, VZB structures many of its equity positions using either index products or OTC derivatives, which are usually cheaper and more liquid than purchases of the underlying stocks.

A little fun

Balboa dropped out of New York University's MBA program to accept a research post with Lipper Analytical. Viegas similarly abandoned a Ph.D. track in medieval history to pursue a career in finance "to have some fun for a few years." Viegas and Mustafa Zaidi worked together as consultants with Cambridge Associates. Viegas' specialty was advising on portfolio optimization in what were then considered "alternative assets": commodity funds, hedge funds, emerging market investments and derivatives. Viegas played a lead advisory role in an historic move by the Virginia State Retirement Fund to allocate assets to a commodity fund. Later, he became an equity analyst in emerging markets at Morgan Stanley. Zaidi meanwhile left Cambridge Associates for London, where he received an M.A. in war studies and subsequently went on to manage private Mideast money.

Despite the precipitous slide of most emerging market indices, VZB has a reasonable-sized pool of approximately $10 million, which is appreciably greater than the amounts originally invested. Viegas acknowledges that the difficult climate for emerging markets during VZB's startup made raising money "a lot more difficult than any of us imagined."

Investors include private individuals and an institution from the United Arab Emirates, Kuwait and Saudi Arabia. Because of tax considerations, the fund is open only to foreign investors and US institutions. VZB says it looks for longer-term investors in contrast to "fast or hot money," which, Viegas intimates, is all too common in this sector. One supporter and investor is Jonathan Bren, managing director of Alpha Investment Management, which manages a number of hedge funds. "We meet a lot of managers in emerging and international markets," says Bren. "What intrigued us about VZB is that they are doing unique things. Their 'info' flow and their background work is very good."

How to simulate a dozen traders sans attitude

On bad days Wall Street CEOs look across their vast trading floors and see a lot of reasons to feel depressed: excessive Christmas bonuses, lack of loyalty, flaming egos in Armani suits. On such days a CEO might long for the day when the entire trading rabble gets replaced by a few quietly purring computers.

That day may be coming sooner than you think, according to Bradford Paskewitz and Hezzie Lamdan. The two former members of Lehman Brothers' technical forecasting group quit their jobs in May 1993 and launched P&L Financial Inc., a money management outfit that offers investors a rare menu of different trading models, each with a distinctive human character - from the contrarian to the conservative.

P&L uses futures and inter-bank currencies to make directional bets almost exclusively and operates in 25 markets around the world. By having several "virtual" money management styles under one roof, P&L is attempting an end-run around the expensive layers of investment infrastructure that burden its larger rivals. The approach also attempts to reduce its clients' need to diversify among several different money managers.

Another important goal: consistent positive returns. Paskewitz estimates that about three-quarters of all traders employ trend following strategies. For much of a typical year, their performance is usually flat or down slightly while they shoot for the two or three winning trades that will pump up their numbers. He thinks it unlikely such trend following can provide steady monthly performance. But over the long term, multiple strategies can create a blended result that outperforms any single approach and registers a continual flow of positive returns. "Single-strategy approaches cannot create positive returns regularly," he asserts. "But we can reasonably expect to be up almost every month."

Lehman alums

Paskewitz, 37, studied computer science and electrical and systems engineering at Princeton and the University of Pennsylvania before going to Wall Street. Before Lehman, he managed portfolios of financial futures and derivatives at Banque IndoSuez. He has also cultivated a long-standing passion for game theory. This has led him to simulate applications of various casino betting strategies and apply them to market trading, where the odds are a little better.

Israeli-born Lamdan, 35, earned a doctorate in image and pattern recognition at New York University. Later, he developed an intelligent fault diagnostic system for Citibank, then decided that trading was more interesting. The two began their model building in 1990 at Lehman Brothers to develop high-tech forecasting applications. The grueling three-year assignment challenged them to employ their computer know-how to quantify the behavior of money-making flesh-and-blood traders. All went well until the splitup between Shearson and Lehman. The staffing and political changes that followed spurred the duo towards entrepreneurship. "We learned to look at different markets with brand new ideas," says Lamdan. "It took a while, but once we had the interaction with the floor, we had a valid, workable way of conceptualizing trading models."

Trading personalities

Each synthetic trader at P&L is expected to contribute to total return by doing its thing. For example, the S&P trading program is traded by trader #1, a "value" investor who buys and sells in response to perceived discrepancies between current price and fair value. Trader #2 is a trend follower, who jumps on the train only when it is moving. Trader #3 is a fundamentalist, who acts in anticipation of or in response to economic news. Trader #4 is a "crash" specialist, who trades after significant market declines. P&L's two other programs, Diversified and Global Diversified, have agents who each trade a unique strategy. "We are encapsulating certain trader behaviors in a quantitative strategy," explains Lamdan. "One trader may focus on long-term trends, while a second may focus on short-term patterns and a third trades on economic and political fundamentals. Others may concentrate on customer and money flows or psychological and sentiment factors."

P&L has high confidence in their models' ability to simulate new learning behavior by adapting themselves to recent trading data. Although the firm uses neural network techniques that simulate the way neurons work in the human brain, Paskewitz says neural nets can lock a model into a trading technique until it stops providing the desired results. Instead, the firm has developed more dynamic "learning laws" that, like good traders, constantly generate new hypotheses to modify a trading style and improve performance.

Freedom to choose

P&L's approach requires a tolerance for contradiction and ambiguity, as each model grinds out its formulaic recommendations. Clearly on any given day one will be more in sync than the others. However, only rarely are models countermanded. "We might override a signal once or twice a year," explains Paskewitz. "The market went wild during the Gorbachev coup. There are certain events when we must respond differently, but they are very few and far between."

What makes P&L different from most other quant funds? One, it makes unhedged directional bets in leveraged markets. Two, it deals in a wide class of assets: equity, fixed income, currency, commodities. Three, P&L believes that no other quant fund has such state-of-the-art adaptive virtual traders.

The partners are reluctant to disclose performance data, saying only that their return is positive and has been every single month. Currently $10 million is under management. Although their official address is Rahway, NJ, Paskewitz operates his Sun workstations from an unmarked office in Manhattan's financial district. The computers are connected to markets via real-time data feeds, and beep and display simple order recommendations and print out fax-ready orders on complex trades. Paskewitz and Lamdan don't even have a secretary. But since when does a computer need one?