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FX MANAGERS

Interview with Henrik Pedersen

Chief Investment Officer at Pareto Management Limited.

fx managers multi strategy investment program Henrik Pedersen

In this interview Henrik Pedersenexplains Pareto’s multi strategy program and how they manage a 44,5 billion USD portfolio. 

Manager

Pareto

Strategy

Currency multistrategy, MECO (Mellon currency option), MELSEC (Mellon Long Short Emerging Currency)

Location

London

Assets Under Management

44,5 bln Usd

Type

Mostly Systematic

Style

Mix

Instruments

Currency forward and options

Currencies

Developed and Emerging

FXTM

How long have you traded foreign exchange and what first attracted you to this industry? Tell us about your career evolution until you got to Pareto

HP

Since 1985. Right out of Gymnasium in 1982 I had been hired as an economic trainee at a large Danish shipping and oil company. Having done the company rounds as part of my training I applied for a job in the Finance department which was always my real interest and ended up at the currency desk. I enjoyed it so much that I never turned back. The main attraction was the markets, trying to understand what was going on, identifying patterns of behavior and looking for arbitrage opportunities, many of which were much more prevalent back then due to regulatory constraints.

Working in a shipping company definitely helped understand the longer term perspective of the market where like for shipping markets what goes up, at some point tends to come down. I also liked the instinctive nature of the currency markets, as it was at the time already a global market place. Deep fundamental analysis often mattered less than they did in say equity analysis and to watch and learn the power of sentiment. In addition I also enjoyed the global nature and international flavor of the markets, daily contact with dealing rooms in New York and London as well as visiting their premises has always impressed me. 

FXTM

What do you particularly like about your job?

HP

The constant challenge of trying to understand what is driving the markets and identifying ways to benefit from opportunities that is presented to you from behavioral biases in the market place and the fact that you are competing with others trying to do the same using similar, or totally different approaches to you,  is very appealing to me.

FXTM

Is FX a unique market? In what trading currencies is different than trading other financial instruments?

HP

I still think that FX is a unique market. Apart from the absence of an official exchange, currency markets are driven by a complex structure of market participants some of which trade currencies for other reasons than profit. At the same time it is probably one of the more accessible markets to analyze, yet the same types of opportunities and drivers seem to reappear time and time again, obviously with some variation. Trying to understand the interplay between short-term factors and the bigger picture has always been a good place to start for me.

FXTM

When was Pareto born? What ideas brought to its creation? 

HP

On the 1st of March 1991, an initial group of investment professionals formed a corporate partnership with Mellon Bank, which provided start-up capital and infrastructure support. Mellon originally owned 65% of the firm, and the six original individual founders owned the remaining 35% share through a special purpose corporation. Five years on, XL Capital Ltd., a Bermuda based re-insurer, was brought into the partnership as a new strategic partner in June 1996. XL Capital purchased a 30% interest in Pareto from Mellon Bank.

In September 2004, Mellon acquired 70% of the corporate partnership making Pareto a wholly owned subsidiary of Mellon. Around the same time, the structure of Pareto Partners was changed to a limited company called Pareto Investment Management Limited.

On 1st of July 2007, Mellon merged with The Bank of New York creating a new global market leader in securities servicing and asset management, The Bank of New York Mellon Corporation.

Pareto is now a wholly owned subsidiary of The Bank of New York Corporation.

Pareto was founded on the principle that advanced technology could be applied to investment management, both to manage risk and to enhance returns.  Pareto’s investment process focuses specifically on downside risk (the risk of loss), rather than symmetrical measures such as volatility or ex-ante tracking error (which also penalise the upside). By tightly controlling the downside risk while leaving the upside potential unconstrained, Pareto is able to generate alpha through positively skewed returns.

FXTM

How is today Pareto structured in terms of headcount and offices/geographic distribution?

HP

Pareto has its headquarters in London. In New York and Australasia, we operate through an FSA Appointed Representative, Pareto NY LLC and Pareto Australia Pty. In Japan, we operate through an Affiliate. The total number of employees of 62 is spread across these regions. 

FXTM

What are the key positions in an FX Management company?

HP

Operations/compliance, Trading/Execution and Portfolio Management/Research should be key areas within any FX Management company. Operations is key when you handle large turnover for 3rd party client as you do when you are an institutional currency manager. Trading/Execution team is key to providing best execution and are also your ear to the market. Portfolio Managers/Research (depending on the strategy you implement) is obviously where your trading ideas are coming from. Without these, you cannot operate effectively.

FXTM

Which authority regulates the company? Do you keep and update procedure manuals and a compliance and risk management policy? How time consuming and important is it to satisfy regulation requirements on one side and internal procedures on the other?

HP

We are primarily regulated by the UK Financial Services Authority (FSA). In addition, Pareto is registered with the local regulatory bodies in USA, Japan, All Canadian regions and Australia.

We do maintain a procedure and compliance manual which covers all investment management processes. The firm’s Chief Compliance Officer carries out a detailed, risk-based monitoring program covering all aspects of the firm’s business activities and maintains the Compliance Manual which covers requirements of all regulators with which the firm is, and oversees the maintenance of the firm’s policies and procedures as well as the compliance monitoring program.

Our Risk Manager is responsible for ensuring that the risk and control framework in place at Pareto is adequate for the investment activities undertaken by the firm. Risk and Control Self Assessments are performed regularly and a register is maintained of the key risks and controls identified. Risk issues are highlighted to senior management more frequently if necessary and formally reported to senior management and the Board on a quarterly basis. In addition, KPMG conducts an annual audit of the control environment and record their findings in a SAS 70 report, which is made available to clients of Pareto upon request.

FXTM

You are in charge of the currency program. How would you describe your investment strategy?

HP

The bullets below summaries our investment approach and philosophy for our multi strategy program. In essence it’s a 3 stage process where we 1) identify environments and potential strategies 2) portfolio construction to create a balanced core portfolio across strategies and markets (developed, emerging and options and 3) dynamic risk allocation between strategies driven by our commitment to control the risk of loss .

•Incorporates a range of Pareto’s ‘best of breed’ currency strategies strategically structured to seek alpha opportunities across a variety of market environments typical to currency markets.

•Alpha attained from a carefully constructed portfolio of proprietary currency strategies each targeting independent and profitable opportunities in developed and emerging currencies via trading in forward contracts and selective purchases of currency options

•Employs Pareto’s risk management philosophy, which strictly controls loss on each strategy without unduly compromising the opportunity for upside capture.  This drives active risk allocation towards strategies that are in favour and designed to deal with the impact of rapid market transitions

•High level of liquidity and transparency in instruments used to implement philosophy. Internal systems have strict embedded risk controls to continually measure exposure to market counterparties.

•Low correlation with traditional asset classes and other alternatives

FXTM

How and when did you develop your current FX management strategy?

HP

The history of our product range began in 1991 with Ronald Liesching who was a founding member of Pareto. Ron was responsible for developing the Currency Risk Management model which has formed the basis of the business and still is with around $43bn of AUM from clients globally.

In addition to the Active Currency Risk Management strategy, we have also dedicated a considerable amount of resources over the years towards developing absolute return programs aimed at the institutional space, but without detracting resources from the core currency risk management strategy. Initially, development was based on the risk management strategy but given the objectives of the program the majority of investment strategies were developed independently. Also in 2007 additional expertise was made available to the business following the merger between BNY and Mellon where we acquired an experienced team who brought their interest rates and emerging markets expertise and new ideas to Pareto.

The result of this effort has provided us with a suite of FX management products listed as follows:

•Currency Risk Management

Currency Alpha

•Currency Multi Strategy (Portfolio with 5-10 Independent alpha strategies, majority of which are unique to Pareto)

•Currency Option alpha (stand-alone fund since 2007)

•Long Short Emerging Currencies (stand-alone fund since 2009)

Global Macro

•Global Risk Adjusted Alpha (stand alone fund since Dec-08) trading global currency and interest rates

FXTM:

Risk, an exciting yet dangerous word. How do you manage it?

HP

Risk management is in many ways synonymous with Pareto and its core beliefs. Our key assertion is that – as opposed to standard practice in measuring risk – risk is not symmetrical as profits are desirable and losses undesirable, hence we consider short and long term skew in market returns rather than standard deviation to assess and manage the ‘risk of loss’ in our portfolios. This is done with a view to create an element of optionality (limited losses, but unlimited profits) in our excess return profile. This philosophy is engraved in everything we do.

FXTM

Can you give us an example of the kind of trade you might have used in the past but would never repeat today, or would not be possible today?

HP

If you think of actual trade drivers, pure fundamental analysis used to play a bigger part in the analysis of currency hedging & trading strategies but experience teaches you that exchange rates can often move much further than fundamental factors dictate, or you would normally expect that some kind of common-sense approach, including risk management discipline, is essential to be able to play another day.

FXTM

Do you use a blend of strategy types for diversification, or one and only?

HP

Our product range is composed both of specialist currency strategies like our currency option alpha which is very focused and targeted to a single investment approach and philosophy on how you can identify and exploit what we call unstable equilibrium that periodically occur in currency markets as well as multi-strategy solutions that combine different alpha strategies into a portfolio where we determine the risk allocation. The single strategy offerings are predominantly targeted for fund-of-funds, or professional investors who add value doing their own portfolio construction, with the multi-strategy offering a one-stop solution for institutional investors looking for a limited number of currency managers.

FXTM

How do you think has your performance been over time? What market conditions are expected to have a positive and negative impact on it?

HP

Pareto has added value on its combined portfolio active currency risk management and alpha programs since 1991. Because we are looking to protect clients against adverse currency moves in our currency risk management programs we tend to add the most value when significant currency moves occur and have the most difficult periods where markets experience significant short-term volatility without direction. Because we are risk focused this will also tend to be the case for our alpha programs.

FXTM

Can you give some recent examples of where you have made a unique winning decision?

HP

In December 2008, we saw that deleveraging flows which took place during the second semester led to a sharp increase in value of the US dollar against the Euro. Our Option strategy correctly identified that the conditions by late 2008 had become stretched. We therefore created a short US dollar position. In typical fashion, the reversal which followed proved brutal, with the dollar losing over 15% of its value in less than a month. This was of course, beneficial to us having taking the short position in the currency.

fx managers multi strategy investment program

FXTM

Do you use less mature currencies, or do you plan to add them to your studies and trading? Or do relative lack of liquidity and wider dealing spreads outweigh any potential gains from being able to capture more inefficiencies? HP: Less mature currency pairs tend to be the less liquid but can also be the most interesting from an opportunity point of view.

Things can vary from one strategy to another. Across our product range, we trade the most liquid markets from developed G-10 currency down to the smaller Emerging currencies subject to certain minimum liquidity requirements. For us, trading a certain emerging market currency is more a consideration of scalability. For example, if liquidity is severely limited in a given currency it does make a difference to the overall portfolio if we trade it or not. On the other hand some strategies can be adapted to deal with less liquid currencies so while emerging markets remain a stable of our alpha programs they are considered on a case-by-case basis.

FXTM

When developing strategies how approximately would you expect to allocate your time among building entry signals, exit signals and money management rules?

HP

For some strategies the core composition (such as carry or valuation strategies) remains relatively stable over time so money management rules become the most important part of the development. For other models the entry and exit signals as well as the risk you are prepared to employ forms the core of the model and it will be developed as part of a whole and so time shared is approximately equal.

FXTM

How much time do you allocate to further research and development of existing or new trading strategies?

HP

A lot of time is spend understanding the drivers of existing strategies in order to improve on them or in preparation to close them down if they are no longer working. While the themes in currency markets remain the same the implementation and methods are constantly evolving as markets and participants themselves evolve even if the underlying philosophy remains intact. A key factor of success lies in risk management and in understanding the limitations of your trading strategies and the kind of environments they like, or more importantly do not like. 

FXTM

Do you believe in ever-valid rules, or every strategy loses its accuracy sooner or later? Have you ever found strategies that come back into phase after a long time in negative?

HP

I think the answer depends on your investment horizon. For example Warren Buffet seems to have followed an ‘ever-valid’ guide to investing in his career, although the implementation has certainly evolved with the increasing instruments available in financial markets. If you are looking for short investment horizon such a ‘high frequency trading’ I think the half-live is relatively short and a high degree of adaptation is necessary.

Consequently for a longer investment horizon I do believe that common sense, or certain rules of thumb if you may, prevails, however the way you implement strategies around this theme evolves.

One of the lessons learned during 2007 and 2008 is that blindly following a ‘rule’ such as carry can lead to devastation so the key thing to recognize is that no single investment strategy will provide stellar performance at all times and to be smart in risk allocation and risk management decisions.

FXTM

Do you agree that one way to react to the ever-changing market is to adjust parameters? Do you already use changing parameters based on volatility measures or filters?

HP

That is certainly one way of approaching it, but the pitfall is to always adjust parameters to what worked yesterday. I think the future increasingly lies in adjusting parameters based on forward looking estimates of the market environment.

FXTM

Do you favour any particular time frames in your strategies, or do you diversify across a range of them? What is your average trade duration, and how high the trading frequency?

HP

Diversification in currency is limited by the finite number of crosses one can realistically trade. Different investment horizons – or time frames – are an interesting alternative route to achieve diversification in a portfolio. At Pareto, our strategies have different investment horizons – while never falling into the category of high frequency trading.

FXTM

What should an inexperienced trader watch when choosing the time frame to trade on?

HP

The pitfall of any inexperienced trader is to start competing in the short-term trading space where they have a significant information disadvantage to the huge trading rooms of banks. Obviously most trading platforms will seek to encourage this approach as they make their money from turnover; however it is hard to see consistent profits available in this space for an inexperienced trader other than the same amount of excitement that can be gained in a casino. In general, the longer the time horizon the higher the probability of ‘beating the bank,’ but also the higher the requirements to have a disciplined stop-loss, or risk management approach.

FXTM

How many execution counterparties do you use? How do you split execution between electronic and “dear old voice”?

HP

We emphasize a strong partnership with our counterparty banks and deal with most of the major names in the industry. Electronic execution is done where practical as there are significant operational benefits to electronic booking of trades, but we are extensive users of ‘voice’ to access market information.

FXTM

How does you backtesting process work?

HP

For all our products, strategies and enhancements to the strategies,  are only implemented after a rigorous back testing procedure is completed, which involves a diversified range of techniques, including Monte Carlo simulations and stress testing. Stress test scenarios are implemented on a quarterly basis or in the event that the VaR measure exceeds 3%. The stress measure is taken by considering the total possible loss should all open positions lose all their value. This is the maximum possible loss that a particular product can incur.

It does vary across strategy. Yes, we do have AUM limit on a number of our strategies as a result of our liquidity monitoring however we are currently nowhere near this limit

FXTM

What is the single biggest strength of your team? And is there any particular advance that has taken place since Pareto started that has particularly benefited your trading?

HP

Diversity and breadth of core skills, required to effectively manage existing programs and introduce enhancements are the biggest strength of the team. Product innovation is a huge differentiator and over the years we have seen a number of these innovations come into play in new products. We have also invested heavily in technology used to assist the firm in its investment process.

FXTM

Can you give us your feeling about the most popular, EurUsd, over the next 6/12 months?

HP

I don’t think at 1.47 there is an obvious answer. Market currently looks for a weaker dollar then a stronger dollar once the US starts increasing interest rates sometime in 2010. Odds are it won’t play out like that. Prefer to look at the USD Index close to all time lows around 72 and we may try one more time over the next 3-6 months, once the world gets disappointed with the recovery the USD may strengthen so lets go for 1.25 EUR/USD in 12 month just to make it interesting.

FXTM

What’s the best advice to give to an individual trader and to a semi professional trader who wants to enter the FX fund management industry?

HP

1) Do not try to prove the market wrong – it will always be expensive

2) Do not get emotionally attached to any position or strategy, be disciplined

3) Find the way that works for you and always be skeptical about exchange rate forecast (almost never correct) and the reasons provided for yesterdays move. Stick with your plan no matter what others say. Some of the best opportunities comes when everybody has got the same positions