CDO- how small insurance packages can reap giant rewards
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The Corona virus and the market impacts related to it came as a shock to all. Markets fell collectively, and asset prices dropped substantially. Yet some funds with limited input costs managed to profit immensely. Most of the funds that made profits did so through CDO’s where they bought cheap financial contracts where they profit if the creditworthiness of the underlying entity diminishes significantly. These financial instruments trade at ridiculously low prices (Pershing Square paid 25 Million for a contract in October that paid off 1.5 Billion last week) due to the market not factoring in collapse as a real possibility. These insurance products are an extremely cost effective mechanism at combating dramatic market fluctuations.
When we look back over the past 15 years we see that this trade worked well in 2007 as well. In cases popularized by the film The Big Short we saw traders utilizing the same financial instruments to make massive profits when the real estate bubble in the United States fell off. It seems as if CDO’s as well as large positions in metals, or their mines offer great upside when markets collapse.Yet have minimal cost to funds while markets are moving up. If this is the case why aren’t more funds taking advantage of these hedged positions to cover them from massive losses? Following is a collection of these profitable trades made in tough market conditions from the funds that made them. An understanding of the past will lead to better results in the future. Take heed of these trades and augment them to profit in the future.
Jorry Nøddekær, Fund Manager at Polar Capital Emerging Market Stars Fund
Less than six months into the pandemic, we are asking about the possibility of a second wave. Even if there is, we believe the stocks we hold have strong staying power and expected profitability over the medium term that fits our valuation framework.
Our view is for a V-shaped recovery in the US, its recovery starting in H2 2020 and on trend in 2021, still allowing for the likes of the travel and restaurant industries (where we have no exposure) a longer period to recover. Economists are referring to a ‘90% economy’ in the US and our take on this is that a 90% recovery will be acceptable given the situation we are in now. It is a risk over the medium term, and will be a real risk if the other 10% does not recover within 18-24 months, but we still believe in people and their ability to adapt and be innovative and we therefore believe that in 12-18 months things will look a lot better.
This is hardly a consensus view so are we being overly bullish? Put simply, we think this is a crisis of short-term demand and liquidity which started out as a supply-side crisis thanks to COVID-19. This will only become a structural issue if it develops into a solvency crisis for the healthy parts of the economy. We have no more foresight than anyone else but believe we will avoid this thanks to an unprecedented response from policymakers who have learned valuable lessons from the global financial crisis with liquidity getting to where it is needed. The US recovery, even to 90%, should be enough to generate the demand we need for our bottom-up argument in Asia to perform well.
Magnas Olsson, Chairman & Portfolio, Manager at Brevan Howard Capital Management
Where markets are pricing a narrow chance of an event happening, but a trader views it as more evenly balanced, the trader may decide to structure a trade to benefit from market mispricing. History provides some interesting examples of how BH Global has performed as a portfolio hedge and safe harbour. In the final few months of 2018, while the MSCI AC World index fell 17.4%, the Net Asset Value per share of BH Global was down just 0.7%. During the sell-off in July-October 2011, while the MSCI AC World endured a peak-to-trough fall of 21.7%, BH Global’s NAV gained 4.0%. Scenario analysis Brevan Howard prepared at the end of February suggested BH Global would make good gains in both a Lehman-style collapse and if the EU implemented a new QE scenario. This illustrates the sort of optionality which Brevan Howard traders build into their books and shows that BH Global can make strong gains from diametrically opposed outcomes.
The first quarter of 2020 showed Brevan Howard being highly dynamic in adjusting exposure and managing risk. In early February, BH Global had long exposure to short-term interest rates (thus benefiting from the cuts), with a view that the US economy was likely slowing but the market was not pricing in this eventuality. Then, in the second half of February Brevan Howard’s traders increased their long positions in US and global interest rates. They also added relative-value positions which would benefit from other investors adopting a ‘risk off’ position and some traders used options to short equities, credit and oil.
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