It pays to be extremely interested in fat tails

When the GFC’s tailwinds blasted through Outer Mongolia and Indonesia, The Cambridge Strategy’s extreme-risk approach had already alerted the boutique asset manager to exit Mongolia Energy and Bumi Resources. The manager claimed its method, which combines long-only global emerging markets equities with an active currency overlay, could generate additional alpha of up to 25 per cent, according to executive chairman Ed Baker. Baker said Cambridge’s position in Mongolia Energy in January this year was cut to one-third of its original size at the beginning of February – just before Mongolia Energy lost 10 per cent in the first week of February. In Indonesia, Cambridge’s stake in Bumi Resources was halved at the end of January – just ahead of Bumi losing 16 per cent.

“In each case, reducing the position protected us from experiencing losses on the stocks that had been flagged by the Extreme Risk algorithm,” he said. Baker said the fund was characterised by three distinct features. “First, we’ve incorporated currency with equities to actively manage the currency exposures in investments in the emerging markets. “Second, for risk evaluation and management, we’ve developed proprietary tools using extremevalue theory (EVT) to help us gauge downside risk. This bespoke software was developed in-house and runs on [statistical modelling tool] MATLAB. “We’re continually researching how to improve and extend the capabilities of the algorithm. This includes the time-window used and the algorithm output.”

The third feature is Cambridge’s top-down approach, which “is not completely unique in the universe of emerging markets managers, but it’s unusual,” he said. This helped reduce “cyclicality” of returns. With assets under management of US$1 billion, the benchmarkagnostic firm also invests in frontier markets. Baker was in Australia last month on his third visit to market Cambridge’s emerging markets equities fund, launched in November with US$3.5 million from two US high-net-worth individuals. Baker has a surprisingly short CV, having had three jobs since 1978, when he joined the then three-year-old risk management software firm Barra. Over 17 years, he accrued a 7 per cent share in the company, which enabled him to exit with more than $50 million after Morgan Stanley acquired it. In 1995, he joined Alliance Bernstein for 12 years. It was here that he met and worked with Peter Henricks, who later co-founded The Cambridge Strategy in 2003.

Here Baker saw the appeal of managing currency and equities concurrently. “I’d always wished we’d managed currencies at Alliance because I’d frequently seen opportunities for adding value. This wasn’t part of (their) mandate,” he said. So, when Cambridge’s Henricks approached him, Baker “saw opportunities to join a more hybrid kind of product” and joined the manager in April 2007. “It takes a certain skill-set to manage both equities and currencies and you don’t find that in many places,” he said. While extreme value theory tools are not unique to Cambridge, it’s the currency overlay that is the group’s distinguishing feature, he said.