convex asia fund pf ltd - monthly update - 2017 02...

CONVEX ASIA FUND PF LTD | FEBRUARY 2017 1

FOR PROFESSIONAL INVESTORS ONLY

CONVEX ASIA FUND PF LTD Monthly Update – February 2017

Monthly Review

The Convex Asia Fund PF Ltd, Class ‘A’ was down -1.69% net (based on Trading Level) and down -3.38% net (based on NAV) for the month of February 2017.*

Performance attribution

CAF Net Outright Net RV Net Outright -1.66% REHEDGE 0.00% Carry -0.01%

Relative Value 0.02% VAR -0.44% Skew 0.00% Other -0.04% Vol 0.00% Delta 0.00%

-1.69% Tail -1.21% Curve 0.00% CVX 0.00% Spread 0.00% Tact -0.02% VARSPREAD 0.00%

-1.66% Term 0.00%

Corr 0.00%

Tact 0.02%

Vol 0.00%

0.02%

*Reflects Convex Asia Fund PF Ltd – Class ‘A’ net investor returns. Past performance is not a guarantee of future returns, and an investment in the Fund could lose value. Performance attribution is based on the Trading Level of the Fund. Trading Level is defined as the product of the fund’s NAV multiplied by the Funding Factor. The Funding Factor is 1x for Convex Asia Fund Ltd, while the Funding Factor is 2x for Convex Asia Fund PF Ltd. Fees and expenses are allocated pro rata with the absolute gross return of each strategy in order to arrive at the net performance figures. Source: City Financial, internal data

Market Review

Interest Rates Two words that our readers will be accustomed to hearing from us are “Imbalance” and “Asymmetry”. When we look at fixed income markets worldwide, despite the obvious notable imbalances within most regions, only Japan and South Korea truly stand out as a really interesting mix of imbalance versus asymmetry, and this is particularly true of Japan. The combination of extended experimentation with monetary policy easing, blended with the huge supply of structured products, makes it a very interesting market to us. The addition of Yield Curve Control (YCC) at the 10-year point complicates the market yet further. Negative Interest Rate Policy (NIRP) prompted some volatility in the market, but YCC has anchored the curve, causing volatility to collapse. The net result is that we expect much higher volatility levels as and when there is a sharp normalisation of the skew, should interest rates increase, with Japanese lifers inherently short high strike vega from their selling of single premium policies. Speaking to structured trading desks in Tokyo, their estimate is total exposure would double if rates rise 1% across the curve.


Despite Japanese lifers buying foreign assets aggressively for high yields (for example, French Government Bonds), Japanese Governments Bonds (JGBs) cannot be so easily disposed of as Lifers are tied to Japanese yen (JPY) denominated liabilities. Pension funds (mainly GPIF) have rebalanced significantly away from bonds and asset allocations are now aligned with global peers. Going forward, the only likely seller of JGBs are city banks, who have around 11% of total assets in JGBs. Theoretically, they could look to sell down a further ¥ 100trillion worth of JGBs to reduce their holding ratio to ~5%, as Japanese banks have increased loans and foreign assets to compensate for loss of carry on JGBs.

Diving into market structuring, historically, tails on 20-year tenors at-the-money (ATM) implied volatility are lower than tails on 10-year tenors on a volatility ratio of 1-year expiry on 10-year or 20-year ATM implied volatility/3-month expiry on 10-year or 20-year ATM implied volatility. The chart below is interesting in the fact that during periods of stress 2008/9, 2011, 2013, NIRP, YCC, the ratio expands beyond 1.0.

JPY 1-year/3-month Vol Ratios on 10-year and 20-year Tails

Source: Bloomberg

However, what is really interesting is the current underperformance of the ratio on 20-year tenors. This is likely due to issuance of callable notes for yield enhancement. If we look at individual ATM implied volatility in the next chart we can see that issuance has compressed 3y20y ATM volatility to post crisis lows.

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ATM Vol Ratio (JPY JPY 1y10y bpv/3m10y bpv) ATM Vol Ratio (JPY JPY 1y20y bpv/3m20y bpv)

ATM 1y expiry / 3m expiry = 1.0


JPY 3y20y ATM Volatility (bpv)

Source: Bloomberg

3y20y for example comprises low outright level of volatility, flat skew, small roll costs and high asymmetry due to the vega selling from dealers which has compressed convexity in skewness and ATM volatility. The below chart shows the changes of JPY 10-year Swap Term Structure for the Period of 1 July 2016 – 28 February 2017 and the change through the same time period on the underlying JPY 5y10y swap. JPY 10-year Swap Term Structure

Source: Bloomberg For now, it appears that the Bank of Japan (BoJ) is committed to YCC, but that does not prevent some opaque comments along the way. Should the BoJ reduce purchases of bonds dated longer than 25 years, as has been rumoured, it would be similar to the move in December last year when it increased the absorption of super-long bonds only to be followed by a reversal just ten trading days after. We believe this reflects policymakers’ intent not to peg super-long yields at levels, and to remain committed to normalising the yield

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JPY 3y20y ATM bpv


curve (steepening). We believe that the obvious risk lies in changes to the YCC target at 10 years, which is the explicit fixed point on the yield curve. Volatility pricing today does not reflect any potential change soon. The below chart shows the reshaping of the yield curve post YCC and the expansion of swap rates at the long end of the term structure versus the front end of the term structure. Current correlation between bond and swap rates suggests that only a 10bp move in the 10-year target from the BoJ within the next year would be enough for ATM payer swaptions to break even. JPY Interest Rate Swaps from the lows of July 2016 to February 2017

Source: Bloomberg Going forwards, the markets will continue to look to the BoJ as to the way they adjust their JGB purchasing operations for guidance and direction around its interest rate policy. If the BoJ announces a plan to reduce the absorption of intermediate bonds in March, the market would likely consider this as evidence that policymakers are looking to prevent yields from falling further, not just in intermediate tenors, but along the curve in general. FX The compression of volatility across FX markets has been little short of astonishing, particularly in the Asian emerging market space where the volatility of some of the most illiquid and volatile currencies has compressed the most. Looking at the chart below, we can see that on an indexed basis over the last year US dollar vs Indonesian rupiah implied volatility has compressed the most, followed by US dollar/Indian rupee, followed by Taiwan, Singapore and Korean currencies.

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JPY Libor 5y10y Interest Rate Swap


FX Implied Volatility (Indexed)

Source: Bloomberg

Consensus appears to accept that the Fed rate rises will be controlled and gradual, and central banks will skilfully engineer an uptick in inflation to their desired levels whilst controlling interest rates. This appears to have sparked renewed interest to sell FX volatility across the banking community, and we have seen interest from dealers to sell almost any type of FX volatility to us lately, in markets and structures that we find very interesting. The following chart is of the JP Morgan Emerging Markets FX volatility Index. This index is calculated based on a 3-month expiry ATMF implied FX volatility in a set fixed weight basket. This underscores the current complacency, especially given the strong upticks in inflation data, and an almost entirely overlooked debt ceiling debate in mid-March. It could be argued that, given US debt is at historical highs, renegotiating the overall ceiling is becoming more complex and so we could expect risks of volatility increasing as deadlines draw near.

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Mar-16 May-16 Jul-16 Sep-16 Nov-16 Jan-17 Mar-17USDJPYV6M BGN Curncy USDPHPV6M Curncy USDTWDV6M Curncy

USDINRV6M Curncy USDIDRV6M Curncy USDKRWV6M Curncy

USDSGDV6M Curncy


JP Morgan Emerging Market FX Volatility Index

Source: Bloomberg

FX spot/volatility correlations throw up some interesting results currently and we highlight the Philippines below. The currency has been weakening for some time. In fact, the Peso is at a decade low as the rate to US dollar broke 50.0 in February. However, 6-month implied PHP volatility has fallen from 8% to 5.5% in recent months. The below regression study over a 2-year and 3-year data series show how the spot/volatility relationship has broken to the point that ATM implied volatility is cheap across the whole volatility term structure. In the “risk-on” environment, we have seen large rallies versus the dollar in Asia, particularly South Korean Won (given substantial inflows from foreign institutional investors YTD approaching ~US$8 billion) and Taiwan dollar, where volatility has naturally eased. PHP Spot v Vol Regression

Source: Bloomberg

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JPMVXYEM INDEX (weekly)


Equities World stock markets continued their march up in a non-volatile fashion. US and Singapore stock markets have led gains since the US election in November, in both local currency and US dollar terms. India, Singapore, Taiwan, Korea and China markets have all seen big gains, at an average of 8.5% in dollar terms.

Normalised Returns of Global Stock Markets since US Elections

Source: Bloomberg

As we see moves higher in market interest rates, it is possible to think that we may have seen the lows in rates this cycle, which would have implications for asset markets in general. Looking back to the previous cycle and comparing 3-month realised volatility (RV) in the SPX and HSI between 2007-2017 and 1997-2007, you can see that SPX realised volatility is currently hitting new 20-year lows, perhaps confirming over-positioning and maximum bullishness that could be associated with late cycle attitudes. The RV in SPX and HSI had ‘coincidentally’ hit decade lows back in 2007 at the peak in the previous credit cycle.

SPX versus HSI Realised Volatility Between 1997 to 2007

Source: Bloomberg


SPX versus HSI Realised Volatility Between 2007 to 2017

Source: Bloomberg

Long term investors in long VIX products, like VXX, are familiar with the difficulty that such long periods of low volatility cause. But, as if to emphasise the point about the cycle, short VIX strategies, using XIV and SVXY ETF etc., have outperformed the underlying long index around three times over, and the most popular short-VIX ETF, XIV, has quadrupled (from $16 to $63) in the past year. Perhaps ‘irrational exuberance’ is alive and well in the short volatility market right now.

Normalised Returns of XIV ETF (Short VIX) versus SPX since 2011

Source: Bloomberg

The short volatility trade does not end at shorting VIX, which is ultimately only playing at the short-end of the volatility term structure. Selling the longer end of the SPX volatility term structure has also proven to be very popular in recent years, usually through selling puts, variance swaps and even corridor variance swaps. In spite of it being the deepest equity volatility market in the world with a natural demand for insurance-led put buying, we see increasing suppression of volatility in SPX.

Most readers understand why we have the keenest interest in the structured product markets in Asia. The desire for yield in a region with consistently negative real interest rates has created a dynamic that encourages investors to sell volatility for income. The same appetite for yield-chasing has now taken hold in the US. One of the most popular trades since the Bernanke/Yellen put has been in place has been to sell


S&P500 puts against any Asia long put position, either as a ‘hedge’ or in a ratio to ensure a positive carry while having a presupposition of a hedge (since Emerging Market Asia tends to get sold off first with a greater impact in a correlated shock). With SPX outperforming all other markets in each subsequent correction since 2008, this resilience in the US markets reflexively translated to more selling of US put options. It also dawned on sell-side trading desks that marketing “Long SPX vs Asia” variance swaps would be a good way to get their long skew positions that they bought from the Korea and Japan auto-callable structured product flow (a specific type of reverse convertibles) off their books. The demand for these variance swap spread trades has since overtaken the supply. Clients, including pension funds, insurance companies, relative value volatility funds, macro funds and some tail risk funds, all got on board this SPX versus Asia variance spread ‘gravy train’. Anecdotally, there is around $100-$150 million vega of these spreads outstanding in the market. Herein lies the risk of short convexity and different forms of basis risk.

However, this is not the end to “The Big SPX Vol Short” narrative. Further leverage is being hidden in the widespread use of:

Volatility targeting strategy ($360-$400 billion estimated) Risk Parity strategy (~$500 billion estimated) Trend following strategy (~$350 billion estimated)

These estimates sum up to a total of around US$1.2 trillion (unlevered). These popular strategies converge to a primary reaction function, to sell or de-lever in the face of an increase in realised volatility (either implicitly or explicitly). Looking at these strategies a little more closely, risk parity essentially translates into a short volatility and short correlation portfolio. Similarly, trend following strategies have benefitted from the declines to historical lows in realised volatility, stock, sector and regional market correlations.

Credit It seems like we are nearing a point of maximum market bullishness, with volatility, convexity and correlation all hitting lows of the past ten years. Little by little, bears have been taken out to the wood shed, and a glance across global CDS indices in the US, Japan and Asia show that they are all trading at or close to the lows of the past decade.

The moves in credit are not surprising, with hindsight. The global economy has enjoyed maximum monetary easing and historical low cost of borrowing over the past eight years. Much of the liquidity created over that time has ended up in financial assets and property markets, and emerging markets seemingly attracting more than their fair share of the monetary largesse. Total credit relative to non-financial sector has increased massively around the world and the growth rate in financial assets has greatly diverged from GDP growth rates, presumably a result of money printing on an epic scale.

However, the GFC in 2008 showed that leverage is a knife that cuts both ways. The US property index doubled from 2000-2008 before suffering a 35% correction. The property boom across the globe in the last eight years has been on an unprecedented scale, presumably fuelled by record low levels of interest rates.

This is not to say that the sky must be falling very soon. However, once borrow cost starts to rise and money printing starts to slow, the ‘tide’ will recede. And as Warren Buffett once said ‘only when the tide goes out do you discover who’s been swimming naked.’


Normalised returns (2010) of the US Corporate HY, EM Corporate HY, Global IG and Sovereign Bond Index, MSCI World and S&P 500

Source: Bloomberg

ITRAXX Asia ex Japan 5-year CDS Spread

Source: Bloomberg


US, HK, Australia, Singapore, London Property Index (in local currency) normalised to year 2000

Source: Bloomberg

US, HK, Australia, Singapore, London Property Index (in USD) normalised to year 2000

Source: Bloomberg


US, HK, Australia, Singapore, Britain Property Price Index from The Economist

Source: Bloomberg Total Credit to Non-Financial Sector sorted by percentage increase from BIS data

Source: Bloomberg


Total Credit to Non-Financial Sector sorted by the increase in the Debt to GDP Ratio from BIS data

Source: Bloomberg Total Credit to Non-Financial Sector sorted by USD amounts from BIS data

Source: Bloomberg


China All system Financing Aggregate (Total Social Financing)

Source: Bloomberg Credit Benchmarks

Source: Bloomberg

Risk Update February was another month of fairly significant “risk on” behaviour. Across the spectrum, risk assets continued to rally hard, and volatility supply through structured product issuance continued at or near record pace. The investment world seems very much onboard with the “reflation” trade. A common theme we hear goes something along the lines of “reflation is the theme - just be long equities and hope that interest rates don’t go up too fast and destabilise things”. We have been saying for some time that, based on the asymmetry we see in our book, the risk in the system seems to be rising interest rates, and the potential


breakdown of the correlation between rates and equities. Oddly, for us, this is far from an uncommon view nowadays. Our long held premise that rates would likely go up once they stopped going down, has turned out to be fairly accurate. Even without policy rate hikes (ex the Fed) we have seen market after market where yields have started to rise once central banks stopped pushing them lower. Someday we may be able to look back at July 2016 as the cyclical (if not all time?) lows for many a yield curve. USD, JPY, KRW 10-year Swap Rates Indexed

Source: Bloomberg

Also, as we have long suspected would be the case, inflation has turned around almost simultaneously with interest rates, much like it continued down in parallel with the policy rate measures. We remain unconvinced whether policy makers actually are clear on the correlation/causation relationship between the two. US, Japan, Korea CPI year-on-year

Source: Bloomberg


All of this leads us to the inevitable question around the confidence that markets hold for policy makers’ abilities calmly and smoothly to manage the normalisation of their unprecedented extreme monetary accommodation. Will they, as broadly expected, manage to raise rates in a gradual manner, avoiding any pricking of unsuspected asset bubbles? History tells us no. Will they be able to provide the traditional backstop to any unexpected equity market instability? They may have proven that there is no such thing as a zero bound, but they likely learned that there is a bound not too very far away from zero. Will they ever be able to wind down their massively expanded balance sheets? It is hard to see how. A nice way to see the challenge, and where various central banks are in the process, is to take a look at how they all compare to simple Baseline Taylor Rule Estimates. US Fed Funds, CPI and Taylor Rule

Source: Bloomberg

Korea 3-month CD, CPI and Taylor Rule

Source: Bloomberg


Japan O/N Rate, CPI and Taylor Rule

Source: Bloomberg

And just because they are our favourites for their unprecedented history of currency debasement, we throw in the Bank of England’s picture. What was Carney thinking? UK Base Rate, RPI and Taylor Rule

Source: Bloomberg

A simple reading of those charts could be summed up as the central banks are potentially “behind the curve”, or in the case of the last one, completely lost sight of the curve. It may not be much of an over simplification to say this is the story for 2017. Call it the year of normalisation. At what pace will the Fed hike? To what extent will other central banks, just as they did on the way down in rates, be forced to follow US rates back the other way? To what extent can a given central bank, e.g. the Bank of Japan, ignore the actions of other


markets and stick to their own independent policy settings, e.g. 10-year bond yields pegged at around 0.00%? And how do potentially significant relative changes in discount rates impact other asset markets? For something that seems to be at the core of market uncertainty, some might be it surprised to learn that we continue to find some of the most attractive asymmetry in protection against just these sorts of concerns. Of course, given the massive levels of volatility supply, there is an attractive asymmetry across a wide range of opportunities, and getting better day after day.


CONVEX ASIA FUND RETURNS

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec YTD 2017 -2.69% -1.69% -4.33% 2016 2.88% 1.81% -3.19% -0.14% -1.29% 0.30% -1.79% -1.68% -1.48% -0.86% 3.66% -0.65% -2.63% 2015 0.61% -0.78% -0.51% -0.45% -0.41% 0.04% -0.25% 3.17% 0.28% -3.26% -0.74% -0.73% -3.10% 2014 -0.17% -0.78% 0.25% -0.55% 0.01% -0.15% -1.39%




Past performance is no guarantee of future results, and an investment in the Fund could lose value. _________________________________ (1) The investment services being offered in connection with this track record are neither offered by, nor associated with, Fortress Investment Group LLC, its affiliates or the directors, officers, employees, members, partners, shareholders or controlling persons of any of the foregoing (collectively, “Fortress”). This track record reflects investment returns resulting from the investment activities of the Fortress Convex Asia Master Fund of which Mr David Dredge as CIO and Mr Julian Ings-Chambers as Managing Director from 11 October 2011 through the termination date, 30 June 2016, on behalf of Fortress clients during the period specified above, during which the track record was maintained by Fortress in the normal course of business solely for Fortress’s use. For the avoidance of doubt, this document is not associated with Fortress’s business in any way, and Fortress will not have any future association with the investment funds or advisory services discussed herein. Further, you should not view the inclusion of the track record herein as an indication that Fortress endorses any such investment fund or services because Fortress expressly disclaims any such endorsement. Fortress disclaims all liability associated with these materials. To the extent you choose to make an investment or otherwise engage in a relationship with any person based on this track record, you do so at your own risk and there can be no assurance that results similar to those in the track record will be achieved. All performance figures through 2014 and 2015 are based on audited financial information and, with respect to 2016 and 2017, are based on estimated and unaudited financial information and are, in each case, confidential. The performance data set forth above reflect returns, net of all fees and expenses, for both Class A and Class B, day one “new issue” eligible investors. Allocation of “new issues” to “new issue” eligible investors may result in returns that are higher than returns earned by other investors. The estimates are calculated using income for day one, "new issue” eligible investors net of all expenses, including management fees, accrued incentive allocation (if any), and other expenses over the Fund’s Trading Level (for estimates identified as Trading Level) and NAV (for estimates identified as NAV). Trading Level is defined as the product of the Fund’s NAV multiplied by the Funding Factor. The Funding Factor is 1x for Fortress Convex Asia Fund Ltd, while the Funding Factor is 2x for Fortress Convex Asia Fund PF Ltd. Investors in Class A are subject to 1.5% management fee, a 20% incentive allocation, and other expenses. Investors in Class B are subject to 1.25% management fee, 18% incentive allocation, and other expenses. The descriptions of the management fees, incentive allocations, and other expenses to which investors are subject are set forth in detail in the Fund's offering documents. The summaries in this paragraph are not binding and do not alter the terms of such documents, which govern in all respects. DISCLOSURE This document is intended for professional use only; it should not be relied upon by private clients. It is provided for information purposes only and should not be interpreted as investment advice. It does not purport to be an inducement, recommendation or offer to invest in any fund. Any offering is made only pursuant to the relevant offering document, together with the current audited financial statements of the relevant fund, if available, and the relevant subscription/application, all of which must be read in their entirety. No offer to purchase securities will be made or accepted prior to receipt by the offeree of these documents and the completion of all appropriate documentation. Whilst the information contained in this document has been prepared in good faith, no representation or warranty, express or implied, is given by City Financial Investment Company Limited or any of its Directors, partners, officers, affiliates or employees. Past performance is not a guide to future performance. City Financial Investment Company Limited (Registration No. 020473901) is incorporated in England and Wales and the registered office is at 62 Queen Street, London EC4R 1EB. The company is authorised and regulated by the Financial Conduct Authority. The representative of the Fund in Switzerland is Hugo Fund Services SA, 6 Cours de Rive, 1204 Geneva. The distribution of Shares in Switzerland must exclusively be made to qualified investors. The place of performance for Shares in the Fund distributed in Switzerland is at the registered office of the Representative.

CONVEX ASIA FUND PF LTD - CLASS A (TRADING LEVEL) NET INVESTOR RETURNS

CONVEX ASIA FUND PF LTD - CLASS A (TRADING LEVEL) NET INVESTOR RETURNS

CONVEX ASIA FUND PF LTD - CLASS B (TRADING LEVEL) NET INVESTOR RETURNS

CONVEX ASIA FUND PF LTD - CLASS A NET INVESTOR RETURNS

CONVEX ASIA FUND PF LTD - CLASS B NET INVESTOR RETURNS

convex asia fund pf ltd - monthly update - 2017 02...

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