F or most emerging market eq-uity managers, 2009 was a year of stratospheric gains – with

some even posting triple-digit re-turns. But those eye-popping re-sults generally came after disas-trous performances in 2008, when many funds produced losses so big that even their huge 2009 gains could not get them back to any-where near their high water marks.

But Charlemagne Capital’s long-running OCCO Eastern European fund did not follow that path. Al-though the fund enjoyed its best year ever in 2009 with a gain of roughly 50%, and lost money in 2008 like most of its peers, the strategy has never put its inves-tors on quite such a lurching roll-ercoaster ride as other emerging markets funds.

This is entirely by design. The fund is meant to be market-neu-tral – and manager Andy Wiles says this approach means the fund has generated more consist-ent returns over time, and with less volatility, than typical long-biased emerging markets equity strategies.

“There are not too many genu-inely non-directional funds in our part of the world,” says Wiles. “Over the last five years we have been positive greater than 50% of the time when the MSCI Emerging Europe index has been down. Our volatility over the life of the fund is in the single digits.”

The fund launched in December 2001 and has produced an annu-alised return since then of over 15%, with an annualised volatil-

ity of less than 9%. In the 2008-2009 combined period, the fund returned 22% – and it has had no down months in the past 14 months.

Wiles is an old hand at manag-ing emerging markets strategies, having previously been part of the team that ran a long/short emerg-ing markets fund at the now-de-funct Buchanan Partners before joining Charlemagne in 1995.

At Charlemagne, he heads up a team of five, including portfo-lio adviser Pawel Szulc, assistant Chris Coghlan, head of operations Adrian Jones and risk manager Pascal Khoury. Between them, the team members have nearly 60 years of experience.

The strategy is highly fundamen-tal. The team keeps a dynamic list

of about 150 small, mid and large-cap companies, each with its own models and price targets. From that list, the managers construct a portfolio of about 30 positions, based on exhaustive fundamental research and numerous company meetings.

“I consider myself an analyst first and foremost. 90% of my time is spent on research,” Wiles says. “The process is resolutely bottom up – we spend most of our time researching individual companies. Geographically, we sit very close to most companies in our opportunity set – as bottom-up managers, that’s essential. You can’t expect those inefficiencies to accrue to you passively.”

The team also divides its uni-verse into sectors, with the top three sectors – financials, mate-rials, energy – comprising about 80% of the portfolio. They account for about 70% of the region’s total market capitalisation.

Wiles says the team does not just aim to cover all the big com-panies. Instead, they try to see where the market is inefficient and where they have an edge and then allocate capital where that information advantage exists.

For example, the team no longer covers Gazprom because Wiles says the analysts do not feel they can add value on a company that is so closely followed by the buy and sell sides and that is so af-fected by top-down policymaking in Russia.

The company used to be the

largest holding in the fund, but Wiles says that when the world changed, the fund had to adapt with it.

“The point is that we are flexible in understanding where we have an edge,” he says. “We are always looking to optimise the way we allocate capital. That’s a bit of an obsession for us.”

Once the universe of 150 compa-nies, models and price targets has been constructed, the fund’s port-folio construction overlay kicks in. The overlay is highly oriented towards risk management and is meant to filter those 150 views into a portfolio that hedges out most of the common factor risks, such as sector or country expo-sure.

Wiles says the overlay has helped to keep the realised volatil-ity of the fund to 8.8% since incep-tion and has enabled the team to understand where the portfolio’s risks are coming from – and also to keep that risk related to the un-derlying securities, rather than to other factors.

“We don’t think we have ex-pertise in forecasting macro vari-ables, so it also ensures we aren’t constructing a portfolio that’s based on a different oil price or cost of capital to the rest of the market,” he says.

The end result is a high-convic-tion portfolio, with one in every five stocks that the team covers ending up in the portfolio. The av-erage position size is 3%, and the minimum position size is limited

18 February 2010 © EuroHedge

Charlemagne sticks to its guns with market-neutral approach to EM equitiesMinimising directional exposure to emerging equity markets enabled the OCCO Eastern European fund to limit its losses in the crash of 2008, while fully exploiting the upside in 2009

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Disclaimer: This publication is for information purposes only. It is not investment advice and any mention of a fund is in no way an offer to sell or a solicitation to buy the fund. Any information in this publication should not be the basis for an investment decision. EuroHedge does not guarantee and takes no responsibility for the accuracy of the information or the statistics contained in this document. Subscribers should not circulate this publication to members of the public, as sales of the products mentioned may not be eligible or suitable for general sale in some countries. Copyright in this document is owned by HedgeFund Intelligence Limited and any unauthorised copying, distribution, selling or lending of this document is prohibited.

to 1%, to prevent low-conviction tail risk from building up.

Some 80% of the portfolio is invested in large and mid-cap names, as Wiles and his team be-lieve the market is still inefficient enough to offer value in the more liquid securities. These inefficien-cies occur as a result of various factors, such as the absence of broker research, erroneous mar-ket research, local accounting standards, a lack of inclusion in indices and local or regional stock

market listings.The team is organised by sector,

with a different analyst assigned to cover each sector, and the idea generation process is fairly com-petitive. “We need to convince each other of the robustness of our approach,” says Wiles. “Eve-rything is challenged and that’s the environment I want to create. There needs to be competition for capital.”

This goes for the short book as well. Wiles says the short book is

meant to add market protection as well as generate alpha. That said, he says the team is happy for the short book to lose money, as long as the fund generates more re-turns on the long side – as main-taining a short book prevents the fund from some of the drastic de-clines suffered by its peers in the space.

The team spends equal time on long and short analysis. The short book tends to be slightly higher beta. Wiles adds that this higher beta embedded in the short book takes the overall portfolio – which on the surface appears to have a 10-15% net long position over time – to a market-neutral position.

On a country level, 50% of the portfolio’s gross exposure is in Russia, with the rest allocated to the Czech Republic, Poland, and, to a lesser extent, Kazakhstan and Hungary.

Russia is the most liquid market in the region and also fairly broad, which accounts for its sizable allo-cation in the portfolio. But Wiles says it delivers a commensurate return.

It also offers the best shorting opportunities. When the fund launched in 2001, shorting was more difficult and the Russian markets were still embryonic. But markets grew quickly from that point – before stalling in 2007 – and Wiles says the market has opened up significantly more to short selling, with few restric-tions on the practice and a host of Russian companies that have dual listings in Russia and New York or London.

“It’s now categorically wrong to say you can’t short in emerging markets,” he says.

But while transparency and cor-porate governance in Russia have improved, there is still a long way to go – as evidenced by the chill-ing saga of Bill Browder’s Hermit-age Capital.

Browder, a shareholder activist, is defending the firm against tax fraud charges levied by the Rus-sian government. Browder claims the government stole several Her-mitage holding companies and used them to commit the fraud. Browder’s lawyer, Sergei Magnit-sky, was sentenced to prison in Russia and died there in Novem-ber 2009.

“It has its faults, and a number of situations that give rise to very serious concerns about how share-holders and citizens are treated,” says Wiles of Russia. “We go into it with our eyes wide open – there are obvious risks and we want to be compensated for those.”

But he adds that Russia is still a very attractive market for the fund, because it demonstrates all the classical inefficiency signs. He adds that the benefit of having a market-neutral strategy is that the team does not need to have a positive view of Russia to make money.

“I don’t need to take a long-term directional view with regard to Russia to generate positive re-turns,” he says.

For now, Wiles says the team is trying to grow assets, which fell from a peak of $300 million down to a low of $65 million following the crisis of 2008. But thanks to performance, the return of some redeeming investors and some new inflows, the fund is back up to $122 million.

The fund lost 19% in 2008, which compares favorably to the 65% drop in the markets in which the fund trades. The EuroHedge Emerging Market Equity index produced a median loss of over 45% that year, and many funds in the space saw declines of well over 50%.

Wiles says the team is still far from happy with its performance in 2008, but it has learned some valuable lessons. “We performed poorly,” he says. “We understand what went wrong and restruc-tured the portfolio in terms of risk.”

He is also determined to stick to the fund’s philosophy of offer-ing market-neutral exposure to emerging markets, regardless of how hot they may become.

“Investors want exposure to the rising wealth levels and de-mographic themes in emerging markets; I understand that,” says Wiles. “But we can generate very good risk-adjusted net returns by hedging out the market volatility and by extracting the inefficien-cies that exist in our regional mar-kets. We tell people if they have a positive view of our markets and want beta exposure, then don’t invest with us. I think people un-derstand that.”

February 2010 19© EuroHedge

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OCCO Eastern European Fund: at a glanceManagement company: Charlemagne CapitalInception: December 2001Managers: Andy Wiles Strategy: Emerging market equityAssets: $122 millionPrime brokers: Credit Suisse, Goldman SachsAdministrator: PNC Global Investment Servicing

“ Overthelastfiveyearswehavebeenpositivegreaterthan50%ofthetimewhentheMSCIEmergingEuropeindexhasbeendown.Ourvolatilityoverthelifeofthefundisinthesingledigits”

Andy Wiles