The return of Paul Marshall
Putting aside political ambitions, a co-founder comes back to help revive Marshall Wace.
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By Barry Cohen
From his penthouse office in central London, Paul Marshall has a bird’s eye view: To the west, he sees the Houses of Parliament, a wistful reminder of ambitions that led him to seek public office in 1987 & has kept him active in politics ever since. Turning to the east, he looks at St. Paul’s Cathedral & the skyscrapers of the City’s financial district, a stark rejoinder to the task that occupies him these days: returning the firm he co-founded, Marshall Wace, to its former glory.
Largely as a result of his passionate interest in politics, the 50-year old Marshall stepped back from the investment side of the firm in 2004 and was rumored to be considered for Parliament in recent years. That had left Ian Wace, with whom he had started the firm in 1997, in charge. As markets began to tumble last year, taking Marshall Wace’s many hedge funds with it, Marshall, who had retained the title of chairman, returned to a more active role while maintaining his policy work regulating hedge funds, arguing against the U.K. ban on short selling and calling for limits on leverage and more disclosure for the industry.
Now, getting Marshall Wace’s own house in order is the task at hand. Most of Marshall Wace’s hedge funds underperformed their indices last year, with its flagship Eureka fund down more than 19%, raising questions about the volatility of its innovative trading system, TOPS (Trade Optimized Portfolio System), which had propelled Marshall Wace to the upper tier of the European hedge fund industry. Poor performance and loose liquidity terms at the once-heralded fund led investors to flee. By the end of June, Marshall Wace’s assets had plunged by more than 75% to $3.5 billion, from $15.8 billion at their peak in January 2008. At that time, Marshall Wace was the sixth largest European hedge fund firm, according to EuroHedge’s semiannual survey. It now ranks nineteenth.
That’s quite a comedown for Marshall Wace, which has long been one of the most successful and talked-about hedge fund groups in Europe, its growth spurred by the introduction in 2002 of TOPS, which was widely copied in Europe and the U.S. But TOPS depends on analysts’ and brokers’ predictions to make market bets and takes positions in large-cap stocks. When those own views proved wrongheaded, and the stocks collapsed, so did the TOPS funds. Was TOPS merely a bull-market phenomenon that tracked the markets, leaving no room for managerial discretion?
Last year’s losses have prompted a rethinking at Marshall Wace. The firm is quickly adding manager-led long/short funds to its stable in Asia and the U.K. and hiring the best talent from places such as Morgan Stanley’s prop desk. It’s also refining the TOPS process. “We have to innovate every day in order to enhance the way we extract and use the information,” says Marshall. Learning from last year, for example, the firm is putting more focus on external risk factors such as correlations with other hedge fund managers. Marshall Wace is also in the vanguard of firms offering new retail funds for sale throughout Europe, using UCITS (Undertakings for Collective Investments in Transferable Securities) structures.
Marshall insists that the firm had not become too one-dimensional with its dependency on the TOPS process. “It’s true that as managers of the business we were heavily focused on the global rollout of TOPS, but we had always wanted to build out the fundamental long/short side of the business,” he says. In addition to its numerous TOPS funds, in November 2006, Marshall Wace issued public stock in MW TOPS, a closed-end investment company, which proved to be the largest ever offering of permanent capital from a hedge fund firm, raising €1.5 billion.
“We realized that we had built a first-rate global information-gathering and execution platform, along with a strong brand name,” says Marshall. “That gave us the bandwidth to expand and also proved to be a big advantage in attracting the right talent, which is always very hard to find.”
MW TOPS shares have slid on the open market, however, and the fund is now worth just €180 million ($230 million). Being a brand name firm didn’t prove helpful in retaining investors’ money in its hedge funds either, although Marshall Wace’s refusal to lock up capital has won it admiration. “Because they acted honestly in the crisis, it’s firms like Marshall Wace that people will return to,” says Caron Bastianpillai, a portfolio manager at Notz Stucki in Geneva.
The money may not be coming back yet, but performance has already started to rebound. That doesn’t answer the question as to whether or not TOPS just follows market rallies, however. Marshall Wace contends that the TOPS strategies capture more of the market’s upside than they do losses on the downside. At any rate, the TOPS comeback may put to rest the argument that its TOPS system was too widely copied to work anymore. This year its TOPS Europe fund is up 18.11% through August, well above both the median of 7.68% for the EuroHedge long/short index, after being down about 20% in 2008, compared with a median decline of 9.21% for the index last year.
Paul Marshall and Ian Wace brought different but complementary skill sets when they formed their partnership in 1997. Ian Wace started his working life at SG Warburg (now part of UBS), where, at the precocious age of 25, he became the youngest ever director. Marshall’s first job was as a scaffolder—despite having earned a degree in history and modern languages at Oxford University and an MBA from the INSEAD Business School near Paris. Marshall went on to become the chief investment officer for European equities at Mercury Asset Management, the largest fund manager in Europe at the time. In contrast, Wace was a gifted trader who rose to become head of proprietary trading at Warburg before moving on to serve as global head of equity and derivatives trading at Deutsche Morgan Grenfell.
“Paul is very articulate and thoughtful and works well as the public face of the firm,” says one former investor, explaining how the two complement each other. Marshall’s public role has been aided by his involvement in British politics and work on hedge fund regulation, which the firm embraces. On the other hand, the investor says, “Ian is an extraordinarily talented and driven individual who can identify decent managerial talent and has largely been responsible for building the global operational infrastructure.” (Further illustrating Wace’s role as the inside man, he declined to be interviewed for this article.)
During its first five years of operations, Marshall Wace focused on building its flagship vehicle, Eureka Fund, a European biased long/short equity fund which was running assets of some $593 million at midyear. The fund is co-managed by Marshall and Wace and has since become something of a multistrategy feeder into the many other vehicles they manage. Despite its losses last year, Eureka still is outdoing the competition over time. Since inception in 1998, Eureka has a net annualized return of 14.32% through August of 2009, compared with 9.87% for the EuroHedge European Long/Short Index.
One of the firm’s earliest backers was George Soros, who alone accounted for half of the initial $60 million raised. Today, institutional investors make up most of the investor base.
The firm really took off following the conclusion of a long-running debate between the founders as to whether brokers’ and analysts’ recommendations offered any economic value. Coming from the buy side, Marshall argued that investment research and sell-side ideas provided virtually no value whereas Wace believed investment banks wouldn’t spend billions of dollars on research if it were a waste of time. Ultimately, Marshall says, “Ian was proved right.” At the very least, these recommendations do move markets, Marshall Wace learned.
The partners decided to resolve the issue by asking Anthony Clake, a young Oxford University graduate, to start measuring the sell-side recommendations. “We asked the 40 people who covered our account at that time to produce their ideas in a virtual portfolio format and send Web-based texts, rather than sending us e-mails or telephone messages,” recalls Marshall.
Clake was asked to design a filter that would assess investment recommendations by not only looking at companies, but also measuring the behavior of brokers and the performance of the ideas they generated. The filtering tool that emerged, TOPS, employs algorithms to analyze and evaluate stockbrokers’ best tips and feeds them into an enormous interactive database of sell-side recommendations. Contributors provide as many recommendations as they like through a dedicated Website, but they are also expected to quantify their convictions by stating how much would be invested in a virtual world. Marshall Wace sets limitations on each stock in terms of market capitalization and liquidity.
“Having created an electronic order trail and measuring every contributor, we found that not only was there very significant alpha in the information we captured, but we could also optimize the alpha and create even further value by translating it into real portfolios,” explains Marshall. “The system reverse-engineers our relationship with the Street.”
Because the system is electronic, TOPS can cope with far more ideas than the average fund manager. The system takes a high number of extremely small positions—the maximum position cannot exceed 3% of net asset value in any portfolio—that are generally held on a medium-term basis for six to 12 months. What the system didn’t anticipate, however, is that the liquidity of its holdings would subject it to extreme turmoil, as occurred last year.
In addition, Marshall Wace broke new ground by decoupling trade recommendations and trade orders by placing a trade with the broker it judges to be most able to execute it. Brokers who provide the best ideas might not necessarily receive a direct order, but they will be paid for their recommendations. But most of the firm’s substantial commissions are directed toward those securities firms whose ideas proved to be most helpful.
“They have always been ready to embrace new concepts when other competitors have never even considered them,” says Kevin Gundle, senior executive officer of London-based Aurum Funds. “Paul and Ian share a combination of a very sharp intellect and an open-mindedness for really pushing the envelope.”
Because the firm trades in large blocks as well as making hundreds of trades each day, it generates a huge volume of business. Until last year, Marshall Wace accounted for an estimated 2% to 3% of overall trading on European exchanges and as much as 4% on the London Stock Exchange. A novice broker at an investment bank could accelerate his career prospects by becoming involved in TOPS, which receives contributions from approximately 3,000 people in more than 50 countries.
Led by 29-year-old Clake, 60 of the firm’s 140 employees are working on TOPS. The team includes actual rocket scientists, such as Aron Cooper, who heads portfolio management in Marshall Wace’s U.S. office. Cooper holds a M.S.in aeronautics and astronautics from the Massachusetts Institute of Technology and worked at the NASA Goddard Space Flight Center before moving into the investment industry.
The success of TOPS generated both controversy and imitators. Critics have argued that although TOPS may have transformed the relationship between the buy side and the sell side, it might be guilty of providing privileged information that could generate conflicts of interest. Marshall adamantly denies these charges, however, and the U.K. Financial Services Authority gave it a pass in 2006.
“If you look at TOPS, every trade comes from a broker, and there is a transparent electronic audit trail from us to the brokers who are then also able to do their own compliance check on their person who puts an idea into the system,” says Marshall. “So, from a compliance perspective, it’s the most bulletproof system that exists. The advantage we may enjoy is that in any market there is always somebody who gets the first call from a salesman with a new idea—particularly if you’re the largest firm,” he says. “We don’t get the first call in the U.S. because we’re not the biggest trader in that market, but we probably do get one of the first calls in Europe. Yet, whether or not we get the first call, TOPS reacts very quickly to that information.”
Marshall’s defense was backed by a report on these so-called alpha capture systems, as the TOPS process became known, by the Financial Services Authority, which said in a 2006 report that largely because of the audit trail, the risk of obtaining privileged information through these systems “might be lower than through traditional communication methods.”
The success of TOPS led a number of hedge fund managers to launch their own version, and rivals are nipping at Marshall Wace’s heels. Firms such as Two Sigma in New York City, which has basically replicated the TOPS process, have proved to be the most direct competitors.
The latest to introduce a rival strategy is GSA Capital Partners in London, known for its quant-based and statistical arbitrage skills, which launched the GSA Alpha Capture Fund in 2008 and has raised about $200 million. “Being quant managers who were very familiar with high-frequency equity trading and short-term forecasting, we had been watching how TOPS operates for quite some time and greatly admired what we regarded as a genius process,” says Jonathan Hiscock, a founder and managing partner of GSA.
Though Marshall Wace may be the first, Hiscock argues his firm might become the leader, as the firm with the “best mousetrap that can suck out as much alpha from the information as possible and create the best returns ... will be the top player. We’re confident that we’ve developed a pretty good mousetrap.”
Another well-known firm using a TOPS-like strategy is Gartmore Investment Management in London. Meanwhile, FactSet in New York City, First Coverage in Toronto, and YouDevise in London have created similar platforms.
But as Sanford Bragg, president and chief executive officer of New York City’s Integrity Research Associates, points out, “These platforms don’t have anywhere near the sophisticated modeling that Marshall Wace possesses. Because they don’t offer performance measurement, customers can’t gauge how to compare them to other sell-side ideas.”
Still, the competition hurts, as has the slide in Marshall Wace’s assets. “The problem for Marshall Wace is that the new platforms have distracted the sell side, and the firm is not getting the tender loving care that it had in the past,” says Bragg. “Wall Street is very mercenary and when your assets drop sharply, you get less attention. It therefore diminishes the carrot that Marshall Wace can offer to the sell side.”
The European track record for TOPS started in mid-2002 when the first allocation to MW European TOPS came from the Eureka fund, which serves as a feeder into several TOPS vehicles as well as having a manager-led component. The firm launched MW Americas TOPS in 2005, MW Asian TOPS in June 2006, and MW Global TOPS MW Market Neutral TOPS in 2007. The latest TOPS offering is called TOPS Bespoke Product Design, which offers customized products either by creating a new strategy within the TOPS platform or through a managed account. “In terms of net capital flows since May, there has been a distinctive bias towards managed accounts where we have seen quite rapid growth,” says Marshall.
With the dual flotation of MW TOPS on Amsterdam’s Euronext exchange in 2006 and later on the London Stock Exchange in 2008, Marshall Wace bolstered its reputation as an innovative firm by having the largest hedge fund flotation to date. Offering daily liquidity and the opportunity to invest in various hedge fund strategies, the closed-end investment company aimed to broaden the firm’s retail base.
The listing benefited from buoyant market conditions and the good returns that the TOPS process had been generating. Last October, however, as a result of a widening discount to the fund’s underlying NAV amid plunging equity markets, Marshall Wace allowed investors to cash out their shares. As a result, the value of the listed vehicle has sunk to $230 million. On September 17, the estimated NAV of the sterling share class stood at 1,032 pence and the closing price was 865 pence, indicating a discount of 14.7%.
Whether or not TOPS remains the firm’s central strategy, Marshall Wace determined it needed to build up other businesses. In June 2008, the firm formed a joint venture, Marshall Wace GaveKal Asia Limited, with Hong Kong’s GaveKal Holdings, a research boutique and fund management company. “We combined their expertise and knowledge of the Asian markets with our stock picking, execution and risk management skills,” says Marshall.
The new venture is responsible for the management of GaveKal’s absolute return funds with nearly $300 million under management. Last December, it launched the MW GaveKal Japan Fund (Market Neutral) and the MW GaveKal Japan Fund (Dynamic Net Exposure).
To broaden the manager-led strategies, Marshall Wace took advantage of the financial crisis to recruit top talent to run additional new long/short funds. After hiring Amit Rajpal from Morgan Stanley, where he ran Asian proprietary trading in Hong Kong and was responsible for the global financials portfolio, the firm launched Global Financials Fund, with an emerging markets bias, in late 2008. This was followed in February 2009 by the Global Opportunities Fund, led by Fehim Sever, a former manager of the award-winning Fidelity European Fund, out of London. Since inception, Global Opportunities has returned more than 19%. Another key hire, Rod Rehnborg, who previously worked for Rosehill Capital in El Segundo, Calif., and is a 15-year veteran of investing in Japanese markets, was recruited to run the MW GaveKal funds.
Marshall Wace is also trying to gain a bigger toehold in the U.S. market. In June, it brought on Jordan Foster, former managing director at Intrepid Capital Management of New York City, as head of marketing for North America to nab more U.S. institutional investors.
Marshall Wace’s U.S. office opened in May 2004, and operations began in February 2005 with the launch of the long/short equity TOPS Americas, with a relatively modest $194 million in assets. As a result, Marshall Wace became one of the few European hedge funds whose U.S. business included an investment management function as well as a marketing operation. TOPS Americas is the only vehicle managed in the U.S.
“The intention of our office from the outset was to prove to ourselves and our clients that the TOPS process was not only robust within a European context, but could also be imported into a new region and still deliver the same sort of attractive risk-adjusted returns,” says Michael Sargent (right), chief executive officer of Marshall Wace, North America.
Essentially, Marshall Wace has created a microcosm of the main London office in the U.S. “Our great advantage is that because we’ve built a globally consistent infrastructure, there is no need to have redundant systems in each region,” adds Sargent. “So our business has many of the same capabilities as London—just writ smaller.”
Although Paul Marshall has returned to a more active role at the firm, he hasn’t totally abandoned his political activities—including those on behalf of the hedge fund industry.
Marshall had his first taste of the rough-and-tumble of electoral politics in 1987 when he unsuccessfully ran for Parliament for the SDP/Liberal Alliance in London’s Fulham constituency. Despite rumors that he was interested in running again, he hasn’t ventured back into the electoral arena and says he has no interest in doing so. Nevertheless, he has stayed heavily involved in the SDP’s successor, the Liberal Democrats, which is the third-largest party in Parliament, and serves as an adviser to Nick Clegg, the leader of the Liberal Democrats. Marshall was the founding chairman of City Liberal Democrats and has also held the chairmanship of the Liberal Democrat Business Forum.
“I’m a ‘liberal’ in the British—not the American—sense, which means combining economic liberalism with social justice,” says Marshall. “I believe everyone should have the same opportunities as I did. We must strive to create a level playing field, but we shouldn’t aim to equalize the outcomes.”
In the past 10 years, Marshall has coedited several books on economic and social policy, including the “Orange Book” in 2004, which had a significant impact on the party’s thinking. “The book was basically trying to get back to the roots of liberalism, because the party was neglecting its liberal economic history,” he says. “We needed to resurrect the philosophy of Adam Smith, John Stuart Mill and William Gladstone, all of whom advocated free trade and a smaller state. So it was necessary to combine the four key strands of political, personal, social and economic liberalism to find solutions to contemporary problems.”
Marshall’s passion for policy has found an intellectual outlet through his chairmanship of the independent liberal think tank, CentreForum, which he launched in 2005. Although CentreForum has attracted various donors, Marshall is the chief benefactor, having underwritten the £1 million launch.
In another arena, both Wace and Marshall were founder trustees in 2002 of the children’s charity, Absolute Return for Kids, undoubtedly the favored charity of the London hedge fund community. ARK annually raises significant amounts of money to improve the lives of children who are victims of abuse, disabled or poor. In addition, Marshall serves as a trustee of Every Child a Chance Trust, which also runs programs to help socially disadvantaged children.
Perhaps Marshall’s greatest contribution to both policy and hedge funds has been his role in the global debate over new hedge fund regulation.
Marshall Wace was one of the 14 principal hedge fund managers to establish the Hedge Fund Working Group in 2007, which eventually evolved into the Hedge Fund Standards Board (on which Marshall serves as a director). The firm is also represented on the steering committee of the Alternative Investment Association, the global hedge fund industry’s trade group.
“It’s very clear that our investment strategies are more complex than those of traditional managers,” says Marshall. “We therefore created a set of standards, which interpret the Financial Services Authority’s 11 principles in relation to issues which are particularly relevant to hedge funds, such as disclosure, valuation, risk management and governance, and which the majority of Europe’s larger hedge funds have now signed up to.”
Marshall argued forcefully against the four-month ban on short selling in the U.K., which he believes has proved to be a mistake. Instead, he says, the relationship between short selling and financial stability should be addressed by a sensible disclosure policy. He thinks the FSA should monitor overall figures on short positions, rather than those of individual funds, and that could be combined with individual disclosure of short positions in excess of 3%, the same standard that is applied to the long side. Although he doesn’t expect a future U.K. ban on short selling, he says, “there may well be a ban on naked short selling, which I think is perfectly fair.”
For Marshall, it’s essential that the fight for regulatory reform adopts a global perspective toward creating a new set of standards for the hedge fund industry and, therefore, he praised the G-20 meeting in April when it announced that the Financial Stability Board would work to develop hedge fund standards. “If you don’t take a global approach, you will have regulatory competition, and that normally leads to a leveling down of standards,” he asserts.
By the same token, he is highly critical of the current draft European Union Directive, which aims to apply regional rules that would transfer power to the Brussels authorities. In a recent article in the Financial Times, he described this move as “a classic exercise in closet protectionism.”
In the U.S., Marshall recognizes that there are political pressures for better regulations and supports the registration of U.S. hedge funds, better control over leverage provided to the hedge fund industry by prime brokers and a willingness on the part of hedge funds to provide a greater degree of transparency for the regulators in terms of the leverage they employ.
“Back in 2006 to 2007, prime brokers were lending to hedge funds which had highly leveraged, illiquid equities,” he says. “But if they had been extending credit to hedge funds on more appropriate terms, many of these hedge funds which blew up wouldn’t have been able to deploy their capital in the same way.”
Having survived the severe downturn in the assets that it manages, Marshall Wace has demonstrated that it has the capacity to come back fighting—partly through the strong performance that many of its funds have generated this year. While the TOPS process will remain at the core of the firm’s strategy for the foreseeable future, the fortunes of the firm will also depend on the success of the manager-led funds it is now developing as well as the new UCITS structures it will likewise embrace.
Marshall Wace was among the first London-based hedge fund firms to offer these European products with the launch of a UCITS III-compliant version of an MW TOPS market-neutral strategy in 2008. The products are taking off because they allow funds to be sold freely throughout the EU both to retail and institutional investors who cannot invest in offshore vehicles and are seeking low minimum entry levels as well as daily liquidity.
Marshall Wace believes its funds are highly adaptable for a UCITS wrapper because they employ modest leverage and are highly liquid.
Says Notze Stucki’s Bastianpillai, “Unlike the typical hedge fund model, Marshall Wace has a key edge in that it can readapt its original classic, long/short model over and over again.”
Assets under management: $3.5 billion (July 1, 2009)
Flagships: Eureka (14.32% annualized through Aug 31), MW European TOPS (9% annualized), MW TOPS Market Neutral (-1.09% annualized)
Founders: Paul Marshall & Ian Wace
Offices: London, Greenwich, HK