HEDGE FUND MANAGER John Burbank III has made a career of anticipating how headline events and political edicts might affect the markets, and that’s why he was on something of a tirade the afternoon of September 19. Like every investment professional, the 49-year-old founder and CIO of Passport Capital in San Francisco had watched U.S. Federal Reserve chairman Ben Bernanke deliver a speech the day before in which he made the surprise announcement that the Fed would not start tapering its quantitative easing program yet.
“It’s cowardly,” Burbank said of the decision, holding court before 30 of his portfolio managers and analysts, assembled in the firm’s conference room for a macro investing meeting. Passport’s offices are on the 22nd floor of the office tower at One Market Plaza, on the Embarcadero, and behind Burbank a wall of picture windows overlooked San Francisco Bay and catamarans racing in the America’s Cup. The yachting races had been scheduled to end that week, but unsettled winds had delayed the final runs at about the same time that Bernanke announced that he was putting off the taper because of the unsettled economy. Burbank had expected the Fed to reduce its $85 billion in monthly bond purchases by about $10 billion; now, he said, he feared the U.S. was becoming overly reliant on quantitative easing as the only way to prop up the economy.
As a global macro hedge fund manager, Burbank is in the business of anticipating big shifts in the economic, political and social factors that move markets. He is the first to acknowledge that on a number of occasions he has made a market prediction that turned out to be accurate, but lost money by trading on the idea too early. This could have been one of those occasions — and it could have been disastrous for Passport’s portfolios.
Burly and bearded, Burbank typically wears a fleece vest to ward off San Francisco’s year-round chill and looks like an adventurer who can handle narrow escapes. But in the conference room, he was just in shirtsleeves, talking in his stentorian voice about how the firm had managed to evade a dangerous financial situation by cutting back on its short positions in emerging markets earlier in the month. Whereas a taper would have been likely to drive emerging-markets prices down and be good for short-sellers, the continuation of the Fed’s program to buy U.S. Treasuries was more apt to boost stock prices around the world.
At the conference table Tim Garry, the bespectacled young head of Passport’s quantitative division and risk committee, nodded as Burbank spoke. Garry, 34, has a deceptively calm demeanor for someone who spends his days looking for scary things going on in the markets; he practices meditation and says it helps him deal with stress. He tends to do more listening than talking when Burbank is in the room. But it was Garry and his team — four quants and several risk programmers — who decided in late August that it was time for Passport to trim its emerging-markets shorts. Growth figures from China were better than expected, and they had detected a condition they described to Burbank and the firm’s other portfolio managers in quantspeak: increased trading momentum in high-beta stocks. Burbank didn’t always understand the importance of making daily calculations of beta, or correlation to market moves, but he does now.
Since Garry’s arrival at Passport from State Street Global Advisors nearly six years ago, the firm has evolved its investment strategy into a unique blend of global macro themes, bottom-up stock picking and quantitative risk analysis. And though there have been a number of speed bumps along the way, in 2013 Passport’s portfolio managers showed that they can use risk management not just to gauge danger but to boost their returns.
“Five years ago we would have said the way we handle risk is to know our companies better than anyone else does,” says Burbank, whose firm manages nearly $4 billion in assets. “But if you don’t understand, for example, apparent liquidity versus the liquidity you see by looking at volumes and whether the volume is coming from high frequency trading or real money, you don’t understand your liquidity exposure.”
Burbank set out to hire a quant in 2007 because he saw algorithmic trading as yet another big shift in the market and he wanted to tap into it. He and Garry began employing algorithms to identify risk factors they could use to trade with more-exacting attention to position size, timing and hedging. Burbank identifies big-picture investment themes. The firm’s fundamental portfolio managers pick assets — mostly equities — that fit into the themes. The quant team tells the others how to size positions, and when to get in and out, based on day-to-day market movements and risks.
Passport’s three-pronged strategy doesn’t have an official name, but it is an advanced version of a practice that some large institutional investors began more than a decade ago, allocating by risk units instead of asset classes. Jeffrey Scott, chief investment officer at Wurts & Associates in Seattle, which provides outsourced investment services for pension funds, has been allocating by what he calls “risk buckets” for about 15 years, dating back to his time as CIO of the Alaska Permanent Fund, one of the world’s largest sovereign wealth funds, and before that as assistant treasurer for Microsoft Corp.
“It’s an old trend, but it’s still evolving,” says Leslie Rahl, co-founder of Capital Markets Risk Advisors in New York. Rahl wrote about the practice of risk unit allocation in a book her firm published back in 2000, Risk Budgeting: A New Approach to Investing. “The idea is to go below the label of ‘it’s a stock’ or ‘it’s a bond’ and look at the behavior characteristics that drive each asset,” Rahl says.
Eugene Podkaminer, a consultant in the capital markets research group at Callan Investments Institute in San Francisco, has been trying to change the way investors look at assets so that instead of thinking in terms of allocating to stocks, fixed income and commodities, they allocate to assets tied to a diversified pool of risk factors. Podkaminer is the author of a 2012 study, “Risk Factors as Building Blocks for Portfolio Diversification,” in which he compares asset classes to molecules and risk factors to atoms that, when broken down into subatomic particles, help explain the high levels of correlation among asset classes. He breaks down the building blocks of risk in much the same way as the quants at Passport have done, measuring such factors as volatility, GDP growth, credit spreads, interest rates, value, liquidity, momentum, currency and inflation.
Passport’s approach, however, is more complex than just investing by risk factors. Burbank and the firm’s other portfolio managers choose their assets the old-fashioned way, using macroeconomic themes and company fundamentals, then dissect those assets for risk factors. But the strategy hasn’t been an easy sell. When a hedge fund firm changes its approach, the shift doesn’t always sit well with investors, who generally don’t like to see style drift. In addition, although most investors want their hedge funds to have robust risk management systems, some are concerned about lower performance. “Some investors look at risk as cutting into return,” says Burbank. “I look at risk as enhancing return if it keeps you out of the wrong things and helps put you into the right things.”
Judith Posnikoff, a founding partner and manager of the portfolio construction group at fund-of-funds firm Pacific Alternative Asset Management Co. in Irvine, California, is enthusiastic about the strategy, although Paamco is not an investor in Passport. “I think Passport is the way of the future, at least for multibillion-dollar firms,” she says. But, she notes, it still has to prove that Passport’s new approach is a way to deliver consistent performance.
BUSINESS WAS THE LAST THING ON JOHN BURBANK'S MIND when he was growing up in New Haven, Connecticut, where his father taught secondary school and his mother was a book editor. While studying English literature at Duke University, he started a summer business painting houses because he needed money. His venture earned him enough to cover his tuition, and he liked the idea of accomplishing something through hard work and strategy. But his BA in literature also has been useful. “I’d say I’ve pulled narratives, characters and plots together in my thinking about investing,” he says. “And when I started investing in the 1990s, I found that anything prevalent in the markets is worth betting against. That’s the iconoclastic part of me, and in literature most stories are not about someone who’s part of the crowd.”
After graduating from Duke in 1987, Burbank considered a few career paths. He was interested in film school. He interviewed for a job as a consultant at Bain & Co. but realized he could earn the starting salary of $35,000 in one summer running his painting business.
What really made him want to understand business and the way the world was changing, however, was his stint teaching English in China in 1988. When he returned to the U.S., he decided that the Stanford Graduate School of Business was the perfect place to learn more. Still, after earning his MBA in 1992, he entertained various career options. He traveled for a while and gave himself three months to write poetry. But he was also drawn to the investment world, and in 1994 he decided he’d take six months to trade, using money he borrowed with his credit cards. “I was interested in figuring out how the market works and the psychology of other players,” he says.
In 1995, Burbank went to work part-time for San Francisco hedge fund firm ValueVest Management Co., which invested mostly in emerging markets and had assets of only $2 million. He accepted a starting salary of $1,000 a month for the chance to learn about the financial world, then worked his way up to being director of research. As an analyst he had a chance to test the merits of a contrarian approach: While investors were flocking to the booming markets of Southeast Asia, he decided that stocks there seemed expensive and instead steered ValueVest to companies in Eastern Europe, Brazil and South Korea. The strategy paid off big-time: By 1998, after 21 straight months of gains, the fund’s assets had grown to $150 million. At that point, no one had considered the risk that the emerging markets might rise and fall together. When the Asian debt crisis began in late 1997, Burbank appeared to have made a brilliant call — until what came to be known as the Asian contagion brought down emerging-markets stocks all over the world. By 1998, ValueVest had lost about 20 percent of its assets.
At about that time, Burbank began to consider another big-picture theme: the technology boom. While ValueVest stuck with emerging markets, in November 1998 Burbank put $5,000 of his own money — all he had at the time — into Japanese investment firm SoftBank Corp., which had a stake in a four-year-old web portal that two Stanford engineering students had started and dubbed Yahoo. The next year Burbank started talking with Roger Richter, who had offices down the hall from ValueVest in San Francisco’s Citigroup Center and was running the JMG Triton Offshore Fund, a $1 billion arbitrage vehicle, and decided to go to work for him.
Increasingly, though, Burbank was thinking about starting a fund of his own. “I wanted to test my ideas in the market,” he says. From his experience with the emerging-markets crash, he had a hypothesis that markets were really bad at predicting big, new secular changes. With his own shop, he figured, he could test his ideas over time and live with the volatility; he was prepared to get by without a lot of compensation over the first three to five years. Richter supported his ambition and even provided him with office space and a Bloomberg terminal. All Burbank needed was capital. He had a little of his own by then thanks to SoftBank: His $5,000 investment was worth $125,000. He cashed that in, put $25,000 into his fledgling fund, then pulled together more start-up capital from friends and launched Passport Capital in 2000 with $800,000.
The pickings were easy at first. Passport started trading in August 2000 on the heels of the technology bust. Burbank shorted tech and telecommunications stocks and took long positions in energy companies, which he believed were cheap and misunderstood. He earned 36 percent the first year. He knew it was important to identify an investment theme and cash in on it just when others were starting to discover it, so he was perpetually on the lookout for big changes. By 2002 he had started investing in gold, which he believed was on the rise because the Federal Reserve was keeping the dollar down and because it would benefit from emerging-markets growth. In 2004 he started riding the boom in China by investing in Western companies that seemed likely to make money from that country’s industrial growth. He says he was somewhat late to that party, but he was well ahead of the crowd in predicting a brewing crisis. Watching then–Fed chairman Alan Greenspan cut interest rates to boost the U.S. economy, Burbank figured Greenspan’s intention was to create a real estate boom that would evade recession. But, Burbank reasoned, eventually the boom would have to end. It was time to start betting against mortgage securities and financial institutions.
In those days Passport had fewer than ten people; Burbank had moved the office to a renovated warehouse building in the Jackson Square area of San Francisco, just north of the Financial District and east of Chinatown. For general entertainment someone brought in a “Rapping Hamster” toy, and it became an office ritual to push the button on the hamster’s toe so that it sang its one musical selection, “Rapper’s Delight,” every day the fund made money. “It was considered bad form if the person in charge of the hamster for the day didn’t make it sing,” recalls Seth Spalding, who began working for Passport in 2003 as a technology consultant and is now a technology portfolio manager. There were weeks when the shrill music played often. The flagship Passport Global strategy made money in each of its first eight years, peaking with a 220 percent gain in 2007, but there were inevitable months of losses, when the hamster didn’t sing.
Burbank had launched Passport knowing that there would be days when his forecasts would seem crazy. His investors also understood there would be rough patches — but in 2006, Burbank learned about the limits of investor patience. His bets on emerging markets and against U.S. subprime securities and financial institutions delivered a 15.4 percent return in January 2006, but the fund lost some 25 percent between May and August of that year. At the end of that decline, the firm’s biggest investor pulled out, redeeming more than 20 percent of Passport’s assets. As Burbank saw it, the market wasn’t pricing in the real value of subprime mortgage securities. Ultimately, of course, he turned out to be right, but the timing was wrong. “I had the right longs, the right shorts and the right insurance, and I still lost money,” he says.
Burbank has become fond of declaring that price is a liar. “Price is just where people agree to buy and sell,” he explains. “It’s equilibrium. I was trying to play on a macro basis, but that wasn’t something I could arbitrage.” He realized that he was facing a rapidly changing world in which markets were slow at foreseeing — and adapting to — change. It seemed dangerous to trust even some of the most basic investment principles, such as Benjamin Graham’s value investing dictum that says you should be willing to buy something no one else wants, as long as you can get it cheaply. What if some assets never recover, he wondered.
The Passport founder saw prices that his investment views couldn’t explain, so he looked for other clues. One market force he observed was the growth of algorithmic trading. Burbank knew that this type of trading was driving a lot of market activity. Though quant funds had a meltdown in August 2007, generally viewed as the result of massive deleveraging, Burbank thought it might be a good idea to bring in some quantitative experts who could tell him what the markets were doing at a given moment that might affect his positions.
Thomas DeMark, founder and CEO of DeMark Analytics in Scottsdale, Arizona, introduced Burbank to Garry. DeMark’s firm provides market-timing and technical analysis to many large hedge fund firms, and he has known Burbank since 2000. He remembers when Burbank told him he aspired to run a multibillion-dollar fund. “I was impressed,” DeMark says. “John seems to think three to six months ahead of others, and he’s conversant in everything.” Now Burbank is an investor in DeMark Analytics.
When Burbank told DeMark he was thinking about bringing a quant on board, DeMark said he knew a very insightful young portfolio manager who was working at State Street Global Advisors in Boston but looking for a change. “I kept describing Tim to John as Doogie Howser,” says DeMark, referring to the 1989–’93 TV series, starring Neil Patrick Harris, about a child genius who becomes a physician at 14.
Burbank and Garry talked for several months, met for a drink in New York and talked some more, about markets and life in general. Burbank invited him to the 2007 Passport Christmas party. Garry, who had grown up on the north shore of Massachusetts Bay and lived in the Boston area all of his life, decided on that trip that he liked both Passport and San Francisco.
For Garry working for Passport looked like an adventure in high-stakes trading. “At State Street most of our quantitative strategies were targeting 10 percent alpha in a good year,” Garry says. “Passport was not just targeting but getting 20 percent-plus. I thought Passport looked a bit more interesting.” He arrived in early 2008.
Spalding had thought all along that it was a great idea to bring a quant on board. “What made me feel excited about joining Passport from the beginning was John’s broad-minded approach,” he says. “When Tim came, the quant style became almost like examining another sector.”
Not all of the firm’s portfolio managers agreed, however. Passport went through several years of transition in staffing, with more than 20 firings or layoffs between 2008 and 2012. It didn’t help that Garry needed time to analyze the firm’s investments and build a risk management system from scratch, or that while he was working on all of that, Passport was on its rockiest ride ever. The flagship strategy had some gains in the first half of 2008, but losses in the second half brought its performance down 50.95 percent for the year — its first losing year ever. The firm’s assets peaked at $5.1 billion in July 2008, only to drop to about half of that by year-end.
Like Burbank, Tim Garry didn’t expect to go into the investment business. As an undergraduate at Boston College, where he majored in philosophy and English and was editor-in-chief of the school magazine, he thought he would become a journalist. His parents were both telecom technicians, and what he knew about finance came mostly from a part-time job he had in high school, caddying for business leaders at the Myopia Hunt Club in South Hamilton.
He was, however, interested in trading stocks. During his junior year of college, Garry began an internship at brokerage firm Josephthal & Co. (now part of Oppenheimer & Co.), working as an assistant to a senior high-net-worth broker. He interned there for two years, starting in 1999 as tech stocks were soaring to record highs, only to crash in March 2000, two months before his graduation. Garry saw those irrationally exuberant years as a great lesson in philosophy, with a few bonus disciplines thrown in. “Markets incorporate history, philosophy, math and social dynamics,” he says.
He was hooked. Instead of going into journalism, Garry earned a master’s in finance from Boston College while working at State Street. He started as a product analyst, but by 2004 he had worked his way up to a position as a quantitative portfolio manager, and there he stayed until he made his big move into the hedge fund world.
The job at Passport might have been short-lived. With the losses of 2008, the firm was teetering between life and death. Garry calls what happened “a form of creative destruction.” Burbank kept the doors open, and the staffers who remained were willing to try something new if it meant saving the firm.
Looking back at 2008, Garry says it isn’t hard to see what went wrong at Passport. If he had structured its portfolios before the crisis, the short positions in U.S. financial institutions would have been smaller. He now has a system in place that sets a maximum conditional value at risk (CVaR), a factor that is measured partly by volatility. If he’d had that system early in 2008, it would have told him that financial sector stocks were becoming highly volatile and that the CVaR was over the threshold. Another problem: The firm was invested in fairly illiquid emerging-markets stocks and suffered from a lack of liquidity when the markets crashed. “We didn’t have constraints on liquidity then,” says Garry. Now he insists that the investment time horizon for every portfolio match the investor capital commitment so that if investors want to cash in at the end of a lockup period, they can.
Under the system that is in place today, Passport’s macro and fundamental portfolio managers don’t make an investment without putting it under the scrutiny of Garry and his small team of quantitative risk analysts. The quants might say an investment presents a challenge because it is a high-beta stock that rises and falls with the market, or it might be vulnerable to currency swings or momentum trades. That kind of pronouncement doesn’t mean the macro and fundamental managers can’t invest in a favorite pick, just that they have to keep the position relatively small and have a direct hedge in place. Sometimes the quants make it possible to go ahead with a risky bet, says Peter Supino, who joined Passport in 2008, manages the consumer products portfolio and is also an analyst for the sector. “Years ago we might have passed on an interesting investment if we couldn’t get comfortable with some external risk,” he says. “Today we can strip out that kind of risk at the portfolio level.”
Arshad Ashraf, an emerging-markets portfolio manager who joined the firm in 2007, is in charge of a portfolio that Garry’s team insisted would work only if the timing was just so: Saudi Arabian stocks. In October 2008, Ashraf and Burbank were traveling in the Middle East as the global economy was collapsing. They saw that Saudi Arabia was in a much better position than most of the world because it had both oil resources and a financial surplus. For Burbank the observation was the germ of a new worldview, which he calls the great separation: He believes the general slowdown around the globe is producing a big divide between the companies and sectors that will be winners and those that will be losers. Saudi Arabia looked like a winner.
Garry, for his part, sees Saudi Arabia as a market where many stocks have extraordinarily low correlations with the rest of the world and even with the local market. But Ashraf didn’t invest there in a big way until March 2011, following Garry’s direction: Go in when the market drops. That opportunity came on the heels of a rumor that demonstrators were about to launch an Arab Spring in Saudi Arabia, when the local stock market declined by about 20 percent. Ashraf had spent enough time there and cultivated enough contacts on the ground to feel confident that there would not be a political uprising, so Passport swooped in. Saudi Arabia today makes up slightly more than 10 percent of the firm’s total portfolio.
Interestingly, both Burbank and Garry are now talking about the great separation and applying it to both a macro view and a risk model that assesses winning and losing stocks based on factors like correlations and volatility. Burbank is looking at what he calls the A students among companies and sectors. He doesn’t expect to see much global growth in the next few years, but he does expect to see the most-innovative companies do very well. He is shorting companies that are dependent on global GDP growth and investing in companies that have been able to innovate by improving on existing ideas and technologies. It doesn’t take a lot of capital expenditure to innovate that way, just some very good ideas.
“That kind of innovation is bad for growth but good for profits,” Burbank says.
Among Passport’s largest holdings are Yelp, a San Francisco–based online city guide provider, and online retailing giant Amazon.com, which is based farther up the West Coast, in Seattle. Proximity to the Bay Area is not a prerequisite for Burbank, but he is seeing start-ups all over San Francisco that are capitalizing on the kind of innovation he is talking about. “The social currency here is about what you’re about to do,” he explains. “It far more matches the zeitgeist of investing than any other place.”
Burbank has been watching the explosion in San Francisco real estate values, and he thinks that is where financial whizzes really should be, rather than on the East Coast. “It’s a good thing we’ve locked in our rent for ten years,” he quips.
His A-student list also includes companies that are able to profit from the growing consumer wealth in emerging markets. “I’m negative about China’s industrialization, but I’m very positive about the individual consumption story there,” he says. As Burbank sees it, China’s e-commerce stands to grow alongside the consumer market, particularly because the sector has little competition from retail chains. Passport’s top holdings, according to investor materials, include SouFun Holdings, the dominant site for real estate listings in China, and Qihoo 360 Technology Co., an aggressive security software company that also has a search engine, as well as Vipshop Holdings, China’s leading online discount retailer. The firm is also investing in Japanese Internet holding company and venture capital firm Digital Garage; Burbank views this as a good way to capture the equity boom he expects to see in Japan if Prime Minister Shinzo Abe is successful in his efforts to reignite inflation.
Garry’s view of the great separation dovetails with Burbank’s, although it comes from a different source: a study of equity market capital flows. Last year the two of them wrote a white paper in which they explained that after three years of closely correlated stocks following the 2008 market meltdown, it appeared that fundamental stock picking was about to have a comeback. Their reasons had to do with a market in which capital flows were creating a great deal of mispricing. Capital had moved increasingly to exchange-traded funds and other passively managed vehicles at the same time that the end of proprietary trading meant that less capital was chasing idiosyncratic investment opportunities. With less competition, those with the skills to identify mispriced stocks were likely to find a good supply.
What Burbank and Garry also found was that company-specific risk — rather than market correlation — was starting to drive returns. Garry has his own worldview when it comes to the markets: After five years in a row of positive gains for indexes, he says, “I think the most important thing hedge funds can do now is not be correlated with beta.”
Whereas Burbank gets animated talking about San Francisco and its embrace of innovation, Garry can talk about a stock’s moving beta and barely come up for air. He has made it clear to Passport’s portfolio managers that he doesn’t want the firm’s profits to come from rising beta. There is academic evidence that long-short investment strategies get as much as 40 percent of their returns from beta on correlations that they don’t recognize, and it’s Garry’s mission to track down that hidden beta. Every day his quant models measure the beta for each portfolio holding for the past ten days rather than the two-year beta that asset managers typically follow. He has taught Passport’s portfolio managers to look at their long-short positions mostly as a function of being long low-beta stocks and short high-beta ones.
“Mathematically, a high-beta stock is the equivalent of being long a stock and buying an expensive call option,” explains Garry. “A low-beta stock is the equivalent of being long the stock and selling a call. We want to be more discriminate when we buy high beta because when you own an expensive call option, timing is everything.”
Garry is concerned that since mid-2013 high beta has been closely correlated with price momentum and growth. He is the first to arrive at the office most mornings. By about 6:00 a.m. he has put Passport’s portfolios through a stress test, looking at how the holdings would be likely to move in such scenarios as the S&P 500 index falling 10 percent, the S&P falling 20 percent, the dollar rallying 1 percent or the dollar rallying 10 percent. He checks a program that has run 5,000 simulations on the portfolio the previous night using historical prices and movements to present every possible outcome based on market history. When the other quants arrive, they look at market patterns to gauge whether momentum, beta, volatility, currency and other risk factors are rising or falling.
The combined strategies have served Passport well over the past two years. Although returns haven’t hit the highs of the firm’s earlier years, the performance has been less volatile. The flagship Passport Global strategy rose 11.08 percent in 2012 and 15.17 percent in 2013 through October, according to data provider HedgeFund Intelligence. When the firm moved to its present quarters in September 2012, the hamster came along, and “Rapper’s Delight” has been heard fairly often of late.
But Garry has been especially pleased to find that Passport’s portfolio managers are learning to look at their stock picks with risk factors in mind. He recalls a day this past fall when the technology portfolio managers decided on their own to reduce some positions because they recognized they had too much exposure to momentum. He almost sounds as if he witnessed a magic trick. “These are fundamental guys,” Garry says. “That isn’t how fundamental investors are trained to think, but they now have that level of sophistication that they can measure how much risk is coming from momentum.”
Of course, it helps that Burbank has assembled a team that, like him, is curious about exploring the intricacies of financial markets. Their newfound approach of combining fundamental, macro and quantitative points of view to understand market prices might just be the beginning. • •