In October 2000, Anthony Faillace, then a senior portfolio manager specializing in international markets for BlackRock, the New Yorkbased fixed-income powerhouse, spied an investment opportunity in Poland. Although inflation had begun to ebb there, the country’s stagnant wages and high unemployment were undermining the government’s efforts to engineer a quick economic turnaround. Faillace believed that the National Bank of Poland would have to lower short-term interest rates, and he wanted to take advantage of a coming rally by investing in two-year Polish zloty interest rate swaps for BlackRock’s Obsidian hedge fund. To his dismay, however, he discovered that he could make only very limited allocations to his firm’s traditional bond portfolios, because by BlackRock’s criteria Poland at the time was neither an emerging nor a developed market and didn’t fit those portfolios’ strict investment guidelines.
“I realized it was not easy for traditional accounts to deal with securities like these,” Faillace says. “I thought, wait a minute -- there is a real barrier here, which means opportunity for a manager who can do whatever it takes to operate in these types of markets.”
Thus was born the idea for a new business. With the help of BlackRock colleague Steven Luttrell -- a friend since their days working for bond guru William Gross at Pacific Investment Management Co. in the mid-1990s -- Faillace began designing a hedge fund that would marry a fundamental view of the global economy with an understanding of markets in which large investors have difficulty maneuvering. The project was a natural for the duo. Faillace and Luttrell had years of experience working at the two biggest fixed-income houses in the world -- Pimco and BlackRock -- and they wanted to create a firm that would be more nimble, flexible and aggressive.
In May 2001, Faillace and Luttrell founded Drake Management with $10 million in venture funding from Hind Corp., a subsidiary of Reykjavík, Icelandbased Kaupthing Bank. The pair spent the next six months building up Drake’s operational infrastructure before launching their flagship Drake Absolute Return Fund on January 2, 2002, with $200 million in committed capital.
Faillace, now 41, is Drake’s chief investment officer; the 40-year-old Luttrell is its chief operating officer. Today they manage $3 billion and oversee a staff of more than 60 at the firm’s posh headquarters on Madison Avenue in New York. During its first full three years, their flagship fund, which now has nearly $2 billion in assets, had an average annualized return of 16.1 percent net of fees, compared with an 8.9 percent return for a diversified index of fixed-income hedge funds compiled by Chicago-based data provider Hedge Fund Research.
From the outset Faillace and Luttrell have had a bold ambition: to build a successful hedge fund operation that would serve as the foundation for an even bigger traditional asset management business. Unlike many of their hedge fund peers, they don’t harbor any bias against active long-only investment management. In fact, having witnessed firsthand Gross’s remarkable trajectory at Pimco, they see long-only investing as vital to their ultimate success.
Pension funds, insurance companies and other institutional investors use long-only fixed-income investments as a bulwark against bad economic tidings, as well as to more precisely match their liabilities. Bonds are among the largest allocations in these investors’ portfolios; hedge funds are typically among the smallest. Faillace and Luttrell decided that to succeed in breaking their former employers’ stranglehold on the institutional marketplace, they would need to start with a suite of hedge funds and then expand into long-only mutual funds and managed accounts.
“They’re really aiming to combine the best of both worlds,” says Leo Tilman, chief institutional strategist for Bear, Stearns & Co. and a former senior risk adviser at BlackRock who has known Faillace and Luttrell since they all worked together at that firm.
Although Drake’s assets under management are dwarfed by Pimco’s $493 billion and BlackRock’s $414 billion, the founding partners have spared no expense to meet the exacting standards of the broad institutional marketplace. Just about every aspect of their firm’s infrastructure, from its proprietary information technology platform (built by a team of former BlackRock IT specialists) to its robust risk management system, was informed by their previous stints.
“These guys were exposed to two ends of the spectrum of investment tools at BlackRock and Pimco -- one being relative value and the other, a macroeconomic style of investing,” says Tilman. “They’re looking to supplement that knowledge with sophisticated risk management processes and technology. This is how they plan to compete.”
The biggest challenge Drake now faces is to extend its reach into traditional asset management without diluting its hedge fund returns. Drake launched its first mutual funds in December 2004. Since then short-term interest rates have continued to rise, the yield curve has flattened, and the dollar has strengthened despite the growing U.S. current-account deficit, which now stands at 6.4 percent of gross domestic product.
Those market headwinds have made profits elusive for many fixed-income investors, including Drake. Faillace, whose bearish views on interest rates and the dollar are at odds with the more sanguine outlook of his former boss at Pimco, got caught off guard in April as a flurry of bad news about March employment, new home starts, retail sales and durable goods orders sparked an unexpected rally in the fixed-income markets. Faillace had anticipated the opposite, and Drake’s flagship fund dropped 4.6 percent that month, its second-worst performance since inception. The fund was down through August; only a 4.3 percent return in September enabled it to get back into the black. It was up 1.5 percent for the first ten months of 2005.
Faillace remains undaunted by his recent difficulties. “Even strong investors will have tough years,” he says.
THE FIXED-INCOME MARKET IS DOMINATED BY three behemoths: Pimco, BlackRock and Western Asset Management Co. Together they manage more than $1.1 trillion. Opening a hedge fund takes skill, but starting a traditional fixed-income asset management firm requires chutzpah.
Clearly, the powers that be at BlackRock saw it that way when Faillace and Luttrell told them in May 2001 that they were leaving to start their own firm. In the weeks that followed, Luttrell says, BlackRock tried to get the pair to sign a stringent separation agreement, but they refused. In October 2001, BlackRock filed a lawsuit accusing Faillace and Luttrell of violating the nonsolicitation provisions in their employment contracts by discussing their business plan with prospective clients, some of whom were investors in BlackRock’s Obsidian Fund.
Faillace and Luttrell countered that they had done no damage to BlackRock’s business because Obsidian was closed to new investment. They fought the lawsuit for more than two years before finally settling with BlackRock in early 2004. The terms of the settlement were never disclosed. (BlackRock declined to comment for this article.)
“The ironic thing is that if Anthony and I had gone together as a team to an established firm, the reaction probably would have been more rational and tempered,” says Luttrell. “But the notion that two individuals -- who had worked together for arch-rival Pimco -- were now going to leave BlackRock because they thought they could do a better job on their own was really viewed as a personal affront.”
Faillace and Luttrell make an unlikely pair. Faillace is lean, dark-haired and detached, with a voice that drops to a bass rumble as he expounds the grim reality of the current-account deficit. Luttrell is compact, sandy-haired and sociable.
Both began their careers in New York. Luttrell got his start on Wall Street in 1992 as a research analyst at J.P. Morgan Investment Management after earning an undergraduate degree in economics at Boston College. Faillace, who graduated with high honors and a degree in economics from the University of Texas at Austin in 1986, found work as a quantitative analyst in the municipal capital markets group at First Boston Corp. that same year.
Kevin Hennessey, the former co-head of First Boston’s municipal securities division, says he was struck by Faillace’s intelligence. Hennessey assigned the new analyst to his group’s derivatives team, where Faillace helped create structured products. One summer, Hennessey recalls, Faillace came to him and said he had saved enough money to travel for a few months and wanted to go exploring.
“That summer turned out to be nearly three years,” says Hennessey, a Drake investor who serves on the board of directors for its hedge funds and chairs the board for its mutual funds.
Faillace’s travels in Eastern Europe, Russia, China and sub-Saharan Africa sparked his interest in international markets. After earning an MBA from the Kellogg School of Management at Northwestern University in 1994, he joined Pimco. Luttrell signed on the same year but left two years later to pursue an MBA in financial engineering at the Massachusetts Institute of Technology.
As Luttrell was researching his thesis on leveraged fixed-income investing, he met James Hedges IV of Naples, Florida
based hedge fund advisory firm LJH Global Investments. Hedges introduced him to Keith Anderson, chief investment officer at BlackRock. Luttrell joined the firm in September 1998 as a business manager for the Obsidian Fund. The next year Luttrell recruited Faillace.
At BlackRock, Faillace was part of a team that invested more than $3 billion in non-U.S. fixed-income assets for the Obsidian Fund, as well as for managed accounts. His specialty was sussing out unusual opportunities in far-flung corners of the world. He forged a strong connection with Iceland’s biggest bank, Kaupthing Bank, while researching Icelandic inflation-indexed bonds. When Faillace and Luttrell began looking for help with launching Drake, they contacted Kaupthing.
Sigurdur Einarsson, chairman of Kaupthing, liked their ambitious business plan and put up $10 million for a 20 percent equity stake in Drake’s management company through the bank’s Hind subsidiary. “What better than investing in two people who have worked together for the top two bond managers in the business?” he says.
Drake’s founders registered the firm with the Securities and Exchange Commission just a few months after the launch of their first hedge fund. “We knew we wanted to manage mutual funds someday, so we decided to hold ourselves to the SEC’s higher standard of regulation early in our development,” says chief financial officer Stacey Feller, a former hedge fund auditor at Ernst & Young who counted Louis Bacon’s Moore Capital Management as one of her clients.
DRAKE MANAGEMENT WAS NAMED FOR THE Elizabethan explorer Sir Francis Drake, the first Englishman to circumnavigate the globe. Faillace and Luttrell admired a lesser-known fact about Sir Francis: his business acumen. He financed virtually all of his voyages by joint-stock enterprises. He had to make a profit to satisfy his backers.
Faillace and Luttrell have taken a similarly entrepreneurial approach. Guided by Faillace’s top-down, global, macroeconomic view of the markets, Drake’s investment team searches for anomalies and mispriced securities in Treasury, agency, corporate, mortgage and sovereign debt markets around the world -- no structure is too opaque, no market too remote.
The partners designed Drake’s hedge funds to have as broad an investment mandate as possible. They hope to gain their edge -- and derive alpha -- from the market segmentation that Faillace witnessed at BlackRock while trying to settle Polish bonds into clients’ accounts. “These types of securities are cheap not because people are unable to see, for example, that the Polish central bank is likely to cut rates,” he says. “They’re cheap because a whole universe of investors are simply not capable of exploiting the opportunity.”
Faillace and his team try to take advantage of market segmentation by investing in “transitional” markets -- Poland, Hungary, Iceland and South Africa -- that are neither emerging nor fully developed. They also try to exploit the opportunities that result from the differing strategic objectives of major market participants. Pension funds and insurance companies, for example, typically look for securities to match their long-term liabilities, while money market funds are restricted from owning investments with maturities of more than 12 months. Drake has made a practice of investing in securities with one- to three-year maturities.
Some fixed-income investors have fiduciary restrictions that create other segmentation effects. In May, for example, when Standard & Poor’s and Fitch Ratings downgraded General Motors Corp. and Ford Motor Co.'s corporate bonds to non-investment-grade, many pension funds and insurance companies had to dump their holdings in the automakers because their regulatory guidelines preclude junk bonds. Such forced sell-offs create opportunity, Luttrell says, because yields tend to pop when debt is downgraded, even though the risk of default may not have become commensurately larger.
Currently, Drake has $2.7 billion invested across its three hedge funds and $300 million in its two long-only mutual funds and five managed accounts. Although Faillace runs the investment portfolio with a global view of the markets, each fund has a strategic focus. The flagship Drake Absolute Return Fund invests in a range of fixed-income instruments, from emerging-markets bonds to mortgage-backed securities. Drake’s Global Opportunities Fund invests in currencies and international fixed-income securities, as well as in equities. The Drake Low Volatility Fund also has a multistrategy approach but focuses more on short-term securities.
“Hopefully, we’re pretty agnostic about how we make money,” Faillace says. “The important thing for us is to have a diversity of ideas in the portfolio at any given time and to always be alert to new anomalies that we can lean against in the marketplace.”
Exploiting such anomalies requires that portfolio managers have reams of information at their fingertips. Chief risk officer Robert Herin spent more than eight years at Pimco and three years at BlackRock before joining Drake in mid-2002. Over the past three years, he and his crew of 12 software program developers and risk management professionals have developed a suite of proprietary trading, compliance and risk applications called Cygnet, which integrates large quantities of data across Drake’s portfolios. Herin designed Cygnet to allow the firm to screen all trades against the risk and compliance requirements of Drake’s different hedge funds, mutual funds and separate accounts.
“We knew from the outset that we were going to be more than just a hedge fund,” he says. “We began by planning for the future -- standing on the shoulders of Pimco and BlackRock -- and building as much functionality and flexibility into Cygnet as possible.”
Having access to a centralized data repository helps Drake assess risk. Although many hedge funds still use off-the-shelf products (as Drake did in its infancy), those systems are not typically designed to assess the overall liquidity across a group of funds. Cygnet can generate reports of the actual “constrained” capital in every single one of Drake’s strategies -- that is, the capital required to hold positions in the face of a market meltdown. “It gives us insight into the liquidity risk across all of our funds,” says Ben Bresnahan, Drake’s head of operations.
Drake’s hedge funds aim high, but they don’t come cheap. The Absolute Return Fund attempts to deliver 10 percentage points over LIBOR, typically employing ten to 15 times leverage; the Global Opportunities Fund aims for 15 percentage points over LIBOR using just four to six times leverage. Both charge a 2 percent management fee and a 20 percent performance fee. The Low Volatility Fund, which aims to deliver 5 percentage points over LIBOR using three to six times leverage, charges a 1 percent management fee, but the performance fee is the same.
Two of the three funds have beaten their targets. The Absolute Return Fund has had an average annualized return of 12.8 percent net of fees over its lifetime; the Global Opportunities Fund is up an annualized 20.9 percent since its December 2002 launch. Only the Low Volatility Fund has fallen short: It has an average annualized return of 4.8 percent since its August 2004 inception. All three funds reinvest coupon income.
Faillace invests Drake’s two mutual funds using the same global macro mind-set that guides his hedge fund investing. The mutual funds adhere to different regulatory guidelines, hold slightly different positions and are much more conservatively managed. They’re also much less expensive. Drake’s Total Return Fund and Low Duration Fund charge advisory fees of 0.25 percent, which when combined with operating fees and expenses total 0.43 percent. All of Drake’s products are intended for the institutional market. The hedge and mutual funds require a minimum investment of $5 million; separate long-only managed accounts require a minimum of $25 million.
Faillace scoffs at the hedge fund industry’s bias against traditional asset management. From his perspective, running mutual funds and long-only managed accounts mitigates risk to Drake’s business as a whole and helps his firm compete for larger institutional mandates. To date Drake has five strategy-specific managed accounts, but will disclose only one: This April, the firm began managing American Express Bank’s new global inflation-linked bond portfolio (part of the bank’s mutual fund group) for investors in Austria, France, Germany, Hong Kong, Italy and Spain.
“The world is not completely governed by dollars and cents,” Faillace says of his willingness to add traditional mutual funds to the mix. “People are subject to ego, passion and a willingness to try to show the world what they can do. For me, at least, the prospect of competing with my former employers goes well beyond dollars.”
MANY HEDGE FUND MANAGERS BEGAN THEIR careers in the world of mutual funds and managed accounts. Few hedge fund investors expect their managers to return to their roots, as Faillace and Luttrell are doing.
“I’m still wondering if it will work,” says Albert Hsu,
co-founder of fund of hedge funds Anchor Point Capital, who invested with Drake in his former role as U.S. investment officer for $3.7 billion-in-assets Atlantic Philanthropies. “But these guys are really ambitious, and they have been from the outset. My only concern is, does it spread them too thin?”
The question is a familiar one to Drake board member Hennessey. “I get asked about it all the time,” he says. “People want to know whether opening a new set of funds will dilute their focus, but I don’t think it will. As a board member and investor, I pay very close attention to that concern, but I don’t see it as an issue at the moment, in any way.”
A greater issue may be potential conflicts with regard to trade allocations between Drake’s hedge funds and mutual funds -- especially in light of last year’s industrywide scandal over hedge funds’ market-timing trades in mutual funds. Drake has an extensive list of regulatory, client and internal criteria upon which it bases its trade allocations. Operations head Bresnahan and Christopher Appler, Drake’s head of legal and compliance issues, keep close watch over the integrity of the firm’s portfolios. Bresnahan’s group oversees the day-to-day portfolio allocations on Drake’s trading floor. Every week Appler’s team conducts an independent check on allocations, looking for potential problems.
“We worked really hard to create standardized methods to capture allocations for audit purposes, and then created a second, independent team to review them,” says Bresnahan, who worked in custody operations at State Street Bank & Trust Co. for six years before joining Drake’s original team.
Drake’s ambitious plan to build a traditional asset management firm on the back of its hedge fund business will work only if the firm’s returns tempt clients to put money in its mutual funds and managed accounts. Without that support Faillace and Luttrell are unlikely to make much headway against their former compatriots at BlackRock and Pimco.
Betting against the boss
Drake Management’s founders, Anthony Faillace and Steven Luttrell, have drawn inspiration from their former boss, Pacific Investment Management Co. managing director William Gross. That doesn’t mean they agree with his investment strategy.
Throughout much of 2005 several of Drake’s core positions have been premised on the possibility of a market correction because of the burgeoning U.S. current-account deficit, which is the excess of the country’s imports over its exports. Drake has been short U.S. bonds and the dollar, expecting both to fall as the market comes to grips with the deficit. The firm is also betting that the credit curve will steepen. It is long spreads in two- to four-year bonds and short spreads on bonds with maturities of five to ten years.
Drake’s investment strategy pits Faillace and Luttrell against Gross, who declined to be interviewed. Since May, Pimco’s bond guru has aligned his thinking with a thesis put forth in a Deutsche Bank global markets research paper by economists Michael Dooley, David Folkerts-Landau and Peter Garber. They argue that China and other Asian countries are so averse to another economic meltdown like the Thai baht crisis of 1997 that they will continue to finance the U.S. current-account deficit by buying Treasuries.
Faillace is skeptical. “I don’t buy the argument that these countries are going to be content to build reserves indefinitely,” he says.
Faillace also takes issue with Gross on interest rates and the housing market. Unlike Gross, who in October wrote in Pimco’s monthly investment newsletter that the Federal Reserve Board would stop raising interest rates in the wake of hurricanes Katrina and Rita, Faillace made the right call: The Fed boosted the federal funds rate by 25 basis points in both September and November. He says the U.S. economy will continue to grow in the months ahead -- despite high fuel prices and hurricane cleanup costs -- and the Fed will continue to raise rates.
When it comes to housing, Gross is worried that the U.S. market will cool fast and drag the economy down with it. In September, Fed chairman Alan Greenspan noted that last year Americans borrowed $600 billion -- nearly 7 percent of their disposable personal income -- against the growing equity in their homes, most of which they spent. Gross wrote in Pimco’s newsletter that those days are over. He expects the housing market to lose its luster as interest rates rise and mortgages and refinancings become less affordable. Gross expects that the Fed may need to lower rates as soon as mid-2006 to avoid a recession.
Faillace is more optimistic. “If long-term interest rates only rise mildly, the housing market could stabilize for a number of years,” he says, which would help the U.S. economy rebalance. -- L.A.
