The Edge Q4 2015

THE EDGE
October 2015
Q4: Women & Investing
Powered by Edgefolio

The Biology of Trading 3
The Rooster vs. The Hen: Who Delivers The Goods? 5
Co-founding a hedge fund 8
Where next for China? 14
The Most Common Operational Breaches Investors Fail To Spot
During Due Diligence 18
TTHE EDGE 2
s the summer turmoil reminds us of the
fragility of the financial system, we examine
the matter of gender diversity in the markets as
a possible moderating influence. With the
increasing breadth of research undertaken on
how gender affects investment styles, preferred
time horizons and performance, we’ve invited
three guests for this quarter’s publication to
discuss ‘Women & Investing’. They will take on
three perspectives - neuroscientist, industry
researcher and hedge fund co-founder.
As Dr John Coates, neuroscientist and former
Wall Street trader (Goldman Sachs, Deutsche
Bank) explains, it seems that men experience an
enormous "winner's effect" (where winning can
feed on itself to lead to more wins). At a certain
point, they go over the top of this inverted U-
shaped dose response curve and there, any
further increases in testosterone decreases the
returns. However, this is not something that
women experience, who often outperform men
over long-term investing.
So why is it that when Meredith Jones, author
and renowned researcher, prompts you to name
a famous investment manager, there would be
few, if any women, in the first 10, 20 or even 50
names that spring to mind? Read on for the six
factors that lead men and women to different
approaches in investing.
Wonderfully exemplifying the intersection
between research on the benefits of investing
with female investment managers and the
entrepreneurial spirit typified in Silicon Valley
culture is Nadine Terman, co-founder of hedge
fund Solstein Capital. The featured article for
this edition, we discuss at length her approach to
investment and her drive to increase capital
allocation to women-owned and -led investment
firms.
As always, our staple sections see guests
comment on topical market outlook and
operational concerns. BlueBay Asset
Management's Head of Credit Strategy David
Riley outlines key points of note for China in the
upcoming quarter and Laven Partners' CEO
Jerome Lussan notes the most commonly
overlooked due diligence red flags accompanied
by case studies.
From the Editor
Maggie Yang
A
We would like to thank each of our contributors - Nadine Terman,
Meredith Jones, Dr. John Coates, David Riley and Jerome Lussan - as
well as Edgefolio's advisor, Aude Thibaut de Maisieres, and designer,
Michael Worley, for giving so generously of their time. and efforts.
££££
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Dr. John Coates
Meredith Jones
Nadine Terman
BlueBay Asset Management
Laven Partners

The Biology of Trading
N your book, you describe the
“winner effect” as it applies to
traders: an upward spiral of
confidence, fuelled by increasing
levels of testosterone in the body,
which inevitably tips into
overconfidence and pathological risk-
taking, leading to cycles of boom and
bust. Are women susceptible to the
“winner effect” in the same way?
Dr Coates: It should be noted that it
wasn't the win itself that was raising the
testosterone levels of male traders, it had
to be an above-average win. At some
point, they go over the top of this inverted
U-shaped dose response curve and there,
any further increases in testosterone
decreased the returns. It looks like that
doesn't happen to women. The consensus
used to be among psychologists, led by
Amos Tversky, that there is no such thing
as a “hot hand” in sports, that a “winner
effect” is a cognitive illusion, just like
streaks of luck in dice. To me that belief is
a complete denial of our biology. The
“winner effect”, as fuelled by rising
testosterone in the body, has been
robustly tested in animal behaviour and
replicated in sport; and it demonstrates
that winning can feed on itself in
humans because of the physiological
processes in the body. In men, we
found an enormous winner effect. And
none in women, who have only 10-20% of
the testosterone of men. As a result they
don’t tend to expand their risk to the point
of owing up.
Although women on average, for their
long-term stress response, have same
levels of cortisol as men, research
suggests that their stress response is
triggered by slightly different events
and that they may be less hormonally
reactive than men. You yourself
actually advocate that greater numbers
of women among risk-takers in the
financial world would help dampen
volatility in the markets. Do you think
women actually have a competitive
advantage in risk taking?
Dr Coates: The trouble with doing these
kinds of experiments in markets is that it's
hard to get a big enough sample of
women traders, who make up at the most
5% of a trading floor. What we know is
that, in opposition to the belief that women
had lower risk appetites than men, our
research shows no difference in risk
preferences between men and women.
However women show a preference for
longer holding periods, which could
explain their relatively larger numbers in
asset management. It would seem that
men are good in the high-frequency
space, whereas women often outperform
over the long haul.
So how could trading floors increase
gender diversity to benefit from this
different skill set and diversification
effect?
Dr Coates: If women have an advantage
over longer holding periods and men in
high-frequency space, the answer is to
have a trading floor with both men and
women and to encourage longer holding
periods than current reporting periods;
I
R John Coates, Research Fellow, University of Cambridge, researches the
biology of risk taking and stress. He previously traded derivatives for Goldman
Sachs and ran a trading desk for Deutsche Bank. He developed techniques for
valuing and arbitraging the tails of probability distributions, and for trading low
probability events such as financial crises. He is the author of The Hour Between
Dog and Wolf: How Risk Taking Transforms Us, Body and Mind.
THE EDGE 3
by EDGEFOLIO Thursday, 1 October 2015
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NEUROSCIENTIST
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and for compensation schemes and risk
management to allow that. It's a problem
if you have someone who's really good
with a one-year holding period, but
they're judged quarterly. Ideally, the
judging period, would take into account an
entire business cycle. As long-term out-
performers, you would find that the
markets naturally select for more women
portfolio managers and traders without
need for affirmative action.
You left trading and the markets to
pursue research. Do you miss it?
Dr Coates: Yes, I miss the markets. I
continued trading after I left Wall Street
and found out that I was better than I
thought (without the resources of the bank
behind me). I probably did some of the
best trading of my life after I left Wall
Street, but then the science I was doing
just swallowed me. Science is 16 hours a
day, 24/7. I used to put on positions
and then I'd be in a lab meeting and
suddenly recall that I'm long on USD-
YEN - I had just completely forgotten I
had a position on! After the meeting, I'd
run out and check the markets and realise
that I'd had the position on for two weeks.
So I had to stop. But lately the markets
have been so interesting that I have made
time to put on some vol arbs. I am also
involved with wearable technology to
access the biological markers such as
rising cortisol levels (in one experiment,
68% rise across the trading floor over two-
week period significantly affected traders'
risk preferences).
A number of cutting-edge hedge funds
see this human optimisation as the next
thing that will give them an
edge.  
N this startling book, physiologist and
former Wall Street trader John Coates
graphically illustrates what happens to your
body when you place a bet in the financial
markets. He tells a gripping story of a group of
traders caught in a bull market and then a
crash. As the excitement builds he takes us
inside the traders’ bodies to see the biology of
risk taking at work, a biology shared by
athletes, politicians, soldiers – anyone
venturing beyond their safety zone. Coates
then discusses how men and women excel at
different types of risks; the stress of failure;
and how we can train our bodies so that they
help rather than hinder our risk taking.
I
Further reading:
— Coates, J. “From molecule to market: steroid
hormones and financial risk-taking.”
— Coates, J. “Endogenous steroids and financial risk
taking on a London trading floor.”
— Barber, B., and Odean, T. "Boys Will Be Boys:
Gender, Overconfidence, and Common Stock
Investment."
THE EDGE 4NEUROSCIENTIST
Many thanks to Aude for leading this interview.

The Rooster vs. The Hen:
Who Delivers The Goods?
Quick! Name a famous investor!
HAT names came to mind? I bet you
immediately thought of Julian
Robertson. Or George Soros. Or Warren
Buffet. I would be willing to bet that if you
scrolled through the first 10, 20 or even 50
names that sprang to mind, there would be
few, if any women, in your list.
Part of the reason has to do with supply.
The number of women in the financial
industry has been and remains remarkably
low. In private equity and venture capital,
roughly 10% of female executives are
women. In the hedge fund universe, there
is roughly an 80:1 male to female ratio.
Morningstar recently determined that
women comprise less than 2% of the
mutual fund world. Even in the relatively
“popular” female roles like Registered
Investment Advisors and Certified
Financial Planners, the numbers are still
abysmal. Less than 30% of RIAs and less
than 23% of CFPs are women.
In an effort to quantify gender inequality at
the highest ranks of society, in 2015 the
New York Times created a “Glass Ceiling
Index” that examined the ratio of men to
women in high-powered positions. They
discovered that there are four CEOs
named John, James, William or Robert to
every one female CEO. There are 2.17
Senate Republicans with those monikers
for every one female Senator. There are
1.12 men of those names for every one
female economics professor. But if you
think those numbers are low, they aren’t
anything compared to the ratio of John-
James-William-Roberts to female fund
managers. My research shows there are 11
male hedge fund managers with those
names for every one female hedge fund
manager. This lack of women is not just
unsettling, it could be decreasing returns
and increasing market volatility. As the old
saying goes, “the rooster may crow, but the
hen delivers the goods,” and new research
is showing that wisdom may also apply to
investment returns.
My 2012 & 2013 research for Rothstein
Kass showed that women-run hedge funds
and private equity funds outperformed
the hedge universe at large by a margin of
six percentage points over six-and-a-half
years. A 2015 study by Kyria Capital
highlighted that women-run hedge funds
are more likely to produce top-quartile
performance. Although a June 2015
Morningstar study was less conclusive, it
did reveal a slight edge for mixed gender
teams. However, by examining the entire
(and growing) body of performance
research on female retail and professional
investors, it is easy to see a consistent and
compelling trend towards outperformance
by female money managers.
And while it’s tempting to write off these
statistics with arguments of “best and
EREDITH Jones is an alternative
investment consultant and the author
of The Women on the Street: Why Female
Money Managers Generate Higher Returns
and How You Can Too. She created the first
Women In Alternative Investments Hedge
Fund Index at the professional services firm
Rothstein Kass. She writes a weekly
alternative investment blog here.
M
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THE EDGE 5INDUSTRY RESEARCHER
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brightest bias,” I urge investors to take a
closer look at the data. Yes, the women that
have attained portfolio manager roles have
had to run a significant Wall Street
gauntlet, one which some would argue
weeded out any weak performers and left
only the strongest female portfolio
managers standing. However, the literature
on outperformance goes beyond the
relatively small sample of professional
money managers to explore the female
retail investor mindset. In that research,
which has been conducted on thousands
and thousands of men and women
investors, we see similar behaviours and
similar outperformance. It seems highly
unlikely that women retail investors would
have investment characteristics and
performance that wouldn’t be present, and
perhaps amplified, in female professional
investors.
At the very least, research shows that
women and men approach investing
differently. While researching my book
“Women of The Street: Why Female
Money Managers Generate Higher
Returns (And How You Can Too)” I
determined that the following factors led
men and women to different approaches to
investing:
Biology – Even though women
are often stereotyped as “more
emotional” when it comes to
investing, that may not be the case.
Brain structure and hormones impact
how men and women interact with
the markets, and can influence
everything from probability
weighting to risk-taking to market
bubbles.
Overconfidence – There have
been a number of studies that
show men have a higher tendency to
be overconfident investors.
Overconfidence can manifest in a
myriad of poor investment practices,
including over-concentration in a
single stock, not taking money off the
table, riding a stock too far down (“It
will come back to me”) and
overtrading.
Better trading hygiene – One
very crucial side effect of
overconfidence is overtrading.
Overconfident investors tend to act
(buy or sell) on more of their ideas,
which can lead to overtrading. Over
time, overtrading can significantly
erode investment performance.
Differentiated approach to risk –
Although women are often
stereotyped as being more “risk
adverse,” the truth of the matter is a
bit more nuanced. Men and women
weigh probabilities differently, with
women generally having a flatter
probability weighting scale. This
means they tend to not to inflate
expected gains as much as their male
counterparts, which can be beneficial
in risk management and in minimising
overall market bubbles.
Avoiding the herd – Women
may be more likely to look at
under-followed companies, sectors,
geographies or deal flow in order to
obtain an investment edge.
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Maintaining conviction – Female
investors may be better at
differentiating market noise from bad
investments. Women tend to be less
likely to sell underperforming
investments simply because of broad
market declines.
I think most investors will agree that
behaviour impacts investment
performance. Billionaire Seth Klarman
once said that “Investing is the intersection
of economics and psychology,” and it seems
increasingly undeniable that that
statement is true. Whether it’s the
behaviour of the individual investor, the
investment advisor with whom they work,
the money managers to whom they
allocate or even the broad market, macro-
economic behaviour (like the “January
effect” or market bubbles such as the tech
wreck).
Even the market turbulence in late August
can, in some ways, be blamed on behaviour.
While some would blame the sell-off on a
single source (China), others argue that the
accumulation of bad news caused under-
reaction (as news started to trickle in in
July) followed by overreaction as the flood
of bad news (oil prices, China, etc.)
continued to come. You simply can’t
escape the fact that behaviour matters
when it comes to investing.
Let’s think of it this way: There are a
growing number of studies that show that
cortisol, the stress hormone, and
testosterone interact in interesting ways
when it comes to investing. One study that
I highlighted in my book looked at men and
women’s trading behaviour as cortisol
levels rose. They put the subjects’ hands in
ice water to simulate stress and increase
cortisol levels. The study showed that men,
as cortisol levels increased, had a tendency
to make riskier trades. Women did not
have a similar reaction. So during a
stressful event such as a market sell-off, an
all-male investment management team has
their hand in the same bucket of ice water.
They may increase their risk-taking,
creating correlated behaviour among
money managers. And we all know
correlation is not our friend during market
sell-offs.
So my question is this: If we diversify
portfolios by geography, liquidity, number
of investments, asset classes and other
factors, why don’t we also consider
diversification from a behavioural and
gender point of view?  
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Women of the Street: Why Female Money Managers Generate Higher
Returns
OMEN of The Street looks at behavioural and biological
investment research to explore how women think about investing,
and to determine why women may have a money management edge. The
book then identifies and interviews 11 top female “market wizards” in
hedge funds, private equity, venture capital, and other asset classes to
see how women’s innate investing characteristics translate in different
strategies and markets into significant profits. From less overconfidence,
overtrading, and testosterone to a greater tolerance for market noise
and more consistent application of investment strategy, there are a
number reasons why women approach investing in a unique way. Women
create both cognitive and behavioural "alpha" with their investment
style, which contributes over the long-run to outsized investment
returns.
W

Co-founding a hedge fund
N 2010, Ms. Terman co-founded
Solstein Capital, LLC with J.C. Torres. At
Solstein, she oversees investments and
operations of the fundamental value, global
manager. Previously, she was a Partner
with Blum Capital Partners and served on
its Investment Committee. Nadine has a
B.A. with Honors and with Distinction from
Stanford University and was recognised
with the Firestone Medal for Excellence in
Research and as Phi Beta Kappa. In
addition, she earned an M.B.A from the
Stanford Graduate School of Business,
where she was an Arjay Miller Scholar.
One of Nadine's key personal initiatives is
to increase the capital allocation to female
fund managers. In 2013, along with
another San Francisco manager, she
created a fully sponsored conference for
the group 100 Women in Hedge Funds that
joins leading asset allocators with woman-
owned or -managed hedge funds. Starting
in San Francisco, this conference is poised
to expand to the East Coast and to Europe.
In 2015, she was named as one of
Institutional Investor's Hedge Fund Rising
Stars.
HI£
Nadine Terman
Solstein Capital
CEO, Co-founder and Managing Member
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INTERVIEW
THE EDGE 8HEDGE FUND CO-FOUNDER
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Click here to visit Solstein's webpage

In line with the theme for the
publication, do you agree with
Meredith Jones (above) that women
create both cognitive and
behavioural “alpha” with their
investment style, contributing to
outsized investment returns in the
long run? Do you feel your gender
has given you an edge in investing?
UR style at Solstein is much more
opportunistic in long-term, high-
conviction investments. When I consider
gender on the investment side, I first think
about it in broader terms of diversity
research (whether at Stanford or other
major institutions), which shows there's
significant, identifiable benefits to diverse
teams – to name a few, it improves
decision-making, breaks up groupthink and
improves effectiveness. At our firm, the key
aspect of our edge is a team-based
approach, so having diversity through
gender (myself and Sandra), nationality
(across the board in our team), professional
experience or other areas definitely
contributes an edge. So I wouldn't say it's
only the woman aspect to it, but diversity
across the board. As an example of how the
advantages of diversity are highlighted in
our investments, when we're performing
due diligence and we want to access key
individuals within an industry ecosystem,
it should be obvious to anyone that you
want your collective network to be as
broad as possible in order to find and
access those key individuals who are going
to help you with due diligence. So rather
than considering whether has gender
helped me, I think about how diversity as a
whole has helped our team.
In relation to Meredith’s research, I'd say
that our investment style of high-
conviction, long-term investing is very in
line with the behaviours that have been
analysed in women investors. From her and
others’ research, women trade positions
less – all else equal, men traded stocks
nearly 45% more often than women and
therefore, their net returns were reduced
by almost a full percentage point compared
to women. At our firm, our turnover
statistic has been around two years,
clearly exemplifying the characteristics and
benefits of female investing.
The second characteristic was that in
periods of major market downturns,
women tend to act differently – they
maintain their convictions and can benefit
from holding positions out of the
downturn. When I look at our strategy,
whether it's because I'm a woman or just
it's the way we invest, we actually like
periods of confusion and dislocation as
providing attractive entry points so we can
find businesses on sale. Then, we monitor
positions and perform due diligence to
ensure the return drivers are coming to
fruition. So again, that's a behaviour
aligned to the universe of research on
female investment behaviours.
Another characteristic that, again, we
exemplify particularly well at Solstein, is
how gender relates to level of confidence
and how women relate to risk-assessing
and risk-taking – how you view risk and,
when you're acting, how you take risk. At
Solstein, from the type of businesses we
target, to the management teams we back,
to the securities we own, we're actually
looking to minimise mistakes – not that
anybody else isn't – but it forms a very
specific focus in our investment process. To
this end, our team has managed losses in
dollar numbers fairly well by maintaining
that focus on that capital preservation.
This strategy enables the rest of our
portfolio to compound over time much
more easily.
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If you don't lose a lot and don't lose very
often, when you do win, it's going to impact
the portfolio more.
So it's several elements, when I was looking
at Meredith's and others’ research, that we
are data point supportive of their research
of the impact of gender on investing.
Hedge Funds are definitely very
entrepreneurial in nature – what
prompted you to co-found one?
OU know, when I saw the question I
laughed because living in Silicon
Valley, it doesn't seem very heroic or
unique to start your own business. But at
the same time, it's probably not as daunting
either. Starting our firm was a destiny in
many ways. Our founding team, we'd
worked together for so many years at a
well-known activist firm before launching
our own fund in August 2011. Throughout
all the years working together, we shared a
set of personal and professional values that
became the foundation of our firm. Most
notably, our team-based approach across
investments and operations is key to
Solstein’s identity and strong foundation.
Also, we designed the firm with the intent
of alignment and longevity. Building an
investment firm requires alignment across
many elements-- culture, capital base,
investment philosophy, incentives,
processes—just to name a few. We were
mindful in how we designed Solstein and
sought to build a firm that would be aligned
with and invested in our clients’ long term
financial success, across these various
elements.
Being based in Silicon Valley, was
the building of your company
culture very deliberate and very
much influenced by the start-up and
tech world?
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N some ways yes, and in some ways,
no. We don't have free food, no one
does our laundry (laughs), and some of the
perks you might get at Google and Uber,
we don't have. But I would say that
entrepreneurial aspect of it is definitely
ingrained in our culture –I think since day
one, everyone's always been ready to pitch
in and help. That's representative of that
startup-type culture that you need to have
when you're building a tech company, or
any type of company.
It was definitely a conscious choice when
we built the culture at Solstein. We had a
long history of working together, but
something we did quite deliberate is that
my co-founder and I went out and
interviewed various investment managers
that we thought really highly of and asked
them to look back 20, 30, 40 years ago, as
they built had built their firm. What were
the challenges that they faced and why,
what might they have done differently,
what were the things that they did well or
think that they do well now, what kind of
advice would they give a new manager? So
for ten months before we launched our
fund, we actually used a blank slate and
worked to design culture and processes. I’d
say the diverse nature of our team was not
a conscious decision – we were picking the
best for the positions. But I think when you
have an open mind, it naturally leads to a
diverse group of people.
With regards your experiences
in the United States investment
industry, do you feel there is still a
significant promotion gap between
top male and female investment
managers?
think there's an entire lifecycle gap, not
even with the promotion, but with the
whole lifecycle – from the number of
women entering the business, to being
promoted, to leading and managing the
business, to starting their own firms, to
raising capital. Meredith [Jones] quotes a
roughly 80-1 ratio in hedge funds, so I
really think you have to look at the entire
professional lifecycle to understand why
that is the case. I prefer to think about
change and what can be and how I play a
role in that future.
It starts with capital allocation. Linking
fund managers to capital allocators is one
example where I think I can make a
difference specifically. If you can get
money to women, more women will start
funds, hire diverse teams. I believe change
can occur faster through capital allocation
than at the start of the pipeline. Let’s
create more firms who are open to
developing diverse teams.
At the end of the day, investing
continues to be a very data-
driven process. As a long-term,
value-oriented investor, how has
data played a role in your investment
processes?
N many respects, we’re playing a
different end game than most other
investors – our edge doesn’t come from
paying for satellite data to get images of
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parking lots so we can count cars outside a
retailer to get an edge on next quarter’s
results. We're trying to understand and
capitalise on multi-year trends within an
ecosystem. Therefore, we collect and use
data in a much different way than other
investors in the marketplace. At Solstein,
when we identify a potential investment,
we also identify a very specific due
diligence process over the short, medium
and long term. Then the team performs
immersive due diligence across the lifespan
of the investment in order to confirm or
disprove the investment thesis. Of course,
our team’s initiatives often include data
collection and interpretation. So there's a
bit of an art and science when it comes to
collection and interpretation, given the
element of time.
Allocators don't want the same names
across their managers’ portfolios, so even
if you have good returns and you manage
risk appropriately according to your stated
targets, you have to be bringing something
different to the table. So it’s the
independent collection and interpretation
of data that lets us reach that
differentiated view as a team and create a
differentiated concentrated portfolio.
With your focus on
predominantly developing and
select emerging markets, your eye
must be on China. Where do you see
the fundamental drivers?
EGARDING China, obviously it’s a big
question. Our take for the long-term
is that, as has been the case with other
major economies of the world, the path to
increased economic development in China
is going to be dynamic. So the US, for
example, went through periods of great
expansion and contraction, but over the
course of time, it's been a wonderful source
of opportunity. So rather than trying to
forecast short-term market swings in
China, we focus on long-term, secular
trends and how they affect businesses at
their fundamental level.
China plays a key role on both the supply
and demand sides of the equation for a
whole host of businesses around the world,
regardless of local stock market gyrations.
So we think about China as it relates to
these businesses, but we also consider the
effect of Chinese political influence on
security prices, which may present a short
run volatility challenge. To put it in
perspective, when there's that choppiness,
we don't really need to call a bottom, we
just need to understand the long-term
drivers more and then understand where
an attractive entry price is.
What key markets will you be
focusing on over the next
quarter?
HE team is highly focused on building
an investment in Spain with specific
value drivers that are identifiable and – if I
can make up a word – “due diligenceable”.
Our targeted business has strong cash
flows, long term contracts, an experienced
management team, and multiple ways to
increase value for shareholders that are
not dependent on the economy. That said,
Spain’s economy has been improving,
which can be seen in various published
data points. Continued improvement
would act as a free call option for our
investment. Also, the business underlying
our investment should be unaffected by
regulation or the upcoming elections, from
a risk perspective, which we care deeply
about.
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We also have six businesses on deck at the
moment, headquartered in Europe, Asia
and Latin America. They span very
different industries, including ﬁnancial
services, healthcare services, telecom
infrastructure and media, and our priority
pipeline is now focused on that list, but it
does change every few weeks as we
complete due diligence. Our goal is to be
prepared so the incremental work we have
to do on an investment before execution is
quite small. We're trying to be very ahead
of the curve while doing work on a few
things so that we're ready if a dislocation
arises.
Finally, what do you believe has
been the most challenging part of
your career and what advice would
you have given yourself 10 years
ago?
HERE were different challenges at
different stages, so perhaps the key
challenge is actually to embrace that fact.
Especially as an entrepreneur and an
investor in the public markets, you can't
expect to be in control of your destiny each
day. So it's about having the right mindset
and being prepared for those unexpected
challenges that change over time.
Looking back 10 years ago, I would advise
myself that just because you haven't seen
many others like you forge your intended
path, it doesn't mean it's overly difﬁcult to
do. My husband and I try to instil the same
message with our three children. Not
seeing a long list of other trailblazers
before you shouldn’t delay you or stop you
from forging ahead. 
8
T

Where next for China?
With the impact of developments in
China having global ramifications, how
can investors position themselves to
avoid the fallout?
Key points
China’s surprise currency
devaluation and manufacturing
downturn was the catalyst for the
sell-off across global financial
markets to become a key source of
global macro and market instability
Chill deflationary winds from
China and decreasing commodity
prices are intensifying and will keep
global inflation and interest rates
lower for longer
Click here to visit BlueBay's
webpage
OUNDED in 2001, BlueBay
Asset Management LLP
provides investment management
services primarily to institutions
and manages a combination of long-
only and alternative strategies
across the sub-asset classes of
investment grade corporate debt,
convertible bonds, high yield debt,
distressed debt, loans and emerging
market debt. BlueBay also manages
a number of segregated mandates
on behalf of large institutional
clients globally. Based in London
with offices in the USA, Japan, Hong
Kong, Switzerland and Luxembourg,
BlueBay Asset Management LLP is
one of the largest independent
managers of fixed income debt
funds and strategies in Europe with
over US$61.1 billion of assets under
management (as at 30 June 2015).
BlueBay's overall aim is to provide a
broad range of credit products to
modern institutional investors
which offer attractive risk-adjusted
returns.
1
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F
THE EDGE 14MARKET OUTLOOK: CHINA

Fears of a China-led global
economic slowdown prompted
the US Federal Reserve to delay its
first rate rise in almost decade,
further adding to recent market
volatility
In our opinion, markets’ have
become too pessimistic on the
outlook for global growth and the
correction and volatility in asset
prices has broadened the opportunity
set for active investors
Pressures are mounting on Chinese policy
makers
ROM China’s perspective, the
potential for mistakes as policy
makers seek to rebalance the economy to a
‘new normal’ i.e. one less reliant on credit-
intensive heavy industries while sustaining
growth and employment, are rising. If
monetary policy is too tight, it could
precipitate a hard landing. However, much
easier credit conditions could prompt a
further unsustainable debt splurge and
increase risks to financial stability. The flow
of weaker-than-expected indicators of
activity and the boom and bust in Chinese
equity markets underline the challenges
facing Beijing.
China’s shift towards a more flexible
exchange rate regime is a significant policy
change motivated by the weaknesses of
the Chinese economy, as well as being a
necessary reform for the International
Monetary Fund to confer global reserve
currency status on the renminbi. China has
now become an aggressive participant in
the global “currency war” and is no longer
an innocent bystander.
Concerns over China are also exacerbated
by weaknesses in the official data and
arguably a more accurate picture of the
current state of the economy is derived
from tracking other measures, such as
purchasing managers’ surveys, trade data
and rail traffic volumes. These indicators
suggest the economy did slow in the first
half of the year even though the official
GDP statistics suggest growth was stable
at 7%. Weaknesses in China’s economic
statistics and opaque policy-making means
China will remain a source of global macro
uncertainty and market volatility.
Moreover, the Chinese government’s
response to the recent equity market
volatility and the unexpected shift in the
exchange rate regime has shaken
confidence in the ability of Beijing to
effectively manage the necessary re-
balancing of the economy and avoid a more
severe ‘hard landing’. Nonetheless, there is
scope for further policy stimulus – real
interest rates remain high in China despite
recent cuts and easing of liquidity
conditions – and the government’s balance
sheet is strong, including some US$3.7
trillion of foreign exchange reserves.
China’s debt problem is domestic and
funded by domestic savings and
consequently the risk of a financial crash is
greatly diminished.
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Moreover, employment and household
incomes remain robust and the consumer
and service sectors that are not accurately
reflected in the official statistics are
expanding even as the state-dominated
heavy industry sector stagnates. Managing
the re-balancing of the economy between
the two, including restructuring of the
banking sector and financial sector
reforms, is the key challenge facing the
authorities. But we do believe that markets
have incorrectly extrapolated recent falls
in the oil price and the stock market bubble
bursting as well as weak industry data to
indicate an economic crash rather than an
economy that we think is still growing at
around 5% and will likely stabilise at this
level.
As the world’s second-largest economy
(and largest trading nation), the
deflationary forces in the Chinese
economy are being felt around the world.
China consumes more than 40% of the
world’s production of iron, steel, copper
and coal as well as being a significant
importer of ‘soft’ commodities such as rice
and wheat. But China only consumes about
10% of world oil production and the
decline in oil prices primarily reflects
excess global supply rather than a sharp
drop in Chinese demand.
Key challenges for investors
The recent fall in commodity prices, the
Chinese equity market crash and mini-
devaluation of the renminbi sparked fears
of an imminent China-led global economic
downturn and led to significant volatility
across global markets. In our opinion, the
Chinese and global economy is fragile but

not on the brink of a deflationary
downturn.
Emerging market assets have been
buffeted by a perfect storm of China-led
global growth fears, falling commodity
prices and the prospect of a Fed interest
rate hike. In our view, these risks to
emerging markets are fully-priced at
current valuations and if, as we believe, the
Chinese and global economy will avoid a
hard-landing, valuations offer attractive
entry points for investors.
Lower commodity prices and China
manufacturing prices imply that global
inflation and interest rates will stay lower
for longer, complicating the Fed’s planned
‘lift-off’ from near-zero interest rates
demonstrated by its decision not to raise
interest rates at its meeting in September.
Even if the Fed raise interest rates later
this year, the impact will likely be
cushioned by the Fed clearly signalling an
even more gradual path for subsequent
interest rate increases. In Europe and
Japan, further policy easing to offset the
deflationary pressures is likely in our
opinion.
Divergent and complex global cross-
currents imply greater cross-asset market
volatility and dispersion that present
opportunities as well as risks for investors.
Exploiting volatility in currency and
interest rate markets as well as the greater
dispersion in returns within asset classes
such as corporate credit offer a much
broader opportunity set for globally active
investors than has been the case in recent
years.
Investors should remain focused on capital
preservation and active management of
the investment risks they face, but also be
ready to exploit the opportunities and
rewards that increased volatility will
present. 
David Riley
Head of Credit Strategy
David assesses the implications for fixed-
income and credit asset classes of market,
economic and political developments. He
is also a member of BlueBay's investment
and asset allocation committees
reporting to the co-CIOs. Prior to joining
BlueBay, David led the global Sovereign &
Supranational rating team at Fitch and
was its most high-profile senior analyst.
During his tenure as Head of the team,
the sovereign and supranational rating
coverage grew significantly and the
ratings were recognised in major
benchmark indices and investment
mandates, firmly establishing Fitch as a
leading provider of sovereign rating
opinion and research.
As an economic policy advisor in the
International Finance Directorate of HM
Treasury and the UK Export Credit
Guarantee Department, David was
involved in sovereign debt restructuring
negotiations at the Paris Club of Official
Creditors, as well as providing advice and
briefing to Ministers on G7 and IMF
policy issues.
£££££££HI££
££HI££

The Most Common
Operational Breaches
Investors Fail To Spot
During Due Diligence
ITH constantly evolving regulations,
changing tax laws and growing best
practice standards, operational due
diligence has never been so relevant and
hard to do. It is burdensome, operationally
heavy, expensive to staff properly, yet
crucial to get right.
Anyone hoping to achieve
reliable operational due diligence (ODD) in
a cost efficient manner faces a big
challenge. A proper ODD requires
expertise in global regulations, compliance
and fiscal reporting, as well as operational
systems and controls but also specific risk
management know-how over a wide range
of areas.
Negligent practices or short-cuts may
result in financial loss or reputational harm.
The cost of getting it wrong is inestimable.
For this article, therefore, we have
aggregated some of the most common
ODD mistakes picked up from the
thousands of ODDs we have performed
over the last decade, as well as selected top
breaches that should always be spotted
(illustrated with examples).
Weak or poor corporate governance
Prominent examples of where governance
is poor and decisions are made in an
informal and unprofessional manner,
usually linked to a strong overall control
arranged around one key personality or
Jérôme de Lavenère Lussan
CEO, Laven group
érôme de Lavenère Lussan is the CEO
and founder of Laven. His background
includes acting as a COO of a hedge
fund and as a financial lawyer at Jones
Day. Jérôme has a broad degree of
expertise in the hedge fund and fund
management industry and is an advisor to
many international financial services
firms specialising in regulatory, legal,
operational and risk matters. He is a
member of the Law Society of England
and Wales, the International Tax Planning
Association and of the CFA Society of the
UK. Jérôme holds an LLB from University
of Edinburgh. In 2010 and 2011, Jérôme
was named by Financial News as one of its
100 Rising Stars, and in 2011 and 2012
one of its 40 under 40 Rising Stars in
Hedge Funds. He is the author of the FT
Guide to Investing in Funds, published in
June 2012.
J
W
THE EDGE 18DUE DILIGENCE RED FLAGS
£££HI£
£££HI£

related family ties include Stanford
Financial Group, Weavering Capital and
Bernard L. Madoff Investment Securities.
This form of governance is conducive to
persons being conflicted and could reduce
independence. This could hurt investors’
best interests. The lack of an established
process to support the functioning of a
proper board of directors for example is a
clear concern. The opposite should help
directors provide independent oversight.
As a ‘factorial’ check point we find that the
absence of minutes or even notes of
meetings is a good indicator of a poor
process, which should lead to further
verification, e.g. if minutes are even signed,
or which points are followed up at
subsequent board meetings.
Lack of restrictions on leverage or
borrowing
The use of high amounts of leverage in the
case of Long Term Capital Management led
to a large loss, due to the Asian and Russian
financial crises. As a result the fund later
needed to be rescued by the US Federal
Reserve which in conjunction with other
banks injected $3.6 billion. It is obvious
that if there are no limits on leverage or
borrowing in any legal documentation such
as a prospectus, then the risk is higher for
investors. This was also the case for
Peloton Partners LLP. Although there are
no laws breached we suggest that this is
treated as below best practice. Short of
doing investment due diligence and stress
testing various portfolio exposures, which
is even harder to do usually because of
limited access to data, the next best thing is
to look for the absence of controls. If there
is nothing specified between the investors
and the fund, then the investor has no
recourse. In conjunction with a review of
the internal risk management culture that
pertains to the controls of any leverage
levels, one can start forming a pretty
precise picture. Today a fund that wishes to
abide by new AIFMD European rules must
justify a level of leverage, which should
make life better for investors.
Click here to visit Laven Partners
stablished in 2005, Laven is a global
integrated consultancy servicing
the financial industry, with offices in
London, Luxembourg, Geneva,
Singapore, New York and Barbados.
Laven’s vision is to empower banks,
brokers and managers by offering robust
regulatory solutions that improve their
operational processes and structures.
Laven’s expertise, experience and
perspectives are driven to sustain that
vision. Delivering solutions in Global
Regulatory Compliance, Operational
and Investment Due Diligence and
Operations Consulting such as Risk and
Strategic Product Advisory, Laven
positively impacts the success, strength
and reputation of its clients.
E

Lack of independence of service providers
The appointment of independent service
providers is deemed to reflect an
engagement by the manager to be
objective when dealing with the affairs of
the fund. The opposite is a concern.
Presently this is rare as there is either a
new regulatory framework that demands
it, or a strong investor preference for it.
Nonetheless it is still valid to check this
through ODD and make sure the
appointment is supported by a contract. If
the fund’s administrator is not an
independent entity, this poses a risk
including inaccurate NAV calculations, as
the manager would have influence and a
clear conflict of interest. The more illiquid
the investments, the more this is likely to
be a risk. Examples of investors being
misled by managers include, Stanford
Financial Group and Market Neutral
Trading LLC. Both used unheard of auditors
to falsely verify their exaggerated financial
performance, with Stanford bribing a small
audit firm, C.A.S. Hewlett in Antigua, and
James Murray of MNT, even going as far as
creating the fictitious firm Jones, Moore &
Associates. Requesting to review the
service providers’ agreements, verifying
the information by sending questionnaires
to the appointed auditor, administrator and
other parties, are compulsory steps for a
proper ODD process.
Low or no insurance coverage
Sufficient insurance coverage is important
as it could protect investors in the case of a
claim which the manager may not be able
to pay for. There are no clear standards on
this, and cynics may point out that few
claims were paid out by insurers.
Nonetheless the absence of insurance
again is evidence of a disregard of the
potential benefit to investors. Further
Laven believes that it is sufficiently
affordable that both Professional
Indemnity and Directors & Officers
insurance should be in place. Coverage
amounts according to best practice
standards should represent a minimum of
1% of the assets under management.
Insurance can make up for certain losses. In
the mid 90’s, AT&T Pension Fund was left
with costs of $150 million due to rogue
trading by the asset management firm.
Those costs could have been covered had
the manager, Rhumb-Line Advisers, had a
reasonable policy in place.
Lack of separation of responsibilities
between front and back office
In 1994, Barings Trust lost millions through
trading activities because there was no or
little segregation between front and back

office activities. The trader, Mr Leeson, did
not just hold a manager position on the
trading floor, but was also in charge of
settlement operations which meant he was
able to book fraudulent trades. Due to the
lack of separation between the front office
and the back office, his activities went
undetected until a massive loss was
realised. Investors can protect themselves
from such cases by gathering information
on the segregation of duties and verifying
that during the on-site visit with the
manager. Evidence of strong processes
reflect a better risk management culture.
Lack of effective Risk Management
A manager should have an independent
risk function in order to make credible
decisions to limit risks on investments. If
this is not independent from the front
office, there will be a conflict of interest,
which can prevent the risk function from
performing its duties and may lead to
potentially greater losses. Some traditional
managers prefer to talk of risk as being
part of the controls and know-how of the
front office, but even if this is true it does
not replace the role of an independent risk
management function. This has been
embedded in the regulatory framework in
Europe now, but should be checked from
an ODD perspective everywhere. The lack
of such a control has led to losses in recent
cases where some hedge funds were
caught out by the Swiss move early in
2015. The absence of independent risk
management was also a factor in
Weavering Capital. Evidence that this
control is in place not just by name but also
as evidenced through minutes and other
verifiable tools is essential to the well-
being of investors. Whether the same
applies in a more illiquid context such as
private equity funds is a moot point, but
some independence has never hurt an
investor.
Poor application of Anti Money
Laundering (AML) checks
It is a requirement for managers to carry
out AML checks on their clients. Two things
can be caught through ODD that reveal a
weak risk management understanding.
Either the manager does no AML as the
administrator of the fund is paid to do it, or
the manager does all the AML checks on
investors. In both cases this is wrong. If the
administrator does all the checks on
investors in the fund, this does not alleviate
the manager from doing AML checks on
the fund (a separate entity which it must
treat as a client) or indeed any managed
account clients. This may never lead to a
prosecution but it is nonetheless a mistake
in a field that includes criminal liability. The
second point relates to this criminal
liability, the more the manager does AML
checks the more it starts incurring liability
on investors being wrongly assessed when
it could have left this to the administrator.
These are complex legal technicalities, but
ones which a professional in financial
services should understand. While Ponzi
schemes such as Black Diamond Capital
Solutions have revealed that sometimes
managers seek to participate in money
laundering, any weakness on this subject is
perilous and another factor that there
could be inappropriate behaviour taking
place.

Lack of thorough background checks on
key individuals
Between 1997 and 2002, investors of
Bayou Hedge Fund Group were defrauded
as funds were misappropriated for
personal use. A simple background check
would have revealed that the CEO, Samuel
Israel, had lied to investors about his
previous work experience and had a
criminal record. This would have given
reasons enough to avoid his management
company. Similarly, a simple internet
search on Kazuhiko Matsuki, who ran AIJ
Investment Advisors’ Ponzi scheme, would
have revealed that he had been charged in
1997 for making illegal payoffs to a
racketeer. Background checks are not
expensive, they just take time. They should
be part of the ODD process at all times. In
our book the FT Guide to Investing in
Funds we listed all the sources that are
available for free to conduct various news,
but also AML and court checks.
Key Conclusions for investors and
managers, wishing to avoid operational
failures
Assess the entire operations of a
manager including internal
operations as well as relationships
with external service providers. This
factorial approach is the only way to
acquire an understanding of the
overall risk management culture of
the manager.
Trust the information received
but always verify. Verification is a
process of corroboration. In an
opaque world, this form of
verification is the only way to protect
your investment.
Perform an on-site visit to
validate information and
particularly to interview staff to
assess that their work corroborates
what the manager is marketing itself
as doing. Anything that cannot be
explained clearly or disclosed
reasonably must be a concern if not a
red flag.
Remain focused on lurking
conflicts of interest and the
independence of service providers,
directors and other parties that may
be tempted to put their interests
ahead of those of investors. This is
true especially where the investment
strategy is not subject to investment
restrictions or pricing policies
designed to protect investors.
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PROPRIETARY)DATA
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