Last November, the local fund management industry saw a new kid on the block in Cross Light Capital Sdn Bhd. So what, you may ask. After all, new fund management companies crop up every now and then. But this one claims to be different.
The key differentiator when it comes to Cross Light’s investment strategy is the fund’s promise to generate good risk-adjusted returns via a hedging strategy, and its performance is not benchmarked against indices, in its case, the S&P 500. Cross Light was founded by Jason Lee and Heng Wui Leng.
Lee says many long-only investors rely on the negative correlation between traditional equity and bonds to reduce risk and volatility. But today, this may not be the best option, as the negative correlation has been disrupted in recent years amid a low interest rate environment and ample market liquidity.
(A positive correlation between two asset classes means their prices move in tandem with each other. Assuming that the correlation between equities and bonds is positive with a 1:1 ratio, equity prices will rise 5% when bond prices go up by the same percentage. However, when the correlation between equities and bonds is negative, at a 1:1 ratio, equity prices will rise 5% when bond prices fall at the same rate. The financial concept of correlation is helpful for fund managers to diversify risk when structuring their investment portfolios.)
“The traditional asset allocation ratio of 60% equities and 40% bonds, for instance, has worked well most of the time in the last three decades. But we see equity and bond prices moving in the same direction more often today and possibly in the future,” says Lee.
“Just yesterday (Feb 25), we saw a fall in both equity and bond prices when the 10-year US Treasury bond yield breached 1.6% for the first time in a year and triggered a sell-off in the stock markets.”
In fact, the correlation between equity and bond prices has not always been negative historically. A research report by Graham Capital, an alternative investment firm based in the US, pointed out that the correlation between the two asset classes had been positive for more than 40 years before the 1990s. “What we are seeing is just a return to the older regime,” says Lee.
High valuations in the equity and bond markets can contribute to a positive correlation between the prices of these asset classes during adverse market conditions.
Lee believes that local investors are caught between a rock and a hard place during a downturn as many local products are long-only funds that benefit from an increase in asset prices. “From the view of a hedge fund manager, it is like fighting the market with one hand, without the ability to short,” he says.
This is where Cross Light’s ability to short the markets comes into play. Lee is no stranger to such an approach. “I was one of the few hedge fund managers who were able to generate positive returns during the 2008 global financial crisis and also in 2009, when the markets rebounded.
“As of 2017, the correlation of my 10-year audited track record with the market was -0.02 while generating good returns. That was achieved on the back of a long-short equity strategy that comes with prudent use of leverage and risk management.
“How many local funds or even foreign funds marketed in Malaysia can short the market, or even go net short with the use of leverage when circumstances arise? My guess is that there are very few locally.”
Lee applies the short-selling strategy in the US markets as there are numerous financial instruments with ample liquidity for him to do so. In Malaysia, short-selling is a regulated activity. It was banned for about two decades since the aftermath of the 1997/98 Asian financial crisis before being reintroduced to the local stock market in April 2018.
However, two forms of short-selling — intraday short-selling (IDSS) and intraday short-selling by proprietary traders (PDT short sale) — were suspended by the local bourse since March last year, when the Covid-19 pandemic hit Malaysia. The suspension is expected to last until Aug 29 this year. Regulated short-selling (RSS), on the other hand, is currently allowed following the lifting of its suspension at the start of the year.
Regulated short-selling of local corporate bonds was also introduced in April 2017, when the Securities Commission Malaysia (SC) announced its Guidelines on Regulated Short-Selling of Corporate Bonds.
By deploying historical data, Lee explains how Cross Light’s short-selling strategy would have weathered choppy market conditions in March last year. In short, the algorithm that underpins the firm’s investment strategy signalled that there was a potential slowdown in industrial production and a surge in demand for safe-haven assets. If Lee had picked up the signal and reacted to it accordingly, he would have shorted the markets more aggressively from January to March, resulting in much smaller losses compared with the S&P 500. He would have also generated positive returns starting in May last year, when the index was still in negative territory.
Lee acknowledges that short-selling is a double-edged sword. It could reduce risk during a downturn or cause significant losses to investors when there is a short squeeze and lack of liquidity. Melvin Capital, the hedge fund that shorted video game company GameStop Corp, is a good recent example. It was once down by more than 50% and lost US$4.5 billion (RM18.5 billion) when retail investors piled in to push up the share price of GameStop.
However, Cross Light has good risk management and will not fall into the same trap as Melvin Capital, he says. “First, you don’t short small-cap stocks. Second, you don’t short stocks with high short interest. Anything within 10% to 20% of short interest against the company’s paid-up capital is considered fine. If it is 100%, you are playing with fire. We only short investment instruments with ample liquidity.
“We also have an adaptive asset allocation strategy, where we would reduce the net market exposure (including the long and short exposure) continuously by 5% to 10% when the net asset value is down by 5%. And we reduce it by 20% when our portfolio goes down 10%. I, as the fund manager, have the discretion to reduce it even further by another 20%, totalling 40%.”
Further diversification in asset classes is another crucial factor that contributes to Cross Light’s low market correlation performance. Lee invests in traditional equities, bonds, real estate, natural resources, private equity, precious metals and Bitcoin.
Such an asset allocation is a rough replication of the Yale’s Endowment, one of the world’s largest and best performing endowment funds. As at June 30 last year, the fund had generated an average annual return of 9.9%, with assets under management totalling US$31.2 billion. In the past 30 years, its average annual return has been 12.4%.
“Many investors see the fund’s investment strategy as the gold standard due to its solid long-term track record. And this gave us the idea of replicating its portfolio,” says Lee.
Cross Light does not have access to the world’s top private equity funds like the Yale’s Endowment, but it can replicate the US private equity industry’s performance by adopting a quantitative technique known as factor risk premia (or smart beta) and investing in value stocks. It also invests in real estate investment trusts (as a proxy to the real estate market) and trades commodity futures for exposure to natural resources, he says.
“The global debt-to-GDP ratio is at an all-time high. And there is the risk of inflation. It is tough to tell how the markets will react. A truly diversified portfolio can provide better protection to investors in an uncertain economic environment,” says Lee.
Investment styles and lessons
Despite almost two decades of working for a sovereign wealth fund and hedge fund, Lee has his strengths and weaknesses. And he is not shy to admit it.
“Every fund manager is different. But for me, I have generally been very good at risk-off episodes. My strength is downside risk management. That was how I was able to make money in 2008 when most fund managers were down significantly,” he says.
“However, my biggest mistakes were usually made in the bull markets. I’m often too cautious and unwilling to add on my bets when markets are recovering. I would have ignored the signals sent out by my [quant] models and indicators.”
For instance, Lee’s portfolio was up 2% in August 2011 when the Euro Stoxx 50 slumped 13% in a month. But he missed the chance to ride the market recovery when Mario Draghi, then president of the European Central Bank, signalled that the bank would do “whatever it takes” to stabilise the region’s economy.
“I didn’t lose money by remaining short after the crisis. But I kept mostly market neutral positions rather than net long positions and missed some opportunities,” he says.
However, the experience of missing out on certain investment opportunities, or even losing money, is crucial for fund managers to improve their skills and make better investment decisions. Another memory that remains vivid in Lee’s mind was an event during the 2008 global financial crisis.
Lee was a trader on a hedge fund team at Oxburgh Partners LLP in 2007. And the team was buying shares of mid-cap companies when their prices had fallen from their peak.
“But the reality of the global financial crisis became clearer in 2008 and liquidity in those mid-cap companies became worse. Instead of selling them, we added on to our long positions. Prices continued to fall and things got even worse when the fund faced redemptions, causing the weightage of our long position to actually increase further.
“We sold stocks that were liquid for redemptions, while holding on to illiquid mid-cap stocks that continued to plunge in prices as other investors continued to sell them down. The historical trading volume often used by risk management systems is of no use during a major crisis as liquidity evaporated quickly. One day you have liquidity, and in the next, you have no buyers and volume at all.”
Lee derived several lessons from the incident, which have become an integral part of his investment style today. First, investors should stick to their investment strategy based on price action. “If the trend is down and you are losing money, reduce risk. Do not increase it,” he advises.
Second, small and mid-cap companies can do well in bull markets, but prices could fall significantly during a bear market due to illiquidity. “The liquidity just dries up and what you think is a liquid position can very fast become illiquid, especially when you are managing a fund and getting redemptions,” he says.
Finally, investors should not average down in mid-cap stocks during a major downturn. “Such a strategy would probably benefit you eight out of 10 times. But it is the two times that would end your career and kill your clients,” he points out.
Such an experience also taught him to constantly keep his emotions in check. Because of emotions, Lee and his team members continued to average down on mid-cap stocks in 2008 and that backfired. It was a valuable lesson learnt.
Lee and Heng met when they were looking for opportunities in the financial markets. Despite their age gap, they hit it off well, sharing the same passion for trading and investing in markets. Lee is 46 while Heng is just 29.
Prior to Cross Light, Lee had spent 17 years in the hedge fund industry before deciding to take a sabbatical to travel the world with his family. He hired a campervan to drive around Sardinia, an Italian island, and arrived in Machu Picchu at the Andes Mountain. He descended to the Galápagos Islands, snorkelling with sharks, before ascending again to the European Alps for skiing.
He finally settled down in Penang a year or so later, where he rented a condominium near a beach. He had migrated to Australia with his parents when he was five years old, but a part of him has always remained Malaysian. Local street food has always been one of his favourites.
“It was good to spend time with my family. It was also an ‘unplugging’ from the markets for me. Hedge fund managers monitor profits and losses in real time, literally every minute of the day. The buildup of stress after decades can be immense,” says Lee.
Before joining Swiss private bank J Safra Sarasin Group as a fund manager, Lee was a partner at London-based hedge fund Oxburgh Partners. He was also an equity trader for the Government of Singapore Investment Corporation for three years.
“I was contemplating my next move when I was in Penang. While working with the Swiss private bank, I had a 10-year, fully audited track record of managing global equities, with an average annual return of 14.95%. The downside during that period was minimal at 2.65% (before fees), which I am very proud of. However, my three-year average until that time was just about 3%,” he says.
“Despite a good long-term track record, raising money for the fund was getting challenging. The new management of the bank then decided to close its internal hedge fund platform in London.
“That prompted me to think about my future. I had earned enough for early retirement. Perhaps I could set up a family office and invest my own money. It was also the last chance for me to bring my children back to Asia as they had reached their final years of schooling before university.”
He works from home for now because of the pandemic and terms the trading room in the house as a “business disruption site”, which is essentially a back-up workplace for him and his team if an emergency occurs, such as a power shortage, which had happened at Cross Light’s main office at Menara Ilham in Kuala Lumpur.
In 2019, Lee met Heng, a young quantitative researcher and a University of Cambridge graduate with a master’s degree in chemical engineering. Heng had worked as an intern and then as a full-time analyst at Citigroup Global Markets Inc in London for about a year before returning to Malaysia. His initial plan was to join a hedge fund three years down the road. “But I returned to Malaysia in 2012 to accompany my parents as I was the only child,” he says.
Like Lee, Heng was looking for job opportunities in the financial industry. But he ended up managing money for his family.
Things quickly took off after the two met as they shared a passion for the markets and were well versed in various investment and trading approaches. In November last year, they registered their fund management firm with the SC. They aim to fill a gap in the market by offering Malaysian investors a hedge fund investment strategy that is implemented locally. “We truly believe it will complement the local fund management industry,” says Lee.
Private mandate only available to sophisticated investors
Cross Light Capital Sdn Bhd, a fund management firm licensed by the Securities Commission Malaysia, provides private mandate services to sophisticated investors with a minimum investment amount of US$1 million. The firm charges an annual management fee of 2% and a performance fee of 20%.
Cross Light co-founder Jason Lee says the minimum investment amount is required due to its active investment approach. Its portfolio is rebalanced almost every day with an annual turnover ratio of about 25 times, pretty much in line with other quantitative hedge funds. “We need a certain fund size to justify the minimum brokerage fee that we pay for our trading activities,” he explains.
In December last year, the founders of the firm put their investment strategy to the test by investing an undisclosed amount (contributed by Lee and co-founder Heng Wui Leng) in the market. As at the end of last month, it had generated a return of 7%, according to Lee.
He adds that investors interested in the firm’s private mandate investment strategy can opt to invest in three portfolios (conservative, balanced and aggressive) with different risk profiles and expected returns.
The firm is currently in talks with a local financial institution to become the external fund manager of the latter’s shariah fund, which is expected to be launched in the second quarter of this year.
“We are looking to launch a shariah fund with an absolute return strategy. We have spent many hours exploring ways to protect investors from an equity bear market in a truly shariah-compliant way,” says Lee.
“We won’t be using leverage, derivatives or shorting the market strategy. But our adaptive asset allocation strategy, which has more than 10 turnovers in the portfolio per year, can protect the portfolio in an equity bear market by quickly increasing our investments in precious metals such as gold.”