Polygon’s Humphries hits heights with distinctive multi-strat approach to CBs

June 27, 2014  

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Mike Humphries and his team have made a remarkable 160% for investors in the five years since launching an unusual convertible bond strategy in 2009 – exploiting a wide range of opportunities with a multi-strategy, event-driven approach to a largely unloved asset class

  Mike Humphries
The Polygon Convertible Opportunity Fund, managed by seasoned convertible bond specialist Mike Humphries at $12 billion London-based asset manager Polygon Global Partners, has good reason to celebrate its fifth anniversary – having notched up a remarkable track record of high performance in an asset class that has been largely eschewed by investors since the financial crisis.

When the fund was launched five years ago, Humphries and Polygon were responding to what had been a massive withdrawal of capital from the convertibles asset class in 2008, during a period of severe deleveraging and a sharp contraction in market liquidity as bank prop desks and many hedge funds retreated from the space.

The Polygon Convertible Opportunity Fund differs from many of the more traditional hedge fund players in the CB space, as it does not focus solely on straightforward arbitrage plays – instead taking more of a multi-strategy approach to investing in the asset class, drawing on detailed fundamental research and employing a variety of different investment styles.

Humphries’ approach has proved successful from the off: launching in May 2009, the fund made an impressive 41% in the remaining months of that year, followed by 25% in 2010, 11% in 2011, and 11.5% in 2012. In 2013 the strategy’s return of 9.15%, combined with an exceptional Sharpe ratio of more than 8, resulted in a comfortable win in the Convertibles & Volatility category at the annual EuroHedge Awards – the fund’s second victory after taking home the same award in 2011.

Since launch and to the end of May this year, the fund has produced a compound return of 162.32%, annualising at 20.89% with a Sharpe of 2.64. The fund is up 10.29% year-to-date, compared with 2.65% for the EuroHedge Convertible & Equity Arbitrage Index.

Humphries was already a highly experienced convertible bond trader when he joined Polygon in 2009. Having started his career in 1993 as a research analyst with James Capel in Toronto, he moved to Goldman Sachs a year later to begin an eight-year stint with the firm – initially as an investment banking analyst and later as a convertibles portfolio manager and trader, first in New York and later in London.

From 2002 until 2005, Humphries was the portfolio manager for European and Asian converts, special situations and credit at Sagamore Hill, and was also responsible for establishing and managing the US-headquartered firm’s European office.

Upon leaving that firm, he co-founded multi-strategy hedge fund boutique MKM Longboat, which amassed $2.5 billion with its flagship fund and performed well in its first two years of trading, but opted to close down the strategy in 2008 amid the Lehman Brothers collapse and a wave of redemptions.

Humphries has seen significant changes to the convertible bond market ever since he first began analysing, and later trading, the asset class during his days at Goldman.

"The opportunity set, like most things hedge funds have touched, has evolved significantly since then," he says. "In those days, there were only a handful of prop desks and hedge funds involved, and the options market was not particularly liquid. There was very little freely traded credit with which to benchmark the quality of the issuer."

In the intervening years, the converts market has grown substantially, both in size and complexity. "There are a lot more credit instruments including, most importantly, credit default swaps," he says. "For me, the evolution of the CDS product was the one thing that changed the market most dramatically. It outsourced credit research to a broader audience and allowed for far greater transparency on the creditworthiness of issuers."

Following nearly a decade of compelling returns and growth among the prop desk and hedge fund players in the space, from 2002 onwards the market traded far closer to fair value – with CB arbitrage funds producing lower returns and running cyclical to flows in the asset class.

By the time Humphries launched his Convertible Opportunity Fund at Polygon in May 2009, the fall-out from the financial crisis meant that the market for convertible bonds had shrunk dramatically, with bank prop desks virtually absent from the market and many hedge fund players having been wiped out.

"Before 2008 there were dozens of convert-arb hedge funds, but now there aren’t many of a meaningful size," he says. "Long-only funds are now the majority of the market and there have been significant inflows into the space, but really only to long-only vehicles."

Investors had been burned by their converts exposures, and were in no hurry to repeat the mistake. "People had been sold convert funds as a long-volatility strategy, but it was probably the worst performing strategy in 2008," says Humphries. "Investors didn’t get what they thought they were getting."

In such an environment, the decision to launch a new hedge fund focused on convertible bonds must have seemed contrarian to say the least. But Humphries was not developing a straight convert-arb strategy; instead, he had plans for a fund that would apply distressed, event-driven and long/short portfolio management techniques to a concentrated, high-conviction portfolio of convertible bond exposures.

"Pre-Polygon, I had been involved in equity, event-driven and more diverse credit strategies – so I could see there were other places to make money," he says. "Converts can be an interesting opportunity to express a fundamental view on a company, or an event view. In a sense, this is almost a multi-strategy fund that’s focused on converts."

He adds: "With equity investing, the product is very simple but different managers approach it from very different angles: you have bottom-up stock-pickers, quant strategies, event-driven and so on. In a more complicated product like converts, you have all that complexity and what does everybody do? Primarily the same thing: arbitrage."

With the Polygon Convertible Opportunity Fund, Humphries and his team manage a market-neutral portfolio of significantly mispriced securities. They focus on situations in which they believe mispricing to be most prevalent, and on events that coincide with the largest moves in valuations.

Attractive mispricing opportunities include poorly understood companies, often where the convertible is the only credit instrument in the capital structure; more complex or non-uniform securities where specific features are poorly understood or modelled; name-specific technical supply/demand imbalances, which are generally driven by long-only investor behaviour or by the liquidation of hedge funds or prop desks; extreme market dislocations resulting in a large number of cheap names; and new issuance, where the opportunity comes either through a discount at issue or from the novelty of the instrument or issuer.

Event-driven opportunities might include bond restructurings, tenders and equitisations; event-specific re-pricing of one or more pieces of the capital structure; credit re-pricing on improved transparency; company-specific events leading to changes in expected volatility; and events leading to significant moves in the underlying equity.

The fund expresses its views on the opportunity set via a high-conviction portfolio of heavily researched strategies, which are typically catalyst-driven and have low correlation to each other and to the market.

"Most of our competitors manage very diversified portfolios; we have a highly concentrated portfolio, especially for the converts space," says Humphries, adding that 40-50% of the fund’s total risk exposure is typically tied up in the largest 10 positions. "If the book isn’t concentrated, you’re just another CB guy who doesn’t have that much conviction in what he’s doing," he reasons.

The lack of correlation within the portfolio plays a significant role in the fund’s risk management process. "Our underlying investments are quite different, one from the next," says Humphries. "When you have a book of things that aren’t correlated to each other – trades that don’t look the same as each other and are dependent on different catalysts – that makes a big difference from a hedging perspective. Our risk management from the portfolio side is partly about having as uncorrelated a portfolio as we can."

Humphries’ desire to invest in a different way from that of his competitors in the convertible bond space has led him to assemble a diverse team. "We don’t hire a lot of convert guys; they tend to be generalists, and I want specialists," he says. "For example, we’d rather have a distressed specialist on the team than a convert guy who has done distressed."

The seven-strong Convertible Opportunity team includes former colleagues from Humphries’ days at MKM Longboat and Sagamore Hill, and the team also draws on time spent at Natixis Capital, Deutsche Bank, Carrhae Capital and Sandell Asset Management, among others.

"We’ve tried, a bit like a multi-strat, to accumulate discrete talent in various areas to ensure there are different things for us to do in the converts space – and different opportunities to exploit – at different times in the cycle," explains Humphries.

By building a team of specialist investors, Humphries has by definition narrowed his fund’s potential investment universe, and this is something he views as an advantage rather than a hindrance. "We’d rather know a lot about a narrow part of the universe and not touch the remainder, than be generalists covering everything but not as thoroughly," he reasons.

His previous firm, MKM Longboat, had a heavy focus on the resources sector, and Humphries has continued to pursue this specialisation via Polygon Convertible Opportunity – playing events in the mining, metals, industrials and oil services sectors via convertible bond exposures. "We really understand those sectors, so when we dig down into those names we don’t think anyone else in the convert universe can be as thorough as we are," he says.

"Raising money in 2009 for a new hedge fund wasn’t easy," recalls Humphries. "Converts had pretty much destroyed itself and had a bad name; people didn’t even want to take a meeting with you. So we decided just to get off the ground and not focus on marketing."

Looking back over his fund’s five-year track record, Humphries acknowledges that the strategy launched at a good time. "As a converts manager, if you didn’t make money in 2009 and 2010, you had some serious problems," he says. "We had some early investors, but when we got into choppier waters, from 2010/11 onwards, our performance bore out that what we were saying we were doing differently, we actually were. And people decided to take an interest."

Family offices account for a large proportion of the fund’s AUM, while more recent allocators have included larger institutional clients such as pension funds, endowments and foundations.

Polygon Convertible Opportunity soft-closed in February 2013, when it managed $300 million. It is now running $366 million, and the firm is planning a hard close at $400 million. This leaves the strategy with a buffer to allow for performance growth, as Humphries estimates the actual capacity at somewhere closer to $600 million.

"We want to stay true to what we’re doing," he says of the decision to limit inflows. "We want to be nimble, concentrated, and able to invest in even smaller or more off-the-run situations."

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