Stockholm (HedgeNordic) – Compounding – the magic of compounding – can do wonders long term, if uninterrupted. “There is one thing that kills the compounding effect,” according to Peter Andersland, who co-founded Norwegian hedge fund powerhouse Sector Asset Management in 1999. That is ‘downside volatility.’

“The most important lesson for investors looking to maximize capital growth is to limit the downside,” says Andersland, who came out of retirement to launch a ‘traditional’ hedge fund under the umbrella of Pensum Asset Management. Joined by Inger-Anne Varmann Vikre and Ermanno Mattio, former colleagues at Sector Asset Management, at the onset of 2022 Andersland launched Pensum Global Opportunities, an equity-focused opportunistic fund pursuing a ‘convexity maximization’ objective, which involves capping its absolute drawdown at a negative 15 percent.

“We like to think of our fund as a traditional hedge fund, the way a hedge fund should be, the way it used to be.”

“We like to think of our fund as a traditional hedge fund, the way a hedge fund should be, the way it used to be,” emphasizes Andersland. “One of the criteria for joining Pensum was the ability to run a strategy that we would use ourselves, for our own money. I didn’t want to launch a fund that investors could want at this moment just because it was trendy.” To bring back a traditional hedge fund to the arena, Andersland and his team relied on a ‘convexity maximization’ portfolio, built on three risk books: a Long Book, a Short Book and a Tail-Risk Book. Plus, an absolute stop loss of 15 percent.

Both the Long and Short risk books are designed to serve as sources of ‘alpha’ for Pensum Global Opportunities. The Tail-Risk Book, meanwhile, pays off during difficult market conditions for equities. Coupled with the risk management protocol that caps the peak-to-valley drawdown to a negative 15 percent, Pensum Global Opportunities has a ‘convex’ return profile, which enables it to accept greater levels of market risk in favorable conditions for equities and to avoid market risk, via lower beta exposure, in difficult market conditions.

Long Book: Capitalizing on Expanding Profit Pools

“On the long side, we employ a ‘go-anywhere’ strategy, upon which we look for what we think are the best opportunities around the world,” Peter Andersland says, when explaining their approach to finding long positions. “The ‘merchandise’ that is actually sold or traded in the stock market is profits, so we are looking for inflection points in the profit pools shared by groups of companies. Often, such profit pools coincide with a sector or an industry, but they don’t necessarily have to.”

“The ‘merchandise’ that is actually sold or traded in the stock market is profits, so we are looking for inflection points in the profit pools shared by groups of companies.”

Russia’s invasion of Ukraine, for instance, has triggered an inflection point in the ‘defense spending’ profit pool. “Europeans have been skimping on defense spending all these years after the end of the cold war, so Russia’s invasion of Ukraine is leading to the rearmament of Europe and the world in general,” says Andersland. “This rearmament means there is an increasing profit pool in the defense industry over the next years,” he argues. “This is not a short-term shift”, says Andersland, “it is a long-term change.”

“After identifying profit pools…, we analyze the industry and the value chain, to try to understand which companies can make money off these changes and which companies can’t.”

When the team running Pensum Global Opportunities finds inflection points in profit pools, they proceed to analyze the range of companies tapping into those profit pools. “After identifying profit pools we believe are likely to experience meaningful future changes, we analyze the industry and the value chain, to try to understand which companies can make money off these changes and which companies can’t,” explains Andersland. More specifically, the team reverse-engineers prevailing stock prices to understand the market’s expectations for future profitability and growth. “Whenever our own analysis disagrees with said market expectations, we have a possible ‘trade’ to exploit.”

Short Book: Capitalizing on Shrinking Profit Pools

Long/short equity managers may use short selling for various reasons, such as reducing net market exposure in times of turmoil. For Andersland, however, the primary goal of short-selling is generating pure alpha. “Shorts are what we call ‘alpha’ trades,” says Andersland. “We short a stock with the only objective of making money in an absolute sense,” he reiterates. Which explains why at times, due to limited opportunity sets, Pensum Global Opportunities can have zero short positions in the portfolio.

“Shorts are what we call ‘alpha’ trades. We short a stock with the only objective of making money in an absolute sense.”

Similar to the process of finding longs, Andersland and his team predominantly find short positions by analyzing profit pools, in this case “sinking” profit pools due to structural changes leading to slowing sales, margin pressures, and other consequences. As an example, after households and businesses stacked up on TV sets, smartphones, tablets, notebooks and other computer equipment during the Covid pandemic, Andersland predicts a “sinking profit pool for the group of ‘stay-at-home’ businesses.” He finds plenty of shorting opportunities in this space. Whenever economically feasible, Andersland predominantly bets against certain businesses using put options rather than outright short positions.

Tail-Risk Book and the 15% Stop Loss

The last risk book in the portfolio held by Pensum Global Opportunities consists of ‘tail-risk’ trades, “negatively-correlated, highly-convex trades, such as put options on broader equity indices,” according to Andersland. The Tail-Risk Book is designed to hedge the equity-focused fund against adverse market conditions. “Although we don’t have a view on what the market is going to do next week or a month ahead, this book is very countercyclical and pays off in difficult market conditions,” says Andersland. This book is mostly populated with put options on stock market indices, call options on oil, or other ‘risk-off’ trades. “In this Tail-Risk hedge book, we can never lose more than the option premium we have paid.” To note, this Tail-Risk basket of positions pays off best when investors need it most.

“Thanks to the protection provided by our Tail-Risk Book, we can afford to concentrate capital on our few best global ideas, the ones with the most asymmetric payoff profile.”

One important pillar of the team’s risk management protocol is a stop-loss of 15 percent at the portfolio-level. “We seek to never lose more than 15 percent.  “Such risk level, ultimately, allows us to make money: as a 15 percent drawdown ‘only’ requires 17.6 percent to get back even, such risk limit keeps the compounding effect alive,” says Andersland. “There are two aspects of our risk management process: one is that we prepare for an uncertain future, and the other is that we adapt to it,” he continues. “Thanks to the protection provided by our Tail-Risk Book, we can afford to concentrate capital on our few best global ideas, the ones with the most asymmetric payoff profile.” Launched in early 2022, Pensum Global Opportunities has so far managed to navigate this year’s difficult market environment, having returned 11.1 percent through the end of April.