21 March 2011, Barron’s

For a 30-year old, living out of a closet in a friend’s Greenwich Village apartment, pitching institutional investors that he knows how to make Long-Term Capital Management’s relative value strategy–the genius-run hedge fund that blew up–actually work takes a lot of chutzpah.

But that’s exactly what Bob Treue, now 41, founder and manager of the $494 million Barnegat fund has done. And he has pulled it off the hard way, starting his fund in 2001 just months before September 11th, right in the midst of a multi-year bear market.

While most funds were down that year, this Hoboken, NJ-based fund was up 13.50%. And in the ten years since he started up, Treue has registered annualized gains of 17.81% through February 2011. And he has generated these returns with much less volatility than the broad market. His annualized standard deviation was 15.99% while that of the S&P 500 was 21.47%.

In today’s cynical world where we often classify such success as too good to be true, in Treue’s case, it doesn’t look that way.

While just 6 people work with Treue, who’s the sole manager, his key service providers are top tier: HSBC is his valuation agent, Ernst & Young his auditor, and Barclays his prime broker. And according to Jonathan Kanterman, a veteran fund of funds consultant who’s not invested in the fund, “a peripheral look at Barnegat’s last audited financials [2009] indicates a transparent, comprehensible operation. Further, it appears he creatively manages counterparty risk to better protect his positions should a trade ever break down.”

But it is Treue’s strategy that makes the most compelling case for his fund’s legitimacy. He doesn’t use a black box or arcane quantitative formulas to deliver consistently strong returns. He succeeds by finding when extraordinary events–such as government intervention or bankruptcy–temporarily skew prices. He then executes this strategy and controls risk by being long an underpriced asset and short a market-rate asset, making money on the spread.

Since such mispricings don’t happen often and can take time to correct, Treue typically has only 15-20 positions in his portfolio of roughly equal size, which he holds on average between 1 to 2 years.

So for Treue, the risk is not ostensibly in his investments, but in the time he must give them to play out.

“That was the Achilles heel of LTCM,” he explains. “The investments they were in eventually played out just fine. But the fund imploded because it was highly leveraged and couldn’t afford to mark to market as prices declined and liabilities rose.”

Treue saw the problem with relative value not in the strategy itself but in the way it has been executed. So he decided to keep half his assets in cash to enable him to ride out volatile margins calls.

But how can such limited investment exposure consistently generate double-digit returns?

Leverage.

The fund is levered 10 to 1, which comes predominantly not from borrowing [though about one-third of his investments rely on the repo market] but from the derivatives he uses–Interest-Rate, Inflation-Rate, and Cross-Currency Basis Swaps–to establish his positions. This means his margin [collateral required to hold his investments] is about 10% of the full value his derivative holdings represent. Treue’s high cash position mitigates the risks of extreme margin requirements associated with leverage.

All this doesn’t mean his fund is loss-proof. Like many of his colleagues, he got whacked in 2008, losing more than 37% versus an industry average of 21.63%, according to hedge fund data tracker BarclayHedge. But that was the only year he lost money.

“At the time we did pare back our positions,” recalls Treue, “as liquidity left the market and assets were being marked down dramatically. But we didn’t see a problem with our investments and largely maintained the same exposure.” And investors in Barnegat who did likewise were well rewarded. The fund soared more than 132% in 2009 as his bets paid off.

Since then, he’s continued to outperform the market, in one instance by identifying an anomaly caused by British Central Bank’s pursuit of quantitative easing. With the bank stating that it would buy £197 billion of UK Treasuries [called Gilts], initially involving maturities ranging between 5 and 25 years, Treue saw that such buying produced a kink in the yield curve during the first quarter of 2009.

“Because British law required the bank to purchase Gilts on the open market and not directly from the Treasury,” explains Treue, “this boost in market demand for Gilts drove up prices and reduced yield.” Yields on 5-year securities declined to 2.8%. But because 4-year Gilts were not initially targeted by government intervention, lower demand kept their prices stable and yields higher at 3%.

So Treue went long the shorter bonds, expecting they would rise in price as yields eventually corrected, and shorted 5-year bonds, which he felt would decline in price to produce higher yields. A year later in March 2010, the central bank suspended quantitative easing and the Gilts did correct.

Around the same time on the other side of the world, Treue was taking note of obscure derivatives targeting interest rates between 2029 and 2039 that were severely mispriced.

In January 2009, he found 10-year Interest Rate Swaps based on Australian 3-month Interbank rates [Down Under known as Bank Bills] that enabled Treue to lock in and pay just 1% in exchange for exposure to a floating-rate Bank Bills. If the latter subsequently exceeded 1%, Treue would make money. Despite global economic panic at the time, that seemed like a good bet considering Australian overnight rates have averaged 5.42% over the past 20 years.

The opposing bet he needed to mitigate risks was found in Australian Cross Currency Basis Swaps, which enabled Treue to exchange Australian with US interest rates. This derivative had completely broken down, Treue believes, because a large hedge fund, which had owned a large chunk of this derivative, went bankrupt.

Counterparty banks whom took control of the fund’s assets rapidly unwound this position, which in concert with prevailing widespread fear, was creating significant mispricing.

Treue quickly established a Cross Currency Basis contract when the interest rate he was suppose to be pay for the Bank Bills bizarrely turned negative. It bottomed at -2.5% when he established his position. This meant Treue was actually being paid to hold a position that was hedging his other Interest Rate Swap.

This was a win-win situation, which quickly turned in Treue’s favor. Leverage inherent in the derivatives and subsequent correction in their underlying values over the next year made this a very profitable play.

In the US, one of Treue’s most successful trades involved US Treasury Inflation-Protected Securities [TIPS] and Treasuries, which started to gap well above inflation in early 2008 when Treue initially established his position. But the spread blew out when Lehman Brothers collapsed in autumn 2008. The bank’s extensive use of TIPS for collateral in its repo trades were dumped on the market after bankruptcy, sending prices lower and yields higher. Six-year maturities presented the greatest opportunity when TIPS yield hit 5% while Treasury yields were half that, despite little evidence of inflation.

Treue went long TIPS and short Treasuries. And he bought an Inflation Rate Swap to eliminate the risk that inflation could have on this trade. By mid-March yield spreads had narrowed to 50 bps.

One trade that’s been dragging on the fund is another UK position Treue put on in the third quarter of 2008. The logic seemed sound. He found 30-year UK Interest Rate Swaps priced only 75 basis points above 30-year Inflation Swaps: 4.75% versus 4.00%. In most developed markets, real returns [Treasury yields minus inflation] normally run between 150 bps and 250 bps.

Treue figured the gap had to widen. “Otherwise,” he surmised, “why would anyone buy UK Gilts?” So using UK Interest Rate Swaps, he started betting that rates would rise to deliver investors adequate real returns. Knowing that inflation typically goes up when interest rates rise, he hedged his position with Inflation Rate Swaps that would pay off if inflation went down. Treue was trying to lock in the difference between nominal interest and inflation rates, which he thought would have to expand for the UK to effectively sell debt.

But the spread has continued to shrink over the 2 1/2 years he has held the trade, currently at 50 bps. Still, Treue is holding on because he’s long rationality.