Caxton’s Law

By Stephen Taub

	Lights, camera, action! The trading floor at Caxton’s New York headquarters (Photographs by Chris Crisman)

Last spring, Caxton Associates CIO Andrew Law was frustrated. Although the outlook for growth seemed okay, several exogenous shocks had hit the global economy: the rash of tornadoes in the U.S., the devastating earthquake in Japan and subsequent nuclear accident, not to mention the simmering European debt crisis and the debate in Washington over the U.S. debt ceiling. “Most people felt they were temporary growth shocks,” recalls Law, 45, who on January 1 of this year added the responsibilities of chairman and CEO of New York–based Caxton when its legendary founder, Bruce Kovner, retired. In May the firm’s flagship macro fund, Caxton Global Investments, lost 2.36 percent. Law took drastic action. Late that month he and many of the firm’s other macro traders liquidated their entire portfolios. In June other Caxton managers who had started to lose money also went to cash. Still, Caxton Global fell 1.42 percent that month, leaving it down nearly 6 percent for the first half of the year.

When Law and his team analyzed what had happened, they were stunned to learn that despite the widespread nature of the modest losses across the different portfolios, the actual realized correlations of the returns among them were lower than they had been historically. The markets had simply gone against different portfolio managers at different times.

What was going on? Contrary to widespread belief, the slowdown in global economic growth was not temporary. Law says there was a large divergence between overall investor positioning and expectations and what the market was saying. This was reinforced in late July with the release of U.S. GDP revisions that showed growth was less than 1 percent despite the Federal Reserve’s celebrated quantitative easing program and sent equities down 15 percent over the ensuing weeks. “This was a catastrophic miss by Wall Street,” Law says. With the benefit of being almost entirely in cash, Law and Caxton’s other portfolio managers made fresh trades that began paying off by August. They shorted the stock market using derivatives containing custom-built portfolios of equities they thought would go down. They made bets on falling interest rates in developed markets, principally in Europe, as well as in developing markets such as Brazil. They also had winning currency and commodity trades; they were short industrial metals and oil, long precious metals.

Caxton Global surged 2.75 percent in August and a further 2.7 percent in September, putting the fund slightly back into the black for the year. It finished 2011 up 0.70 percent.

“This is a good example of why it is a good idea to get out of positions when you are losing more than you are willing to lose,” says Law, seated in a conference room at Caxton’s Midtown Manhattan offices, directly across from a large-screen TV displaying real-time quotes for a variety of global markets. “This liquidation fire drill is what you do when you don’t understand what is going on for a significant period of time.”

Law’s shrewd, deft trading and portfolio calls last summer illustrate Caxton’s obsession with risk management — especially since Law took over as CIO in 2008 — and capital preservation, as well as its ability to listen to the markets and read and ride trends when market forces shift direction. It is perhaps no coincidence that Kovner, who had stopped taking the lead on the trading side on a day-to-day basis since at least 2007, and co-founder and president Peter D’Angelo last fall officially announced their retirements, which took effect at the beginning of this year.

“Andrew has a tremendous sense of risk management,” says Christian Siva-Jothy, who in 1996 hired Law to work with him on the prop desk at Goldman Sachs Group, where he was then sole partner in charge of fixed income, currencies and commodities trading. “He can smell disaster a mile away.”

	Top lieutenants:COO and CFO John Forbes (top) and chief risk officer Matthew Wade serve alongside CEO Andrew Law on Caxton’s risk committee

Although Law has been overseeing investments for one of the oldest and most successful hedge fund firms for more than three years and is now totally in charge, not many people outside Caxton know much about him. In fact, there are no pictures of Law on the Internet and he refused to sit for a photograph for this article, even though he agreed to several lengthy interviews. Of average stature, with an unassuming, somewhat humble demeanor, Law lacks the regal appearance of the silver-haired, 6-foot-2 Kovner. Those who know both Law and Kovner say the two men have more similarities than differences, but Law is considered to be more of a hands-on boss, who regularly walks the trading floor and has introduced more-stringent risk controls and policies.

Few people know that Law racked up close to a triple-digit return in 2008, allowing Caxton to make money when most of its competitors lost large sums. “Andrew saved the firm in 2008,” says one person very knowledgeable about Caxton, who prefers not to be named. “He was largely responsible for Caxton’s success that year.”

Now, as Law and his management team, including COO and CFO John Forbes, general counsel Scott Bernstein and Michael Bolitho, who oversees back-office functions, begin the next era at Caxton, they must assure investors that the brand of a macro, directional trading shop with a strong emphasis on absolute return and with good liquidity and risk discipline has not changed since Kovner founded the firm nearly 30 years ago. Today, Caxton — which has delivered an average annual return of 21 percent since inception — manages $9.3 billion in assets, with 200 people in offices in New York, London, Sydney and Princeton, New Jersey.

“Our message to investors is, it is business as usual at Caxton,” emphasizes Law, who spends about three weeks of every month working from Caxton’s London office and one week in New York.

Law knows full well that Caxton’s main fund has compounded at only about 8 percent a year since 2003, less than half of the firm’s long-term performance. Although Caxton was up 12.95 percent for 2008, when most other hedge fund firms were down well into the double digits, Law also knows that the past few years have been tough for macro traders. Last year was especially challenging, heavily affected by unpredictable political developments and at times by illiquidity as a result of the reduction in trading activity and the dismantling of Wall Street proprietary trading desks.

The Caxton CEO, however, sees plenty of opportunities in the near future. Although he is expecting a mild recession in Europe in 2012, he says the European Central Bank’s program to inject liquidity into the banking system over the next three years will help prevent the economic downturn from being more severe. Law is more upbeat about the prospects in the U.S., where he believes a reduction in leverage has helped pave the way for an economic recovery. As a result, he is betting on the rise of the dollar, a turnaround in housing and related industries, and the strength of companies that don’t export, especially companies that don’t export to Europe.

“I am bullish on U.S. assets versus European assets,” says Law, who is also optimistic about domestic consumption in China.

Investors have signaled their confidence in Law’s ability to steer Caxton through this treacherous global minefield. By year-end 2011, thanks to substantial inflows and normal redemptions, full-fee-paying assets hit their highest level since the end of 2008.

John Johnson, CIO of the Wyoming Retirement System, which made an initial investment in Caxton Global and a handful of other macro hedge funds in mid-2011, says his team analyzed Caxton based on its lower recent performance record. “The point of the allocation is to help diversify a noncorrelated approach to the portfolio, and it has worked,” he explains.

“They may not make a lot of money [each year], but they make money year after year, which few funds can claim,” says a person knowledgeable about the inner workings of Caxton, who declined to be named for this article.

The smooth transition was the culmination of ten years of Kovner’s preparing for his eventual retirement. “Bruce had seen firms closed down when the founder ceased to be actively involved,” says COO and CFO Forbes, who has been with Caxton since 1995. “He did not want that to happen at Caxton.”

	Jeffrey Enslin: The 17-year Caxton veteran runs a quantitative macro trading system

KOVNER’S STORY IS WELL KNOWN. The Brooklyn-born, California-raised son of an engineer and descendent of Russian Jews received his BA in political science from Harvard College in 1966 and studied at Harvard’s John F. Kennedy School of Government until 1970. The oft-repeated lore is that a bad case of writer’s block prevented him from completing his Ph.D. The true story is that Kovner finished the course work and general exams for his degree and worked on his dissertation for more than a year but didn’t think it was very good. A friend who had heard that Kovner was bored with graduate school called to ask him to be the research director for Nelson Gross, a New Jersey Republican running for the U.S. Senate against incumbent Harrison Williams Jr. It didn’t take long for Kovner to learn he wasn’t suited for the political campaign trail. He moved to Manhattan to be closer to what he did enjoy: the cultural life of the city.

He also never took harpsichord lessons at the Juilliard School, another oft-repeated piece of the Kovner legend, although he did take several courses at the school’s Evening Division. He did drive that celebrated New York City taxicab, but that was not until a few years later and then only for a few months, when he was working three jobs to try to scrape together enough money to spend a year in Europe.

Kovner applied his thirst for knowledge to commodities trading, studying everything he could find on the subject for more than a year, and started testing his ideas with “paper trading.” He then borrowed $3,000 on his MasterCard and put on three trades: a bull spread in copper, an interest rate arbitrage in Ginnie Mae futures and an old crop–new crop bull spread in soybean futures. The first trade lost money, the second made a little, and the third went more or less straight up when people realized that the supply of soybeans would run out before the new crop came in. Kovner made about $20,000 on the soybean trade by the time he liquidated it, despite some costly mistakes in managing the position.

In November 1977 he joined Commodities Corp., the respected pioneer in commodities trading founded by Helmut Weymar, and spent five years honing his trading skills. He left in March 1983 to launch Caxton, named after a 15th-century English printer he admired.

Kovner enjoyed early success. In 1987 he racked up returns in his two funds of more than 90 percent. Through 2002, Caxton’s funds had enjoyed double-digit gains in all but two of their full years of existence, taking advantage of the opportunities in four asset classes: commodities, currencies, equities and fixed income.

	Scott Gordon: The generalist portfolio manager is opportunistic

In February 1997, Kovner launched Caxton Global Investments. By 2002 his business had $10 billion under management, topping Institutional Investor’s Hedge Fund 100 ranking as the world’s largest hedge fund firm. In November 2002, Kovner raised his management fee to 3 percent of assets and his performance fee to 30 percent, saying he needed the additional revenue to lure top talent. One of those key hires was Law, who in 2003 left Goldman Sachs to join Caxton’s London office. That same year Caxton returned 20 percent of its capital to investors, a significant move at a time when many other hedge fund firms were beginning a decade of aggressive asset gathering. By then Kovner was getting involved in politics and charter schools, becoming chairman of the board of trustees of conservative think tank the American Enterprise Institute, and Caxton had created a risk committee as well as a disaster recovery plan. “We assured investors a plan was in place should something happen at any time,” COO and CFO Forbes recalls.

That was also about the time that Caxton’s era of consistent double-digit returns — then averaging about 28 percent a year — abruptly ended. Beginning in 2003, Caxton started its run of single-digit returns in at least one of its funds for seven of the next nine years. The falloff in performance was in part a reflection of the environment, as it became harder to make money in macro markets thanks to a sharp drop in volatility amid a bull market in equities. Caxton’s macro teams as a whole trailed the performance of the equity group headed by Kurt Feuerman in three of the five years from 2003 through 2007. In 2008 the equity group — which had been created in 1998 when Feuerman left Morgan Stanley Asset Management, where he ran the U.S. equity business — managed about $2 billion in risk capital for the main fund, according to sources.

KOVNER married his second wife, socialite Suzanne Fairchild, in February 2007, the same month that global banking giant HSBC Holdings reported the first subprime mortgage loss. That fall, on one of his many trips to Caxton’s London office, Kovner discussed with Law the stresses in the LIBOR markets and how it was becoming increasingly apparent that the U.S. economy was slowing down. It was shortly after the so-called quant crisis that summer, when a number of quantitative long-short equity funds suffered huge, unexplained losses. Kovner and Law had grown very nervous about the stability of the credit markets, and the housing and subprime markets were starting to show some cracks. The pair recognized that the credit cycle was turning, and they discussed what Caxton needed to do to react to the changing investment landscape. In this new, volatile environment, they felt macro investing would again reap benefits.

“We concluded the order of events of the last five years was over,” Law recalls. “We were entering a new era of economic and policymaking uncertainty, and one that was likely to reward macro trading.”

By then it had become apparent that Caxton needed a CIO — someone who was actively trading and could interact with the other portfolio managers.

Kovner and Law continued to have these types of discussions over the next six months or so. Meanwhile, Caxton Global was struggling, eking out a meager 1.1 percent gain in 2007, when the Standard & Poor’s 500 Index rose 5.5 percent and competitors were up significantly: Moore Capital Management’s Remington Investment Strategies gained 22 percent, and Tudor Investment Corp.’s Tudor BVI rose 7 percent.

At the same time, Kovner was pulling back from his expansion plans, halting private equity investments, which had accounted for nearly 8 percent of assets; shutting down a fund-of-funds business; and closing Caxton Healthcare Trading, a long-short fund created in 2005 to invest in pharmaceuticals and biotechnology stocks. In late 2007, well before other macro hedge funds, Caxton created a “side pocket” to exit private equity investments. In 2008, European stock specialists Abe and Jack Eisenstat left the firm, as did Roy Lennox, who had joined Kovner from Commodities Corp. when he started Caxton in 1983.

Throughout that tumultuous 2007–’08 period, one person continued to shine brighter than most others at Caxton: Law. When Caxton Global finished 2007 up a mere 1.1 percent, Law’s portfolio had a high double-digit return, according to sources, generating what for him was a personal record at the time. He bettered that feat the following year, helping Caxton Global post a 12.95 percent return. Law won’t confirm returns on his personal portfolio, only slyly acknowledging, “I did very well.”

Kovner must have been impressed. In early 2008 he named Law CIO.

How did Law post such astounding returns? In the second half of 2007, the Brit responded to the changing global events by adding risk. He made aggressive leveraged bets on the widening of certain credit markets, going long fixed income, thus riding the steep subsequent drop in interest rates.

Law stayed with these trades in 2008. Fortuitously, he went short equities before Lehman Brothers Holdings filed for bankruptcy in September, while being long fixed income at the same time. He also bet on falling interest rates in the U.K. and Europe. Law’s adroit trading allowed the firm to make money in a year when most others didn’t. Yet few knew him outside Caxton’s London office.

Law grew up in Cheshire, England, south of Manchester, and is an avid follower of his local Manchester City soccer team — not the world-famous Manchester United team. He is known as fiercely competitive yet understated, and for his dry sense of humor. Law likes to swim several times a week, usually during the lull after European markets open and before U.S. markets start trading. He enjoys hunting, mostly pheasant, and the occasional ski trip. He also likes fine wine and is an avid reader of books on history, economics and politics.

After graduating in 1987 from the University of Sheffield with a first-class BA in economics, he joined County Bank, an old English merchant bank later acquired by National Westminster Bank, working in asset management, mostly managing fixed income and currencies for pension funds. But after two years he became much more interested in trading. So he joined Chemical Bank — which later became part of JPMorgan Chase & Co. — starting out on the proprietary trading desk. “I had a few lucky trades,” he says dryly, reflecting on his first few weeks on the job. He eventually headed the interest rate proprietary and fund trading desk. One of his more successful trades, he recalls, was made when he shorted sterling futures as U.K. interest rates more than doubled, to 15 percent. It was a volatile time in Europe. Spain had just joined the Exchange Rate Mechanism in 1989, and the U.K. signed on the following year. Spain wound up devaluing its currency, the peseta, several times over the next few years, and the ERM ejected the U.K. in 1992, one day before expelling Italy.

In the middle of 1996, a friend invited Law to join the prop trading desk at Goldman Sachs, where he mostly traded fixed income, currencies and some equity indexes, eventually running it. Siva-Jothy remembers Law for his consistency and for taking risk to the limits. He says Law had come from an institution that was not a big risk-taker and he wanted to step up his game. “He did incredibly well,” Siva-Jothy adds. “He was one of the most consistently profitable persons on the desk and had one of the best risk-adjusted returns.”

Siva-Jothy attributes Law’s success back then — as well as at Caxton — to his calm temperament. He recalls that Law would not put on a trade if it did not feel right and that he was very careful with how he used risk. “Law had a great understanding of the yield curve, and he would use that knowledge to both protect his downside and maximize returns,” Siva-Jothy adds. “He has a sharp sense of the fundamentals and a firm hand in where we are in the business cycle.”

“He had one of the best risk-constructed portfolios, which allowed him to have among the best returns of macro managers at Goldman Sachs,” recalls Caxton chief risk officer Matthew Wade, who worked at Goldman at the same time as Law.

However, Law felt that being a prop trader at a firm like Goldman was not a good cultural fit, as most of its employees seemed to be heavily involved in what he calls “soft things,” such as recruitment and reviews designed to boost managerial careers but not necessarily trading. Those who know Law say he also was frustrated that he would need to wait longer than he would have liked to become partner.

In 2003, Law decided to look for a job at a hedge fund. He got in touch with a former Goldman partner who had worked at Caxton and made the introduction to Kovner. When the pair met at Kovner’s former residence near the Metropolitan Museum of Art one snowy day, it became clear to Law that Kovner’s trading style and approach to investing jibed with his. It was a shared passion for listening to the market and respecting where it was going instead of having a preconceived notion of the fundamentals, which might or might not determine price.

Law remembers an in-depth discussion they had about risk control and how Kovner seemed to know when a trade wasn’t going to work and how to react when that happened. “A big part of the discussion was about how you react,” he says.

He was also impressed that, unlike many traders, Kovner came across as calm. Law then met with other Caxton employees, a rigorous process that resembled Goldman’s recruitment culture. “It is important for people to buy into other people’s personalities,” Law says. “It is a personality business. How you get along with people from a managerial sense is important, besides your ability to produce numbers.” Law liked Caxton’s environment, and he and Kovner wound up agreeing on terms quickly. He joined Caxton in April 2003.

Kovner hired Law to build out the London office’s macro trading. At the time, London accounted for only about 7 percent of Caxton’s capital, but Kovner had always felt it was in the best time zone for macro trading. When Law joined the firm, there were about 20 people in the London office, mainly equity-oriented and credit investment professionals. There were just four or five portfolio managers. After Law’s arrival the macro teams got more involved in commodities, equity baskets and single stocks. The goal was to establish a meaningful track record and bring in more capital while building out the London team. By the end of 2008, Law’s London group was controlling 30 to 40 percent of the firm’s assets. Today it employs about 50 people.

Since becoming CIO, Law has jettisoned several strategies and returned Caxton to its macro roots, with the goal of concentrating on the most-liquid markets. Caxton shut down the once very profitable — albeit highly volatile — European long-short equity group run by the Eisenstat brothers after it suffered large losses in the global financial collapse.

In 2009, Caxton reduced substantially Feuerman’s U.S. equities allocation after its return declined by 4 percent in 2008. The performance rebounded — Feuerman was up 11.22 percent in 2009 and 5.58 percent in 2010 — but by then his allocation accounted for only a sliver of Caxton Global’s overall portfolio. In May of last year, AllianceBernstein bought Feuerman’s group, Pyrander Capital Management, which had roughly $1.8 billion in assets — $1.4 billion from outside investors — the majority of which was long-only. It was a major event, which Caxton did not publicly announce — it does not generally issue press releases — but which underscored the firm’s desire to return to its roots. During Feuerman’s 13 years with the firm, his long-short fund generated a better-than–10 percent annualized return and had only one losing year.

In early 2011, Lucidus Capital Partners, a liquid credit specialist that at one time managed $1 billion in notional capital for Caxton, became independent, with Kovner and D’Angelo retaining a 25 percent stake in the $1.8 billion firm. Lucidus returned the money it was managing for Caxton at the end of May 2011. Lucidus founders Darryl Green and Christon Burrows had joined the firm in 2001 when they folded their Green T fund into Caxton Europe. Geoffrey Sherry was also a founding partner of Lucidus and joined Caxton in 2005.

A.R.T. International Investors, a statistical arbitrage fund headed by Aaron Sosnick that operates from Caxton’s offices, opened to outside investors in 2007. It continues to have a fairly modest allocation from Caxton, which calls A.R.T. an affiliate. Caxton Associates is also a minority owner of Hawk Quantitative Strategies, a $310 million quantitative trend-following macro fund primarily run by Jeffrey Enslin, a Caxton partner who joined the firm in 1995. Caxton provides administrative functions to Hawk, as well as a variety of back-office functions.

In April 2011, Caxton announced that effective January 1, 2012, it was taking a minority stake in Wadhwani Asset Management, a London-based quantitative specialist with $1.2 billion in assets. Founder and CEO Sushil Wadhwani became a Caxton partner. Law and Wadhwani have known each other for a decade or so, and Law says they share a passion for economics and financial markets.

Despite — or because of — all of these changes, Caxton has struggled the past few years, gaining just 5.8 percent in 2009, when the S&P 500 raced back up by 26.5 percent, and 9.3 percent in 2010, when the benchmark climbed 15 percent. And despite rebounding sharply last August and September, Caxton Global finished 2011 with its lowest annual return since 2007.

Although disappointed with 2011’s performance, Law says the firm remained true to Caxton’s tradition of generating absolute returns and not losing money. “We are disciplined when we don’t understand what the markets are doing, and this is evidenced by our outperformance of the hedge fund industry, particularly in times of adversity,” he adds.

LAW’S TRANSITION TO THE TOP at Caxton is the culmination of a well-choreographed, decadelong plan. When he was named CIO in 2008, the plan called for a multiyear transition. Still, at the time of the announcement last September that Kovner would be retiring, Caxton instituted a “soft close” to new investors to better manage assets.

Today, Caxton has 25 different trading teams focusing on areas such as commodities, currencies, equities, fixed income and systematic trading. This number should soon rise to 29. (Historically, Caxton has had 25 to 30 teams.) Still, Law stresses that the firm is a macro fund, with macro trading accounting for roughly 65 percent of capital. Seven partners who are traders represent 50 percent of the capital allocation. Law currently manages about 20 percent of Caxton’s assets.

Scott Gordon, a partner and portfolio manager with a focus on emerging markets, says he decided to join Caxton from Marathon Asset Management in 2009 because he was interested in being part of a macro shop. He too felt that the trading world had become more macro-driven after the global financial crisis. “Liquidity is king here,” he says. Gordon, a generalist, spends his time looking at the relationships among many different asset classes, including credit, equities, fixed income and commodities. “I’m very opportunistic,” he adds.

The specialist groups that make up the other 35 percent of capital are expected to contribute uncorrelated returns to the fund. Caxton also looks to them as a source of information about their areas and to be conduits between the investment banks and the macro traders. “They are the go-to resource for the macro trader who has a view in the specialist area,” Law explains, adding that the specialist trader might help construct a trade, advise where to get the best trades and identify the best sell-side analysts. Law says macro traders these days must look beyond traditional, broad instruments — dollar-yen trades, ten-year notes and the S&P 500 — when expressing trades: “You need to be far more micro than that.”

Law instituted several changes as the firm geared up for its transition to the new era. The biggest move took place back in 2009, when the firm became a Delaware-based partnership, something Law and Kovner had been mulling since 2007. Initially, eight individuals were named partners, seven of them portfolio managers. Since then, one retired and three others were named partners. One of them is a portfolio manager, bringing the total number of partners to ten. The partners maintain their own trading lines and benefit from their own P&Ls but also share in the success of the overall firm.

When he took over as CIO, Law maintained the firm’s weekly trading videoconference every Tuesday afternoon, but he also started a brief daily telephone conference call at 8:00 a.m. New York time so everyone can share their market views.

Caxton has become more transparent to investors. In the fall of 2008, Law began sending out a monthly letter detailing performance and providing an analysis of the firm’s risk exposure. Beginning this year Law established a new operating committee, which runs the firm day-to-day and meets with him weekly. The committee includes COO and CFO Forbes, a 22-year Caxton veteran; Bolitho, who took “enhanced responsibilities” within the middle and back office; and general counsel Bern–stein, who has been with Caxton for 21 years. The committee discusses progress on existing and new projects and generally keeps Law apprised of what is going on at the firm, freeing him up to trade.

Managing and controlling risk has always been a cornerstone of Caxton’s success. One of the keys to this is the firm’s risk committee, which is now made up of Wade, Forbes and Law, as well as one of the senior trading partners on a monthly rotating basis. The committee meets formally every month but engages in regular discussions on a variety of issues.

Its most important task is to set each portfolio manager’s capital allocation every six months. These allocations are rarely adjusted significantly from one period to the next. Rather, Caxton prefers allocations to take an evolutionary path. “It is not good to double the allocation or halve it in a single day,” Law stresses. “It is better if [the allocation change] is smoother.”

The capital allocation is determined based on managers’ performance, the liquidity available in the markets for their investment styles and the impact of size on their ability to trade in the same manner as their allocation rises. Psychological issues also are considered, such as a manager’s ability to run large sums of money at a given time. Overlaying this decision is the risk committee’s best guess of where it sees the markets headed for the next six months. Law stresses that a reallocation to trending or busy markets can be instantaneous but must be discussed by the committee.

“Risk management is at the heart of what we do here,” says Wade, who was named chief risk officer in 2010 after joining Caxton from Goldman Sachs Asset Management in New York, where he was global head of manager strategies. “It is ingrained in the culture,” he says. “Andrew is always aware of the risk of the fund.” Wade explains that one of the central tenets of the Caxton culture is humility: the ability to listen to the market and not believe that you know more than it does. He says that when Caxton’s managers put on a position, they must be aware of the potential upside and downside, and the level of pain they are willing to take.

One of Wade’s jobs is to make sure the portfolios are not excessively correlated with one another. For macro traders risk is raised or lowered using foreign exchange forward contracts or futures contracts on commodities, interest rates or equities. Among nonmacro strategies traded by macro portfolio managers, index baskets are used, as well as custom baskets and specific longs and shorts.

Law has tightened Caxton’s drawdown rule, which had already been stringent, saying it better reflects current market conditions and the firm’s trading style. Until a few years ago, portfolio managers who were down 10 percent would be forced to sit out for a short period; they would have to go to cash if they were down 20 percent. Law now stops out managers once they are down just 5 percent, allowing them to restart three to five days later.

Some industry experts say this is a particularly onerous drawdown rule for equity managers because they could miss a sharp market rebound. Other firms, such as Moore and Tudor, generally don’t shut down traders until they are down by 15 percent.

Caxton’s CEO says the 5 percent threshold is not as puny as it sounds because it is based on leveraged capital: The firm’s traders are generally allocated two and a half to three times notional capital. In general, if Caxton is down 5 percent, it really works out to being down 12.5 to 15 percent of the underlying capital. Caxton has found that the 5 percent level works well historically, Law says.

In explaining this policy to portfolio managers, Law said that it usually takes three months to suffer a 5 percent drawdown, and when that happens, it probably means they are getting the markets wrong. “If you are losing money for three months, we think it is a good idea to eliminate most of the problem positions,” he explains.

Behind this theory is the fact that Caxton does not try to forecast where markets will be at a specific time. So if someone loses money for three months, something is not working and it is time to rethink, Law explains. He believes that typically when traders are down 5 percent, if they are forced to sit out, when they come back — whether it is the next day, week or month — 19 out of 20 times they don’t wind up doing the same things.

In fact, Law and Wade say they expect people to hit the 5 percent drawdown every 18 months. If portfolio managers do not reach that mark for several years, they are either very good, lucky or not taking enough risk. If portfolio managers do it several times in a year, it means they’re taking too much risk.

If portfolio managers are down 10 percent from the peak, they must write up an analysis of what caused the loss and interact with Law and Wade’s risk group. They then typically can trade again within a few weeks. “People usually come out of that process learning a lot about their own trading style,” Law says. Adds Wade, “You can think a lot clearer when you do not see your position going against you.”

Last year only two of Caxton’s 25 portfolio managers were stopped out entirely. In fact, Law admits that he personally has hit the 5 percent level several times, but never 10 percent. “It is very psychologically cleansing for a trader,” Wade stresses.

Law has also altered Caxton’s compensation policy, instituting a performance hurdle that portfolio managers must vault. Some critics, however, say the new policy makes it harder to earn money at Caxton and this could make it more difficult to recruit top traders. They say the hurdle rate, combined with the 5 percent drawdown rule, is especially tough for equity traders because stocks that quickly sink often rebound just as sharply.

Law has little patience for this argument. “We have had this discussion many times,” he says. “It doesn’t matter what the asset class is. Successful PMs should be able to risk one to make two or three in whatever asset class they specialize in. Equities are not a special asset class with superior return characteristics. We stress to all our traders that the more volatile the instrument, the smaller the position should be.”

The people who do best at Caxton, Law says, are those who can take chips off the table when performance is high and buy some back when it has corrected. “That’s trading,” he emphasizes. “That’s what we do. If people can’t trade, they shouldn’t come here. They should go work for a long-only shop. Yes, equities are volatile, but they should still be traded in more modest size.”

This approach to trading will be especially critical as Caxton navigates a world Law describes as fraught with uncertainties, despite recent positive developments. In Europe, for example, he is anticipating a mild recession even after the ECB’s unexpected three-year Long Term Refinancing Operation (LTRO) has pumped liquidity into the banking system by offering banks three-year loans at a discount. The news sparked an enormous rally in Spanish and Italian Treasuries. The yield on Spanish two-year notes dropped from 6.5 percent in late November to roughly 3.5 percent in mid-January; the yield on two-year Italian paper fell from 7.5 percent to 4.5 percent.

“This has provided a massive liquidity offset to the austerity and tough medicine politicians have been delivering,” Law says. Although the LTRO kicks the can down the road again, he adds, it has bought more time for governments to enact fiscal austerity. “If banks buy more sovereign paper, then the sovereigns will have fewer financing problems,” Law explains.

According to Caxton’s CEO, the overriding question is whether the troubled European countries and their citizens have the staying power to absorb austerity moves over the long term. The key variable is growth. “Until we get nominal growth in Europe, the debt situation will remain challenging,” he adds.

How can there be growth in an otherwise austere environment? It won’t be easy, Law says, which explains why he expects a slight recession this year on the Continent. Slow growth or no growth makes most European markets look expensive, he notes.

Law is most optimistic about the prospects in the U.S., declaring its economy in better shape than it has been in for some time. The U.S. is further along than Europe in deleveraging its banks, he explains, and its housing market is in the best shape it’s been in for five years. Housing construction is well below normal levels and not keeping up with household formations. “The risk in housing is on the upside,” he says, “particularly in terms of construction activity and eventually prices.”

The CEO favors U.S. assets over European ones and hopes to capitalize on the economic imbalance between the U.S. and Europe by shorting the euro, among other means. In equities Caxton can play these trends several ways, he says. It is buying building-related companies, regional banks and U.S. companies in domestically focused sectors that are not exposed to the rest of the world.

Meanwhile, Caxton has been winding down its bearish bet on the credit cycle — a sign, Law says, that the credit crisis has come to an end and that some areas are able to grow. Still, he expects European--based companies in banking, construction and real estate to continue to struggle. “Being bearish on these sectors in Europe and bullish on them in the U.S. is a good trade,” Law says. And although investors still cannot short financial stocks in some European countries, they can short German banks, he stresses.

In China, he says, politicians want to cool off the property and housing market — construction has fallen 30 percent over a multiyear period — in favor of pushing domestic demand. Law explains that this is showing up in several ways. The Beijing government is letting its currency appreciate against the U.S. dollar and is maintaining a tight monetary stance despite a slowdown in the property market. As a result, there has been a weakening in commodity prices around the world, especially for copper and iron ore.

Still, wages in China are growing by about 13 percent annually, Law says. He contends there is money to be made investing in companies that have exposure to China’s mass market. “If [the Chinese economy] has a successful soft landing, emerging Asia will do well,” says Gordon. “If it is a hard landing, the notion of Asian emerging markets’ outperformance is questionable.”

For his part, Law is not buying Chinese-based companies. He prefers European and U.S. companies that sell into China. They include most of the European carmakers and U.S. restaurant chains. In fact, Caxton generally makes only modest investments in Chinese or Asian stocks, or in companies in other emerging markets. “We just don’t understand them as well,” Law says.

After all, for Caxton the key to investing successfully is to listen to the markets and to manage risk.