Best Sub-$50 Million Hedge Fund: Winner

Inefficiencies in the market it creates underlie the investment process of the Liontrust Credit Fund.

The fund invests primarily in listed European investment grade and high yield fixed income securities and derivatives utilising a credit-based, opportunistic approach.  It uses a top-down macro view of European credit markets and fundamental, bottom-up credit analysis to make its selections. The fund maintains long and short positions in over and undervalued securities in order to make returns.

This say the managers Simon Thorp and James Sclater, incorporate a top-down macro view of European credit markets with fundamental, bottom-up credit analysis.

The fund aims to identify changes in a company's debt servicing capacity using Liontrust's proprietary credit selection process.

According to Thorp and Sclater because of the complex nature of forecasting a company's creditworthiness, investors and analysts often use simple rules of thumb and "anchor their estimates". These forecasting errors mean investors can be slow to identify changes in a company's situation. As these errors are identifiable they create investment opportunities.

Such opportunities are realised through taking long/short positions in over and/or undervalued securities to achieve capital appreciation, explain Thorp and Sclater.

The Liontrust credit selection process uses four key measures of a company's cash flow and debt structure, assessing its strength of earnings and access to liquidity in relation to their interest and capital repayments.

The managers first measure cash flow at four stages: gross margins, EBITDA, cash flows from operations and free cash flow. They then look at liquidity and the company's ability to repay its liabilities. Then leverage is studied, analysing the relationship between company debt and the quality and stability of its earnings. Fnally, the company's covenants are examined in order to be confident there is sufficient "headroom" to avoid a breach.

These measures identify companies with improving or deteriorating ability to retain cash and service their debt to give Thorp and Sclater their universe of credit investments. They then use a proprietary valuation measure to identify which of these credits are currently cheap or expensive.

Taking advantage of the significant inefficiencies across the markets is done by exploiting a number of areas. For example, explain Thorp and Sclater, divergence in the spread between cash and CDS, fluctuations in demand for investment grade and high yield bonds, fluctuations in discount levels on primary market deals, anomalies on the CDS curve which have little relation to risk on the actual maturity profile of a company and index-driven distortion.

The managers believe opportunities will exist in most of these areas in future.

In the short term they expect forced selling which began during the credit crisis. During that time when many funds were obliged to sell bonds to reduce name exposure and raise liquidity. This created what Thorp and Sclater term "excellent opportunities to buy non-stressed credit from stressed investors". This they both think will also continue, providing further opportunities for the fund.

Looking  into 2010 Thorp and Sclater expect the most significant danger for credit and equity markets will come from the rising cost of capital.

As quantative easing ends and sovereigns begin their own deleveraging, cash-rich investors are likely to demand an ever-increasing price in return for deficit financing, believe Thorp and Sclater. If this happens too quickly it will upset the appetite for all risk assets and perhaps push economies back into negative growth. With spreads not currently pricing in such an outcome, credit markets would sell off, they warn.

Fund facts: Liontrust Credit Fund

Full name of fund: Liontrust Credit Fund
Name of portfolio managers: Simon Thorp and James Sclater
Name of investment/management company: Liontrust Investment Services
Contact information: 2 Savoy Court, London WC2R 0EZ (+44 (0)20 7412 1700)
Launch date: Novmeber 1, 2000
Strategy: credit-based, opportunistic long/short
Assets under management: €15.9 million (at March 31, 2010)
Net cumulative performance since inception: 146.8% (at March 31, 2010)
Annualised return: 10.07% (at March 31, 2010)
Annualised volatility: 7.72% (at March 31, 2010)
Sharpe ratio: 0.96
Share classes: US dollar, sterling and euro
Administrator: Citi Hedge Fund Services
Auditor: KPMG (Cayman Islands)
Custodian: JP Morgan
Prime broker: JP Morgan
Domicile: Cayman Islands
Listing: Irish Stock Exchange
Management fee: 1.5%
Performance fee: 20% with a high watermark
Minimum investment: €100,000, $100,000 or £75,000
Redemption/liquidity terms: monthly dealing with a 20 day notice period