AIM13 Commentary - 2017 Q2

“It ain't what they call you, it's what you answer to.”

- W.C. Fields

August 29, 2017

Dear Investor,

With all of the name-calling and political acrimony in the press these days, we thought we would take the opportunity to talk about how a name attributed to something does not always equally apply to all things that commonly share the name. We do not mean this in a political sense. Rather, in this case, we mean “funds of funds,” which we believe as commonly understood do not represent the way we invest alongside our partners.  And to lead off our case, we call upon one of our favorite movies of all time.

Psycho:  The name's Francis Sawyer, but everybody calls me Psycho. Any of you guys call me Francis, and I'll kill you.

Leon: Ooooooh.

Psycho:  You just made the list, buddy…

Sergeant Hulka:  Lighten up, Francis.         

                          - Stripes (Columbia Pictures, 1981)

People today are very quick to assign labels, as anyone who watches the news or what is coming out of Washington can quickly see. Likewise, name-calling happens a lot in our industry – whether it be “hedge funds,” “private equity funds,” or even worse, “funds of funds,” all frequently used derisively. Indeed, sometimes we think managers of funds of funds have a lower approval rating than politicians. Moreover, once you are labeled as something, it is very hard to persuade someone that you may have attributes or qualities that others with the same label do not share.   

“It depends upon what the meaning of the word ‘is’ is…”

- Bill Clinton

Whether what we do here at AIM is managing “funds of funds” depends on what the meaning of the phrase, “fund of funds,” is. Of course, our entities technically are funds, and the investments we typically make are in funds managed by other investment managers. If you stop there, then, yes, we do manage funds of funds.

Why do we care what we are called? Let us first point out that a lot of the negative feelings towards funds of funds is, in fact, warranted.  Many fund of funds managers deserve the negative press. The fact is the goal of most fund of funds managers – and many hedge fund managers or other “asset managers” – is to get as big as possible. We have pointed out before that a hedge fund manager who charges 2% and 20% with $1 billion in AUM can generate $20 million in management fees annually and, if he or she performs well (say, posting a 20% gross return), the 20% performance fee generates another $40 million, netting a total of $60 million. However, that same manager is more incentivized to grow AUM to $3 billion. Then the management fee alone will net the $60 million – and the manager does not even need to generate any returns for the investors. Investors are not naïve and are right to be critical of the many managers who just focus on assets, not performance. The problem is that these negative views have been very detrimental to our industry. Some of the best hedge fund managers will limit or not even accept any capital from funds of funds since they are looking for investors with aligned interests (i.e., a focus on performance).

For these reasons, we wanted to point out that there are important differences from the investments we make with our partners as opposed to other firms that manage “funds of funds”.  These are the reasons we have been able to invest with managers who otherwise shy away from funds of funds as investors.

• We stress alignment of interest: At AIM, we are the largest investors across all of our funds and approximately 17% of our total assets is internal or affiliated capital. As such, we will not invest with a manager unless we think they are the best for our capital and subsequently that of our partners. From our early days of investing just our own capital, we have always told current and new partners that first and foremost we are investors; if others share our philosophy (and, as noted below, can help us to be better investors), then we welcome them to invest alongside us. If they do not, regardless of how much money they want to put in our funds, we respectfully suggest they invest elsewhere. Our belief is that many “funds of funds” do not approach new investors in that way.  In short, we view ourselves as an investment firm, not an asset management firm.
   
• We focus on “hedged” funds:  As strong believers in the Power of Negative Numbers, we focus on hedge funds that are truly hedged, not just those that call themselves a “hedge fund.” Saying you manage a hedge fund carries a lot of weight in investment and social circles. However, as we like to remind ourselves, “saying it does not make it so.” Many managers of so-called hedge funds (and likewise of funds of “hedge funds”) only spend time on long ideas and just include index shorts so that they can charge higher fees. That is why you will see us refer to “hedgeD funds” – managers typically need to demonstrate skill finding both long and short single security ideas before we add them to the portfolio. Of course, we have our long biased funds, long only funds, etc. However, when it comes to hedge funds, you can call us old fashioned, but we insist that they hedge!
   
• We are motivated by investment returns, not management fees: Many fund of funds managers are primarily motivated by management fees, since the bulk of their compensation comes in that form, rather than from investment returns on their own capital. Our greatest economic incentive comes from growing our own capital. Even our performance fee structure, typically 5% over a 5% hard hurdle is relatively modest compared to the many funds of funds that charge a 10% performance fee with no hurdle.
   
• We do not create funds solely in response to investor demand:  In our last letter, we talked a lot about how the customer is not always right. Over the past 18 years, if we had responded to every investment fad or newfangled idea brought to us, we would have launched – and subsequently abandoned – countless vehicles. Unfortunately, that is precisely what many funds of funds have done, offering customized portfolios, increased liquidity, and specialized products just to raise money. Investors, however, are fickle, and the tide of current opinion can turn fast, as the headlines below demonstrate:

Here today…        “Demand for Liquid Alternatives Increases,” Markets Media, September 2014
                             “Liquid alts demand set to surge as traditional lines blur,” Portfolio Adviser, June 2015

Gone tomorrow.   “Liquid-Alt Mutual Funds Disappoint,” Barron’s, December 2016
                              “Alts Flows Hit the Brakes,” Morningstar, December 2016

Our favorite is the now infamous 130/30 funds. We remember in 2007 when Merrill Lynch said that assets in 130/30 funds would reach $1 trillion by 2012. That forecast has proven a bit aggressive, to say the least. As Morningstar’s John Rekenthaler said earlier this year on MarketWatch, “I don’t think you can find a fund with 130/30 in its name anymore.”

• We view our funds as a portfolio, not just as a series of individual investments: We are sometimes criticized for sticking with a manager who is down or redeeming from a manager even though the manager has posted recent strong returns. We do that because we view our hedge fund investments as a single allocation in our overall portfolio. When viewed in that context, we can tolerate underperformance of one manager and not be afraid of hiring a manager whose long term approach may include down months from time to time. We are also willing to trim or redeem from a manager who has posted strong returns if our outlook of future performance is undermined by such things as rapid asset growth or style drift. In fact, we are constantly asking ourselves, if we were not invested today, would we invest?

In this regard, we agree with Byron Wien’s commentary from thirteen years ago:  

“In my mind to achieve truly superior performance a hedge fund manager must identify concepts and themes that are undervalued and have considerable long-term potential. They can do some trading around their core positions, but the thrust of their performance will come from having a substantial weighting in a number of non-consensus ideas that turn out to be right. This often requires both conviction and patience, but along with those manager qualities comes portfolio volatility.”

                 - Byron Wien, In Praise of Hedge Fund Volatility (2004) (emphasis supplied).

Portfolio volatility is anathema to many funds of funds, since they try to align themselves with their investors’ short term outlooks. Why stick with a manager who is underperforming?  In their view, since they answer to their investors who may second guess their line-item manager selection, it is better to quickly swap out the manager for another that might perform better. We think differently.

• When it comes to new LPs, we value all strategic partners, not “the bigger, the better”:  We are often asked why our investment minimums are relatively low given that we provide access to managers whose minimums are as high as $25 million. However, when we think about expanding our partner network, we primarily think about attracting new partners who can make us better investors. An arbitrary minimum initial investment is not as critical to us as it is to many funds of funds. Rather, we hope to partner with investors who are value-add, often with industry expertise or contacts and relationships of their own that we can leverage to find new managers or help our existing managers. 

When it comes to attracting investors for most funds of funds, it is usually, “the bigger, the better.” The industry reinforces that mindset. Whenever we see a list of the “top” funds of funds, the ranking is almost always by size. How often have you seen a listing of “top” funds ranked by order of long term performance? Or by their after tax results – which matter to us as taxpayers? The answer is, almost never!

Yogi Berra famously said, “If you don’t know where you’re going, you’ll end up someplace else.” Investors in “fund of funds” strategies or in any managed investment need to understand what motivates the manager (returns vs. asset growth), what the manager is trying to deliver, how the manager thinks about the underlying investments, what other types of LPs are invested in the fund, etc. There are definitely other funds of funds out there that think like we do. However, the widely-held preconceived, and largely negative, perceptions about our industry unfortunately are applicable to many funds of funds.

Nobody Is Thinking Anymore

“Most people do not listen with the intent to understand; they listen with the intent to reply.”

                                                                        - Stephen R. Covey, The 7 Habits of Highly Effective People

In a recent research paper entitled, The Use of EDGAR Filings by Investors, published in the Journal of Behavioral Finance, authors Tim Loughran and Bill McDonald wrote, "The average publicly-traded firm has their annual report requested only 28.4 total times by investors immediately after the 10 K-filing.” They concluded that “The lack of annual report requests suggests that investors generally are not doing fundamental research on stocks.” Philip Grant, writing about the study, noted in June, “Nowadays, few people even bother to read company filings.”

What is going on? We have one theory: in the so-called information age, we are so inundated with data that people are increasingly becoming incapable of absorbing and processing real information (or too lazy to do the hard work required). As an analyst, why bother reading through a 10-K when with a quick Google search you can get someone else’s take on the company?  In short, the Internet and the near instantaneous dissemination of derivative thinking (i.e., “someone else’s take”) has made many investors lazy.

This truism is borne out by the increasing amount of time we all spend staring at screens:

The problem is that while we are all so consumed with absorbing information and data, no one is really thinking. Abraham Lincoln famously said, "Give me six hours to chop down a tree and I will spend the first four sharpening the axe." If he were alive today, Honest Abe would be shocked at how superficial our collective thinking has become. 

Brian Scudamore, a noted serial entrepreneur, has written about how successful people carve out time just for thinking. According to Scudamore, AOL CEO Tim Armstrong, for instance, makes his executives spend 10 percent of their day, or four hours per week, just thinking. Jeff Weiner, CEO of LinkedIn, schedules two hours of uninterrupted thinking time per day. Bill Gates was famous for taking a week off twice a year just to reflect deeply without interruption. Likewise, Warren Buffett has said that he has spent 80 percent of his career simply reading and thinking. We would do well to follow these examples.

Not surprisingly, the decline in real thinking is reflected in the diminishing patience investors have for long term investments:

Market Observations

“Financial markets have been so strong for so long that fear of market risk has mostly evaporated.”

- Seth Klarman, Letter to Investors, June 1999

A friend of ours pointed out this observation from the renowned value investor that was pulled from a letter he wrote in June 1999. At that time, the market had risen sharply for almost six years. Some might have said he called the top too early; indeed the S&P 500 gained almost another 20% before losing about 50% in the tech crash of 2000-2002. From the chart below, we can see that his caution might equally apply today:

Indeed, just like what Seth Klarman witnessed in the late 1990’s, it seems today that stock market complacency has reached all time highs. In early August, Deutsche Bank's Jim Reid pointed out that at the time the S&P 500 had moved less than 0.3 percent in either direction for 13 consecutive days. That was the first time a run that long has happened since 1927. "Advisor and client concerns dropped this quarter as markets rallied and volatility subsided," said John Moninger, managing director of retail sales at Eaton Vance, which recently released its latest Eaton Vance Advisor Top-of-Mind Index (ATOMIX) survey, a quarterly survey of more than 1,000 financial advisors. According to the survey, just fifty-three percent (53%) of advisors said their clients are motivated by fear more than greed, a stark contrast to Q3 2016 when 82% said fear was their clients' top motivator. Mr. Moninger also noted, "However, there is an underlying feeling of wariness as we head into September, driven by political uncertainty, geopolitical issues and the pace of U.S. economic growth."

On August 1st, the Dow crossed the 22,000 threshold for the first time. Notably, it took the index only 154 calendar days to climb from 21,000 to 22,000, according to S&P Dow Jones Indices. In contrast, it took the Dow 2,119 days -- or nearly six years -- to go from 14,000 to 15,000 (due to the Dow's more than 50% plunge during the 2007 to 2009 bear market). The tide is rising faster and faster!

Despite the rising markets, pockets of data suggest investors should be cautious. According to CFRA's chief investment strategist, Sam Stovall, the average price-earnings ratio for the S&P 500 at market tops is 18.1. Currently it stands at 23.5 times earnings. Maybe for that reason and many others, it seems that fund managers are not as sanguine about the markets as the broader investor public pushing up stock prices. The chart below, taken from the most recent BofA Merrill Lynch Global Fund Manager Survey indicates that the percentage of all fund managers who think the markets are overvalued is the highest it has been in over twenty years (we will leave aside the debate about corporate tax rates and equity valuations):

Anthony Mirhaydari captured it well on CBS’s Money Watch earlier this month: “There's just no other way to say it: We are truly in an unprecedented environment. And based on market history, and the tendency for stocks to underperform after similar periods of complacency and quiet, the dangers to investors are high and rising. And many are ill-equipped to absorb market losses right now.” We could not agree more.

Consumer Debt

We often talk about consumer debt and its impact on our market outlook. A recent report from The Wall Street Journal said that U.S. household debt reached a record of $12.8 trillion in the second quarter. Rising mortgage debt and auto loan originations, and an uptick in credit-card balances, which reached their highest level since 2009, all contributed an ever-growing debt bubble:

*     *     *

Taken together – an elevated stock market and ballooning consumer debt – we believe we need to be as cautious and guarded about the future as we ever have been. From our conversations with most of our managers, they feel the same. Yes, we have said before that the best thing about being bearish is, you’re never wrong, just early. However, we also say, “This time is different are the four most dangerous words in investing…”

A Final Word About Investor Behavior and Perceptions
Versus Reality

There is a poster that has appeared at bus stops in Manhattan that says, “Every year, New Yorkers bite ten times more people than sharks do worldwide.” That got us thinking about perceptions versus reality in investing and in life. All of us who spend time following the markets and investing must guard against the steady creep of popular opinion or fads that distract us from what is true and persistent over time. This requires a combination of intelligence, humility, and above all discipline. When faced with investment decisions, we can all be swayed by emotion, bias, and rumors; we ourselves are not above those things, but we do recognize the detrimental effect that many human behaviors have on growing capital in the capital markets. We must be honest with ourselves.

In that spirit, we came across this humorous depiction of investment decision-making, which many investors can relate to:

Source: 8 Common Biases That Impact Investment Decisions by Brad Sherman, Investopedia

We bring this all up because it relates to why we do not like being called a “fund of funds” and goes to the very heart of what we do here at AIM: We recognize that we cannot pick individual securities with anything near the skill, focus, and experience of the most talented investment managers. We therefore apply our talents and the tools at our disposal, which include our deep due diligence and network of our partners, corporate executives and finance professionals, to find the very best managers out there and construct a portfolio that will produce superior risk-adjusted returns over time. In an age where passive investing is the hottest investment trend, there is a perception that investment talent is not scarce, that trying to identify investment talent is a fool’s errand, and that all “funds of funds” are just asset-gathering schemes. That perception is not our view of reality.

We welcome any questions or thoughts you may have.

Sincerely,

Alternative Investment Management, L.L.C.