AIM13 Commentary - 2017 Q3

 “If everyone is moving forward together, then success takes care of itself.”
- Henry Ford

November 30, 2017

Dear Investor,

We have mentioned in the past how general partners’ interests are often not aligned with the interests of their limited partners. Having invested in private partnerships for several decades, we have realized that true alignment of interest can only happen if we understand what motivates investment managers we consider. By understanding people’s motivations, aligning yourself with others with a common goal, and working together, you can achieve great things. Henry Ford understood this better than anyone of his time. Unfortunately, it is often easier said than done. In this letter, we explore hedge fund manager motivations – what we call “short term greedy” versus “long term greedy” – and how divergent motivations have plagued our industry and other parts of the investing environment.

Readers of our letters will not be surprised to hear that sometimes we feel like the man pushing the car up the hill in the cartoon above. If the car goes backwards, the GP will be fine, but we will be flattened!

“It is not from the benevolence of the butcher, the brewer, or the baker
that we expect our dinner, but from their regard to their own interest.”

- Adam Smith

We are not naïve. We accept that capitalistic self-motivation drives value creation and is a fundamental part of successful investing. Indeed, the original hedge fund structure was designed to align a manager investing (and growing) his or her own money with others who wanted to invest alongside the manager. The problem with hedge funds today, however, is that there is a huge misalignment of interests. In technical terms, this is known as an “asymmetric risk-reward.” More bluntly, we call it heads the GP wins, tails the LP loses.   

Many hedge fund managers today are motivated most by making as much money as soon as possible. They are “short term greedy,” rather than “long term greedy.” This motivation is illustrated in several practices that create downside risk and are inimical to superior long term returns. Unfortunately, they have plagued hedge funds (and hedge fund performance) for over a decade:

• Offering short term liquidity options that LPs want but which also make investing long term difficult.
• Running overhead expenses through the fund to maximize the GP’s own P&L.
• Spending a lot of time on CNBC and the like to raise visibility (and money from new investors).
• Telling investors that the fund is “closed” to create an aura of demand but then accepting capital.
• Getting lazy with research and following the herd by investing in crowded hedge fund names.
• Reducing exposures late in the calendar year solely to “lock in” performance fee compensation.
• To save a business after poor performance, increasing risk with a “Hail Mary” investment.
• Trying above all else to be a “safe” investment to attract pensions and big institutions.

We want our hedge fund managers to be, like us, “long term greedy,” but how do we spot a manager with interests that are aligned with ours? First, when it comes to tax efficiency, which is important to us as taxable investors, we like to ask to see a manager’s personal K-1. What better way is there to see how focused the manager is on after-tax returns which ultimately is the most important thing for us? When a manager claims they invest the fund as if it is all their own money, but then responds with a puzzled look to our question, we have our answer: often a manager is less aware of the after-tax returns because they are more focused on raising money from large, tax exempt institutions that can write big checks (and generate management fee income). When it comes to investing our own and our partners’ taxable funds, we know to look elsewhere.

Another way is to monitor internal capital, which we do in a variety of ways. A common provision in private equity fund legal documents requires the general partner to make a certain minimum commitment to the fund so that limited partners know that the general partner has adequate “skin in the game.” Fewer hedge funds have these provisions, unfortunately, but the better ones do, with notice requirements for when the manager withdraws capital. This is important since without a significant GP stake, the manager can view the fund solely as “other people’s money” – with a carry or incentive fee provision that creates a free call option on any positive gains for the fund. Again, heads the GP wins, tails the LP loses…

Managers whose interests are truly aligned with their limited partners do things that “short term greedy” managers would never do. For instance, the best managers voluntarily return capital to their partners when the opportunity set does not warrant managing the capital they have in the fund. For the manager more motivated by growing management fee income, this makes no sense. However, for the manager looking to earn the best returns (and incentive fees), sacrificing management fee income for better returns on their own money is a good trade. Two of our managers even unilaterally lowered their management fees after concluding that the level originally set upon their formation was not warranted at their current AUM level.

We are not shocked that managers act in ways that are not always in the best long term interest of their LPs. Rather, we are shocked when we see others shocked or angered by this. Limited partners must remember no one is holding a gun to their head forcing them to invest.

Moreover, the problem of misaligned interests is not just in hedge funds. We see similar divergent motivations in many other areas of the investment world today:

• What motivates many CEOs versus a company’s shareholders? CEO pay at the largest 350 public companies has risen 930% since 1978, according to a study by the Economic Policy Institute released earlier this year. These top CEOs now make more in two days than the average worker does in one year. Annual CEO compensation has become so large that it necessarily dwarfs other considerations that historically have motivated CEOs, such as accumulating wealth over time through equity ownership, building a long term professional reputation, or creating an enterprise that betters people’s lives and serves as a legacy to the CEO’s vision. Regulators are taking notice: starting in 2018, publicly traded companies will be required to report to the SEC the compensation ratio between their CEO and the median worker. 

CEO pay at public companies is too often tied to short-term results. Investors must recognize that executive compensation that amounts to one-year windfalls and is based on quarterly earnings or other short term metrics is at odds with building long term shareholder equity. 

“Would the financial crisis of 2008 have occurred if the CEO of Lehman,
Morgan Stanley, Goldman and Citibank had to take a very small percentage
of every mortgage-backed security or every loan they made?”

- Aubrey McClendon 

• What motivates a pension fund manager versus the long term goals of the pension beneficiaries? “Nobody ever got fired for buying IBM” is a stock phrase for anyone more concerned about their own job security rather than the betterment of the organization they work for. Dr. Srini Pillay, the well-known psychologist, has written extensively on this overriding “fear of failure” that drives most decisions. We see this when large pension funds invest with “safe” managers. From the pension fund manager’s perspective, a safe choice can never be second-guessed. The mega public pension funds suffer disproportionately from this dynamic since they are also the most under-staffed and have had to fight with one hand tied behind their back. A McKinsey report in 2015 noted that top public pensions average more than $1 billion in assets under management for each employee, including noninvestment and administrative staff. These over-stretched professionals can be motivated first and foremost by following the crowd – and not losing their job.

“On this team, we're all united in a common goal: to keep my job.”

- Lou Holtz

It has been said that “you can be wrong, just not alone.” However, the goal of pension beneficiaries is not to minimize fear or to make sure their manager does not get fired. When it comes to managing investments, following the crowd is often at odds with superior risk-adjusted returns.

• What motivates an investment consultant versus an institutional client? There are many good investment consultants out there, and we are fortunate to work with some of the best of them. However, not all are created equally. A research analyst at a large, well-known institutional investment consultant told us recently that she is inclined get rid of an underperforming investment or manager in the client’s portfolio because it leads to unwanted scrutiny and the uncomfortable question of why the investment or manager was included in the first place. Firing “losers” quickly may work if you do not have a single track record to defend and you want to leave a vague impression of good returns. However, in our business, where we have one overall fund return to live (or die) by, the fund return comes first and single manager returns come second. As such, we can be more patient. Some of the best money we have made has been with managers who have been down. In contrast, the motivation of some consultants to fire underperforming managers quickly is not aligned with an institution’s objective of maximizing the portfolio’s overall risk-adjusted return over time.
   
• What motivates an analyst versus a portfolio manager? An analyst’s primary job is to provide good investment ideas to his or her portfolio manager. For many analysts, their personal goal may be to eventually run their own fund on the back of these individual ideas. In that regard, like the investment consultant servicing an institutional client, they are motivated more by the particular rather than the general. The analyst can have little regard for how the idea fits into the overall portfolio; they want to see their idea included so that a good trade translates to real dollars (which is how they get paid). The portfolio manager must manage this dynamic, however, in the context of the portfolio’s overall return.

A rogue trader never gets fired for making money...

An analyst’s home run that remains on the watch list provides little consolation for the analyst. (Though, a bad idea not acted on is often overlooked, not unlike the rogue trader who makes money…). Analysts and portfolio managers’ motivations are not aligned in this respect.

As Adam Smith pointed out above, everyone is in this business for themselves – as they should be. We do not blame managers for acting in their own self-interest. In that regard, we are reminded of the old saying about what something is worth – that is, whatever two people are willing to buy and sell it for. Just ask the new owner of Leonardo da Vinci’s Salvator Mundi who paid $450 million for the painting earlier this month. Or, for that matter, ask anyone buying bitcoins! (More on that phenomenon below.) The challenge is discovering what really gets a person out of bed in the morning, and making sure that that motivation is aligned with our goals of maximizing the returns on our capital and your capital over the long term on a risk-adjusted basis. The shortest path to making money for the GP is not necessarily the best path for the LP over time.

Due Diligence Tip

While it is important to understand what motivates someone, it is equally important to recognize that motivations evolve over time. We are often asked whether we have a bias towards unattached, hungry (and younger) money managers who are singularly focused on making money or more experienced (and older) managers who have gained perspective weathering various business and market cycles but who also may have interests and family needs outside the firm. Our answer is … yes. Not to be facetious, but we believe it is important to recognize that while certain motivations change over time, alignment of interest between a manager and his or her partners must endure regardless of a manager’s age for both parties to achieve their common goals. It is not whether the manager is young or old, single and sleeping on a cot in the office or has a dozen kids. Indeed, great managers figure out how to do more with less time. What matters is that the manager is rowing in the same direction you are.

How do we monitor motivations over time? The simple answer is, ongoing due diligence. Many people think due diligence ends when you make an investment.  We think the opposite.  Here are some examples of things we do in ongoing due diligence to make sure our managers’ motivations remain aligned with our own:

• We regularly ask what the manager’s optimal amount of assets would be for the strategy. When we see the answer drift upwards as AUM grows, we refer back to earlier statements and get to the bottom of why the answer has changed.
   
• We scrutinize fund operating expenses. When we see a manager shifting overhead costs to the fund, like by outsourcing trading, we want to know why.
   
• We monitor outside business and personal activities of our managers with regular internet searches, by querying our managers and senior staff, and by talking to other investors and contacts. This goes beyond looking for things commonly associated with the distractions of wealth and success (like having multiple homes or buying a sports franchise, etc.). We are looking more for subtle signs, like joining boards, taking stakes in private companies or becoming politically active.
   
• Whenever new people are hired, we want to know why they were hired, what they will be doing and who was doing the work previously. One manager’s four most recent hires were all marketing or client service-related. That tells us where they are putting their resources and time.

As you can see from these things we focus on with our current managers, the amount of due diligence we can do as a prospective investor is much less than the amount of due diligence we can do as an existing investor. Therefore, the majority of our due diligence efforts are spent on our existing managers. This makes sense – they are the ones who have our money and yours!

Market Observations

“Dancing on the rim of a volcano.”

- Alan Bokobza, Societe General, November 19, 2017

As of this writing, the S&P 500 is on its longest streak ever of days without a 3% fall from its previous record, according to Bespoke Investment Group as reported recently by CNBC. This streak is now 21 days longer (and counting) than the previous streak which ended in 1995. With favorable tailwinds – increasing corporate earnings, low interest rates, and a broad-based recovery around the globe – the market just seems to go up and up. Moreover, many of the big banks have bullish views for 2018. For instance, Goldman Sachs sees the S&P 500 at 2850 by the end of next year, about 9% higher than where it is now. UBS says it will hit 2900, with the potential to go even higher (as high as 3300) if tax legislation passes. Ken Fisher even told the Financial Times recently that he thinks the bull market could go on for another three years. There are, however, some contrarians: Societe Generale released a report recently (with the quote above) in which they forecasted the S&P 500 to fall 22.5% to 2000 by 2019.

“I look back on it now, it’s obvious that studying history and philosophy
was much better preparation for the stock market than, say, studying statistics.”

- Peter Lynch

With the S&P 500 on pace for its 9th consecutive positive year, tying the record from 1991 to 1999, we are ready to admit that we did not (and could not) predict the extent to which the equity markets have recovered from the depths of the financial crisis and we tend to agree with Peter Lynch’s observation. Notwithstanding that, we still read our share of statistics and analyze available data, and we continue to be guarded about the markets. We do not know when the market will turn, but we do know that it will turn eventually. For that reason, as noted above, our portfolios remain conservatively positioned.

As we have done before, we wanted to highlight a few things that make us wonder what late inning of this recovery we are in (is it the ninth?):

The FAAMG Dynamic:  Fewer Stocks Driving Market Returns

Goldman Sachs regularly publishes its “Breadth Index” which measures the degree to which index returns are driven by a narrow slice of the market or by a broad group of stocks. The index ranges from 0 (narrow breadth) to 100 (wide breadth). The 30-year average is 35. Today the index stands at 11.

       Source: Goldman Sachs

The biggest drivers of return have been the FAAMG stocks, which is Goldman Sachs’s version of Jim Cramer’s original “FANG” stock acronym. Comprised of the five largest companies in the S&P 500 by market capitalization, FAAMG includes Facebook, Apple, Amazon, Microsoft and Google. While those stocks represent only 13% of the S&P 500 by marketcap, as of mid-year, they represented nearly 40% of the return, according to data published by FactSet. When the outperformance of a narrow slice of the market carries a much broader group of stocks that are underperforming, the overall positive return masks company-specific problems.

Self-Driving Markets

We have all read about the massive inflows into passive equity strategies and the growing concern about what passive investing is doing to equity market valuations. There is now an ETF of stocks of the companies driving the growth of the ETF industry – sort of an ETF of ETFs – as reported by Zerohedge earlier this year.  (This reminds us of CDO-squared from ten years ago…) This is not surprising when you consider that in the past decade, there have been $2.9 trillion of inflows into passive funds, and $1.3 trillion outflows from active funds:

We believe the biggest issue raised by the explosion of passive strategies relates to price discovery. Passive funds are price insensitive, so the flow of money into these strategies goes to the stocks that have risen in value, causing them to rise more. As such, these funds overweight stocks that are overvalued and underweight stocks that are undervalued. This drives momentum trading, and so it is not surprising that MSCI’s Momentum Index is having a banner year, beating the S&P 500 TR by almost 12% year to date, according to the Financial Times. This is the strongest outperformance since 2007 and, before that, 1998/1999. We all know what happened after those periods.

Bitcoins

Jamie Dimon, the JP Morgan Chase CEO, made news in October by saying he would fire any of his traders who dealt in bitcoins. More recently, he moderated his comments by saying, “If you’re stupid enough to buy it, you’ll pay the price for it one day,” according to Bloomberg.  Apparently, Mr. Dimon must believe there is a lot of stupid people out there:

To us, the bitcoin mania has all of the hallmarks of mass speculation. That is not to say that it will not be a viable currency alternative long term. We are not smart enough to make a call on that. Rather, when we see an asset rise nearly ten-fold in such a short period, in the context of an already super-frothy market, it reinforces our view generally that investors are not acting rationally. Art Cashin said recently on CNBC that “we’re in the fear-of-missing-out phase now.” Needless to say, that is not a reason to buy an asset. It is, however, dare we say, a sign of the same “irrational exuberance” that Alan Greenspan spotted in 1996 during the dot-com boom. 

Closing Thought

Alberto Gallo of Algebris Investments recently compiled a list of ten views, practices, and sentiments that he found commonly present in market bubbles:

1. This time is different
2. Fear of missing out
3. Sky is the limit
4. Flipping
5. No credit, no problem
6. Buy the dip
7. Borrow while you can
8. Bidding wars
9. The trend is your friend
10. Financial engineering

When we saw the list, we realized that we had heard or read all of these things within the last year. When we shared this list with a friend of ours, he came back with a nice quote from Charlie Munger: “A lot of other people are trying to be brilliant. We’re just trying to be rational.”  In this environment, we need to keep telling ourselves that if we “stay rational,” we will be better off in the long run.

We welcome any questions or thoughts you may have.

Sincerely,

Alternative Investment Management, L.L.C.