AIM13 Commentary - 2018 Q4

I need a hero!

“I need a hero!
I’m holding out for a hero ‘til the end of the night
He’s gotta be strong
And he’s gotta be fast
And he’s gotta be fresh from the fight…”

— Bonnie Tyler, Holding Out for a Hero (1984)

The last four months of 2018 saw the largest peak-to-trough pullback in the S&P 500 Total Return (“S&P 500 TR”) since 2008 (based on market close prices). Indeed, the index dropped -19.78% from its September 20th high to its December 24th low, just 22 bps shy of the technical definition of a bear market. In fact, using intra-day prices, during the afternoon on the day before Christmas, the market did breach the -20% bear market milestone. It is safe to say that we have now moved away from the period of “easy money,” and we are already seeing a lot of investors and managers “swimming naked” as the market “tide” pulls out. In today’s markets, we believe alignment of interest is paramount. Yet too many managers are putting their interests above the interests of their partners. In that regard, as Bonnie Tyler belted out in 1984, when it comes to investing our capital and our partners’ capital and finding the best managers to partner with, more than ever what we need today is a hero.

At the end of the year, we were not surprised to see the very same people who had given up on shorting and on hedge funds – and who were skeptical of being hedged when the market seemed just to go up –bemoaning the steep losses shortly before Christmas. Indeed, had the year ended on December 24th, investors would have gotten year-end statements showing nearly a 10% drop in their S&P 500 index funds, quite a lot more than “only” the -4.38% decline the market squeaked out for the year. This reiterated for us the folly of focusing on arbitrary time periods. As we have said before, the markets do not follow calendars. In that regard, we think the rally in the last four trading days of the year, when the S&P 500 TR gained over 6%, masked a much riskier environment than what the year-end results suggest. We saw a similar dynamic in the late September to early November period:

The lesson we draw from this is that investors should take calendar-period performance reports with a certain grain of salt. As we discuss below, we cannot tell you where the market will go from here, but we do know that short termism is the bane of every successful long-term investor. We also believe that having a large allocation of our overall investment portfolio in hedged strategies will help us achieve our long-term investment objectives.

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We wake up every morning asking ourselves, as every investor should, whether IF we were not invested with a manager today, would we now invest? This forces us to put aside long, successful track records or the fact that the manager has made us money over the years. We also put aside whether we like the manager personally or whether we view her or him as a friend. We need only to think about whether the manager is an exceptional investment right now. Just as Bonnie Tyler “holds out for a hero” – and, granted, her definition of a hero may be a lot different than ours – we hold out for managers who are the very best at what they do and are committed to doing the right thing. Our definition of a hero also is someone who is willing to be “wrong,” even when they are alone. When Bonnie Tyler says a hero is someone “fresh from the fight,” we are thinking about a manager who stays the course despite the bruising and battering that the markets inflict; she or he may be beaten down, but that does not stop them from popping right back up. That is not to say our hero is obstinate; our hero-manager has “gotta be strong” (i.e., willing to admit when something is wrong and fix it) and “gotta be fast” (i.e., able to figure that out quickly and cut losses early).

Unfortunately, in today’s investment world, what is in our best interests is not necessarily in the manager’s best interest. Heroes are few and far between. At the risk of making a sweeping generalization, we have been extremely frustrated by how allocators of large pools of capital such as pensions and institutions have fallen short when it comes to ensuring managers do the right thing. Reflecting on that, we are drawn back to re-consider what being a “fiduciary” really means:

fi·du·ci·ar·y (noun): one often in a position of authority who obligates himself or herself to act on behalf of another (as in managing money or property) and assumes a duty to act in good faith and with care, candor, and loyalty in fulfilling the obligation. (Merriam-Webster)

We feel strongly that many allocators of capital are falling short when it comes to “acting on behalf of” their clients and beneficiaries. There is a lot of complaining but no one is really shining the light on managers and complaining about things we see managers do all too often. Here are four examples of things that particularly bother us:

Charging Fees on SPV Distributions. In the wake of the financial crisis, many investors redeeming from hedge funds cried foul when they received in-kind distributions rather than cash. Adding insult to injury, many managers charged fees on these long-duration securities. A backlash resulted, and the phrase “side pocket” all but disappeared from fund documents. Creative lawyers, however, have kept this option for managers alive, innocuously allowing GPs to distribute “special purpose vehicles” (SPV’s) or the like comprised of fund investments – and telling LPs that the manager can charge fees on these SPV’s for an indefinite period of time. This is the very practice we all condemned a decade ago. We call on every hedge fund investor to demand that the SPV fee provisions be removed. There is no right of permanent employment (or, rather, perpetual compensation) in the hedge fund industry!

Out of Control Organizational Costs. We can also blame the lawyers for this one. Private fund documents provide that fund set-up expenses (mostly legal fees) are covered by the fund. That is okay; the problem is when the “org expense” line item seems to become a law firm partner’s slush fund. Since when do we need an associate at a big law firm reviewing LP subscription documents at $700+ an hour? Private equity managers are especially culpable in this regard. We have seen PE funds with caps on org expenses in excess of $3 million – even for second or third funds where the majority of LPs are re-ups from the prior funds. This is outrageous! There needs to be more accountability for this expense since every investor bears the cost.
Failing to Return Capital When Adequate Opportunities Do Not Exist. We cannot blame lawyers for this one since it squarely is a matter of a manager’s greed taking precedent over an investor’s return. Suitable investments for any strategy are finite, and the best managers will not deploy capital simply because there is money sitting in the fund. Disciplined managers who put returns above management fees return capital when adequate opportunities do not exist. How many do this? The number is appallingly too low. (However, in our portfolios, we have had several managers return capital, such as Appaloosa, Stonehill, and Deerfield, among others.) Through our ongoing due diligence program, we try to stay on top of every manager we have partnered with to make sure they make only the very best investments – or give us our money back, thank you very much!

Denying LPs the Benefits of High Water Marks and Clawbacks. The obligation of hedge fund managers to make up any prior losses before charging incentive fees (“high water marks”) and of private equity managers to pay back unearned performance compensation (“clawbacks”) should be considered assets of the investor. Managers, however, do not always see it that way. Too often we see hedge fund managers walk away from a fund with incentive fees in their pockets even though the fund is under its high water mark. Although private equity funds have clawback provisions, almost all fund documents allow for a reduction of that amount based upon an assumed highest tax rate. This does not account for the GP member’s actual tax situation or such things as the deductibility of state and local taxes. As such, investors not only are not made whole, in some cases the GP member can actually still benefit from a loss carryforward. We call this, heads the GP wins, tails the LP loses!

“Character is doing the right thing when nobody’s looking.”

— J.C. Watts

When we point these things out to managers, we cannot tell you how often we hear, “You’re the first person who has raised this,” or “No one else has a problem with it.” Unfortunately, we have a sinking feeling that managers say these things because no one else is taking a close look. However, that should not mean managers can get away with it. We continue to challenge managers to adhere to the highest standards of fairness and transparency. When we see that a manager’s objectives do not align with ours or that those objectives “evolve” during the time we are invested, we need to be aware of that and act accordingly. So as we look for our “hero” among managers today, although our criteria may be different than Bonnie Tyler’s, we do know that if our objectives and interests are not aligned, we will fail. All managers stumble at some point and have a difficult stretch. Indeed, our best performing manager over the last four years posted the worst return in the fourth quarter among our managers. Our conviction, however, remains very high, and we took the opportunity to add capital. Managers do not go dumb overnight. Shared interests, however, between a GP and its limited partners can diverge, and when that happens we need to take action.

The reality is that it is easy to look good when the market goes straight up. However, a bull market does not relieve us or any other true fiduciary from shining the spot light on a manager. This means rigorous initial and (even more so) ongoing due diligence. Not surprisingly, difficult times expose the weaknesses of both investment managers and those whose job it is to conduct due diligence on them. The largest allocators naturally carry the largest stick, and we think they are falling short.

Due Diligence Tip

During the Cold War, Ronald Reagan adopted as his own the Russian proverb, “Trust, but verify.” When it comes to conducting ongoing due diligence, we are always looking for ways to verify what managers tell us. One way is using 13F filings. Form 13F is a quarterly holdings report investment managers who manage over $100 million in public securities must file with the SEC within 45 days after the end of each quarter. The filing represents a snapshot of the manager’s portfolio at quarter end and can be a starting point for questions where the manager is not otherwise providing full, real-time position-level transparency. Our analysis of manager 13F’s has yielded insights about manager AUM, position concentration, and turnover, among other things.

The value of 13F’s is limited, not solely because the information can be as much as 45 days old. Another limitation is that sometimes the security prices filed by the manager do not tie to the quarter end closing price of a particular security. Mispricing can expose weaknesses within the manager’s reporting controls, such as when one manager included holdings for Pfizer stock that implied a price of $206.00 per share when the actual price was $20.60 per share. Another manager similarly moved the decimal point, but on all securities held, implying a total portfolio ten times larger than the actual portfolio. Other managers have used the wrong trading day. Aside from these type of errors or simple rounding, discrepancies can also occur if the manager applies a haircut to the closing price if the securities are thinly traded or under post-IPO lock-up.

What is important here is that investors should take every opportunity to triangulate data sources both to true-up what the manager says and expose things – such as a weakness in controls – that would not otherwise be apparent.

Market Observations

“2018 has been like a rebellious teenager suddenly aware of their own mind, independence, and the world around them after years of being guided and cajoled in everything they do.”

— Jim Reid, Deutsche Bank, December 21, 2018

It bears repeating that the fourth quarter of 2018 was truly one of the most challenging in history. Indeed, it was the 3rd worst quarter since the S&P 500 was expanded to include 500 stocks in 1957:

In 2018, for only the fifth time in the past 28 years, the S&P 500 was down by more than -2%. The other four times were 2000, 2001, 2002, and 2008. The year also had the largest intra-year drawdown since 2009:

The markets in 2018 can be summed up as follows: Very few things worked. According to a Deutsche Bank note in mid-December, 93% of assets were in the red for the year, the highest since the bank started tracking it in 1901 (and exceeding peaks reached in the worst years of the Great Depression). In terms of sectors, as noted above, only healthcare posted a decent return:

Looking across the globe, among the more established markets, there really was nowhere to hide:

We did, however, find one place where investors made money… Qatar!

Source: Novel Investor 1/6/2019, Morgan Stanley Wealth Management

Leaving aside the probability of finding 2019’s version of Qatar, we think there are as many risks out there as there are opportunities. Recent consumer confidence data supports the view that trouble may be upon us sooner than most people expect. At the end of January, the Conference Board released its updated Consumer Confidence Index. It showed a troubling trend that DoubleLine Capital’s Jeffrey Gundlach called, “the most recessionary signal yet.” As the chart below illustrates, when the gap between current sentiment (which is very positive) and future expectations (which has recently weakened significantly) widens, it often is a portend of recessionary periods to follow:

The Widening Gap Between Present Consumer Confidence and Expectations for the Future

What do we view as the some of the greatest risks and challenges for money managers for 2019?

Auto-Pilot Trading: According to a report in the Wall Street Journal in December, roughly 85% of all trading is now driven by non-fundamental traders and computers. In this category we include the four broad categories of non-human security trading: algorithmic, quantitative, automated, and high-frequency. Each is different but the common theme is the absence of manual traders studying company and market conditions, analyzing the signals and charts, and creating a trading logic accordingly. “These ‘algos’ have taken all the rhythm out of the market and have become extremely confusing to me,” Stanley Druckenmiller recently said on Real Vision television. The rise in computerized trading corresponds to the outflows in active equity funds, which hit a record in December:

No deal Brexit in March: The United Kingdom is set to leave the European Union on March 29th. However, according to comments made on CNBC by the former chief sovereign analyst, Moritz Kraemer, "This is not fully incorporated, partly because markets understandably have a very hard time trying to assess what this would actually mean … We have never been through anything remotely similar.” Evidence that a “no deal” exit scenario is not fully priced in, at least with respect to U.K. equities, includes the FTSE 100’s relative valuation versus Europe remains at the 10-year average, despite having dropped over the last year to an eight-year low. Likewise, the FTSE’s volatility is still below the Euro Stoxx 50 and the S&P 500. Other scenarios, such as a delay in Brexit or a second referendum, would only further increase uncertainty.

Corporate credit crisis: Moody’s reported in late January that its Loan Covenant Quality Indicator rose to a record 4.16 in the fourth quarter, breaking the previous record of 4.10 hit in the third quarter of 2018. The indicator uses a 1-to-5 scale in which 1.0 shows the highest possible investor protections and 5.0 shows the weakest. The weakening of credit corresponds to the ever-increasing leveraged loan issuance, which reached new highs in 2018:

According to a report in the Wall Street Journal, the leveraged-loan market is now the second-largest corporate debt class in the U.S., behind investment grade, standing at $1.3 trillion. We have written before about the scary state of credit over the last few years, whether it be consumer debt, the national debt, or, like here, corporate borrowing. Almost every measure indicates unsustainable levels, and no one needs to be reminded that out of control borrowing was a big cause of the last financial crisis.

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While risks and challenges abound, we also see reasons to be constructive about the environment for hedged strategies:

Low correlation and high dispersion of returns in the S&P 500. Eric Costa, managing director and global head of hedge funds at investment consultant Cambridge Associates LLC, told Pensions & Investments in January that “lower correlations and higher dispersion mean that the year is setting up nicely for hedge funds." Indeed, correlations have been trending down now for a number of years:

Rising interest rates generally supports HF returns. Despite the Fed’s indication on January 30th to keep rates steady for now, coming after a year where the Fed raised interest rates four times, the clear trend since 2015 has been to raise rates:

The higher rate environment has been a tailwind for active managers. Most obviously, higher rates help short sellers because they can earn more on collateral, known as the short rebate.

When the VIX is high, it’s time to buy. When the VIX is low, it’s time to go. According to a Wall Street Journal report in January, the VIX climbed 130% last year, its biggest annual jump since its inception in 1993. That followed 2017, when it recorded its lowest average for a calendar year ever. Volatility creates opportunity for active managers and is important for a healthy market over time. Since efficient markets need investors who fear losses, when the fear of loss is too low (i.e., volatility is too low), too much risk-intolerant capital can make its way into high-risk investments. That can have very bad outcomes (e.g., the financial crisis), and so we welcome volatility and believe it fosters an environment where hedged strategies can provide superior, risk-adjusted returns over time.

As we weigh the risk and opportunity set, one thing we do know is, as we said above, we cannot say where the market is going from here. The Financial Times put it aptly when it said recently, “Markets tend to veer between two extremes: fear and greed. But right now, the dominant emotion appears to be confusion. … Where once there was certainty — whether bearish or bullish — there is now mostly doubt and indecision.” In this uncertain environment, we do know that, for the majority of our equity exposure, being hedged makes the most sense.

Twenty Years (and Counting!)

Twenty years ago, in January 1999, our first fund, Rebel Industries, L.L.C., commenced operations in the waning years of the stock market boom of the late 1990’s. Readers of our letters know that we might see a parallel, at least in the markets, between 1999 and today. Aside from a “long in the tooth” bull market, there are several other things that were going on in 1999 that may have more obvious echoes or corollaries today:

The debut of the Euro marked a victory for pan-Europeans, a defeat for Euro-skeptics.
Bill Clinton’s impeachment trial ended in acquittal, leaving the country more polarized than ever.
Columbine High School was the tragic scene of the country’s first mass school shooting.
Y2K loomed as a crisis, a wake-up call for “cybersecurity,” a new word for most of us.
The S&P 500 ended 1999 at 1,469 – and would not see a year-end that high until 2013…

The more things change…? Perhaps. Reflecting on how many of these things overlap with the same crises, concerns, and worries we have today re-enforces one of our core principles: in many ways, investors have faced the same challenges and uncertainties for decades (if not more). It should follow then that what worked in the past should work in the future: stay the course, do not panic (as we said in our last letter), and partner with smart managers who can navigate these challenges.

Closing Thought: Pigs and Punxsutawney Phil

The Year of the Pig began on February 5th, 2019. According to the Chinese calendar, this 12th year of the cycle represents “a year of fortune and luck.” That might run contrary to one of Wall Street’s oldest observations that bulls make money, bears make money, and pigs get slaughtered. However, we did come across an association that might bode well for the markets: On February 2nd, the famous groundhog in Punxsutawney, Pennsylvania could not see his shadow this year (a favorable indication that spring will come early), and it was pointed out to us that the furry animal has not seen its shadow during the Year of the Pig on the last four occasions (2019, 2007, 1995, and 1983). Considering that the Punxsutawney Phil has always seen his shadow in difficult years for the markets over the last twenty years (2018, 2008, 2000-2002), and the average calendar year S&P 500 TR return of the last three “Years of the Pig” is 18.30%, perhaps 2019 will be a year of fortune and luck after all!

We welcome any questions or thoughts you may have.

Sincerely,

Alternative Investment Management, LLC