Investment Manager's Letter September – October 2013

Jack D. Schwager’s new book "Hedge Fund Market Wizards" is series of interviews with twelve hedge fund managers. What these managers all have in common is a great record, and that they run huge sums under hedge fund rules. Few of them do the same thing, and there are only two that claim to be value investors. There are quants, long equity, and long-short equity, long-short fixed income, statistical arbitrage and commodity traders. Curiously, there is even a sprinkling of day traders - two of who claim to make in excess of 500 trades a day. After reading the book, we are left with notion that while out-performance is rare, it is real.  In most cases, the methods used are eclectic and mostly transitory. The material here puts to rest to the rather silly notion that market are efficient. Markets may be efficient collectors of data, but what they do with that data after they collect it is rarely rational.

The book holds some important lessons for value investors. First a high percentage of institutional money is very short term oriented ("What have you done for me this month, quarter, and year?"). Since their customers are only looking at the short term many professional money managers cannot afford to hold long term positions. This together with the fact the amount of money in pension funds, 401Ks, IRAs private equity,  and endowment funds has grown from next to nothing at the end of World War II to many trillions today means that there has been a fundamental change in the way markets will behave. Market trends will tend to last longer and volatility will increase.

Value Investing does not work all the time

There has been and will be are long periods where value investing doesn’t work (1998-1999, 2005-2007) when the hot money all goes someplace else. Value will have periods of a year or two where it underperforms the market so the hot money flows out of the value sector. Since Hedge Funds deal with large institutions and mutual funds with the investing public there are many trillions of dollars in the markets with very nervous feet, and when short term performance lags it leaves.

Value gets a negative image with the big money, so hedge fund managers mostly do something else. Even for value managers with their assets under management going south the pressure becomes intense to nudge your style toward the short term. But as Schwager helpfully points out Value Investing works but does not work all the time, and that is why it works. If it worked all the time every one would do it, and then it would not work anymore.

Value investing still works, but it works for a different reason today that it did when Buffett was running his partnerships, the values that where available in the 1950’s are not available today. Value works today because a very large portion of the actively managed money has a very short time horizon and professional money managers can not generally afford the patience that is required value investments to work out.

The lessons for investors are many but the most important is that value investing works because of its long term bias. So while recent changes in market structure can work to the benefit of the investor this is true only if you remember that long term performance is critical, and that decisions based on short term performance make long term out- performance difficult. To be successful the investor has to become a true contrarian and add to value investments when the style has been under-performing and stocks in the sector have become unpopular. When market get bubbly and high risk is ruling the market it is time to raise cash.

Of course it has always been important to be a contrarian, but it is even more important today with all that hot money running in and out of things, and because it is important it is harder to do. With so much information available and so many internet tools it keeps getting harder to sort out the noise.

Keep in mind that invasion of the market by huge quantities of investment dollars and large numbers of investment advisors may have changed the definition of value investing away from the old style Benjamin Graham value more towards the Charlie Munger style of buying really great companies and sitting on your ass. I do not have much luck with cigar butts instead of a few cheap puffs I usually just end up with a bad taste in my mouth. The increase in information available to the investor makes it more likely that what looks like dog really is a dog. The huge increase in hot money increases volatility and that volatility can make stocks with good long term prospects temporarily cheap when their short term develops problems.

Edward Thorpe

My favorite part of the book was the interview with Edward Thorp who has been one my heroes since he wrote "Beat the Dealer" in 1962. A PhD in Mathematics, Thorpe taught at UCLA, MIT and University of California. In 1959, he developed a strategy for winning at blackjack by counting cards. His success in finding a formula to beat casino games, together with the fact that casino’s did not like to be beaten as demonstrated to him in several very unpleasant ways, moved Thorpe to study ways to beat the biggest game of all, Wall Street. His work on casino games and his 1969 founding of a Quant Fund may well have given birth to that whole segment of the hedge fund industry.

The interview provides an interesting perspective on the very early history of hedge fund industry, and the reasons why results that were available to early hedge funds are much more difficult today. In 1969 Thorpe founded Princeton Newport Partners which was probably the country’s first Quant Fund. To begin with, Thorp’s strategy consisted of trading warrants and other convertible securities by hedging them with offsetting stock positions. He found that, at that time, Warrants with less than two years to run typically traded at premiums that were too high.  So, he would short the warrants and buy the stock. This was quite successful, with results running around 20% per year, and worked for a few years, but then stopped working as more funds discovered the statistics.

In 1967, Thorp developed a formula that was the functional equivalent of the Black-Scholes, but instead of publishing the formula he decided to use it for the benefit of Princeton Newport Partners. When asked by the Author if he thought he should have published and received the recognition later received by Professors Black and Scholes, he said he had no regrets.  He said after the formula was published in 1973 the systems he used, based on the formula, lost their edge. Throughout the interview, Thorp makes it very clear that he believes that quant funds in particular, and hedge funds in general, which start with an edge with eventually lose that edge, because their competition will work till they discover that system. Money will flow in until the edge disappears. To maintain strong returns it means you have keep finding new winning formulas.

After Princeton Newport Partners shut down in 1989, Thorp went back to managing his own money until 1992, when he was asked to run a statistical arbitrage strategy for a large institutional client. In 1994, he opened these strategies to outside investors and started his second hedge fund, Ridgeline Partners. Ridgeline traded actively and he ran these statistical arbitrage strategies for ten years with an annual return of 21% per year until 2002 when he felt that his system lost its edge.

When asked about investing in hedge funds today Thorp had a warning;

"Twenty years ago I understood the details of the hedge fund world very well because I was running one myself, and I knew a lot of the players and methodologies. I had a pretty good idea of which hedge funds had an edge and which ones were just asset gatherers. Since then, there has been an explosion in the number of hedge funds and assets under management, trends that have been accompanied by the entry of many more mediocre players. The increase in assets under management also tended to lower the return per dollar invested, as more money chased similar strategies. Finding the good hedge funds also became more difficult as there were much larger numbers of managers to wade through. Over the years, hedge funds began to shift from having edges to being asset gatherers."

Thorp still has some of his money with hedge funds but not near as much as ten years ago. He has a few positions he has retained from earlier years, but says he is not able to find new funds with an edge that he understands.

Another example of Thorp’s remarkable insight came when he met Buffett in 1968 and played bridge with him a few times.  Thorp commented to his wife,

"Given his ability to analyze companies, his rate of compounding, and the scalability of the approach, I thought he would be the richest person in the world someday."

This was at the time Buffett was getting out of the market and closing his partnerships. Thorp lost track of Buffett, until he learned in 1982 that Buffett was using Berkshire Hathaway as his personal investment vehicle. In 1982, Thorp bought Berkshire but not without complaining about paying $985 a share when it had been selling for $12 in 1964. Unfortunately, the book does not enlighten us as to whether or not he still owns the stock, or if he sold when he sold.

Colm O'Shea – Comac Capital

Colm O’Shea 43 years old, is a Global Macro Trader, making calls on economic and policy decisions around the world through instruments such as debt securities and currencies. O’shea worked from 1992, when he graduated from Cambridge, until 2003 as a trader for Citicorp.  He did a brief turn at Soros’s Quantum, before he started Comac in 2006. As a Global Macro Trader, he is basically a trend follower who tries to benefit from economic trends that are currently in place with the use asymmetrical leveraged trades. This is an investment philosophy that is the polar opposite of value investing, requiring a large number of positions aggressively traded. O’Shea favors a trend following approach with a very quick exit if a trade goes against him.

O’Shea has a list of rules that he claims have made him a successful trader, but the list basically describes what we would consider the behavior of traders in the classical sense who have learned through years of experience and lessons learned the hard way. Many of them have been able to create a good record for a few years and that has enabled them attract money from big institutions and high net worth individuals, but that does not mean that their style will last.

In 2011, when the book was written, O’shea was ranked Number 21 on Forbes list of top hedge fund managers with over $5 billion under management, with a record from 2003 to 2011 of plus 11.3% per year. At that time he had never had a down year, and the British press reported that he was paid $41.8 million in 2011. We will hope that he has not spent all that money in view of the fact that a September 6 article in Wall Street Journal said that Comac has experienced two years of investment losses, and was laying off a third of its employees. The fund has seen their asset under management shrink to $2.2 billion. As a result of being bearish on the Euro, Comac was down 9% last year and 5% so far this year.

An edge for the typical hedge fund is fleeting, because of violent competition between the smartest people in finance. A true investment edge erodes away as others notice the money piles in, and the edge it is competed away. Or market conditions simply change. The result is that funds blow up, fold because the get too far below their high water mark, or as key people decide to go it alone.

A story in the Financial Times of October 3, about the difficulty of comparing hedge fund results to stock market averages, quotes from a paper from Imperial College about the transitory nature of the hedge fund industry. The paper put together data from five major hedge fund data bases. What they found was that, excluding hedge funds which survive for less than a year and so never really get going, on average a hedge fund reports its performance to a database for 62 months, a shade over five years. Of the 24,749 listed in these data bases only 8,512 are still active. Long term results quoted from these data mean nothing because the average fund only lasts a little over five years.

My main take away from the book is that there are in the market today people that are managing billions of dollars, in some cases hundreds of billions, who are by and large obsessed with monthly and quarterly results. They are so obsessed because the people that send them money have very good tools, and using them to measure the hedge fund results against the market on a monthly, or even daily, basis. It is interesting to speculate on the impact of all this short term money on today’s market behavior.

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