AIM13 Commentary - 2016 Q3

“Great things are not accomplished by those who yield to trends and fads and popular opinion.”
- Charles Kuralt

November 30, 2016

Dear Investor,

There are many lessons we can all take away from the recent presidential election, and we will not try to offer any additional insights here about what happened and why. The outcome does, however, illustrate the importance of one of the key tenets of our investment philosophy, as expressed in an Oscar Wilde quote we used in our May 2011 letter: “To expect the unexpected shows a thoroughly modern intellect.” Donald Trump’s victory over Hillary Clinton was wholly unexpected by the most attuned prognosticators and armchair pundits alike, ourselves among them. That is not to say, however, that we were not prepared, since as truly hedged investors, we try to anticipate all contingencies. Things happen, and we need to be ready for them. We believe that the best way to stay invested in the markets over the long term is to hire the best investment minds, with nimble and opportunistic investment programs, to navigate any market environment or political development. Mike Tyson famously said, “Everyone has a plan until they get punched in the mouth.” Our plan is to be always prepared for the proverbial punch in the mouth.

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There was something bittersweet about the Chicago Cubs’ historic World Series win on November 2nd. Certainly the win, which ended a 108-year championship drought, brought us great joy and satisfaction. However, it also means that we may need to find another metaphor for what we do here at AIM: persistence and purpose with a focus on what matters for long term results regardless of the prevailing wisdom at any one time. In fact, the Chicago Cubs’ World Series championship demonstrated that by focusing on what is important and investing in the right people, the franchise could deliver superior results. We see a lot of parallels between those ingredients for success and how we approach managing our own money and our partners’ money invested alongside us.

1. Focus on what is important.

When it comes to investing, especially in more complex investments like hedge funds and private equity, losing focus on what is important has been a problem for many investors. Here are some of the things we see too many investors focus on:

  • Short term investing: When given the option, many investors prefer managers with monthly or even daily full liquidity as opposed to those that permit withdrawals only quarterly or even annually. These are not investors who need the money short term. Rather, they believe that when they decide the manager should no longer be entrusted with their money, they want all of their money back as soon as possible. We do not think this necessarily makes sense. If a manager goes through a difficult performance period or is invested in a position or theme that takes time to develop, and investors can run for the exits on short notice, the prospect of full withdrawals will negatively impact how the manager invests. We want managers thinking long term, since we believe that is the best way to make money over time. Therefore, we look for managers whose investor base is comprised of similar long-term investors.
     
  • Fees:  We believe fees and expenses are one of the most important areas to focus on when evaluating a new or existing manager. However, we also believe the prevailing discussion on fees is often misdirected. For example, CalPERS raised a storm last year when it disclosed that in the prior fiscal year it paid $1.1 billion in fees to its private equity managers (who in fact delivered the highest returns in the portfolio net of all fees). That seemed like a huge amount of money but on a closer look, nearly 70% of those fees were incentive fees – fees paid to the manager for generating returns. We wake up every morning hoping that we are going to pay a HUGE amount of incentive fees. That means that our managers are generating returns. Indeed, our best performing manager over the last two years charges one of the highest fees we pay. Unfortunately, people get myopic and focus just on fees. We believe that is a mistake, since, as we said at the outset, what matters is net return.
     
  • Investor-level withdrawal gates: Many of the best managers have restrictions on how much a limited partner can redeem at any one time.  Known as “withdrawal gates,” these provisions typically allow up to a certain fixed percentage (often 25%) of an account at each redemption opportunity (quarter end, year end, etc.).  This mechanism makes sense since it allows the manager to raise cash for withdrawals in an orderly way. Not all investors agree. A research director at one advisor recently told us, “We would never invest with a manager who had LP level gates.” However, when we look at the funds the firm has invested in, we wonder what will happen when any fund has a run on the bank. The fund’s performance would be negatively impacted, since the manager would need to hastily liquidate the portfolio. For us, withdrawal gates allow the manager to remain fully invested through a redemption cycle for the benefit of all partners in the fund.

2. Invest in the right people.

The Cubs were willing to spend money to attract athletes, staff, and fans to Wrigley Field. The lesson is that sometimes you need to spend money to make money. In the equity markets, that is not necessarily accepted wisdom. Indeed, with all of the talk of low cost index funds sometimes we feel like Jan from the Brady Bunch – “Marcia, Marcia, Marcia, all I ever hear about is Marcia.” For us, it’s “index funds, index funds, index funds....” However, for the many investors who use index funds exclusively to gain market exposure, we would remind them of Mark Twain’s advice: “Whenever you find yourself on the side of the majority, it is time to pause and reflect.”

Index funds, no doubt, have a role in a portfolio – provided that the investor has the discipline to stay invested through the dips (or even plunges) in performance.  Not many investors can do that, and we scratch our head when we see investors give up their hedged allocation in favor of low cost index funds. As we have said in the past, in March of 2009, buying index funds and leveraging them up would have been the right call. Realistically, however, who would have done that?

In addition, an “index” return is not the same as the “market” return for several reasons. First, index funds have fees and expenses that will always cause the index to lag the benchmark. Second, when a stock is set to be added to the S&P 500, its price goes up on that announcement alone, before index investors have to buy it. Moreover, the price of the stock it replaces falls before the index fund can sell it. This creates a drag on returns that passive investors cannot see since they conflate index performance with a passive market performance. The point is, don’t confuse index returns with market returns.

Active management is expensive, but on a net return basis (which is all that matters), we think that it makes sense for the majority of our portfolio. While index funds have beat active managers in recent years, that is beginning to change. Barron’s reported on November 5th that 60% of actively managed funds are beating the S&P 500 TR since July 1st, the highest level in nearly two decades. We think the performance of actively managed strategies, relative to passive strategies, will continue to improve for one reason above all else:  As we discuss more below in our Market Observations, we believe interest rates are set to rise for the foreseeable future.  In a rising interest rate environment, active management tends to outperform, as the chart below from Barron’s illustrates:

 Source: Barron’s, Nomura Securities

Source: Barron’s, Nomura Securities

Many people think that active management is dead. That mentality works when the market is only going up. However, the current bull market run is already 37 months longer than the average bull market since the 1920’s, according to data compiled by J.P. Morgan and Bloomberg. Indeed, August 2018 is looming as the month this bull market will become the longest of all time. Just to remind people that the market does not always go up, we thought we should share the chart below:

Bear Markets and Bull Runs: 1925 to Present

 Source: Alternative Investment Management; J.P. Morgan Asset Management

Source: Alternative Investment Management; J.P. Morgan Asset Management

As this table shows, since the 1920’s, there have been ten market declines of 20% or more. When the next pullback or recession happens, we do not want to be invested in an index fund that follows the market down. We won’t pay $55 for a World Series Cubs hat after the game when they were selling for $18 hours before, but we are willing to “pay up” for quality.

“Talent wins games, but teamwork and intelligence win championships.”
-  Michael Jordan

We thought about the importance of hiring and working with the right people when we read recently that the CIO of the New York State pension fund has privately told hedge funds that they must earn a minimum 10% per year or risk getting fired, according to the New York Post. Similarly, as reported in the Wall Street Journal, the Rhode Island treasurer offered this insight in October: “Going forward, we will only remain in funds that deliver consistent performance and strong returns.” What was the objective before??

The mentality of these pension investors illustrates the difference between risk measured by volatility and risk as a permanent loss of capital.  As long term investors, we measure risk as a permanent loss of capital.  Some of our best managers have lost significant capital on a percentage basis with contrarian investments that are at times far out of favor with “mainstream investors.” Firing them at the time would have been a big mistake.

At AIM, we do not identify managers by screening for minimum performance or require “consistent” performance. Rather, we look for managers who invest their own capital alongside us, who have the demonstrated intelligence and market acumen to yield superior investment ideas, and who understand the importance of risk management and the preservation of capital. These managers come at a price, but we are willing to pay that price for superior investment management. With a diversified portfolio, our fund can tolerate inconsistent returns or a period of underperformance from a single manager without impairing the return profile of the fund as a whole.

Many of us here at AIM are parents of young kids. We want them to set high goals and be successful, as every parent does. However, we also want them to have realistic goals. As we have said before, the difference between expectations and reality is what we call stress. Demanding a certain fixed return or mandating consistency while remaining hedged in this environment is unrealistic, and its only return will be stress.

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We chose the Charles Kuralt quote above since we wanted to talk about the dangers of being distracted by “trends and fads and popular opinion.” Short term investing and inexpensive index equity funds are very popular today. We, however, do not think that makes sense for the majority of our portfolio invested in equities. In that regard, our approach is similar to what ended the longest World Series drought in history: focus on what is important and pay for quality to achieve superior results over time.

Market Observations

“It’s now conventional wisdom that we’re in an unconventional environment.”
- Bridgewater Associates, September 12, 2016

In our view, markets continue to be highly unstable. Although the third quarter saw the yield on the 10-Year Treasury fall to a record low of 1.36% in July and volatility in equities and fixed income low compared to recent quarters, we still see many troubling signs. Leading up to the election, the S&P 500 TR posted a losing streak of nine sessions, the longest in almost 36 years. At the same time, the volatility index (VIX) rose for its own 9th consecutive day, the longest up streak in history, according to research published by Charlie Bilello.  Deutsche Bank issued a market research report in September with the opening line, “We think an 8-10% S&P decline looms.”  HSBC has been even more dire, suggesting a “severe fall” in the stock market under the heading, “Red Alert!” 

In terms of the most important sectors for GDP growth, the chart below highlights recent economic weakness:

 Source: Wall Street Journal, Federal Reserve, and the BEA.

Source: Wall Street Journal, Federal Reserve, and the BEA.

The well-regarded macro hedge fund manager, Ray Dalio of Bridgewater Associates, provided an assessment in September of the current market environment that included the following observations:

  • Current tools of monetary policy will be a lot less effective going forward.
  • Risks are asymmetric to the downside.
  • The obvious path forward is pairing greater fiscal spending with increased debt monetization.
  • Asset returns will be low going forward.

We agree with these assessments, which only bolster our view that now is not the time to switch the hedged exposure in a portfolio for index funds.

Interest rates: The market’s sensitivity to interest rates was highlighted to us by a recent observation by Nick Savone at Morgan Stanley: Since 2008, more than half of the increase in the value of the S&P 500 TR occurred on the day the Fed’s Open Market Committee (FOMC) issued their decisions on interest rates. That is a startling statistic, especially given that it now seems inevitable that interest rates will rise as a result of, among other things, higher infrastructure spending and the likelihood of a tax cut (and a corresponding budget deficit increase).  We also believe that Congress will be more able to pass business-friendly legislation, which should cause inflation to rise, thereby providing further impetus for rate hikes.

Notably, however, according to research recently published by Merrill Lynch, rising interest rates have not been adequately priced into the current market prices:

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Rising interest rates will directly impact hedge fund returns. Short rebates, which are rebates paid back to the borrower (i.e., the hedge fund) on the interest earned from the cash proceeds of short sales, will increase with higher rates. On the other hand, highly leveraged strategies, which are not a part of AIM’s hedge fund program, will see a greater drag on returns as borrowing costs increase. 

The prospect of rising rates and uncertainty surrounding the election has caused volatility to spike, with the VIX reaching levels in November higher than in over a year. Indeed, in the last three months, the market has seen a significant selloff (over 4%) and then a post-election rebound, bringing the S&P 500 TR to roughly flat within that period:

S&P 500 TR (August 18 to November 19)

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Since then, the market has continued to climb, posting record highs on November 21st. We expect these market swings to continue which, along with rising interest rates, should improve the opportunity set for active managers.

Income Disparity: Growing income inequality and slackening income growth were the subjects of a recent McKinsey & Company report entitled, “Poorer Than Their Parents? Flat or Falling Incomes in Advanced Economies.” According to McKinsey, over the past nine years, 65-70% of households in 25 advanced economies (roughly 540-580 million people) had real market income – their wages and income from capital – that were flat or had fallen. This compared with less than 2% (fewer than ten million people) who experienced this phenomenon between 1993 and 2005. We find that statistic utterly shocking.

Quantitative easing has produced huge wealth gains for the top 10% of households. However, since wealthy households have a lower propensity to spend the increased wealth, monetary easing policies are not translating into spending – which would help the bottom 90% in terms of jobs, economic growth, and wage inflation. One sector enjoying robust demand as a result of the surge in the super-wealthy are million dollar homes:

 Source: Deutsche Bank

Source: Deutsche Bank

Widening income inequality is not good for anyone in the long run, even for the very rich on the right side of the divide. Globalization, technology, and a growing minority population in the U.S. have all contributed to the growing disparity in incomes. In addition, according to a study by David Jacobs of Ohio State University published in the American Journal of Sociology in October, political factors are one of the biggest drivers. Moreover, “the presidential administration in power was far and away the biggest political factor linked to economic inequality in each year of the study,” according to a report on the study in Science Daily. In a spirit of optimism at the outset of a new presidential administration, we are hopeful that policies and programs can be enacted to reverse recent trends and, for everyone’s sake, narrow the gap between the haves and have nots.

A Final Thought

We participated in an event this summer honoring Paul Singer, the legendary investor at the helm of Elliott Management for nearly forty years. Accepting his award, he offered the following observation in his prepared comments:  “Managing money, especially in a free-form hedge fund, is more jazz than symphony.  Meaning, it is not written out, it is not played note for note, there is a lot of improvisation riffing around themes.” More than ever, in today’s environment, we believe that investment management requires a lot of “improvisation riffing around themes,” or in terms as we said at the outset of this letter, nimble and opportunistic investment programs run by smart and experienced investment managers.  

We thank you for the confidence you have placed in us and welcome any questions or thoughts you may have.

Sincerely,

Alternative Investment Management, L.L.C.

Blair Cohen