The Argonaut Absolute Return is now up 12% so far in March and 20% YTD (compared to a market down 25% this month and 34% YTD) and tops the AR and Lipper Long/Short sector over 3 years. The aim of an Absolute Return Fund is to make attractive returns and diversify market risk. In the last five negative market months (March 2020, Feb 2020, Jan 2020, August 2019, May 2019) the fund has now returned a cumulative +33.2%, during which the market has returned a compound -45.3%. Over the past few years, a rampant bull market in liquidity has dulled the need for diversification and chronically undervalued short alpha capability. Now that the tide has gone out, to paraphrase Buffett, we see who’s been swimming naked. It appears almost the entire asset management industry has been on the nudist beach.
We believe that the fund’s return profile is relatively unique in the industry. As we are currently witnessing, all long only funds rely largely on market beta for returns and are highly correlated to the market, each other, and therefore offer little in the way of diversification benefits. Absolute Return Funds offer an alternative but often have undistinguished track records falling into two categories: either a “go nowhere” return history with high fees, or a more volatile “return free risk” profile. It is also important to point out that we have actually been net long of the market throughout these negative months in which we have made positive returns, believing that the only way to generate consistent returns irrespective of market conditions is not through market timing of negative beta, but through well diversified “Double Alpha”.
The ability to generate short alpha has become a lost art in a bull market. Since we launched the fund, the market has returned 54% (in local currency). In the same period, we have now made a 28% positive return on our short book. This translates to 8% of short alpha per annum (compared to 8% long alpha since I began running money in 2002). We have made absolute positive returns from our short book in 6 years; the market has generated negative returns in only 3 years. Our short book has outperformed the market in 8 out of 11 years. Although the benefits of having a short book are most clearly seen in periods such as we are currently witnessing, the power of long/short works best with consistent “double alpha” generation, delivering compounding absolute returns whatever the market conditions. We believe that this distinct “double alpha” is relative unique in the UCITS world.
The fund has had periods of inconsistent returns, particularly when we failed to appreciate the dangers of shorting in liquidity bull markets. In 2016 the fund lost 25% (its first negative year). This failure rather than my multiple successes has come to define my recent career. No one remembered the 80% I had made in the previous three years, nor considered the illusion of strong foreign equity market returns caused by GBP depreciation for most non-FX-hedged funds. Nevertheless, for 5 quarters I made small compounding losses. The fund suffered large redemptions, first from institutions whom I had never met, and subsequently from those who had no stomach to stay invested, apparently solely because our fund flows were stuck in reverse gear. The pressures intensified and for the first time in 15 years of running money I had to fundamentally reappraise my approach to investing.
It has taken me 3 years to return to the high-water mark (to put this into perspective the market is now back at 2011/12 levels). It took me roughly the same amount of time to properly understand what went wrong. My initial inclination was to believe that I had got my stock analysis wrong. When I dug further in search of stock specific answers, the hole got deeper. I can now look back and see that the problem was not individual company analysis; it was the bigger picture. I had failed to anticipate significant macro events: global reflation following Chinese stimulus and Fed easing, the Brexit referendum result; the election of President Trump and its consequences. The market during 2016 largely defied fundamental analysis of individual stocks and instead was one long macro momentum inflation trade (temporarily interrupted by the whipsawing Brexit referendum) which re-floated previously zombie assets. Then in Q2 2017 when macro volatility died coincidently the fund began to perform again. And on almost everything we were short of in 2016 that lost the fund a lot of money (e.g. banks, commodity stocks) we turned out to be right about all along. That was scant consolation to anyone.
When you are right in the long term but so painfully wrong in the short term the lesson, which took me time to realise, was not actually that my fundamental stock analysis needed to improve, it was that the fund was not sufficiently diversified to deal with short-term failure. Having been right about most things for most of my career, I thought I could get by on having the most prophetic investment Weltanschauung . But no one who manages money for long periods of time (short track records are statistically insignificant) will be consistently correct in their view of the investment world. When the fund is daily priced with daily liquidity - unlike private equity (and to a lesser extent offshore hedge funds) – there is no hiding place when you get it wrong, even for a few days.
I had prepared only for continuation of success: the irony was that I failed in 2016 because I was not prepared sufficiently for failure. I had not appreciated the value of diversification because I had previously considered diversification for its own sake, more for losers, or at least the kind of mediocre fund managers who take no risk in order to cling on to their undistinguished careers. I would now differentiate between this negative passive diversification: taking no risk because you realise you have no edge from positive active diversification: having multiple differing investment ideas on which you have the same high conviction, but where the fundamental catalysts are independent. So initially my reaction to the drawdown was that the root of the problem was to be found in faulty macro and micro view(s). Then I realised that if I had been right after all, but that if the consequences of being wrong temporarily were so painful, then the solution did not involve any analysis at all: it involved better portfolio management.
One important aspect of portfolio management which I needed to improve was better mitigation of drawdowns. When we analysed our drawdowns using ten years of data, we found the following:
In the best 10 months for the fund, it made +70% against the market +11%. The market was negative in 4 of the funds’ best 10 months.
In the worst 10 fund months, the fund made -57% against the market -1%. The market was positive in 7 of the funds’ worst 10 months.
In the best 10 market months the fund made +3% against the market +77%. The fund was negative in 4 of the markets’ best 10 months.
In the worst 10 market months the market made -65% against the fund +2%. The fund was positive in 4 of the markets’ worst 10 months.
In other words, our drawdowns and the market drawdowns were entirely uncorrelated. Note this is different from saying that the fund is consistently negatively correlated and will always go up when the market goes down (or the opposite which would be a very undesirable quality in a bull market), although the fund has overall made a double digit return in negative market months (so called negative downside capture which is a highly desirable attribute for a hedged fund). We can therefore conclude that the fund is pretty good at diversifying market risk. But simply offering a product that had drawdowns that were uncorrelated did not cut the mustard: we needed to generate positive returns more consistently. Since single stock positions did not cause significant drawdowns either, the source of our drawdowns appeared to be something more complicated; something much more difficult to remedy: our own investment style.
We adopt an “earnings surprise” style which has worked well over “value” and “growth” led stock market cycles, where our long positions are predominantly in stocks with underestimated corporate earnings potential and our shorts in those where earnings are overestimated by the market. Because there is usually such a high correlation between earnings forecasts and share price performance (i.e. it works if you can identify the earnings trends) there is a second order factor risk of price momentum. There are periods in the stock market when price momentum reverses, often violently, sometimes with no rational explanation. This is then exacerbated by hedge funds reducing gross exposure at the same time to mitigate the short-term P+L pain. Double alpha quickly becomes double trouble, with previously winning longs sold and laggard shorts rising at the same time, independent of market direction. This historically has been our greatest source of pain.
A solution to this problem could not be to reinvent our investment philosophy and begin to pick stocks based on any random alternative criteria, solely to avoid temporary but painful setbacks, otherwise we could not be sure of making any progress in the first place. Despite several investment banks claiming (always in hindsight) to predict momentum reversals, this in my opinion does not stand scrutiny in real world investing. We should dismiss the notion that momentum reversals could be predicted with any certainty in advance. Consequently, this would be an exercise in mitigation rather than a cure.
I concluded that this could only be achieved both from active diversification, better avoidance of crowded trades (commonality with other hedge funds) through more optimal position sizing of our contrarian ideas and simply by not being too greedy: taking profit from winning trades in a more disciplined fashion rather than waiting to take profit at the same time as the market. Another important aspect of the epiphany was to realise that I needed to run more positions and to position size them in a more disciplined fashion. Although running a concentrated portfolio certainly maximises alpha, it also brings with it more lumpy returns. With volatile stocks, which most shorts tend to be, it also causes too much stress running over-sized positions which often leads to poor timing of trades caused more by emotion than rationality. By adopting a more modest ambition of trying to make a little bit of money every day, we were more likely to avoid losses, but if our small successes could compound, this would lead to more consistent positive returns.
There was a further area where I thought the fund could improve, which came as a result of our experience in 2019, which was overall a positive year. Post the Fed rate U-turn of January 2019 we became expressly bullish on market direction a consistently ran a 50% net long exposure through the year. However, we ended up making 80% of our 13% return in the only two negative market months (May and August). It was ridiculous that our bullish correct view on market direction did not translate into any significant gains during positive months, but that we made out like bandits in market drawdowns. And whilst our short book was outstanding in the negative months it was largely an unnecessary handbrake on returns for most of the year.
My experience is that even relatively sophisticated hedge fund investors are sometimes confused by the concept that we could run an uncorrelated fund without being money-for-money “market neutral”. I believe this is a function of the hedge fund platform model where sector analysts sweat out alpha through pairs trades, as cogs in a more levered machine. In my broader investment universe, where I use less leverage, I could exploit opportunities between sectors as well as those within an industry. If, for example, I was positive on the (low volatility) drug sector but negative on the (high volatility) oil sector, in order for my portfolio to have a neutral beta in stands to reason that I would need to be more long the drug sector than short the oil sector to neutralise the higher beta of the shorts. Additionally, not every long position has a positive beta to the market. Gold stocks, for example are often negatively correlated. If you are long gold and short oil, you would essentially have two positions which were both short the market which would not be captured be any traditional concept of money-for-money market neutrality.
We have consistently found that our long positions are in aggregate always significant lower beta than our shorts, hence net exposure of 50% at the headline level, has consistently resulted in much lower historic market correlation. When this beta adjustment to the net takes place, in order to have a 0.5 correlation (or actual beta) to the market we would need to run a headline net exposure of closer to 80% than 50%. If we got to a situation again (perhaps when the coronavirus eventually disappears) where we had such strong conviction on positive market direction, we vowed to be more flexible in our net to take advantage of this opportunity (though do not think it desirable for the correlation to the market to be over 0.5).
The current market environment (bear market) is a supreme test of the skill of portfolio construction: aiming to deliver positive returns whilst managing volatility and correlation in a highly volatile, negative market where individual stock correlations often converge. Not only does this make delivering a positive return difficult; it makes delivering a positive return consistently doubly so. Our results so far in 2020 have been encouraging: out of 54 trading days we have positive returns in 39 with annualised volatility of 15% and the biggest daily drawdown of 2.99%. The market has been positive in just 25 days with annualised volatility of 36% and the biggest daily drawdown of 11.5%. We will therefore see over the weeks and months ahead just how much the portfolio construction process has evolved. By conveying my experiences of the painful process of self-appraisal, I hope that you may find the lessons learned interesting and an aid to better evaluating the long-term success of funds and fund managers in general. I would also not underestimate the need for resilience, determination and clarity of purpose for anybody engaging in a long-term career in fund management, hence the relevance of the words of Sir Winston Churchill:
“Success in not final, failure is not fatal: It is the courage to continue that counts.”
Barry Norris,
Fund Manager of the Argonaut Absolute Return Fund
March 2020