Smart Money Insights: Weekly Brief Apr 11
The start of the second quarter saw equity markets decline – continuing a pattern, the S&P fared better than pretty much any other index. The whipsaws in the market this year are taking a big toll on active investors. In March, the average large cap fund underperformed the S&P by almost 800 basis points on an annualized basis – a record going back to 1998 – and less than 20% outperformed the index – also a record low. In some areas, like growth funds, the numbers were far worse. Hedge funds continue to have problems with crowded trades, and technical factors seem to drive currencies and other non-equity markets more than fundamentals. Read below for updates on the liquid alts space, fallout from crowded trades and other topics.
A Follow up to: They’re Shooting the Wounded in the Liquid Alts Space
We noted last week that Fidelity had redeemed $700 million from a Blackstone mutual fund it seeded in 2013. Last week, Blackstone announced that it was closing the same fund – presumably, Fidelity pulled the remainder. The articles overlook two interesting points. First, Blackstone has been the standout performer in the space: yes, they’re down 4% this year, but they put up exceptional numbers relative to their competitors since inception. Second, Blackstone still manages $4 billion in a similar fund, so it looks like Fidelity is doing a major pivot away from these products. Our view since 2013, as articulated here, is that the constraints of 40 Act funds and high fees (250-300 bps expense ratio) will be difficult to overcome over time. There are simpler, lower cost and better solutions to get to the same diversification benefit. For an overview of liquid alts and diversification, please see our webinar Diversification and Liquid Alternatives in 2016.
A Different Kind of Position Crowding…
A big theme since last summer has been position crowding. Last week we saw the sudden termination of a $160 billion merger between Allergan and Pfizer after the Obama administration introduced new rules to deter tax inversions. Allergan, consistently one of the “favorite” hedge fund stocks, immediately dropped 15-20%. Some hedge funds clearly took several hundred million dollar hits, but this equates to a few percentage points of returns, not the 10% plus we’ve seen from stocks like Valeant. Investors know that playing mergers is like picking up nickels in front of a steamroller, so position sizes typically are smaller.
Speaking of Position Crowding, the Sequoia Disaster has a New Twist…
The collapse of the Whitman distressed debt mutual fund last Fall was a wake up call that daily liquidity and illiquid, concentrated bond holdings create a potentially fatal asset-liability mismatch – even for mutual funds. The SEC reportedly is closely examining the issue. The Sequoia Fund is one of the most prestigious and long-standing mutual funds – the one Buffett famously recommended when he closed his investment partnership decades ago. Primarily due to a 30% position in Valeant, Sequoia was down a lot last year, is down again this year, and is facing a wave of redemptions. The Wall Street Journal reported that some shareholders redeeming from Sequoia are receiving stock instead of cash – one former shareholder was given shares in O’Reilly Automotive. We found this to be a stunning development. First, instead of cash, stock shows up in your account, which you now have to sell – let’s hope someone at all the retirement plans that own Sequoia was paying attention and caught this. Second, you’ve now received stock in kind – presumably, your tax basis in the mutual fund attaches to the stock – but are your systems set up to do this? Now assume the stock goes up or down a bit before you sell it – I can’t imagine the tax treatment here is simple (what’s your holding period?). Finally, the article implies that the taxable gain for the mutual fund somehow disappeared by handing it over to a shareholder – is this what the IRS intended and, if so, why don’t mutual funds do this more (actually, ETFs do, but for them redemptions in-kind are normal business activity)? The point is that mutual funds are supposed to be predictably liquid, and this seems to seriously undermine the core argument.
Conspiracy Theories and the US Dollar
As the year opened, the strong consensus was for renewed dollar strength in 2016 – e.g. the yen was expected to weaken a few percent by the end of the first quarter. After all, Japan’s economy was grinding to a halt as the impact of Abenomics proved short-lived (see a primer here). To combat this, in late January the BoJ aggressively expanded quantitative easing in part to drive down the yen and boost exports. Instead, the yen has shot up to 108, a 10% gain year-to-date. A similar story has played out with the Euro, where fundamentals also point to a weaker currency: an unexpectedly large expansion of bond buying by the ECB, slow growth, and Brexit contagion fears. In spite of this, the Euro is up 5% year-to-date. Several theories are circulating. Central banks may have agreed to let the USD weaken in order to alleviate pressure on China to revalue. Another is that carry trends – where investors borrow in yen and Euros to invest in higher yielding currencies – have been unwound en masse. A third is concern about the election, but given the political chaos in Europe it’s hard to take this seriously. A fourth is that rising inflation expectations in the US has reduced real interest rates to the point where deflationary Japan and Europe offer better returns. None of these theories, unfortunately, is particularly compelling given how other markets have reacted this year. The most likely explanation is that this is a technical adjustment across thousands of portfolios that had gradually become overweight US assets over the past several years due to persistent outperformance and that an industry wide rebalancing is underway. The US Dollar is still up 20% in less than two years, and the decline year-to-date is still moderate in that context.