Ray Dalio: Lessons From 2008

2008 will forever be remembered in the financial world as one of the greatest market crisis of all time. It was a year in which a lot of mistakes occurred, and a lot of errors that had been covered up during the years before, were finally exposed.

All investors, no matter what their experience, industry or firepower were tested during 2008 and 2009 but the crisis also provided a case study for investors about the risks and opportunities that lie ahead.

By analyzing the mistakes made in the run-up to and during the crisis, we can streamline our investment process today to ensure that we don’t make the same mistakes again. And this is exactly what Ray Dalio did in his year-end 2008 annual letter to clients of Bridgewater Associates.

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More ValueWalk coverage on Bridgewater Associates:

• Unscrambling The Bridgewater Story And Issues With The Wall Street Journal
• Bridgewater Responds, Calls WSJ Article “Sensationalist Mis-characterization”
• Bridgewater Associates- Fight And A Big Vote At The Top
• Bridgewater: M&A Cycle Not Over, Equities Will Continue To Rise

Ray Dalio: A crisis driven by human nature

Using the typical Bridgwater approach, Dalio starts the letter by laying out the root cause of the market turbulence during 2008. At the time writing, Dalio believed the root cause was a reflection of human nature. The crisis was wholly caused by people operating in a manner consistent with their individual characteristics and together in ways typical of group dynamics. In other words, people created their circumstances, which they reacted to, which caused new circumstances that they reacted to, and so on. And they did this in ways that weren’t very complex or unique.

It's easy to explain why investors reacted in such a way. As Dalio points out, what happened in 2008 has happened many times before. However, unlike previous recessions, which occur regularly frequently and most investors know how to handle, the dynamic that occurred in 2008 had never happened before in most people's lifetimes.

Most people learn from their previous experiences, which prepares them for every eventuality if the experience occurs a second time. But as most of the general population never experienced a decline such as the one seen in 2008, almost all of the investors, businessmen and government officials affected by the decline, couldn’t believe it was happening as they had never planned for it, considered it implausible, and didn’t understand it.

To quote Dalio, “2008 was a year in which those who built their strategies on the basis of what happened in their recent lifetimes did not understand what happened in 2008 and did so badly, and those who had a perspective of what happened in long ago times in faraway places did well.” In other words, if you build a strategy optimised to the prevailing investment environment at the time, without planning for all eventualities, considering how it would work in all circumstances, and not just those seen in recent years, you will inevitably do very badly— exactly what happened to a lot of people in 2008.

“Since I believe that a big common mistake that caused many investors problems in 2008 was not having a broad enough perspective, I believe that one of the most important lessons for those who did badly in 2008 is to have a “timeless and universal investment” perspective, which means to broaden your perspective to understand what happened in long ago times (e.g., in the 1930s) and faraway places (like Japan and Latin America)” -- Source: Ray Dalio 2008 letter to investors.

It’s been proven time and again that even Wall Street’s highest-paid analysts don’t know what’s about to happen, so investors always need to consider the full range of possibilities and make sure the worst-case scenarios are tolerable.

The biggest mistake

Investors and asset managers' biggest mistake in 2008 was that they had large, concentrated exposures to assets and portfolios that do well when the economy does well, and badly when the economy does badly. In other words, the majority of the investment world held highly cyclical investments heading into 2008 and many haven’t considered the effect a worst-case scenario (an economic slowdown) would have on their portfolio.

Dalio points out that Investors and asset managers had this skewed exposure for three reasons.

Firstly, beta exposures were not diversified; exposures were concentrated in cyclical assets. Why? Human nature. Investors are biassed to invest in those assets that performed best during the timeframe is that in their frame of references.

Secondly, alpha exposures also lacked diversification and portfolios were skewed to do well in good times and poorly in bad times. Dalio writes that the average hedge fund was about 70% correlated with stocks during 2008. Why was this the case? Well, the root cause once again lies in human behaviour. There is a tendency for investors to chase those strategies that have worked well in the past so, alphas like betas became those strategies that worked in the recent past, the strategies that worked in good times.

And thirdly, the risk and liquidity premiums effects on returns are correlated to the betas and alphas in the portfolio. So when the economy did badly, these premiums rose and also hurt returns.

All of the three key points above made every investor's and asset managers portfolios highly sensitive to cyclical trends. But as Dalio points out, investors would have been reluctant to own such cyclical portfolios if they considered the disaster scenario, which in this case was Japan. At the time Dalio penned his year-end 2008 letter to Bridgwater investors, Japan’s leading stock index was down 70% from where it was 20 years before after years of poor economic performance.

“So, in reflecting on 2008 and the lessons for the future, I believe that one the most fundamental questions investors should ask themselves is whether or not it is logical to have this huge bias to do well in times that are better than are discounted (i.e., to be so concentrated in assets and alpha strategies that are positively correlated with equities). Personally, I believe that having such huge biases is never logical, let alone at this time. So, I believe that another important lesson of 2008 for most investors is to avoid having systematic biases in your portfolio, which means to restructure your portfolio so that it is less vulnerable to any one environment by having better diversification between and within betas, alphas, and risk premiums.” -- Source: Ray Dalio 2008 letter to investors.

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Democratic U.S. Rep. Alan Grayson has spoken out endorsing presidential candidate Bernie Sanders, despite sitting on the Hillary Clinton campaign’s “Florida Leadership Council.”

Grayson, who is now a candidate for the U.S. Senate, announced that he was backing Sanders in a fundraising email. Democratic representative Grayson has come under fire in political circles for his double life as both a politician and a hedge fund manager, writes Adam C. Smith for the Tampa Bay Times.

Controversial politician combined Congress with hedge fund management

The populist hedge fund manager likes to cast himself as an anti-establishment candidate, which works out well seeing as the Democratic establishment sees him as a disaster. Sanders is the logical choice for Grayson, who said he was inspired by the former’s campaign message of “Not me. Us.”

“I will vote for him as a Super-delegate at the Democratic National Convention. And I enthusiastically join, shoulder to shoulder, his political revolution,” read the letter.

Grayson was previously subject to investigation by the House Committee on Ethics due to his shady dual role as a sitting House lawmaker and hedge fund manager. The story became even more complicated when it was revealed that the hedge fund had operations in the Cayman Islands.

Hedge fund controversy dogs Congressman Alan Grayson

While Grayson’s hedge fund managed only $16.4 million in assets as of October and only four investors, its manager encouraged potential clients to profit from the unrest that he observed during his official trips abroad. He even told them that money could be made especially when there was “blood on the streets.”

Not only did Grayson encourage questionable ethics, it appears that his activities as hedge fund manager interfered with his work in Congress. In August 2015 Grayson introduced a bill which would have implemented larger annual increases in Social Security benefits. Despite plans to advocate for the plan in Tampa, Florida, he had to call off the event when Chinese markets crashed and he had to pay more attention to the hedge fund.

Grayson denies that he used his position in Congress to attract business to the fund. “Here is something that is not true: that I somehow traded on my membership as a U.S. congressman to get clients for this fund,” he said in an interview.

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A number of progressive groups in the New York State assembly are working to close what they call the carried interest loophole.

Assemblymen have started a campaign to close the loophole, which allows hedge fund managers to pay far less federal tax on a large proportion of their income. The state politicians are due to introduce a bill this Monday which would raise taxes on residents who currently pay less federal tax, writes Noam Scheiber for The NYTimes.

Interest Loophole – Extra New York tax revenue could be used for economic projects and schools

The members believe that the current situation unfairly benefits some members of society, and it hopes to generate extra revenue for the state by changing the tax code. It is thought that the extra money could be used to invest in schools and economic projects.

“People from Buffalo, when they work, they pay their taxes,” said Assemblyman Sean Ryan, one of the two Democratic legislators who are sponsoring the bill. “We don’t have a lot of hedge funds in Buffalo, but we do have a need for state assistance.”

It is thought that the bill could raise $3.7 billion per year in New York. It is contingent on similar legislation being passed in neighboring states to prevent fund managers from moving across state lines to avoid the tax.

Campaign reaches across the United States

Patriotic Millionaires and Hedge Clippers are two of the groups involved in the coalition, which aims to campaign for similar legislation in California, Illinois and Pennsylvania. The proposed changes have received support from both Republicans and Democrats in U.S. Congress, but so far no changes have been made.

The movement is opposed by those who claim that hedge fund managers deserve to pay a lower rate of tax because they are being repaid for the “sweat equity” that they have invested in their business. Some argue that hedge fund managers should be treated like Facebook founder Mark Zuckerberg, who is taxed at a lower rate.

However the argument for Zuckerberg “is that there’s an undersupply of entrepreneurs, and the world needs more Zuckerbergs,” said Victor Fleischer, a professor at the University of San Diego School of Law. “You can’t make the argument that there’s an undersupply of venture capitalists or private equity fund managers.”

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Crispin Odey Down 22.5% So Far This Year

Crispin Odey’s flagship Odey European fund ended 2015 on a high note, as the fund’s bearish China bets paid off.

Odey’s run of good luck continued into the first few weeks of 2016, as the financial world panicked about the state of China’s the prospects for global economic growth.

According to sources familiar with the matter, Odey’s flagship fund produced a 14% return for investors during the first few weeks of 2016.

Odey Near Top of Hedge Fund List On Back Of Short China Bet

Odey Has Big Gains As Bearish China Bets Pay Off

Unfortunately, Odey’s outperformance hasn’t continued. Odey’s OEI MAC fund, which invests in Odey’s European fund, lost 10.6% during February, according to a letter to investors reviewed by ValueWalk. This performance compares to the MSCI Daily TR Net Europe USD return of -1.8% and a MSCI Daily TR Net Europe GBP return of -0.0% for the same period. After taking into account this dismal performance, Odey’s OEI MAC fund has lost 23.5% over the past 12 months.

And according to sources with knowledge of the matter, Odey’s run of bad luck has continued into March. As the Independent reports, Odey’s European fund has lost approximately 25.5% so far this year, with most of these losses suffered during the first two weeks of March when the fund slumped 22%. For 2015 as a whole, Odey European lost 12.8%.

February winners and losers

Odey’s largest losers for December were the fund’s core FX positions, specifically, AUD/USD and EUR/USD positions which contributed -0.86% and -0.37% respectively. The long FX book made a positive contribution of 0.96%. During the month, active currencies made a negative contribution of -0.3% to performance.

After currency hedging the short equity book made a negative contribution for the month of -6.6% and the long book made a negative contribution after currency hedging of -4.8%.

On the short side, the largest negative contributions before currency hedging came from Anglo American (-213bps), Las Vegas Sands (-54bps) and Royal Dutch Shell (-39ps). The most substantial positive contributions before currency hedging came from Coloplast (+21bps), CocaCola HBC (+19bps) and LaFargeHolcim (+18bps).

On the long side, the largest positive contribution before currency hedging came from Randgold Resources (+37bps). The worst negative contributions came from Nokia (-92bps), Sky (-58bps) and Bank of America (-50bps).

Crispin Odey: Managers commentary

2016 shaping up to be a very turbulent year for Odey’s European and Crispin Odey offers some explanation as to why this is the case in the fund’s February manager’s report.

Crispin Odey blames the central banks for his poor performance. He states that “Bull markets do not die of old age. They are murdered by central banks” and when central banks saw the markets start to collapse in January, their responses injected new life into the long-running bull market.

Odey further adds:

How far away we are from that old adage. The last six weeks have seen yet again central banks responding to further weakness in the world economy, by lowering or at least not raising interest rates and continuing to subsidise the weakest. Wherever they see any sign of distress as with the CDS market in Europe, their response is to believe that risk premiums are unfairly rising and immediately to take action to cancel the effect.

Crispin Odey goes on to write that while the actions of central banks have resulted in higher asset prices, they failed to address the underlying problems of unemployment and falling productivity:

“However, several years of watching central banks responding to ever falling productivity numbers by reducing interest rates have shown that they can effect asset prices with their actions, but that not only do they have almost no effect on economic activity, but they positively damage it.”

“The reason is simple. Banks work, like everyone else, off profit margins and the lower and longer interest rates remain close to zero, the more that net interest margins shrink and the less inclined, because profits are falling, are they to countenance new lending.”

Without credit expansion, there can be no strong nominal growth of GNP. Over the last twelve months, there have been 20% more dollars created in relation to GNP in the USA than a year ago. In China, there have been over 30% more renminbi created, “That a 20% increase in dollars has only resulted in inflation of 2.1%, reveals that strange things are happening.”

Odey Still Bearish Says Yuan Will Have To Fall “By At Least 30%”

Overcapacity still plagues China’s economy and many companies are struggling to keep the lights on but China remains unwilling to close capacity and industries continue to run at a loss. The problem is many banks, who have lent these loss-making industries cash to fund expansion, are now faced with a dilemma; bank profits aren’t robust enough to absorb the loan losses, so banks keep extending credit lines, giving companies the helping hand they need to pay maturing obligations:

“Banks now need rights issues but the central banks’ attention remains on trying to lower rates to reflect falling productivity. There is thus no story to attach to a rights issue for a bank. The only way that the banks would be a buy is if interest rates were to go up, repricing assets relative to deposits, but that can never be because down that route lies recession. And strangely recessions are no longer permitted. However, negative productivity rates are already telling the central banks that any growth in nominal GNP is the equivalent of eating your capital.”

Crispin Odey’s doomsday scenario has been set back this year after a rally in China related companies. The fund has cut back its position in these companies as a result of this rally, but volatility has continued. By mid-March, the fund was rising and falling by over 5% per day, at which point, “this was no longer an investment market but a battlefield.” When Draghi came out with his massive market support operation markets rose 2.5% and then closed down 1.5% on their lows before rallying the next day vigorously. Odey writes that this rally was extremely painful to watch and on the same day he made the decision to reduce the short book by third and cut the size the long book by 10%.

Still, despite central banks’ desire to eliminate recessionary forces, Odey’s outlook for the global economy remains negative:

Markets need equilibrium to prosper. When the authorities have a problem, markets have a problem. We have been hurt by this rally in China-related companies, and indeed we reduced the gross and net positioning of the fund significantly in mid-March, to help reduce the short term volatility of the fund, but we remain convinced that China is in many ways in an even greater bind over policy than the developed world. By mid-March the fund was rising and falling by over 5% per day. At which point this was no longer an investment market but a battlefield. On the day that Draghi came out with his

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So You Want to Start a Hedge Fund?

Ted Seides began his professional career at the Yale Endowment working under David Swensen, and transitioned his early experience in hedge fund investments into the foundation of Protégé Partners. The fund of funds launched in 2002 with the explicit mandate to invest in small managers and startups, and allocated to 120 early stage hedge funds over the last 14 years, including 40 seed investments.

Ted recently published a book entitled, So You Want to Start a Hedge Fund: Lessons for Managers and Allocators, in which he provides a roadmap for managers to learn about the intricacies of launching a hedge fund. He includes lessons on why hedge funds make the same mistakes over and over again, particularly in their business processes. He pinpoints pressure points that can lead to the success or failure of a fund, including best practices in marketing, team building, investment strategy, and performance. He also discusses the misconceptions of many allocators about investing into smaller hedge funds, and why and how investors should take a closer look at them.

– Ted Seides: From the Yale Endowment protégé to Protégé Partners
– The investment philosophy behind a 14 year fund of fund mandate to invest in small managers
– Lessons from 120 early stage hedge fund investments, and from seeding 40 managers
– Why startup funds make the same mistakes over and over again. The single biggest mistake that early stage hedge fund managers make
– How some start ups are able to get investors “crowd” into their hedge fund
– Key lessons on how to build a successful hedge fund team. Why staff turnover at a start up can be a good thing
– Can a hedge fund “coach” add value?
– Why start-ups should avoid the equal co-portfolio manager structure
– Allocators should view an investment with a manager and the timing of that investment as independent components·
– Why nearly all successful launches are coming out of existing hedge funds

Start a Hedge Fund

The post So You Want to Start a Hedge Fund? appeared first on ValueWalk.

Hillary Clinton’s son-in-law, Marc Mezvinsky, is about to shut down the Greek-focused hedge fund that he founded two years ago.

Mezvinsky is reportedly about to close the fund after it lost almost 90% of its value. A report in the New York Times cites two investors with direct knowledge of the matter who spoke on the condition of anonymity. Investors in the fund, Eaglevale Hellenic Opportunity, were told last month that it would be closing down.

Mezvinsky’s firm to close Greek hedge fund

The fund had raised $25 million from investors to buy shares in Greek banks as well as government debt. Eaglevale Partners, the Manhattan hedge fund firm founded by Mr. Mezvinsky and two former Goldman Sachs colleagues, raised funds for the Greek fund during a time of hope for economic recovery.

Mezvinsky even appeared at conferences promoting his theory that Greece was due to recover. He is married to Chelsea Clinton, the daughter of former President Bill Clinton and Mrs. Clinton, the former secretary of state who is hoping to be the Democratic presidential candidate.

Betting on Greece has proven to be a risky business. Some people have made serious money while others have lost large sums, depending on when they invested. Hedge funds on the whole have had a hard time in the past 17 months, even those run by the biggest names in the business.

Clinton’s son-in-law started firm with two former Goldman colleagues

Eaglevale’s flagship fund, which has approximately $330 million in assets under management, is down 1% this year. It specializes on macroeconomic bets based on global events in the economic and political spheres.

In the first quarter of this year the average hedge fund was down 0.63%, according to the HFRI Fund Weighted Composite Index. Eaglevale started raising money in 2011 and has had mixed results since.

Mezvinsky graduated from Stanford University and worked for Goldman Sachs for 8 years before moving into private equity. He later left that job to form Eaglevale with Bennett Grau and Mark Mallon, who had both previously been at Goldman.

Top Goldman partners were among the first investors in the fund. Lloyd C. Blankfein even let the firm use his name in marketing the fund.

Although the Hellenic fund had lost around 40% of its value by early last year, Eaglevale has waited until now to close it.

Some investors continue to bet on Greece

In 2015 Greece suffered a particular set of economic convulsions. In fact the economy nearly collapsed after tense negotiations between creditors and national leaders. The government finally agreed to implement a set of reforms in return for a new bailout deal.

The economy continues to suffer as Greece struggles to deal with its problems. The country is suffering as it attempts to work out a deal to reduce its debt burden, but some Wall Street firms continue to promote investment in the country.

Richard Deitz, of the hedge fund VR Capital Group, recently told an audience at a charity dinner that he was betting on shares in Greek banks and government bonds. Mezvinsky and his partners sent a letter to investors in 2014 in which they claimed that Greece would soon be heading for a “sustainable recovery.”

However they started to acknowledge that they had been wrong later that year, when they stopped taking new money for the fund. Investors in the fund may be able to find solace in the fact that they can claim a larger tax loss on investments next year.

Interestingly, Mezinsky’s father is an even more interesting character.

Wikipedia notes (citing major outlets – CNN, NYT, ABC etc)

Beginning in the early 1990s, Mezvinsky used a wide variety of 419 scams. According to a federal prosecutor, Mezvinsky conned using “just about every different kind of African-based scam we’ve ever seen.”^[10] The scams promise that the victim will receive large profits, but first a small down payment is required. To raise the funds needed to front the money for the fraudulent investment schemes he was being offered, Mezvinsky tapped his network of former political contacts and dropping the name of the Clinton family to convince unwitting marks to give him money.^[11]

In March 2001, Mezvinsky was indicted and later pleaded guilty to 31 of 69 felony charges of bank fraud, mail fraud, and wire fraud.^[12] Nearly $10 million was involved in the crimes. Shortly after his indictment, he was diagnosed with bipolar disorder, but the judge at his trial disallowed a mental illnessdefense.^[5] He served his time at Federal Prison Camp, Eglin.^[13] Mezvinsky, Federal Bureau of Prisons # 55040-066, was released in April 2008.^[14] He remained on federal probation until 2011, and as of 2010 still owed $9.4 million in restitution to his victims.^[15]

What is next for the younger Mezvinsky? That is unclear but if we had to venture one suggestion how about Paulson and co.

The post Clinton’s Son-In-Law To Close Greek Hedge Fund After 90 Percent Drop appeared first on ValueWalk.

Roslyn Zhang, a managing director at China Investment Corp.(CIC), has slammed hedge fund managers on a number of different issues in what seems to us like some high profile trolling.

Zhang works at the Chinese sovereign wealth fund CIC, and has spoken out against short bets on the yuan and the lack of money-making skills among hedge fund managers, according to Bloomberg.

CIC managing director rails against fund managers

“Over the last couple years I’m kind of disappointed by the performance,” Zhang said Wednesday at the SkyBridge Alternatives Conference in Las Vegas. Zhang is responsible for CIC’s fixed-income and absolute-return investments, and claimed that the SWF is a “sizable” investor in the hedge fund industry.

Zhang said that while Chinese retail investors have been criticized for driving up prices by crowding into markets, hedge fund managers should be called out for similar behavior. She said that “herd mentality” affects fund managers, and emphasized the widespread betting against the Chinese yuan.

“All kinds of strategies, they run different strategies, they all have the same trade,” said the CIC managing director. “They really don’t know much about China but they just spend two seconds and put on the trade. Should we pay 2 and 20 for treatment like this?” she said, referring to the industry’s fees. On the other hand, Chinese hedge funds have not had great returns recently either, although in their defense if they are good their CEOs probably disappeared somewhere.

The fees charged by hedge fund managers are usually 2% of assets as a management fee and 20% of profits. They are among the best paid finance professionals in the world, but their fees have been criticized by investors such as Warren Buffett.

Debate over China rumbles on

Hedge fund managers have been betting on a hard landing for the Chinese economy, but Zhang says it continues to be strong. The CIC managing director believes that the economy could absorb more construction.

“If you’re worried about China, you should be twice as worried about here,” she said, referring to the United States. The International Monetary Fund projects a 6 percent expansion on average over the next five years, which is below what Chinese leaders are aiming for.

Zhang sparked a heated debate between Don Brownstein, founder of Structured Portfolio Management, and Milton Berg, founder of MB Advisors.

“I would rather put my money with a communist government than a capitalist government,” Brownstein said, without providing any further details.

Berg said that the Chinese stock market provided more than enough evidence for the weakness of its economy. Stocks have dropped around 20% so far this year, while the S&P 500 has risen around 2%.

Zhang recommended that money managers learn some new skills. “Only less than 10 percent of managers are actually capable of adapting to the new reality,” she said, without providing details. “Probably 90 percent of the managers think they are part of the 10 percent anyway.”

According to the WSJ, Zhang is not just trolling.

The CIC official later told The Wall Street Journal in an interview that she was booting managers from her approved list and beginning the process of evaluating whether to slash the fund’s investment in hedge funds overall.

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Here is a value fund that managed to beat the S&P last quarter, and we know that there haven’t been many this year. The well-known value hedge fund Half Moon Capital gained 4% in Q1, smoothly sailing while most in the hedge fund industry experienced a downturn, according to a letter reviewed by ValueWalk.

Half moon Capital gains in long portfolio with JBSS, StarTek and Headwaters

Regarding its performance during a difficult period, the fund said it does not target short-term returns but is nevertheless pleased with doing well this year. Eric DeLamarter, managing partner at Half Moon, said their approach focuses on managing risk and preserving capital, and this has helped them.

On the long side, Half Moon generated a return of 8% as a position in John B. Sanfilippo & Son, a nuts distributor in the U.S., climbed with its positive earnings report. Other positions that boosted the returns were Headwaters, which deals in ;building materials, StarTek, a customer care company; and Imvescor Restaurant Group. However, Half Moon’s top performer was a position in an undisclosed real estate company that gained over 30% in the last quarter.

After selling its long in Continental Building Products, Half Moon holds 11 positions in its portfolio. The fund wrapped up Continental in January owing to weakness in wallboard prices and volumes which will affect the company’s earnings this year.

Half Moon Capital shorts Teladoc, Control4 and Fenix Parts

Half Moon’s short book was also up in the past quarter, returning 1% on a gross basis. The best performers in this category were Teladoc and Fenix Parts. The hedge fund said all the weaknesses in Teladoc that were hidden have now become apparent and are causing major problems. The tele-healthcare company has experienced increasing competition and slower growth in member accounts and has been burning cash zealously during this time. All this culminated in a decline of 40% in its shares, which helped Half Moon’s short portfolio.

Regarding Teladoc, Half Moon states:

“Almost all the challenges facing the business that we outlined began to manifest themselves and become increasingly evident: 1) lack of differentiation and entry barriers; 2) significant adoption hurdles; 3) disintermediation and intensifying competition putting +80% of revenue at risk; 4) stagnating organic member growth and increasing member churn; and 5) acceleration in cash burn. This resulted in TDOC’s stock dropping precipitously, generating a 41.2% gross return for the Partnership in the quarter.”

Another profit maker on the short side was Fenix Parts, which is a seller of recycled auto products. Half Moon said this particular industry has already consolidated with LKQ Corp acquiring other companies, so Fenix Parts is just buying even a cheaper level of junk than before.

Specifically, DeLamarter opines:

“The biggest issue we cited, among several, was that LKQ Corp had already consolidated the higher quality operators in the industry, thus leaving FENX literally buying the junk of the junk. Awareness of this reality and the overall low quality of the business enabled us to generate a 29.4% return on the short in the quarter.”

After covering its short in Control4 in the fall, the fund is now thinking of shorting the home automation solutions company again after its stock has bounced 50%. The factors that are diminishing Control4’s worth, in his opinion, include a bad acquisition, competition from Amazon’s home automation solution and the falling prices of its home controllers.

Half Moon Capital notes the following red flags:

“Low earnings quality: In 2015 levered FCF was -$4.3M vs adjusted net income of $8.1M.

Inventory has been consistently growing well ahead of revenue. In Q4’15 inventory grew a staggering 40% Y/Y while revenue only grew 4%. Timing of the new product releases can only explain part of this inventory build. The more likely scenario is orders have not been meeting anticipated demand and the Company will likely need to take some write-downs.

For six consecutive quarters, A/R has grown well ahead of revenue, suggesting aggressive recognition/ pulling forward of sales and/ or that CTRL is being forced to extend credit terms to its dealers.

The CEO, CFO, VP of Marketing, VP of Business Development and VP of Product Development collectively own 0 common shares. It is also rather telling that Pakedge totally cashed out and did not take any stock in the deal. Not favorable signals or incentives.

Board Members Bailing Out: On February 27, 2015, the board members representing two of the three largest shareholders and original backers, Foundation Capital and Frazier Ventures, announced they were resigning from the board of directors effective April 28, 2015. This may signal that these VC groups are going to begin selling their shares. These two groups hold 23.7% of the shares outstanding so such selling would clearly put substantial pressure on the stock.”

In terms of valuation, the hedge fund opines:

“CTRL’s current 23.7x LTM P/E multiple is predicated on unattainable mid-teens organic revenue growth and a 100% increase in net income (all number proforma with Pakedge). The reality is the recent price cuts and competitive pressures are leading to negative revenue growth and further margin erosion in the near-term. We believe the Pakedge acquisition only accelerates the Company’s demise. Control4 has limited IP and no discernable strategic value, thus the stock is likely not worth more than its ever-declining net cash position of $1.78 per share for a potential 75% return.”

The fund initiated a new short in an unnamed healthcare IT company.

Badger Meter (BMI) is another short mentioned, without a discussion of the thesis.

DeLamarter said he is confident about their disciplined approach to value investing and believes they will sail smoothly through the difficult spell in the business and investment industry. The fund is currently maintaining 86% gross exposure, of which 61% is invested in longs and 25% is invested in shorts.

Half Moon Capital closes off the letter with the following statement:

“As Howard Marks wisely puts it:

‘Over their careers, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners. Skillful risk control is the mark of a superior investor.’

Consistent with these sentiments, the Partnership performed well during a time when most others were severely challenged. When the fog of a market downturn hides the signposts upon which some other strategies rely, our value discipline keeps us focused on analyzing price versus value, and on only buying when a desirable discount exists. The market environment remains tenuous, but we are confident our disciplined investment approach will keep us in good stead.”

The post Half Moon Capital Outshines With 4% Return In Q1; Details Control4 Short appeared first on ValueWalk.

The long/short equity value fund Cooper Creek Partners managed to return 0.6% in the first quarter, according to a quarterly investment update reviewed by ValueWalk. Despite gaining more than 7% in February and March, Cooper Creek Partners was barely able to even out the losses incurred in January when it was down 6.4%.

In the last quarterly update, Cooper Creek, which was up 7.3% in 2015, laid out its thesis on Seritage Growth Properties, one of its biggest long positions. The hedge fund’s other significant longs are Newcastle Investment, Krispy Kreme Doughnuts, Engility Holdings and the Intertain Holdings.

Cooper Creek bullish on Engility Holdings

The fund talked about its position in Engility Holdings this time, which is a new stake. Cooper Creek said that Engility’s new CEO, Lynn Dugle, is capable of executing a turnaround at the company with the proper refinancing of its corporate debt. The company merged with TASC at the end of 2014 in a $1.1 billion all-stock deal. Engility provides a range of technical services, including defense, engineering, analytical and logistic services.

The merger with TASC caused Engility to stumble in the beginning; however, the new CEO is expected to smooth out the integration of both defense services companies, said the hedge fund.

On valuation Cooper Creek states:

There is another noteworthy aspect to the TASC acquisition. Prior to the actual issuance of stock to TASC holders, Engility paid a special dividend of $11.43 per share to its shareholders (thus shrinking the equity value per share), in order to enable the TASC holders to own 51% of the pro forma Company. By TASC retaining 51% ownership, the net operating losses and other assets could be utilized by Engility to reduce future tax burdens. We estimate the tax shield to be worth $1.5 billion, including $390 million of NOLs and $1.1 billion in unamortized intangible assets. Our analysis suggests that this has created a shield for EGL of $560 million in cash taxes over the next decade, and has a net present value of $370 million.

Therefore, this is a significant part of EGL s equity value, equating to $10.00 per share of hidden value. While our overall investment thesis is not premised on a takeout of the Company, we remain cognizant that these NOLs could hold significant value to a potential acquirer. Should EGL not garner an appropriate valuation in the public markets over time, we believe the underlying stability of its government end markets, its robust free cash flow, and the NOL asset would tempt a potential acquirer. Based on precedent transactions in the government IT space, we believe a takeout multiple of 12.0x-14.0x EBITDA is reasonable, suggesting a share price of $36.51 to $47.52 per share, which does not account for the value embedded in the NOL asset.

Corporate restructurings are not enough for market performance

Cooper Creek also said that a value-based long investment cannot just stand on the back of corporate restructurings in today’s market. For a company to perform well in the market, strong operating fundamentals are necessary. The fund said that corporate action in the past two years has done more harm to stock prices than good as the market adapts a “sell-on-the-news” approach.

Cooper Creek has acquired new positions in The Finish Line, a specialty footwear retailer, Callaway Golf Company and Vonage Holdings, a cloud services provider, based on a fundamental bottom-up approach.

Cooper Creek Partners shorts Main Street Capital

Cooper Creek said that over half of its short portfolio is now new short bets made in the first quarter. The fund spoke of its largest short position in Main Street Capital, a small-cap investment firm. In the hedge fund’s opinion, Main Street has exposure to energy, which is a headwind, and false financial estimates for the companies it invests in. Both factors have the ability to negatively affect the investment firm in the future. Cooper Creek also said that Main Street Capital had accounting irregularities. The fund said it presented its short thesis on Main Street at the BTIG Best Ideas Conference.

According to an update from RBC Capital Markets on May 7, MAIN was able to beat consensus estimates in Q1 with NOI (net operating income) of 57 cents per share; however, this was less than what RBC was expecting.The report said that Main Street Capital’s focus on the middle market makes it valuable. RBC said that at current prices, MAIN is not very cheap, but the business model and dividend yield make it an attractive buy. The report rated it at Outperform, setting a price target of $32. MAIN currently trades at $31.87, and the shares have gained nearly 10% this year.

A report from National Securities analysts dated May 9 said MAIN’s net interest income came in below their estimates at 54 cents per share, as they expected 56 cents. The portfolio grew by $20 million in the quarter, from $1.8 billion to $1.82 billion, including unrealized losses of $26.2 million. National Securities analysts said they are reducing their PT from $34 to $33 and are closely watching Main Street’s credit.

Prioritizing preserving capital and managing risk

Cooper Creek was founded in 2008 and currently manages $163 million. The hedge fund believes in maintaining low exposure and averaged 12.9% net exposure in the first quarter. It was able to generate alpha on both the long and short side of its portfolio in the first quarter. Increased volatility in the past quarter caused Cooper Creek to reduce the holding period in which it looks for a catalyst for a position. Cooper Creek said its foremost priority at this time is to preserve capital and manage risk in case a downturn hits the market.

The quarterly update shows that Cooper Creek has high net short exposure in the Consumer Staples and Energy sectors. The largest net long exposure is in the Restaurants and Real Estate sectors, whereas exposure is almost equally hedged in Industrials.

The post Cooper Creek – Lays Out Short On MAIN Street Capital appeared first on ValueWalk.

Like many others, Lansdowne Partners was burned by volatility in the first quarter. The flagship Developed Markets Fund was down 7.99% in the first quarter, whereas the Developed Markets Long Only Fund Ltd was down 4.5% in the same period, according to a quarterly update reviewed by ValueWalk.

Volatility shook up assets across the board

The firm’s management said that volatility was so extreme in the first quarter that it made for the most difficult period in their careers. While most asset classes swayed even though there was no fundamental change, the move in the USD and lower U.S. bond yields were rational, considering that U.S. monetary policy slightly relented from its aggressive stance. However, so far, it appears the Fed will not be easy on the market as in its mid-June meeting, it hinted at tightening the ropes with higher interest rates. Lansdowne also agreed with the ECB’s and BoJ’s decisions not to reduce interest rates by weakening currency as it would place the local banking sector at risk.

Lansdowne’s portfolio managers were scratching their heads at the universal underperformance that was seen in the first quarter. Even those who held contrary portfolios seemed to miss gains during the period of volatility. They commented that it looked like all kinds of “active management” was at fault, perhaps alluding to trend-following money managers, which are becoming even more popular as hedge funds have been underperforming.

Lansdowne Partners increases shorts in Pharmaceuticals, bets against automotive

The fund was able to record a gain of 2.1% in its short book and overall made a net positive return in Financials while losing the most in commodity shorts. Despite underperformance in most areas, Lansdowne’s managers seem satisfied with the way they managed risk, scaled back exposure and resisted unloading or overloading on positions that were not turning in their favor.

The letter particularly comments on the firm’s long position in Lloyds Banking Group, where there was better-than-expected margin improvement and return of capital to shareholders, and yet, its shares underperformed. The fund added to its position in Lloyds while reducing in Goldman Sachs. The hedge fund has major stakes in JPMorgan and Wells Fargo as well.

Lansdowne also underperformed in LinkedIn, which disappointed the market with its earnings report. Shares of LinkedIn are down nearly 50% for the year.

In the long book, the Lansdowne Developed Markets Fund’s largest five positions are, Alphabet Amazon, BT Group, Comcast and Delta Airlines.

In the short portfolio, Lansdowne said it profited off one in aerospace and from another in the Chinese Internet, both of which were new bets, said the letter. The fund scaled up its short exposure in many areas in the first quarter. As we have discussed before, Lansdowne Partners has quite a large short book in the U.K. alone. In the U.S., the fund added to shorts in the Retail sector and also added negative exposure in Pharmaceuticals. The letter commented that some of these companies have questionable accounting practices. Moreover, valuations are based on drugs that are in trials or under review, and these estimates do not consider competition or account for pricing pressure. The hedge fund’s position in the Pharmaceuticals sector is in contrast to the many money managers who have hoarded money in pharma companies and have been buying up positions in dozens of them at once.

Lansdowne also added a short in an unnamed automotive company and said that the sector is looking “at a range of disruption, likely over the next decade that is unprecedented.”

Lansdowne Partners shorts Capita plc in the U.K.

While Pharmaceuticals may be a short theme in Lansdowne’s portfolio in the U.S., for now the positions disclosed to the Financial Conduct Authority in the U.K. have no name in this sector. In the Industrials and Energy sectors, Lansdowne has short positions in Tullow Oil, Glencore Xstrata, Weir Group, Capita plc and Aggreko. Shorts in the Consumer Retail sector include bets against Sainsbury plc and Wm Morrisons Supermarkets; Lansdowne Partners is also betting against Prudential plc and Provident Financial.

All of the mentioned shorts have been in place for more than a couple of years. The one in Capita plc is the most recent, disclosed in late February. Capita offers business and technical solutions ranging from healthcare, IT, property and insurance services. The fund has had an 0.75% short position in Capita since February 25. Shares of the company have slipped 10% during this time.

Lansdowne also discussed its bias against commodity-driven companies and said that the recent lift in oil prices does not have them worried. The fund said that after the limited increase in oil prices, the valuations have become even more far-fetched as they would require a huge rise in oil prices and increased production, so management feels safe sticking to their short in commodities.

The post Lansdowne Partners Discloses New Shorts; Sees Massive Disruption Coming In Autos appeared first on ValueWalk.

HG Vora Capital had a relatively flat first quarter, which is not bad since most other hedge funds did not have that luxury. The fund was up 0.3% last quarter as its long portfolio did well, but its short positions detracted. according to a letter to investors reviewed by ValueWalk.

Capacity of loan portfolio increased to $1.5 billion

HG Vora Capital Management is an event-driven fund with investments in both credit and equity. The fund bumped up the capacity of its leveraged loan portfolio to $1.5 billion after increasing it by $300 million in the first quarter. The leveraged loan portfolio currently has assets of $985 million.

In its long credit positions, the fund made money on Caesars Entertainment Operating Company’s bank debt. The debt traded higher after an examiner’s report affirmed that CEOC’s parent company, Caesars Entertainment Corp., had looted the operating unit after siphoning assets away from creditors. The $18 billion bankruptcy had left CEOC’s creditors angry as it became hard to reach an agreement over debt restructuring. HG Vora was optimistic that the creditors and Caesars would reach a deal on the payment of the debt and that the fund would receive par value, plus accrued interest on its holdings.

New investments in the first quarter included first lien bank debt from YP Holdings, a digital marketer, and YRC Worldwide, a goods transportation company. Vora also bought some of payment solutions provider Harland Clarke’s senior unsecured bonds.

HG Vora Capital profits in Hyatt Hotel and Hilton

In equities, HG Vora’s longstanding investment in Pinnacle Entertainment was once again profitable. Shares of Pinnacle performed well as the company came close to concluding a  $4.4 billion sale leaseback transaction with Gaming and Leisure Properties. The hedge fund is also bullish on Pinnacle’s upcoming acquisition of Meadows Racetrack and Casino. Other equities that did well for the fund were Hyatt Hotels and Hilton Worldwide. Parag Vora continued his bias towards leisure and entertainment companies with new investments in these hotels. Their shares fell at the start of the year on multiple fears, and that’s when the fund initiated positions in both. However, the fund has since exited Hyatt Hotels after cashing in a quick profit. The fund also closed its position in Homeinns Hotel Group, a Chinese company, in the first quarter.

The largest negative impact on the long portfolio was made by telecommunications company Parrot S.A. The French company makes Bluetooth technology equipment for unmanned aerial vehicles, and this is where HG Vora sees potential. The fund’s management said that Parrot’s ability to make a position in the commercial drone industry convinced them to hold on to the stake even after the shares fell by over 30% in the first quarter. The letter said that the fund wrapped up stakes in Cabela’s and La Quinta Holdings in the first quarter. At the same time, positions in Hilton Worldwide and MGM Resorts International were further increased during the period.

The fund welcomed Amit Amos as a new investment analyst; he has previously worked at Claren Road Asset Management and Avenue Capital. Another analyst added to HG Vora’s team is William Mauzy, who has experience in distressed debt, from Macquarie Capital.

The post HG Vora Capital Profits Off Caesar Debt, Pinnacle Entertainment In Q1 appeared first on ValueWalk.

Visium Hedge Fund Plans Shutdown

The multibillion-dollar hedge fund Visium Asset Management has collapsed in the throes of an insider-trading crisis. The fund told investors Friday that it planned to shut down. Business Insider wrote that it “imploded in the biggest scandal to hit the industry in years” — the largest such closure since officials forced the shutdown of SAC Capital…

The post Visium Hedge Fund Plans Shutdown appeared first on ValueWalk.

Hedge funds’ performance or lack of it has been a hot topic this year. Despite their high fees and reputation for attracting only the brightest talent around, market volatility in the first quarter caught many funds off guard, with the HFRI Fund Weighted Composite Index declining by -0.6%. Yet despite this lacklustre performance, the average management fee remained steady at 1.5% while the average incentive fee pocketed by managers decreased by just 0.1% to 17.6% according to data compiled by Hedge Fund Research Inc.

Hedge funds: Losing clients 

Deteriorating performance and high fees have resulted in a number of high-profile money managers, pension funds and insurers withdrawing their cash from hedge funds recently.

Event Driven Hedge Funds Up 2.96%; Distressed Debt Funds Up 2.66% In May

In April of this year, New York City’s pension for civil employees voted to exit its $1.5 billion portfolio of hedge funds and at the beginning of May MetLife Inc., the largest U.S. life insurer, said it’s seeking to exit most of its hedge-fund portfolio. Last September, California Public Employees’ Retirement System (CalPERS), the largest pension fund in the U.S., announced that it would pull its entire $4 billion investment in hedge funds.

These high-profile withdrawals have sparked a fierce debate about the future of the hedge fund industry. Blackstone Group LP President Tony James even went so far as to predict that hedge funds may lose 25% of their assets.

Finance & Law: Compliance Is A Growing Problem At Hedge Funds for Managers & Investors

And he could be right. Even with the recent reports of several high-profile hedge fund launches, more funds shut than started in the first quarter of 2016, with 291 funds liquidated while only 206 started, according to Bloomberg citing HFR data — this was the second consecutive quarter that closings exceeded openings. 

305 funds shut during the fourth quarter.  During the past 12 months, 910 hedge funds launched while 1,053 funds liquidated, as managers struggled to raise capital and some put off starting new funds. Last year saw the most closures since 2009.

Hedge funds: Cyclical trends?

There is an argument to be made that the hedge fund industry is currently experiencing a wave of natural attrition or a cyclical contraction. Since the financial crisis, the value of assets managed by hedge funds has swelled to $3 trillion. But as market conditions become more normalized, volatility and dispersion returns, it’s only natural to assume that some hedge funds will be forced to close their doors. 

Sigma – What Is A Good And A Bad Way To Invest In Hedge Funds

As more funds have started since 2008, it’s fair to assume more would fail when the going gets tough.

Rebound in performance 

The second quarter of 2016 has seen a rebound in hedge fund performance after the worst start to a year on record. According to HFR, funds reported their third positive month of performance in a row for May returning 0.4% for clients bringing gains for the year to 0.8%. Bloomberg’s analysis of the data shows that funds focused on distressed and energy-related strategies led gains. HFR’s data shows funds that invest in distressed securities are up 2.9% year-to-date.

Third Point LLC’s flagship event-driven fund rose 1.7% in May bringing year-to-date gains up to 1.2%. Bloomberg reports that Mudrick Capital Management’s Distressed Opportunity fund rose 3% in May, bringing year-to-date returns to 13.2%, according to a person familiar with the matter. Coatue Management’s flagship fund also rallied about 4% to wipe out this year’s losses. 

Larry Robbins’s Glenview Capital Management gained 3.1% in its main fund in the month, paring this year’s losses to approximately 7%. Meanwhile, Brevan Howard Master Fund fell 0.3%, extending this year’s losses to 2.1%, while Paul Tudor Jones’s flagship BVI Global Fund fell 0.5%, bringing the year-to-date drop to 3.2%. These figures are all as reported by Bloomberg citing people with knowledge of the matter. Bloomberg reports that these funds declined requests for comment.

The post Hedge Fund Performance Picks Up In May appeared first on ValueWalk.

Two New Tools For Addressing Activist Hedge Funds – Sunlight Bylaws And Reciprocal Disclosures

G. Mead

Stearns Weaver Miller Weissler Alhadeff & Sitterson, P. A.

May 20, 2016

21 Fordham J. Corp. & Fin. L. 479 (2016)

Abstract:

Publicly-traded companies have the power to pass sunlight bylaws to address hedge fund activism. Sunlight bylaws would require activist hedge funds to publicly disclose any strategic proposals and their financial interests in companies earlier and at thresholds lower than current securities laws. Sunlight bylaws would also require disclosure of additional information, including: (1) the percentage of the fund’s portfolio invested in the company; (2) the fund manager’s compensation; (3) the fund manager’s investment in the fund; (4) the fund’s portfolio turnover; and (5) the fund’s prior holding periods after any announcements of an ownership interest and a strategic proposal. Academic proponents of hedge fund activism defend activism based on the theory that activist hedge fund managers are systematically better agents for long-term stockholders than the incumbent board and executive management. These proponents argue that fund managers have large stakes in their funds, the funds’ profitability is highly contingent on the financial performance of its investments, and the funds hold relatively few concentrated investments. Sunlight bylaws would target factual information essential to that claim and require its disclosure in succinct, summary form. Sunlight bylaws would also state that if a stockholder violates them, that stockholder cannot nominate a candidate for a seat on the board or propose any issue for the next stockholders’ vote.

But institutional investors and proxy advisory firms support hedge fund activism in the abstract, and a board that passed a sunlight bylaw might precipitate litigation or a proxy fight. Public companies should therefore, on a case-by-case basis, request the same or similar information when an activist that has held shares for a brief period of time makes a strategic proposal. Public companies should negotiate confidential treatment of any disclosures for a period of time so that the activist can reap the full benefit of the short-term increase in share price after the disclosure of its investment and strategic proposal some academics and institutional investors think necessary to incent activism. But public companies should also make very clear that they reserve the right to publish any questions that the activist refuses to answer or for which it insists on confidential treatment. And the other stockholders, who likely invest over longer timeframes, should carefully consider any information that the activist discloses — or, equally importantly — refuses to disclose.

Two New Tools For Addressing Activist Hedge Funds – Sunlight Bylaws And Reciprocal Disclosures – Introduction

Activist hedge funds have repeatedly invested in public companies, successfully pushed for the adoption of their strategic proposals, and then exited within one or two years. Companies can enact sunlight bylaws, which would require such funds to disclose online any such proposal within one day and to disclose any direct and indirect financial interest in the company above 5%. Other information bearing on the fund’s incentives, such as the fund manager’s compensation, the fund and fund manager’s compensation based on performance and the amount of money managed, the percentage of the fund’s assets the investment represents, and the fund’s portfolio turnover, would also be disclosed. If an activist hedge fund violated the sunlight bylaw, its strategic proposal or director nominee could not be proposed for a stockholder vote without board approval.

But support from a public company’s institutional stockholders for a sunlight bylaw may often be lacking, and a sunlight bylaw may precipitate litigation or a proxy fight. Thus, public companies should begin, as a first step, by requesting that any activist making a strategic proposal also make voluntary, reciprocal disclosures in response to the same questions posed by sunlight bylaws. The public company could make the activist’s disclosures confidential for a period of time. That would enable the activist to realize the entire short-term gain caused by its disclosure of a strategic proposal and investment and should not reduce an activist’s short-term profits. The public company, in its request for reciprocal disclosure, should also make clear that it can publish to stockholders any questions the activist refuses to answer, any questions that it has agreed to answer only confidentially, the terms of any negotiated confidentiality agreement, and the activist’s refusal to update answers.

Part I of this Article outlines the debate over activist hedge funds. An activist hedge fund typically identifies a target company it deems ripe for intervention, buys shares in the open market, and then publicly announces its beneficial ownership and a strategic proposal by making a filing under the securities laws. Research has shown about a 5% increase in the company’s share price in the twenty days up to and including the activist’s disclosure, followed by about a 2% increase in share price in the next twenty days. Lead activists frequently communicate with other hedge funds while acquiring a financial interest in the company, and those other funds acquire their own interests and support the lead activist’s strategic proposal. Hedge funds acting collectively have been dubbed “wolf packs.”

Proponents of activist hedge funds claim that hedge fund managers have strong incentives to boost short-term share price and systematically make proposals that increase both net present value and long-term value. They assert that hedge fund managers’ compensation depends highly on performance, hedge funds hold few concentrated investments, and hedge funds use derivatives and other financial instruments to amplify their investments. They assume that the hedge fund managers’ incentives are systematically stronger than the company’s executive management and directors’ incentives to increase share price.

In response, many with enormous practical experience, such as Delaware Supreme Court Chief Justice Leo Strine, corporate lawyer Martin Lipton, and Blackrock Chairman and CEO Laurence Fink, point to activist hedge funds’ short average holding periods of one or two years in the company’s stock and high portfolio turnover to argue that hedge funds’ focus on short-term returns can harm long-term value.

They claim that activists often force cuts in long-term investments like research and development in favor of financial engineering that boosts share price in the short-term to the detriment of net present value and long-term value.

Empirical studies accepted for publication about activists’ intervention and long-term value conducted by those who defend hedge fund activism have shown that over the five years following activist hedge fund interventions firm value sometimes increases and sometimes decreases. Other studies have shown that activist interventions decrease research and development spending and long-term return on assets.

Part II describes the debate surrounding activists’ current disclosure obligations under the federal securities laws. Section 13(d) of the Securities Exchange Act of 1934 (the “Exchange Act”) requires activists to publicly report any strategic proposals ten days after acquiring over a 5% beneficial ownership of a company’s outstanding shares, but does not count derivatives or short positions toward that threshold. Activists have increased their ownership up to as much as 27% in the ten days between hitting the reporting threshold and the disclosure deadline. In part because activists in modern financial markets can increase their stake so quickly, Wachtell, Lipton, Rosen & Katz petitioned the United States Securities and Exchange Commission (the “SEC”) to require large stockholders to report any strategic proposals a day after acquiring a financial interest above

The hedge fund industry is currently going through a transition. As investors re-evaluate their exposure to the sector, due to the high fees and poor returns, which often negate the benefits of investing in hedge funds, more funds are now closing than opening.

Hedge Funds 1H16 Round-Up: Winners And Losers

According to data compiled by Singapore-based Eurekahedge, so far this year there have been more hedge fund closures that launches and closures have outpaced launches for six consecutive quarters for the European hedge fund industry.

However, while more hedge funds are shutting down than opening up, Eurekahedge’s data shows that during the first half of 2016 hedge fund industry assets under management rose by $19.9 billion. For the sector as a whole during the first half of 2016, investor inflows of $25.1 billion offset performance driven losses of $5.2 billion.

Hedge Funds Up 0.63% In June 2016; Big H1 Inflows

It’s clear that some parts of the hedge fund industry are doing better than others. CTA/managed futures funds topped the tables across strategic mandates for the first half of 2016. On the other hand, funds of hedge funds appear to be rapidly falling out of favour with investors.

Funds of funds losing out as hedge fund industry restructures

According to Bloomberg, funds of hedge funds lost more than $100 billion during the past 12 months due to outflows and poor performance. Over the four quarters through March, clients pulled $50.3 billion from the funds while managers posted $51.5 billion in investment losses that’s according to data compiled by eVestment, which studies performance figures from more than 2,500 funds. eVestment also reports that hedge funds lost $101.8 billion in the 12 months through March because of outflows and poor performance.

A loss of more than $100 billion is significant for the funds of hedge funds sector as the industry has less than $1 trillion in assets under management. In fact, after recent investment losses and redemptions assets in the industry shrank 11% to $841.6 billion, the lowest since June 2009. The total AUM for the global hedge fund industry currently stands at $2.26 trillion and as of 1H 2016. Before the financial crisis, funds of hedge funds were the single largest investment hedge funds, accounting for almost 50% of industry assets in 2008. Today, they make up 28%. According to Bloomberg funds of hedge funds have reported net investor outflows in 16 of the last 20 quarters.

Gold Prices Lose Turkey Coup Spike as Equities Gain, Hedge Funds Cut Bets, GLD Shrinks

Another study, this time, conducted by Credit Suisse Group AG, which polled more than 200 allocators with almost $700 billion invested in hedge funds found that most investors pulling money from funds of hedge funds were planning on redirecting the money to other managers, rather than exiting. Only 9% of the respondents said they were planning to reinvest the money withdrawn from funds. Of the sample, 84% stated that they had made hedge fund redemptions during the first half of 2016, but most of these investors were planning to reallocate redeemed capital. Funds of hedge funds saw the largest rate of redemptions. 91% of the respondents said they had pulled money from funds of hedge funds during the first six months of 2016.

King Street Capital Management, the large and notoriously secretive credit hedge fund founded in 1995 by Brian J. Higgins and Francis Biondi Jr. produced unaudited gross returns for the second quarter and first half of 2016 of 1.46% and 1.4% respectively.

According to the fund’s August 2nd second quarter letter to investors, a copy of which has been reviewed by ValueWalk, King Street’s first half profits were driven by gains in energy and power investments as well as the fund’s investment in Lehman Brother’s debt and structured credit, a popular trade among hedge funds.

Also see best hedge fund letters

The key bets that paid off for the fund in the second quarter were its long position in TXU, which performed well on stronger pricing power driven by natural gas price improvements. Structured credit also performed well during the three months to the end of June as both CLO equity tranches and mezzanine bonds rallied following a decline in new issuance. Spreads comparable to high-yield and loan instruments narrowed. The fund was adding exposure to this sector throughout the quarter.

See also: Hedge Funds Continue To Profit Off Crisis Bets

With regard to the Lehman position, King Street writes that the US Lehman estate received the proceeds from its derivatives claim settlement with JP Morgan during Q2 and was, therefore, able to pay a special interim distribution in June. Also in June, the Lehman US broker-dealer paid a distribution of nearly 50% of its remaining asset value.

King Street: Steady returns 

Overall for the second quarter, King Street saw gains of 1.9% on its long portfolio and -0.1% on the short portfolio for a net performance of 1.82%.

Value Hedge Funds Most Loved Stocks

Directional hedges detracted 0.2% from performance and other losses cost the fund 0.34% for a total return of 1.46% quarter. For the year to the end of June, King Street’s long positions have returned 2.56%, short positions have cost the fund 0.32% for a net return of 2.25%.

Other losses detracted 0.84% from the fund’s performance for the first half for a total P&L of 1.4%.

A long overdue credit cycle 

Brian J. Higgins and Francis Biondi Jr. use King Street’s second quarter letter to issue a warning to investors. The duo writes that they believe we are in the early stages of a long overdue credit cycle that has been exacerbated by years of extremely low-interest rates, resulting in capital misallocation. Even though the equity bull market is well into its seventh year, GDP growth and corporate profitability remain challenged and political risks are growing. Brexit, Turkey the Italian banking system, uncertain levels of Chinese growth and the upcoming elections in the US are the major upcoming risk events that markets now face.

Hedge Fund Shorts – More Alpha than Meets the Eye?

King Street’s founders believe that Brexit may only accelerate the unwinding of the credit cycle and as a result, the billionaire managers adopting a cautious investment strategy.

The fund is investing in stressed corporate and structured credit instruments, which have additional upside. The underlying issuer must have a strong underlying business that is facing short-term concerns. On this front King Street sees a strong pipeline of distressed energy and consumer focused issuers. In Europe, the fund sees opportunities in the banking sector and commercial real estate market.

On the short side, King Street is targeting high-yield issuers that have benefited from the search for yield but are overleveraged and have deteriorating fundamentals.

As the credit cycle progresses and corporate distress surfaces more broadly, King Street expects to find plenty of additional opportunities in the credit market, a view echoed by others including Anchorage Capital.

Photo by conorwithonen

Tim Eriksen‘s Cedar Creek Partners has produced an average annualised return since inception for investors of 14.1% compared to a gain of 7% for the S&P 500 over the same period. Inception was January 15, 2006, so unlike many other smaller hedge funds, Cedar Creek was around to experience the financial crisis.

Hedge Fund Letters To Investors

For the first half of 2016, the fund produced a return of -3.5% compared to 3.8% for the S&P 500. At the end of June, the fund had 17 positions, with 56.5% of assets invested in the fund’s top five longs and 89.5% of assets invested. For the second quarter, the fund gained 5%.

Cedar Creek is a value fund at its core and the fund seems to prefer “investments trading at a discount to cash or securities but with little upside potential due to the lack of a strong money making business.”

One such investment was Associated Capital a spinoff of Gamco, which was sold during the second quarter as Cedar’s managers were concerned about their large exposure to investments of this type. With little or no earnings power, there was no indication as to how long it would take before Associated Capital’s discount would begin to narrow, and as a result, Cedar’s managing partner Tim Eriksen believe the cash could be better used elsewhere.

“While value investing is all about paying less than a dollar for a dollar’s worth of assets, it is also important that over time the value of the assets is growing, so the investor can capture not only the elimination of the discount in valuation but also the gains of the business over the holding period. In Associated Capital’s case we decided that due to the relatively low earnings power of the business and the unknown timeframe for a narrowing of the discount, that we would be better off allocating capital elsewhere.”

Associated Capital is out, but another stock with similar traits was added to Cedar’s portfolio in the last quarter.

Vulcan Value: Small-Cap Value Plays

Virtus Investment Partners is an investment manager that is suffering from declining assets under management. However, according to the fund’s research Virtus has nearly $50 per share in cash on its balance sheet and trailing earnings over three dollars per share, including some one-time costs. Stripping out cash, Cedar estimates it paid around five times earnings for the business at the date of acquisition an extremely attractive multiple for a cash rich business.

Cedar Creek: Turning activist

Another investment Tim Erikson writes about in Cedar’s second quarter letter is Solitron Devices.

The fund originally purchased Solitron in 2014. At the time the company had $7.2 million in cash, a market value of $9 million and earnings of approximately $80,000 per year. The problem was management had a severe disregard for shareholder rights. No annual meetings were held between 1993 and 2012 and when annual meetings were eventually held in 2013 and 2014, shareholders voted against every director, but the board would just appoint someone new.

Price And Value

Cedar turned activist in 2015 and announced its intention to run two rival directors for board seats. Shareholders voted overwhelmingly in favour of Cedar’s nominees, but the existing board decided to fight the fund and its shareholders. Legal fees have pushed the company into losses in three of the last four quarters but finally, a few weeks ago Cedar finally got its way, as Tim Erikson writes:

“After an immense amount of effort by the Board, we are pleased to report that last Friday after market Solitron issued a press release announcing significant changes. The CEO is retiring, the company entered into a separation agreement which includes the company repurchasing his stock and options, a new COO has been hired, I have been named CEO, and David Pointer, the other nominee in my proxy fight, has been named Chairman.”

“My duties will be to improve shareholder relations, corporate governance, capital allocation, and financial reporting. As one shareholder told me over the weekend, “You already are handling shareholder relations” which is really true as shareholders have had way more contact with me than management over the past year.”

Tim Erikson and Cedar are certainly worth keeping an eye on as this situation plays out.

Below is a summary of 2Q equity hedge fund holdings from June. 30 13F filings by several top funds, with some of the new, added, cut as well as exited positions for each; some stakes may have previously been reported in separate filings. But before you read make sure to check out hedge fund letters article.

Also check out the actual Hedge Fund Letters To Investors

13F Filings For Q2 2016

Other ValueWalk Q2 hedge fund trends coverage:

Jana Partners hedge fund 13F filing

• Buys: LBRDK, CCE, EXPE, HRS, PF, TIME
• Adds: CSRA, HDS
• Cuts: WBA, MSFT, GOOG, CAG, CSC
• Liquidates: PFE, SRCL, LVNTA, AGN, TDG

Jeffrey Ubben — ValueAct Capital hedge fund 13F filing

• Buys: MS, TRN, AFI, STX
• Adds: BHI, ADS, WLTW, CBG, MSFT
• Cuts: MSCI
• Liquidates: MSI, AGU, ADBE

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Ray Dalio -- Bridgewater Associates Hedge hedge fund 13F filing

• Buys: JNJ, PH, CVS, VFC, IVZ
• Adds: EWZ, ABX, LYB, GG, SPLS
• Cuts: EEM, VWO, VMW, MSFT, DIS
• Liquidates: MU, RL, T, QCOM, POT

Oaktree Capital Management hedge fund 13F filing

• Buys: ABEV, BATRK, NGVT, TERP
• Adds:VALE, BCOR, CEO, ALLY
• Cuts: DYN, TSM, SBLK, JD, BRFS, AU, YNDX
• Liquidates: None.

Markel Asset Management hedge fund 13F filing

• Buys: BBU, MCK, BATRK, PAG, BATRA, SRCL, HEI, LILA, MRK, PCLN, CMCSA, LSXMA
• Cuts: LMCA, LMCK, SYNL

Dan Loeb -- Third Point LLC hedge fund 13F filing

• Buys: FB, CHTR, MON, SHW, SHPG
• Adds: TDG, STZ, BUD, DHR, NOMD
• Cuts: DOW, GOOGL, YUM, TAP
• Liquidates:  ROP, AVGO, SIG

Seth Klarman -- Baupost Group LLC hedge fund 13F filing

• Buys: C, LVNTA, CAR, BATRK, SRAQ
• Adds: EMC, TBPH, PRTK, AGN
• Cuts: AR, PYPL, INVA, NG
• Liquidates: SRAQU, LQ, BXE, GNW.

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David Tepper -- Appaloosa Management LP hedge fund 13F filing

• Buys: WDC, USFD
• Adds: AGN, MHK, ALL, SYF, FOXA
• Cuts: HCA, AMLP, ETP, LUV, KMI
• Liquidates: DAL, FB, BAC, PFE, RRC

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Warren Buffett -- Berkshire Hathaway hedge fund 13F filing

• Buys: LSXMK, LSXMA, LMCK, LMCA
• Adds: AAPL, LILA, LBTYA, LILAK, PSX
• Cuts: WMT, SU, VRSN, DE, CHTR
• Liquidates: None

Michael Larson -- Bill & Melinda Gates Foundation Trust hedge fund 13F filing

• Buys: None
• Adds: LILAK, LILA
• Cuts: BRK.B
• Liquidates: None.

David Einhorn -- Greenlight Capital hedge fund 13F filing

• Buys: CPN, RAD, AYA, PRGO, ABC

• Adds: MYL, CC, HTS, AER, CYH
• Cuts: AAPL, KORS, TWX, VOD, TERP
• Liquidates: M, AGN, AGNC, EMC, BAX

Kyle Bass -- Hayman Capital Management hedge fund 13F filing

• Buys: None
• Adds: None
• Cuts: NMI Holdings
• Liquidates: None

Icahn Capital Management hedge fund 13F filing

• Buys: AGN
• Adds: AIG, XRX, IEP.
• Cuts: HTZ, NUAN, PYPAL
• Liquidates: ENZN, SSEIQ

Stephen Mandel -- Lone Pine Capital hedge fund 13F filing

• Buys: SHPG, ATVI, SHW
• Adds: YUM, MNST, PCLN, BUD, DLTR
• Cuts: MSFT, GOOGL, FLT, NOC, FB
• Liquidates: JD, AGN, BXLT, ILMN, HZNP

Prem Watsa -- Fairfax Financial Holdings

• Buys: LXK, CVT, GD, NOV.
• Adds: RFP
• Cuts: None
• Liquidates: None.

Glenview Capital Management, LLC

• Buys: IMS, WMB, Q, DD, FDC
• Adds: HUM, CHTR, HTZ, LBTYK, LBTYA
• Cuts: WOOF, TEVA, DOW, TMO, MAN
• Liquidates: TWC, MCK, ARMK, PNR, CDNS

Glenn Greenberg -- Brave Warrior Advisors

• Buys: LBTYA, BBU, LILA, T
• Adds: AR, BAM, LBTYK,
• Cuts: SCHW, CMPR, PRI, JPM, JPM.WS, AXTA, HAL
• Liquidates: None.

Leon Cooperman -- Omega Advisors

• Buys: ARRS, SHPG, C, NFLX, EPD
• Adds: PVH, FNF, SLW, EA, ETFC
• Cuts: RLGY, CIM, ASH, AIG, AER
• Liquidates: SIRI, GILD, XLP, GLPI, AAPL

Paulson & Co hedge fund 13F filing

• Buys: EMC, VMW, TTWO, SNY, JNJ
• Adds:  SGYP, VRX, FB, ALXN, DXCM
• Cuts: AGN, TMUS, PRGO, TEVA, SHPG
• Liquidates: WC, LRCX, POST, CIT, CVC

Soros Fund Management

• Buys: LBRDK, ROVI, GLD, CSAL, SUPV
• Adds: DISH, EXAR, MODN, SYNA, CBPO
• Cuts: ABX, VIAV, EBAY, ZTS, AGRO
• Liquidates: EQIX, TWC, FB, BXLT, RACE

Tiger Global hedge fund 13F filing

• Buys: CHTR, AMZN, PCLN, QSR
• Cuts: AAPL, SQ, FLT, PSTG, XRS
• Liquidates: NFLX, DATA, XON, GME, Z

Andreas Halvorsen's Viking Global 13F filing

• Buys: ICE, MSFT, RICE, AIG, HIG
• Adds: BIIB, TMUS, MA, APC, NWL
• Cuts: AGN, TEVA, AET, GOOGL, NFLX
• Liquidates: ANTM, TDG, PRU, ENDP, CB

Starboard Value -- Jeff Smith 13F filing

• Buys: BLOX, DK, PNK, MKTO
• Adds: AAP, WRK, IWN
• Cuts: DRI, M, NSP, FCPT, CW
• Liquidates: ACM

Eddie Lampert -- RBS Partners 13F filings

• Buys: STX, FOSL
• Adds: GPS
• Cuts: SRG, IBM
• Liquidates: None.

Fairholme Capital Management, LLC

• Buys: None
• Adds: BAC, JOE, SRSC, SHOS, LE
• Cuts: SHLDW, SRG
• Liquidates: DNOW

Data via Bloomberg and Dave Lutz Jones Trading

With most hedge funds struggling to turn a profit this year, any fund that has been able to achieve a double-digit return in the first half is worthy of a second look.

David Capital, a small hedge fund founded and managed by Adam Patinkin CFA, achieved a high-teens for investors during the first half of 2016 despite market volatility. In the fund’s second quarter and first half letter to investors, Adam Patinkin writes that these returns demonstrate “the value of uncorrelated, research-intensive stock-picking in an uncertain market.”

Hedge Fund Letters To Investors

David Capital is at its core, a value fund. The partnership is looking for investments that are severely mispriced and have a clear event part to revert to fair value over a two-to-three-year time horizon. When it comes to shorts, David Capital is on the lookout for what it calls “unsexy” shorts. They tend to be boring, well-run businesses with honest management and no accounting irregularities. The company’s targets generally face a wave of incoming supply whether that means overproduction of a commodity, overbuilding of an asset class, or the entrance of one or more new competitors – that will disrupt pricing and likely lead to substantially lower future returns. Specifically, Adam Patinkin writes in the second quarter letter:

“We have been short iron ore miners, offshore oil-drillers, and chicken producers. We have been short a children’s tablet company as Apple Inc. (NASDAQ: AAPL) expanded production of the i-Pad, a consumer drone company as GoPro, Inc. (NASDAQ: GPRO) readied to launch its own drone model, and a chemical processing business just before several new competitors finished construction of new competing facilities. Today, an important theme in our short book is the hotel industry, which is seeing substantial new hotel construction (spurred on by cheap financing caused by near-zero interest rates) plus a second-whammy of supply from alternative marketplaces such as Airbnb, VRBO, and HomeAway.”

Mott Capital Management 2Q16 Letter To Investors: TSLA Short

The importance of portfolio analysis

David Capital’s second quarter letter contains a fascinating few paragraphs on the fund’s portfolio management. At the end of the third quarter of 2015, David Capital conducted a comprehensive, data-driven review of the fund’s historical track record and reached several important conclusions about its performance.

First off, the data showed that the partnership had a poor track record of investing in negative FCF businesses. The fund’s returns in positive/neutral FCF businesses were excellent with a success ratio of 74% whereas negative FCF companies had meaningfully detracted from returns with a “batting average nearly one-third worse at 45%.” As a result, the fund has banned all negative FCF businesses from its portfolio.

Secondly, the research showed that when the fund’s gross exposure went above 200%, returns and volatility suffered. Therefore, gross exposure is now capped at less than 200%.

You Don’t Actually Own Your Securities

And finally, concentration was identified as a factor holding back performance. By targeting a slightly more diversified portfolio of 15 to 20 long positions, up from 10 to 12 long positions, David Capital believes it can reduce the risk of single-name downside volatility while enhancing flexibility to capitalize on market mispricings.

By identifying and acting on these three drawbacks, the partnership is already reaping the benefits.

Flowers Foods: Sharp Price Decline Creates Opportunity

In the quarter following the implementation of the changes, the fund reported gains in the mid-teens and in the three-quarter since returns have exceeded a third.

Here is a valuable lesson for investors. One of the most valuable skills in investment management is the capacity to step back and be objectively self-critical. After taking a step back to look at its historical performance, this fund became aware of the mistakes it was making and acted to rectify the issues.

Returns since the changes confirm that this was the correct action to take here.