Expertise and Diligence Need Not Apply

By Cliff Stanton, CFA and Jeremy Frank, FRM

January 2017

The year 2016 is in the books, and thanks in part to a strong fourth quarter, equities again delivered in spades. Value stocks and small caps led the way, with returns of 18.4% (Russell 3000 Value) and 21.3% (Russell 2000). Outside of the U.S., results were more mixed, but still positive. The Russell Emerging Markets Index posted a respectable 10.5% return, while international developed stocks generated a minuscule return of only 1.0% in dollar terms (MSCI EAFE NR). All of this was achieved in an environment that was largely devoid of volatility, despite how it may have felt at times. The VIX averaged 15.8% over the year, well below its long term average of almost 20% going back to 1990. There were of course a few spikes at the beginning of the year, around Brexit and the U.S. presidential election, but otherwise volatility was lacking.

Turning to the bond market, while things were much more interesting on a month-to-month basis, looking only at starting and ending data, one could be forgiven for thinking it was a rather staid year. Consider that the move in the 10-year Treasury’s yield was modest, going from 2.27% at year end 2015 to 2.45% at the end of 2016. Despite that 18 basis point increase, the Bloomberg Barclays Aggregate returned 2.65% for the year. Further, with credit conditions highly favorable to borrowers, high yield bonds had one of their best years on record, advancing by 17.1%, followed by bank loans, which were up 10.9%.

Wrapping up the asset class review, commodities had their first positive year in the last six, based on the Bloomberg Commodity Index, which was up 11.8%. The commodity space was boosted by a big move in oil (Brent Crude was up 52%) and to a lesser extent, gold (+8.1%).

With all major asset classes in positive territory for the year, the shift away from active managers to passive vehicles continued to gain steam. According to Morningstar, passive mutual funds (ex-sector and leveraged funds) took in $221 billion, and passive ETFs brought in an even greater $265 billion, for a combined total of almost half a trillion dollars. And active funds and ETFs? They bled $341 billion.

And so it is with great pleasure that we announce that clearly, making money is officially easy again. There’s seemingly no reason to pay for active managers generally, and certainly not the even higher fees charged by hedge funds and alternative mutual funds. Arguments to the contrary would seem hollow in the face of such overwhelming evidence. In fact, things are going so swimmingly well that we are reminded of the jubilant conversations with cabbies and hair dressers in 1999 who turned us on to, eToys and Worldcom, and the dancers highlighted in “The Big Short” who explained in 2007 how to buy 3, 4, 5 houses and make a bundle, fast. And…oh, um, hmm.

The Data

Equity markets continued to trend up in December, leading to strong performance for U.S. equity markets for the year. The Russell 2000 earned 2.80% for the month and over 21% for the year. International developed markets didn’t fare as well in 2016, ending the year up only 1.59%. All alternative strategies that we track had positive performance during the month; Long/short credit turned in the month’s best performance, earning more than 1%, while Equity Market Neutral had a slightly positive 0.09% return. For the year, derivative hedged equity had the strongest performance with gains of over 5%, while Managed Futures came with the lowest average performance, losing more than 2.5%. Looking longer-term, over the last three years domestic equities seem to have been the best place to park your assets, with the S&P 500 Index gaining nearly 9% annually. Alternative strategies were clustered, as derivative hedged had the best performance with a 2.78% annual gain and multialternative came in at the bottom, earning 0.79% per year. Clearly, alternatives have struggled relative to most long-only indexes, making for an overall difficult environment for anyone not heavily weighted to U.S. equities.

Long/Short Equity funds experienced modest inflows for the month, which helped the category to its first quarter of positive flows since the three-month stretch ending in September of 2014. Going in the other direction was the Managed Futures category, which saw almost $1.6 billion leave during December, perhaps in part due to tax loss selling in a year when most asset classes and strategies were in positive territory. Even with the month’s outflows, the managed futures category had a strong year, pulling in close to $8 billion, while all of the other major categories experienced outflows.

Alternatives in the News

Some Good, Bad and Ugly from Hedge Funds in 2016
Despite earning 15% on the day of the Brexit, Crispin Odey’s flagship European fund followed up a rough 2015 (-13%) with a disastrous 2016, losing nearly 50% as he made large bets that stocks would plummet, predicting that UK stocks could drop as much as 80%. While Crispin Odey finished the year deep in the red, David Einhorn’s Greenlight Capital earned 9.4% as the fund took advantage of the year-end rally. The fund has an annualized net return of roughly 16% since its 1996 inception, with only two down years: 2008 and 2015, when it was down more than 20%. Not to be outdone was Platinum Partners and their potentially fraudulent performance. The firm’s top executives were arrested in December for allegedly scheming to defraud investors by overvaluing illiquid assets among other nefarious activities.

Programming Dalio’s Brain
It appears the team at Bridgewater isn’t only trying to forecast markets but is also attempting to engineer a computerized version of Ray Dalio’s brain. The function of the software will be to implement the firm’s founder’s somewhat radical management philosophy, referred to as “Principles”. This could make for a much easier succession plan amid internal problems that came to light in early 2016. The crew responsible for this task is led by David Ferrucci, who was responsible for leading the development of IBM’s Watson computer. If successful, this should be one very interesting piece of software!

TD Earnings Impacted by “The Donald’s” Tweets
As an investment team we are constantly looking for creative ways to generate profitable trading strategies, so of course we’ve discussed (mostly in jest) the potential profitability of building an algorithm to trade based on our new President’s incessant, market moving tweets. There’s even a new app to help with this endeavor. It seems TD Ameritrade, and I assume other brokerage firms, are already profiting from Trump’s tweeting habits, as TD saw trading volumes increase 11% last quarter. The CEO went as far as saying that “Everyday we wake up hoping Trump will tweet something.” Even Jack Bogle has thoughts on Trump’s social media habits and ways of getting more views on youtube, stating that “Investors should ignore his tweets, but speculators should hang on every word.” It is undoubtedly a strange new world, where tweets erode or add billions of dollars in a matter of minutes.


Pass-through Fees?
The last decade has seen extreme fee pressure on traditional hedge funds, especially as liquid alternatives have grown, providing not only more liquidity and transparency, but typically lower fees. The standard 2 & 20 (2% management fee and 20% incentive fee) has come down for many funds. However, many investors may not be aware of so called pass-through fees, recently highlighted in a Business Insider article. These are fees above and beyond the management and incentive fees, and are used for firm expenses such as trader bonuses, technology, travel and even the development of intellectual property. On the extreme end, these fees can account for 5-10% of assets. It is amazing to us that these types of expenses are still pushed on investors, given that a 2016 survey by consulting firm EY (formerly Ernst & Young) found that 95% of investors prefer no pass-through expenses (surprise, surprise).

This whole situation has come to light due to unusually low performance by many top hedge funds. However, we’re not as concerned with the expenses themselves as we are in the lack of transparency around them, as net returns do reflect all costs at the end of the day. While supporters of the fees say they are necessary to keep elite talent and maintain top technology, our argument is that if true, hedge funds should simply charge higher management and incentive fees, and then defend those fees in the market place. Hiding such fees as a line item in a fund’s annual audit (click here to see a historical example) seems a bit cowardly. Of course, investors in hedge fund-like mutual funds don’t have to worry about such fees. Just something to think about as you make changes to your portfolio in the coming year.

And Lastly

Making the United States Golden Again, Beginning Today