On behalf of our Chief Investment Officer Tim Travis…
In today’s WSJ, there is an interesting article about the largest U.S. pension plan’s decision to exit their hedge fund portion of the portfolio. The rationale behind the decision is that the hedge funds have underperformed the overall market and the costs are higher than some more traditional types of investments, such as basic stocks and bonds for instance. Calpers has a history of reacting to short-term trends such as when it loaded up on speculative real estate investments prior to the Financial Crisis, which it then ended up selling at rock bottom prices prior to the recovery. Most hedge funds are both long and short stocks; thus they often can provide some level of protection in a down market and should by definition underperform in a market that has been so persistently positive, as this bull market has been. Most market participants don’t realize how difficult it is to keep up with the S&P 500 in years like 2013 when the index was up about 32%, but that doesn’t mean that short-term underperformance is indicative of what to expect in the future. With stocks trading at high valuations and interest rates likely to go up at some point, it seems very likely that Calpers is making this decision at precisely the wrong time.
Recency bias is one of the biggest reasons that most market participants underperform the indices. In fact, most investors in mutual funds actually dramatically underperform the investment results of the funds themselves because they are chasing recent past performance. This means that investors are getting into the funds after the stocks within the fund have rallied and reached higher valuations, then they pull their money out of a fund when the fund has suffered from short-term underperformance and the stocks might actually be really cheap. For example, from 2000 to 2010 the best performing U.S. mutual fund was the CGM Focus Fund, which returned 18.2% annually. Sickeningly, the average investor in this fund had an annual return of -11%, which is a full 29% lower than the actual return of the fund. This is not an uncommon phenomenon and while the numbers may differ, the basic facts are that market participants are their own biggest problem by chasing short-term performance and being plagued by recency bias.
Now at T&T Capital Management, we are not a hedge fund but we do offer strategies similar to a hedge fund, although we do have dramatically lower fees. Now as I’ve written before, normally we should have underperformed in a year like 2013, but we were fortunate in that we had really good stock selection and avoided serious mistakes. I believe that the full value of our strategies will be on display over the next 3, 5, and 10 years when I believe markets will get a lot choppier. I believe that our focused approach allows us to have the ability to avoid the most overpriced areas of the market, which index funds and closet index funds such as most mutual funds, cannot do. In addition, our utilization of cash-secured puts and to a lesser extent covered calls, provides us with protection in down markets. This would be a great strategy for Calpers to employ; but fortunately for us and unfortunately for Calpers, there are very few firms that practice this style of investing. Now it is important to note that we aren’t making a call on what will happen for the remainder of 2014 or even 2015 for that matter, but at some point the market once again will more closely resemble a weighing machine than a voting machine, just as Benjamin Graham proclaimed many decades ago. When this occurs you will be better served by taking a value-based and rationale approach to investing, as opposed to getting caught up in the emotional hype that most momentum market participants fall prey to. Below is a link to the article.