“Most institutional portfolios are badly out of balance. The returns of most institutional portfolios are 90+% driven by the return of equities, exposing them to a single adverse event which could last for decades, a poor performing equity market….not balancing the portfolio is so risky as to be imprudent.”
– Bob Prince, Co-Chief Investment Officer, Bridgewater Associates |
First a tiny bit of history: the first hedge fund was launched in 1949 by Alfred Winslow Jones. Jones used the investing partnership structure that’s now the basis for most hedge funds and, more importantly, he utilized the idea of hedging the portfolio (hence the name).
Essentially, a hedged fund is one that buys the stocks they believe will be most likely to appreciate and sells (or goes short) a smaller percentage of stocks that they feel will perform less well or decrease in value (now this type of hedge fund is known as a long/short equity fund). A common long/short fund might be long 130% of its capital and short 30%. This allows it to purchase a larger selection of stocks than it otherwise could, and to hedge the portfolio with its shorts to help cushion the fund in case of a market drop.
Or at least that was the original idea.
Now, of course, the term “hedge fund” just means a private investment partnership that pools the funds of its investors and uses many more strategies and securities than the typical investor. And for many hedge funds the idea of hedging, or defense, has been completely lost. And there’ve been a couple of very public examples of this in just the past few months:
Melvin Capital v Reddit
I’m sure you’re all aware of the GameStop (GME) craziness that happened earlier this year (and is still ongoing). Well, when the Redditors all piled into GME, they were fueled about 5% by an idea that the company had better prospects and 95% by the combination of greed and “sticking it to the hedge funds”.
See, at the start of the year, GameStop was one of the most highly shorted stocks out there (aka: high short interest – it was well over 100% of shares outstanding). So, the Redditors assumed that if they could bid up the price of GME enough, they could cause the shorts so much pain that they’d have to throw in the towel and buy back the stock – adding even more upside fuel and causing the price to skyrocket (which is exactly what happened, for a while).
Now, the most notable short on the other side of this trade was a fund by the name of Melvin Capital. Melvin had been short GameStop since the fund’s inception six years ago, and had a total position valued at more than $113 million at the end of 2020. And then came the squeeze. GME was up over 18X in a matter of weeks and Melvin was forced to close out its entire short position on Jan. 26, one day before the stock hit its peak closing price.
Melvin only survived after it received a multi-billion dollar cash infusion (for a percent of profits and ownership) from two other, larger funds (Citadel and Point72). Note: This was not a government bailout, as has been claimed.
That is the very definition of a short squeeze.
And of a non-hedged (or verrrry poorly hedged) portfolio.
Bill Hwang and Archegos “Family Office”
The second example is more recent and doesn’t involve a short-squeeze: Archegos Capital Management. Technically, Archegos is a “family office”, meaning it’s just an individual family’s wealth and not run as a pool of multiple investors. But for all intents and purposes, its investments are just like those of many hedge funds.
Archegos’ founder and investment director is a Bill Hwang. Bill is a veteran of the hedge fund industry, having started investing under on of the industry’s titans, Julian Robertson at Tiger Management (hedge fund firm names are just fantastic, right?). Bill left there to start Tiger Asia and then was subsequently banned from the investment industry for five years for insider trading.
So, what do you do when you’re a hedge fund manager who can’t manage a hedge fund? You change the name and start a family office (just like Steve Cohen did at the aforementioned Point72)! Not only does a family office allow you to go on investing, but it also means you don’t have to file pesky registration and periodic updates on your holdings to the SEC.
Archegos did very well for quite a while, but his positions look to have been very concentrated. From the New York Times:
“Mr. Hwang was known for swinging big. He made large, concentrated bets on shares in South Korea, Japan, China and elsewhere, using ample amounts of borrowed money — or leverage — that could both supercharge his returns or, in turn, wipe out his positions…. By the beginning of this year, Mr. Hwang had grown fond of a handful of stocks: ViacomCBS, which had pinned high hopes on its nascent streaming service; Discovery, another media company; and Chinese stocks including the e-cigarette company RLX Technologies and the education company GSX Techedu.”
But two weeks ago (Monday, 3/22) ViacomCBS announced that it was going to issue up to $3 Billion worth of new shares. But within the next couple of days (partly due to Bill’s changing his mind to participate), the offering raised significantly less than planned. At the same time, his holdings in the Chinese stocks RLX and GSX both spiraled down in Asian markets.
Again from the NYT: “By Thursday, March 25, Archegos was in critical condition. ViacomCBS’s plummeting stock price was setting off margin calls, or demands for additional cash or assets, from its prime brokers that the firm couldn’t fully meet. Hoping to buy time, Archegos called a meeting with its lenders, asking for patience as it unloaded assets quietly, a person close to the firm said. Those hopes were dashed. Sensing imminent failure, Goldman began selling Archegos’ assets the next morning, followed by Morgan Stanley, to recoup their money. Other banks soon followed.”
ViacomCBS shares fell as much as 60% for the week. Archegos losses haven’t been fully determined, but Archegos reportedly had exposure to at least eight stocks that lost a combined $35 billion in market value on Friday alone, based on Business Insider’s tracking. And two of its brokers/banks, Credit Suisse and Nomura of Japan, announced they would have significant losses; Nomura announced as much as $2 Billion in losses and CreditSuisse revealed at least $4.7 Billion in losses.
Again, a glaring example of a not-at-all hedged, poorly diversified and massively over-leveraged fund.
Although Bill Hwang is by all accounts a nice guy – he’s a family man that lives modestly in a $3 million house in New Jersey and gives generously to charity – I’m still reminded of the scene from a Ferris Bueller’s Day Off when they drop off the Ferrari in the garage:
Ferris: Professional what?”
The ARK Innovation Fund (or the “Ten Percent Tesla Fund”)
And with that we come to Ark Invest’s ARK Innovation ETF (ARKK). It might as well be the ARK Tesla Fund. ARKK and ARKQ, another of Ark’s funds – the Autonomous Tech & Robotics Fund, both hold more than 10% of their assets in Tesla (from Ark Invest’s own site):
And, I assume in an attempt to justify this (and their additional recent TSLA purchases), on March 19th Ark released a real-humdinger – their case for a $3,000 TSLA share price in 2025 (TSLA is currently at $690). To give that some perspective, that’s a market cap of $2.8 Trillion; or by one estimate “The 2025 valuation of Tesla implied by [Ark’s] base case share price is 3 times the entire automotive industry today.” And we’re not even talking about their “Bull Case” target of $4,000/share – it’s bull something alright… (This is their second, updated TSLA analysis, btw).
Needless to say there are all kinds of problems with their analysis: stratospheric assumptions, oversimplifications, poor use of Monte Carlo analysis, zero CAPEX assumed, no competitive analysis, etc. If you want to see just some of the craziness, there’s a good overview of some of the issues here.
ARK Space Exploration & Innovation ETF (or the “#Space #Buzzword Fund”)
Also of some note at Ark Invest is the recent launch of their eighth ETF, the ARK Space Exploration & Innovation ETF (ARKX) “that will invest under normal circumstances primarily (at least 80% of its assets) in domestic and foreign equity securities of companies that are engaged in the Fund’s investment theme of Space Exploration and innovation. The Adviser defines ‘Space Exploration’ as leading, enabling, or benefitting from technologically enabled products and/or services that occur beyond the surface of the Earth.”
Yea! Space Fund!
Ok, so let’s take a look at its holdings. There are some names you’d expect such as Lockheed, Boeing and the like (although not especially “innovative”). But there are also some surprises, such as Deere & Co (as in tractors), and the most ubiquitous of names including Amazon, Google and Netflix (??).
And the best of the bunch? The second largest holding at 6% of the fund is actually another ETF – PRNT, a “3-D printing ETF”, run by, guess who?…ARK Invest. Now, they’re not double dipping on fees, but given the holdings here is there actually a reason for this new ETF to even exist (other than to generate 0.75% in annual fees for Ark)?
So again, we see a whole family of funds that have highly speculative holdings, with no defense and high leverage (represented here by the fact than many of Ark’s Funds’ components don’t turn a profit).
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Given more than a decade of ZIRP and continuous QE, I suppose it’s inevitable that many investors will forget the lessons of history. That they’ll buy into the false sense of security from a market that only goes up and a massive Fed backstop. The risks in the market are many: possible inflation or hyperinflation, geopolitical risk (see China v US for Taiwan semiconductor production), economic inequality, massive debt, to name a few. And many investors are currently acting like another storm will never come.
Professional and individual investors alike are being lulled into the illusion that “this time is different”, yet again.
I’ve always said that our goal isn’t to predict the market, but prepare for possible outcomes. Which is exactly why our approach uses global diversification, strong defense and long/short opportunities. We’ll ride the wave, but also work to be prepared when it breaks.
So, don’t forget the lessons of financial history: don’t over-concentrate your holdings, don’t over-leverage, and defense wins championships.
If you’re looking for a strategy that is designed for paradigm shifts and multiple environments, at Taylor Morgan Capital our dynamic, proprietary investment approach does just that:
- We assess 60+ assets classes and sub-classes all over the world for the best opportunities.
- Our defensive algorithms monitor every position to protect profits and avoid losses – we are sometimes 100% in cash when conditions warrant.
- Our quantitative futures component can make money in up or down markets.
If you’re interested in the possibility of avoiding the worst of the next paradigm shift and even the possibility of profiting during challenging times, we’d love discuss our investing approach and see if it’s a fit.
Please leave a comment, question, or get in touch. We’re here to help.