Neal Berger is is President of Eagle’s View Asset Management and an investor and allocator I’ve known and respected for many years. His most recent extended market commentary, which is in parts included below, is a highly recommended read and a candid analysis why ‘the lackluster performance from some historically smooth and steady strategies can no longer be dismissed as simply random coincidence in a low volatility environment.’
Having started as a global macro trader at New York-based Millennium Partners, Neal’s Wall Street career spans nearly 30 years. Eagle’s View seeks to capitalize upon market inefficiencies often overlooked by most traditional hedge fund investment vehicles and investing across a variety of unique strategies.
“June was only the 2nd time we’ve ever experienced a losing month exceeding -2%. While we are pleased that we remain positive YTD, the lackluster performance from some of our historically smooth and steady strategies can no longer be dismissed as simply random coincidence in a low volatility environment. We’ve analyzed our portfolio and returns over these past 18 months thoroughly and have come to some conclusions which we believe will have a positive impact upon our portfolio immediately ahead.
Naturally, it took us some time to determine whether we were witnessing normal variations amongst certain Managers, or, something larger was at play. We are not willing to sit idle and assume that historically robust strategies will necessarily return to their glory days. To be crystal clear, we do not find fault with our overall philosophy, and, most of our portfolio holdings.
In short, the portfolio is undergoing an adjustment to account for the changing market which we expect will accrue to the bottom line in very short order. We expect to return to smooth and steady performance which has been the hallmark of Eagle’s View. It is important to note that any portfolio moves are not being made in a sharp manner. Given that our portfolio is already designed with substantial diversification and wealth preservation in mind, we have the luxury to make our moves methodically and rationally without fear of material drawdown during the process. Given that none of us have perfect foresight, we have to allow for the possibility that we could be wrong and moving methodically hedges that possibility.
The World has Changed:
We believe that the world has changed and consequently market behavior and the opportunity set has shifted for the foreseeable horizon. We feel we’ve identified some key developments that have caused certain inefficiencies to degrade, and, other opportunities to become more attractive. We analyzed our underlying portfolio performance over the past 18 months and we noticed some patterns that emerged. We have some notable observations about how things have changed and why strategies that were once working regularly have mysteriously stopped working.
The bulk of our thoughts center around quantitative strategies and volatility oriented strategies.
I read the hedge fund press every day. Not a day goes by that there isn’t a story on Artificial Intelligence, Big Data, Machine Learning, etc. More so, quantitative hedge funds seem to be more the norm than the exception these days. While this has been a gradual process, it has accelerated over these past 1-2 years. As investors know, we were early adopters of quantitatively oriented strategies when few investors were focused on them. Hedge funds are searching to hire programmers, developers, coders, software developers, mathematicians, etc. To be sure, many quant Funds have put up fantastic returns over the years. This has attracted attention among Fund Managers and investors in a world that is starved for alpha creation. Furthermore, advances in information availability and storage have led to new opportunities. While this is a fact, we believe that extracting alpha from the data has become quite difficult particularly with increased competition. With all the geniuses in quant, high-powered computers, and enormous data, where are the “suckers” who are providing the juice for all of these absolute return quantitative strategies? Simply put, the ‘edge providers’ have moved aggressively into passive index funds and broader market ETFs. As such, we have a condition amongst the traditional quantitative strategies whereby we have robots trading against robots. Without a steady source of ‘edge providers’, these ‘edge demanders’ are just trading money back and forth with each other. We believe increased quantitative trading coupled with passive indexation by retail, and, low levels of realized and implied volatility may be creating a feedback loop that has caused unusual price movements in a variety of securities that have challenged trading oriented strategies.
From our viewpoint, the massive movement by a broad swath of investors toward passive indexation has caused a very unusual condition. Index funds and market tracking ETFs are simply ‘bookkeepers’ who buy and sell underlying securities based upon inflows and outflows. Passive index products do not distinguish between fundamentally good companies and fundamentally weak companies. Rather, they just cover every number on the board. Rational thinkers (man or machine) attempt to distinguish between attractive securities and unattractive securities. The “old-fashioned” idea of buying good companies and selling weak ones (man or machine) has ironically caused a condition whereby the weak companies are often going up more than the good companies. Why? Rational thinkers or machines that have been programmed utilizing fundamental inputs are forced to cover shorts of fundamentally weak companies that continue to see inflow from passive index products driving the prices of these weak companies even higher on a relative basis versus fundamentally good companies that have fewer shorts that need to cover as prices rise.
Without causing this commentary to be longer than it already is, the shift toward passive indexation by those investors who have historically been the ‘edge providers’ has no end in sight. While one might argue that fundamentals always win out in the end (and we agree), we need to make money over a much shorter horizon for our investors and cannot sit idle in a world where hedge funds are expected to produce regular returns and stay ahead of the curve even if fundamentals are irrational. Over my nearly 30 year Wall St. career, I am a firm believer in the adage that “the markets can stay irrational longer than we can stay solvent”.
In sum, we believe quantitative strategies still have a place in our portfolio. Traditional and more ‘pedestrian’ quantitative strategies such as fundamental factor, momentum, and mean-reversion based statistical arbitrage do not. We have already, or, are in the process of exiting those strategies and Managers who we believe run more pedestrian quantitative strategies that have not recognized or kept pace with the increased competition in quant and the reduction in available alpha due to the reasons mentioned above. While we are reducing quant broadly, within quant, we are increasing our allocation to strategies and Managers who run idiosyncratic and highly capacity constrained strategies that either require a highly specialized skill-set and knowledge to effectuate, or, are simply too capacity constrained to attract competition from the larger players. Furthermore, quantitative strategies in non-mainstream markets such as Electricity, etc. will remain in our portfolio as the conditions described above do not apply to those non-mainstream markets.
All active trading strategies require volatility to create an opportunity set. Without volatility, trading oriented strategies cannot make money. Both implied and realized volatility in mainstream markets have been some of the lowest in recorded history. I read a statistic that the VIX closed below ten on eleven occasions in the past 20 years. Seven of those eleven days have been over the past two months. Furthermore, the realized volatility of equities was the lowest in the history of recorded markets during the month of May. I am not writing this note to tell you what you already know, rather, I want to propose some thoughts as to what is happening here and how we are responding.
It is impossible to say with certainty why both realized and implied volatility are at historical lows despite the geopolitical and monetary risks faced by the markets. On the geopolitical side, we appear to have a rapidly changing world fraught with risks. Changed political alliances, emboldened moves by certain dictators, and, a world that one might argue is searching for leadership would seemingly cause a logical participant to expect market turbulence.
On the monetary side, we have a Fed that has embarked upon a tightening cycle coupled with a plan to shrink the balance sheet. Although we avoid too much macro thought, one might argue that the expansion of the balance sheet since the crisis of ’08 has been a big contributing factor to asset price inflation and the stability of markets since the crisis. We are in the midst of embarking upon a reversal of this. Again, a rational participant might come to the conclusion that these events might cause some turbulence in markets. Incredibly, we have seen the polar opposite.
The market is pricing very little possibility of any sustained down move in markets and out of the money options are trading exceedingly cheaply relative to historical norms. For those who have fought this trend, they have lost in a big way. In fact, the persistently low level of volatility has brought out an increasing number of hedge funds strategies oriented toward regularly selling volatility. Although we believe that this is “picking up nickels in front of a bulldozer”, shockingly, these Funds have been some of the best performing strategies over the past years. Again, the market can stay irrational longer than we can stay solvent.
I don’t know a single person who doesn’t believe that volatility will rise. This has been the case for quite a long time now and I’m still waiting. As participants rather than analysts, we do not have the luxury to sit with a static thought or commentary until proven right. We must react to the facts as they are and find a way to navigate the markets as they are, not how we hope and expect they will be ahead. Of course, we are not “crazy” enough to invest in volatility selling strategies as we believe they will be wiped out at some point, rather, we need to exit strategies that are tied to higher levels of realized and implied volatility.
Although our guess is as good as anyone’s, we believe the shockingly low levels of volatility has to do with an increase in computer driven, quantitative trading coupled with banks selling options to offer “yield enhancement” structured products to investors who are starving for this yield. This feedback loop, the increase in assets run by hedge funds, and, the rise of quants, has created unusual patterns, dislocations, and low levels of volatility. While those simply following the broader market indices wouldn’t realize anything is amiss, it is our belief that these factors have created a challenging mix for trading oriented strategies. It won’t last forever, but, it could last longer than we can. Again, we have either already, or, are in the process of exiting those strategies and Managers who rely upon higher implied and realized volatility to generate returns. We will return to these strategies if/when markets return to a more normal volatility regime.
What Are We Focusing On Now?
We have some truly fantastic managers in our portfolio. Literally, some of the best in the world both from an absolute return and risk-adjusted return perspective. These are strategies that are focused on research activism, electricity congestion trading across the US grid, capitalizing upon inefficiencies in shipping derivatives, IPO flipping, Natural Gas Basis trading, High-frequency quant and algorithmic trading, etc. Our portfolio merely needs to some modest adjusting to get back to smooth, steady, and robust returns. It certainly does not need a complete overhaul. Despite June’s performance, we are positive YTD, however, we are continuously evaluating and observing the world and markets to access changes in the landscape where we need to respond and get in front of the curve.
Our focus has shifted almost entirely away from mainstream quant strategies due to the fact that we feel that they are too crowed and without enough juice available for all to feast. For the same reasons, we exited all trend-following oriented strategies many months ago. This has proven to be a good decision. Furthermore, we are shifting away from volatility oriented strategies that require higher levels of realized and implied volatility to generate returns. We’ve never invested in volatility selling strategies and have no intention to do so ahead.
We currently have approximately 35 different investments. We feel that we can shrink this number somewhat and still remain highly diversified across a variety of strategies and investments. As usual, we will continue to focus on non-mainstream products (such as electricity, shipping, etc.), and, will consider adding to those strategies that have been immune to the issues outlined above. We will continue to seek strategies that cannot be arbitraged away by quants whereby specialized knowledge and human intervention is a necessary condition to effectuate the strategy. We are not interested in competing with the best computers in the world and engaging in an arms race in that regard. Of course, we will continue to seek strategies that seek to capitalize upon market inefficiencies without making directional bets or macro opinions. Finally, we are examining possible inefficiencies that are being created as a result of investor shifts toward passive index funds and broader market ETFs and the massive capital flows into those products.
If you’ve read this long, thank you. Eagle’s View is trying to achieve a very specific goal for investors which is to produce reasonable returns that are non-correlated to the direction of mainstream markets in a low-stress manner. We are not trying to beat equity market returns, or any other benchmark. We measure ourselves as either making money or losing money. Obviously, we need to achieve a reasonable level of acceptable return over time which we believe we have done historically and will continue to do so. Although we are disappointed by our June performance, having two -2% months over a 7 year period is not the end of the world in our view. We live and breathe this stuff and we have decades of experience to back up our approach and thoughts.”