It’s been like a surreal sense of déjà vu as conversations I’ve had over the last couple months keep bringing up similar themes.
The market, increasingly indistinguishable from a petulant, impulsive, and near sighted toddler, rewards intelligence, risk management, and logic with a swift kick in the nuts. The advantage to those who manage their own money (likely you) slants increasingly towards vertical.
My buddy and fellow investor Kuppy recently wrote about how performance pressure lead to underperformance.
Performance Pressures Lead To Underperformance…
A few weeks back, I was catching up with a friend of mine who runs a very successful high yield fund and naturally, the conversation turned to the markets.
Me: “Congrats on yet another great year in 2016.”
Him: “Yeah, we beat our benchmark, but I’m sort of bummed. 2016 was the year we really should have killed it. They just gave away money in fixed income.”
Me: “So, why didn’t you crush it?”
Him: “Well, even though we made some room at the end of 2015, we went into 2016 over 80% invested—so there wasn’t much room to buy the crash in energy and MLP names like you did. The thing that pisses me off, is that we felt like spreads were too tight near the end of 2015 and we wanted to make room, but we couldn’t.”
Me: “Huh? Why not? If it’s not priced right, get out of the way.”
Him: “You’re lucky you run your own money. Most of my investors need regular income. We’ve been giving them about 90bps a month, unleveraged, for over a decade—during a time when rates are ultra-low. That’s why they invest with us. If we were only half invested, even for a few months, they’d go to some other firm that would give them that sort of income. No one is going to stick around at 30 to 50 bps a month, hoping I can time the market.”
Me: “What about the overall fund volatility? They must hate it when spreads widen and you take mark-to-market losses.”
Him: “They’re adults. They understand that if a bond goes from 95 to 70, there’s still a good chance it goes out at par. They know how thorough our due diligence process is. We have a long track record with very few failures. They give me leeway there, but they want to know that they’re earning their yield each month.”
Me: “Isn’t that a silly way to look at things?”
Him: “Absolutely!! Look, when you think about high yield credits, you don’t really own these things to get a few hundred basis points over treasuries. That’s silly. High yield is risky. The whole industry is doing it all wrong.
If it were 100% my money, I’d sit in cash and wait. Every five to ten years, the whole market implodes and you can buy bonds at 30 or even 20 cents on the dollar that will almost certainly go back to par. The assets underlying them are still good—just everyone is in a panic or getting some sort of redemption or margin call. Every year or two, some sector goes kaplooey and you can deploy 20-30% of your capital into that sector at similar discounts to par.
Finally, at all times, there are always a few screwy situations where you have a unique perspective and can maybe buy in at 30-40 cents and get par. The big money is made by buying at 20 and getting out at par. That’s a 5-bagger. Tell me how many years I need to own something at 90bps a month to make a 5-bagger? Why bother…??”
Me: “Fixed income is marketed to people as a dull product—five times your money isn’t a dull return—that’s better than most growth equity guys. Additionally, you get a few hundred basis points while you own the thing.”
Him: “But you don’t want to own it for the current yield—you own it because you’re closing that gap from 20 to nearly par. I wish my investors would try to understand that, but it’s hopeless. Fixed income investors want the yield. They don’t want to pay you fees to work on your golf game and wait for the market crashes, so I give them what they ask for.”
Me: “You know, over the past few years, I’ve made much more money buying the crash somewhere in the world, than buying the good news growth story.”
Him: “Agreed. It seems like a better way, especially with how the market is set up lately.”
Me: “What do you mean?”
Him: “All the investors now; they’re all fast capital. They redeem their portfolio manager as soon as there’s a down quarter. Fund managers know this, so after a few bad weeks, they’re already making sales to raise liquidity—the whole thing feeds on itself. Then, the ETFs pile on with endless liquidations of product. 20 years ago, a bear market would take a year or two to evolve. Now, the whole process plays out in two quarters and no matter what the product is, it dramatically overshoots.
When you have a bond fund that owns thousands of individual securities and this fund needs to sell, what do you think happens? Who is actively looking to buy some 2022 maturity, 5 5/8 junior subordinated issue with $50 million outstanding? No one!! If some fund is liquidating, there won’t be any real bids on the screen because no one follows this issue. If you have $3 million face value of some obscure security that you need to dump, what fund is going to take the time and research it and then make you a bid?
In the past, some prop desk would step in and warehouse that inventory, but Dodd-Frank killed all that. Now, when there’s a “bid wanted” situation, it’s simply bombs away. That’s what happened in Q1 of 2016. That is what will happen again and again—liquidity is down and when high yield gets hit, it really gets hit as everyone gets redeemed at the same time. In high yield, we should be looking for these dislocations with lots of excess cash—instead of waiting around fully invested earning our basis points.”
Me: “Agreed. So why are you fully invested now?”
Him: “I’m not fully invested!! We’re 20% cash—which is my way of saying that I am bearish as all hell. I want to be lightening up—I want to be almost all cash. Spreads are silly tight and interest rates are going up. It seems like an awful time to be fully invested, but I’ll lose my clients if we sit in cash and spreads don’t blow out right away. It’s the perpetual dilemma of asset management. Do what’s right for your clients or your business. It’s hard to do both. In the end, asset management is set up to aggregate assets, not to have great returns.”
Me: “Why don’t you raise a fund that sits in cash and waits for something interesting to happen? Specifically market it that way.”
Him: “You’re kidding right? Maybe I could raise it, but it would have to offer monthly liquidity to have any hope of getting investors. You’re almost forced to do something, just to show returns and appear active. Even then, after a year or two, all the cash would be redeemed, unless we got lucky and got a real fat pitch during that time.”
Me: “That’s why I don’t want outside investors. I want permanent capital. It lets me think smart and act patient. I can sit and wait for the fat pitch.”
Him: “And guys like me will be selling to you over and over at bottoms—it’s simply the current market construct where funds allow monthly liquidity on illiquid assets while having to stay fully invested.”
Me: “I know that all too well and it’s why I wait around with plenty of cash. It’s boring, but that’s where the returns are.”
Him: “I wish I could do that too…”
Remember, something interesting always happens. Patience is key. Until then, it’s a whole lot of fun to travel the world.
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