Crescat Capital August Letter – Shift out of large & LT underperforming hedge funds has created an unsustainable and unhealthy market melt-up situationVW Staff
Crescat Capital commentary for the month ended August 31, 2016.
In the current environment of negative real interest rates, investors will need to take risk, not only to build wealth, but just to preserve capital by staying ahead of inflation. Taking risk means enduring short downturns and reasonable volatility in the pursuit of prudent long-term gains.
Taking calculated risks is what Crescat Capital does well. We follow an investment discipline that my team and I have honed over the last seventeen years of managing discretionary money. In the process, we have developed a single, firm-wide investment process of combining macro themes with our fundamental equity model and disciplined risk controls that applies to three unique Crescat strategies. All three strategies have beat both the market and the vast majority of money managers substantially over time net of our fees. Crescat’s long-term clients have done very well and we appreciate the trust they’ve placed in us.
Our two hedge fund strategies are true hedge funds in the sense that they hold both long and short positions. Our short positions are there to help our clients protect capital in market downturns and to capitalize on important themes and opportunities in any market environment. We have an excellent long-term track record of shorting stocks, just as we have a very good track record of picking stocks on the long side through both bull and bear markets.
We need to point out that there has been a perverse phenomenon going on in the markets since March that points to extremely frothy market conditions. The problem is that many of the stocks with the poorest fundamentals and highest valuations based on our time-tested fundamental model have been some of the ones rising the most in the market. This is has caused short-term underperformance in our funds. But what is really causing this problem it is that collectively investors are now chasing passive indexing strategies and giving up on hedge funds after a seven-year bull market and corresponding stretch of underperformance by hedge funds at large. Our shorts have suffered because hedge funds at large are been forced to cover otherwise good fundamental short positions.
This shift out of large and long-term underperforming hedge funds has created an unsustainable and unhealthy market melt-up situation. This melt-up has been caused by not just hedge fund outflows (i.e. forced short covering liquidations), but also more generally by a large shift from active to passive management.
To prevent from getting further run over by this phenomenon in the short run in our hedge funds, we have been increasingly seeking out opportunities to go opposite crowded hedge fund positions. We also are reducing crowded positions even if they are supported by our fundamental model. Rest assured, we are continuing to follow our model, and continuing to short stocks as well as go long. As always, our positions are supported by a combination of our macro themes and our model. Our model does extremely well on the short side over time, and we’re confident that our shorts will begin working well again soon. We have seen encouraging trends in that regard already in the last few weeks.
The market is at all-time highs and in the eighth year of bull market. Now, all of a sudden investors are piling out of hedge funds and into index funds? It’s almost certainly the time for investors to be doing the exact opposite! Fear and greed will constantly tempt investors to make foolish decisions. Beating the market over time is indeed possible for managers who have developed a sound fundamental discipline. We are part of a small group of asset managers who have been able to prove this over a very long time period. Our clients must now more than ever have the confidence and fortitude to believe in us. I am very confident that our actively managed discipline will get investors through the next inevitable bear market period substantially ahead of index funds. I also believe that we can outperform in what may prove to be just a low return environment for the indices.
The mass movement out of hedge funds and actively managed long-only funds and into index funds today is a significant warning sign of a possible market top. Regardless of whether a market top is near, this is the ideal time for Crescat and our investors, simply because we are a nimble hedge fund that can grow and perform for our clients in both the short and long-term. Large hedge funds that have underperformed over a long period absolutely deserve to be redeemed from. However, this money should not be going to passive strategies; it should be going to asset managers like Crescat that have proved that they can outperform over the long-term!
While other hedge funds are shrinking, Crescat has been growing. We just finished two strong years of outperformance compared to other hedge funds and the market. We have received significant capital inflows this year. We aim to continue this trend and hope that our clients support us in this effort. While our hedge funds are down slightly year to date, given the short term trouble with some of our short positions, the year is not over. For those who have been following us but have yet to act, I strongly believe now is the time to get in!
Crescat Capital – August Performance Attribution
The worst performing theme in August across all three strategies was our Global Fiat Debasement theme, yet it remains our top performing theme year to date across all three strategies and has begun performing well again today and should be very strong into year end. Precious metals and related mining companies remain a critical holding for us given the ongoing historic global debt-to-GDP imbalance. This imbalance can only be reconciled with significant future inflation in our view. In the meantime, the valuation of the world above-ground gold supply compared to the global fiat monetary base remains at all-time lows. Our China Currency and Credit Bubble theme and New Oil and Gas Resources themes, predominantly short themes in our hedge funds, also worked against us in August but have seen gains in the last several days. Our Asian Contagion theme, also a short theme, made money in August in both hedge funds. Additionally, Twilight in Utilities, a new short theme, also made money in August in the funds. Rise of the Machines, our artificial intelligence theme, was a strong performer in all three strategies in August based on our long positions in Twitter and NVIDIA.
Of course we are going to have short-term periods of underperformance. They are a necessary part of the path to long-term outperformance. We understand and can certainly appreciate that our investors might be concerned. Please be assured that we are sticking to our time-tested disciplines that over time been key to substantial outperformance relative to the benchmarks net of fees, and more importantly, protected and grown capital for our clients. And our money is invested right alongside yours. We remain well hedged with a good mix of longs and shorts, and cautious on the markets overall heading into this weak seasonal period for stocks, along with risks posed by China, Presidential elections, and a flip-flopping Fed.
We are and will remain committed to truly independent thinking and non-correlation with other funds and the market.
Active versus passive? We are sticking with the active camp, because we strongly believe it is much more rewarding for our clients over any reasonable stretch of time. Let the battle rage on and its victors rise to the top.
Lastly, August performance reports will be available in the next few weeks. Thank you for the continued support as we continue to work hard to deliver growth and protection of capital.
Kevin C. Smith, CFA