Chilmark Air 2017 LLC letter for the fourth quarter ended December 31, 2015.
The fourth quarter of 2015 was an opportune time to launch Chilmark Air 2017 LLC (the “Fund”). Credit markets declined during the quarter as investors large and small withdrew capital from hedge funds and mutual funds. It is easier to build a portfolio for a fund such as Chilmark Air in a declining market than during the stimulus-fueled rallies of recent years.
The Fund showed a 1.09% decline in the fourth quarter. However, our performance compares fairly well with benchmark indices, as illustrated in the table below.
This first investor letter for Chilmark Air 2017 LLC will include a discussion of my investment approach and philosophy. Future letters may discuss market developments and portfolio holdings in depth, but will likely be shorter.
Chilmark Air 2017 LLC - Investment Approach & Philosophy
“Markets look a lot more efficient from the banks of the Charles than from the banks of the Hudson.” --Fischer Black (after leaving MIT for Goldman Sachs)
My investment approach is the product of three perspectives: my experience as a bond dealer at Lehman Brothers, my time as head trader at Cerebellum Capital (a quant fund), and my study of the distressed debt strategy used at Oaktree Capital, the $90 billion fund run by Howard Marks.
Lehman Brothers: Trading bonds at Lehman Brothers taught me that not all decisions on the sell side are made with profit in mind. Investment banks have many incentives and they often conflict. Fees charged for stock offerings and new debt issues make up a large part of a bank’s profits; the bank’s traders are therefore willing on occasion to lose money to support the longterm profitability of those business lines. In addition to intentional losses (which are typically small) there are also unintentional losses. In my time as a market maker I certainly made mistakes, all traders do. It’s easy to get caught short a security in a fast moving market, or to accidentally take on too much inventory when the market looks strong. Knowing that these mistakes are an inherent part of the business, I look for opportunities to be there to buy securities that a dealer needs to unwind following a mistake or to sell when regulatory pressure forces them to liquidate.
Mistakes from other investors come to my attention as well, sometimes with details that are both funny and sad. I was contacted by a salesperson who said his client needed to sell all of their bonds “as part of a bankruptcy liquidation. All bids must be submitted to [his] lawyer for approval, which might add several days to the process.” When a lawyer is managing the liquidation process we’re well beyond the realm of efficient pricing. To put it another way, when your back is against the wall, you might sell cheap, but if you go bankrupt your lawyer sells cheaper!
Cerebellum Capital: Running the trading desk at Cerebellum Capital for three years was a great way to get current with quantitative trading (an approach I have used in the past, not to mention that my father has been a quantitative investment manager since the 1980s) and it provided a “view from the trenches” of the battle between quant investors and their more “fundamentally-driven” competitors. From that vantage point, it is clear that quant investing works, but not necessarily at all sizes and scales and sometimes it works too well and things get crowded and annual returns drop to low single digits.
Post-Cerebellum my conclusion is that one needs to be selective when considering quant strategies. Successful players in the industry have at least a billion in capital as well as a team of 30 or more researchers able to explore many strategies at once. But what about the set of securities which don’t work for such funds? In the age of automated and high frequency trading, what part of the market is safely out of reach of quants? Their domination of markets may or may not be inevitable, but what is certain is that they are making more progress in some markets than in others. Anything that requires lots of reading, or is made up of heterogeneous parts, or can only be traded via telephone is relatively safe from the competition that these traders bring. On one end of the spectrum are stocks which are liquid and viable for trading using automated methods, and on the other end of the spectrum are real estate and leases/loans, which are truly difficult to trade electronically -- there are too many nuances and legal matters which must be considered. A good example from our portfolio would be a late-90s aircraft leasing securitization, collateralized by a mix of Boeing and Airbus jets of varying ages and engine configurations. Not the ideal thing to try to model with math and software!
Oaktree Capital: The saying that “all good investments begin in discomfort” is true, especially for distressed debt investing. While the advice of an industry legend can never help one decide whether to pull the trigger on a given opportunity, the philosophy used by Oaktree Capital (credited to Howard Marks and Bruce Karsh) combined with my own experience is useful in narrowing the universe of bonds to the few that are the best combination of risk and reward. Much of what Oaktree has published is vague or non-specific. For example, Marks’ quote that “the only way to make money is to buy something for less than it’s worth” sounds either simplistic and obvious, or near impossible, depending on what you believe about the efficiency of the markets. This advice is not, in fact, helpful to the equity investor but for me as a bond investor its meaning is much clearer. If we consider a bond backed by loans or leasing assets which are in a state of serious distress, combined with a bond structure which is failing or broken (in other words multiple classes of the bond structure are no longer paying and will never receive cash flow again), and further combined with a seller who is liquidating their fund one can see how it is possible to buy something for less than the sum of its future cash flows. No catalyst is required to unlock this value; over time the cash flows will be paid to the investor.
In summary, my approach combines the following:
- Stay in close contact with bond dealers and be alert for mistake-driven selling by traders or investors.
- Limit the universe of investments to those which do not fit quantitative investors.
- Purchase bonds with distressed loans/leases, broken structures, and sellers in their own state of distress.
In applying the approach, I try to view it as a constant “advantage” or “profit margin,” which reduces the need for forecasts and predictions. To make an analogy to real estate investing, I act more like a "real estate developer/landlord" than a "real estate speculator." In a downturn, the latter would be at the mercy of mark to market declines in real estate because his or her strategy profits by buying properties and later selling them at higher prices. The former is of course also exposed to real estate mark