Vilas Fund letter to investors for the fourth quarter ended December 31, 2016.
To Our Partners,
The Vilas Fund, LP returned 27.02% net of fees during 2016, which was ahead of the 11.96% return of the S&P 500 Index, including dividends. Looking at the Fund’s 5 year return of 23.36% annualized, there are only 20 unique mutual funds that have a better 5 year performance record than the Vilas Fund (Morningstar, 12/31/2016). This is out of roughly 8,500 mutual funds in the industry, at the end of 2010, and ignores the survivor bias created when poorly performing funds close. Also, the Fund’s five year annualized return of 23.36% compares favorably to the 14.66% annual gain for the S&P 500 Index. As a general rule, equity mutual funds have done far better than the average hedge fund over the last 5 years as the vast majority of hedge funds had materially less exposure to the rising stock market.
To be frank, while these long term returns are decent, they aren’t good enough. Value strategies, such as ours, have been swimming upstream over the last decade as value has under-performed glamour by a significant margin, though we sense the tides are turning lately. We can do better.As a firm with deep ties to the State of Wisconsin, including the area in Northern Wisconsin, Vilas County, that is the location of our family summer lake home and is the source of the firm’s name, we thought that the following quote from Green Bay Packers Head Coach Mike McCarthy, after a four game losing streak this past November, was pertinent.
“Let’s just state the facts: I’m a highly successful NFL head coach,” McCarthy said Monday as part of an answer that lasted 2½ minutes. “With that, I’ve never looked at the ride to this point as smooth or whatever the words you used. To me, it’s always bumpy, and to me that’s the joy of it. That’s this game. That’s how hard it is in the NFL.”
The Packers went on to win seven games in a row and defeated the NY Giants, convincingly I might add, to enter the playoffs.
In the past, I simultaneously ran two mutual funds, one equity and one fixed income, for nearly 16 years. Both of these funds, at various points in their lives, were top performers in their categories over long periods of time and, due to this historical outperformance, grew into multi-billion dollar funds. This performance also led to feature stories in many media outlets, including Barron’s, Wall Street Week with Louis Rukeyser, The New York Times, and the Wall Street Journal. Thus, I could argue in a similar way that I’m a successful investment manager. While we, at Vilas Capital Management, would like to generate returns that exceed the S&P 500 Index with smooth, monthly regularity, the reality is that some years are far better than others and we won’t win every game.
“The Golden Era of Hedge Funds Draws to a Close With Clients in Revolt” – Bloomberg, December 28, 2016
The Investment Management Industry, including many of the professionals at allocating institutions, investment consulting firms, portfolio managers, brokerage firms, and the end customers, at times tends to ignore one of the most powerful concepts in finance: buy low, sell high works better than the other way around. If we look at the flow of funds data from the Investment Company Institute, there were massive inflows into equities in the second half of the 1990’s, mild inflows in the mid 2000’s and large outflows from the financial crisis until just recently. As bond yields fell, there were massive inflows into bond funds. In a very big picture analysis of the flow data, the investment community at large bought stocks when they were expensive and ignored bonds when yields were high. Then, when stocks fell twice, they sold stocks en masse and bought bonds when yields were low.
One form of selling stocks and buying bonds was the mass flow of money out of public equity strategies and into hedge funds post the tech bubble bursting in 2000 and the 2008 financial crisis. Hedge funds touted that they would keep correlations to the equity market at a low level post these two large downdrafts. Investors wanted the diversification benefits for when the next big market correction occurred. The only way to accomplish this was for the hedge fund industry to have very little exposure, on a net basis, to equities, the best performing asset class over long periods of time. Post the Financial Crisis, nobody seemed to bother to ask two fundamental questions: Are stocks cheap? and When should we expect the next market crash to occur? The answer to the first was a screaming “Yes.” And then, by corollary, the answer to the second would be “A long, long time from now.”
To make matters worse for the hedge fund industry, it is clear that investors would have been far better off using a 40% equity, 60% government bond blend over the last 10 years if volatility reduction was the true goal. This portfolio, constructed using Vanguard Funds (VBLTX and VFIAX), would have produced a 6.83% weighted average compound annual return. In one of the worst years in the last 80 years, 2008, this portfolio lost 9.75%. The HFRI Fund Weighted Composite Index, a great proxy for hedge funds as a group, produced a return of 3.37% annually over the last 10 years but fell 19.03% in 2008. Thus, investors would have been far better off using a simple 40% equity, 60% bond strategy in both returns, which were almost exactly twice as high, and losses in 2008 which were roughly half the level of losses in the average hedge fund. It is our sense that due to the lower long term net returns and larger risk profile of the average hedge fund when compared to a simple blended portfolio, the industry will contract significantly over the next few years.
What makes the Vilas Fund different?
First, the Vilas Fund is a value fund that makes concentrated investments into underpriced equity securities and sells short overpriced securities. Ever since the financial crisis, most managers of hedge funds shunned equities, as described above. Over the last seven years, it was our belief that equities were extremely cheap, especially in the financial sector, at a time when financing costs were near 100 year lows. It turns out that financials were cheap partially because financing costs were near 100 year lows. Thus, an investor could borrow very cheap money and buy cheap equities. If this was real estate we were discussing, in which individual properties trade seldomly and are generally marked via appraisals, the investment industry would cheer the purchase of a nice apartment or office building at a high cap rate (cash on cash rate of return) with inexpensive money. In fact, they would, and did, shovel tons of money in that direction. Why would the same not be true, then, when buying equities? Because nobody wanted them or their lousy, stinking volatility. Volatility reduction of portfolios became the driver, not trying to make money with a buy low, sell high