Alluvium Global Fund commentary for the year ended June 30, 2017.

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Baupost Letter Points To Concern Over Risk Parity, Systematic Strategies During Crisis

Snapshot

Welcome to the inaugural annual report for the Alluvium Global Fund (Fund).

The Fund posted a net return of 18.3% over the year to 30 June 20171. This was almost solely due to the performance over the first six months of the financial year. The performance post 31 December 2016 has been, frankly, a little disappointing.

The most current net returns of the Fund (as well as some “benchmarks”), in Australian dollars (AUD) over a variety of time horizons are always available at alluvium-am.com. As at 30 June year 2017, they are also provided below:

Alluvium Global Fund

Alluvium Global Fund

General Commentary

We are quite satisfied with the Fund’s annual return. If we could generate it year in, year out, we would have almost thirty times our capital in 20 years! But even the most optimistic amongst us realises this isn’t going to happen.

So, why are we only “quite satisfied” and not cracking open a bottle of Moët? Because the Fund has benefitted from a period of abnormally high market returns. For example, over the last year the Index4 has returned 14.7%5 - a level we consider to be quite unsustainable. To the extent that the Fund did benefit from the favourable investment climate (such extent being indeterminable), we view those returns unrepeatable over the longer term. Anyone that thinks otherwise and invests with an expectation that the Index will provide a return in the order of 15% over the long term is headed for a severe reality check (the timing of which is, of course, unknown).

The investment objective of the Fund is to “Generate attractive investment returns over the long term without regard to a specific benchmark and with an emphasis on capital preservation”. The evidence suggests that we are on the way to meeting this objective, but we have been privy to the most favourable of market conditions. So, let’s save the mutual back slapping and all-round high fives for ten to twenty years time after a period of less buoyant markets.

The annual return of 18.3% comprised two contrasting half years. During the six months to December the Fund returned 17.6%, but over the following six months it returned a rather measly 0.6% (As most readers would know - compounding - the “the eighth wonder of the world” according to Albert Einstein, accounts for that extra 0.1%). The corresponding difference in Index returns between the half years was far less pronounced (9.8% and 4.5% over the respective half years).

So why did we not keep pace with the market over the second half? Here are a few reasons:

  • the Fund held an average of around 20% cash (although admittedly it also did during the first half);
  • the cash was predominantly held in USD, which declined in value relative to other currencies;
  • the Fund held little investment in Technology companies which returned 13.7% in AUD terms (20.5% in USD) over the second half5. For example, the Fund did not own any of the “FAANGs” - Facebook, Amazon, Apple, Netflix and Google (Alphabet)6. These have high Index weights (totalling 5%)7, and they posted USD returns in the second half of the financial year ranging from 17.3% to 31.2% (average 24.7%)5; and
  • the Fund only holds securities that are listed on developed global market exchanges - which significantly underperformed business listed on emerging markets exchanges (the MSCI Emerging Markets Index returned 11.8% in AUD terms over the second half).

We do wish that we had listened to the advice from our great mate Harry Hindsight. He suggested to us in late December that we should invest the 23% cash the Fund held at the time in an equally weighted split of the FAANGs. I vividly recall Harry saying “it’s easy, we’re in a momentum market, these stocks are on a roll”. He was right - at that time the FAANGs were already up 15.2% over the prior six months. Had we taken Harry’s advice our returns would have been almost 6% higher - we would have posted an annual return of almost 25%! Perhaps then we would have cracked open that bottle of Moet?

Harry also reckoned the USD was way over-valued - “it will continue going down…you gotta short it!” he said. But over the last year or so we have repeatedly expressed our wariness not only about high equity prices, but also with what we saw as a highly priced AUD. So, again we foolishly ignored Harry’s forecasts. And so - in retrospect - not only did we hold way too much
cash, but we also held it in the poorly performing USD (down 5.9% during the second half relative to the AUD)5. This rising AUD continued to cost the Fund dearly (1.1% over the year).

This begs the question - should the Fund be hedged? As an example of “value add” the returns of an AUD hedged version of the Index were 8.9% over the half year and 20.4% over the year8. This is significantly greater than the Index returns of 4.5% and 14.7% respectively5. But in times of market distress the historical experience has been that currencies that are viewed as risky, such as the AUD, have fallen relative to those seen to be “less risky”. For example, in the 2008 calendar year, the hedged version of the MSCI World IMI Total Return Index fell a whopping 39.4% - decidedly more painful than the unhedged version which fell - wait for it - only 25.5%9. We would rather take advantage of this naturally provided “equity” hedge than incur the costs, time and effort that is involved with hedging the Fund’s currency.

The Fund’s returns simply reflect the result of operating our investment process. And this process applies rules with the intent to ensure risks are kept within levels with which we are comfortable. This means the businesses we hold must be:

  • priced reasonably;
  • of sufficient quality and not at risk of financial distress;
  • available across a variety of sectors and geographies; and
  • accessible via well regulated exchanges in developed markets.

Otherwise, we will simply hold cash.

It was very pleasing that during the buoyant markets of the first six months of the year, despite investing in this manner (that we consider conservative), we still managed to surpass market returns. However it simply could not continue. To have generated a similar return in the second half (and even to match the return of the broader market) would have required us to accept risks beyond our “comfort level”.

So what has led to this extraordinary high market return? We believe it is largely a result of the increased prominence of index investing. This has not been a short term phenomena. Since 2008, US managed fund investors have withdrawn more than $800 billion from actively managed funds and invested $1.8 trillion into index funds10. In the US Vanguard now owns 6.8% of S&P 500, and more than 5% of issued capital in more than 485 of

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