DIVESTMENT GUIDE

May 2022

Our absolute focus on seeking the highest annualised returns would mean that we have seen the rise — and, the fall — of many a fund over the course of decades. Naturally, you might ask: how do we draw the line between tolerating a loss versus exiting a position?

1. Recovery MATH

Whenever an investment, or hedge fund hits a -50% loss, it needs +100% to recover. Since we typically look at funds with above 20% annualised returns, those who survive a -50% loss and are able to continue performing within their historical return range should be able to recoup all losses within 3 years on average.

Once the loss goes beyond -60%, the recovery math becomes untenable as it may require up to +400% to recoup all losses. If we work out the corresponding annualised returns to achieve that feat, it requires a fund to attain +70% every year, for three years in a row, merely to breakeven. Based on precedent, we know that such a feat is almost impossible even for the industry’s top dog. Hence, a manager that disregard Recovery Math and allow losses to accumulate to untenable levels are clearly, as some would call it, ‘uninvestable’.

2. LOSS RATIONALE

We broadly categorise losses as being widespread or unique to the particular fund. Often times, it could be a mix of the two so it might be harder to discern.

Widespread

• The best analogy of widespread is ‘everybody is in the same boat and suffering’. It’s typically driven by large external shock such as the 2008 global financial crisis, Covid-19, various recessions including the current technology stock rout.

• For widespread systemic losses, we would compare the fund’s loss to the relevant market / asset class to assess whether it’s in-line, worse off or better than the market.

• Next, we assess if it’s temporary shock or a reflection of permanent decline for a particular market / asset class. Generally speaking, it is more likely for individual companies & even industries to be permanently wiped out as opposed to an entire asset class.

Unique

• Sometimes, a fund could suffer a huge loss even in calm market conditions. That raises a red-flag to further investigate whether the explanations provided for the loss are plausible.

• We see this more often in discretionary funds - which is fine because no one gets it right all the time. Nonetheless, we’re always on a lookout out for signs which requires us to take more drastic action such as when a manager may be adamant that their view is right and the market is wrong. While they could be correct, there is a saying that the ‘markets can stay irrational longer than you can stay solvent’. Hence if the markets continue to move against them, the losses may grow to a point-of-no-return where the immutable laws of Recovery Math takes over.

3. WILL TO SURVIVE

We cursorily gauge a fund’s will to survive using what we call ‘skin-in-the-game’. Ideally, managers should have an unyielding alignment with a fund’s drive to succeed. The most direct manner of exemplifying this spirit is when managers’ personal and/or their family’s net wealth is invested in the fund as a significant ongoing percentage of the fund.

We emphasise the term ‘ongoing percentage’ to stay clear of managers who over the course of their fund’s success, would collect annual fees which are magnitudes higher than their lifetime net wealth to-date. If such sums are not proportionately reinvested into the fund, the manager’s alignment would fade over time as his non-invested portion of wealth could serve as a backstop even if the fund ceases to exist (meaning, he/she is already a billionaire so your personal loss is just an unfortunate inconvenience).

Second, we hope that managers would be more prudent if they manage a large proportion of their own monies. Hopefully, they would be less inclined to make incredibly risky, ‘Hail Mary’ type of trades with low probability of success but high pay-outs, to get out of their predicament. That being said, nothing can be done with a manager who has investment suicidal tendencies, either.

Third, even if faced with daunting losses, managers could be more willing to endure incredible hardship for the next 3-5 years to recover their own monies. If it’s merely a profession, closing and reopening anew is the easiest path to reset the High Water Mark. Investors who have short memory spans and would flock back once a manager have a few years of regained stellar performance. Hence, the will to survive is clearly a more nuanced factor to assess.