Weekly Edition #68

In this edition:


Crispin Odey is a hedge fund manager that has had some trouble in the last couple of years. At the end of April 2015, he managed around 3.1 billion euros. He went on to suffer a 68% loss over the coming 6 years. However, during 2021 and 2022 his fortunes have changed. His fund has returned 110% this year and is finally above its high point from 2015. He stuck to his strategy and eventually recouped all the losses and then some. The problems is that most of his investors did not stick around to benefit from this increase. He now manages only 245 million Euros. His total return over the period from 2015 until now is roughly 2.9%, but his assets are down 92% since then. Therefore, most of his investors lost a ton of money and did not stick around to recoup their losses.

Unfortunately, this is a very common occurrence. Investors tend to invest after good performance and redeem after poor performance. However, this is exactly the opposite of what investors should do. Assuming an investor believes in a strategy/manager, they should invest right after a poor period of performance and redeem after a period of good performance. Mean reversion is present in many aspects of finance, but investors oftentimes ignore its effect and do the opposite.
 We do give credit to Crispin, faced with deep drawdowns many hedge fund managers decide to shut down their fund and either convert to a family office, or launch a new fund a couple of years later. They do this because the largest incentive for a fund is the performance fee. And when a fund is in a drawdown, there is no performance fee, even if returns are positive. Most funds tend to have a high watermark so managers will not earn any performance fees until that high watermark is breached. If a manager shuts down the fund and starts a new one, then this high watermark is reset, and they can start earning performance fees again. The latest manager to do this is Gabe Plotkin from Melvin Capital. He first tried to get his investors to waive the high watermark, and when that didn’t work, he shut down his fund and converted to a family office; leaving his investors with huge losses and no means to recoup them.

One feature of private markets is that they don’t have a liquid market, hence why they are called private markets. This means that private equity funds have a lot of leeway in marking their assets (marking just means estimating how much an asset is worth). Remember that fund managers get paid on their performance, so there’s an incentive to adjust these marks to favor performance. That’s why private equity supposedly has lower volatility and higher returns than public markets.

There has been a boom in private equity fund raising. There is roughly $1.8 trillion in private equity dry powder (money which has been committed to funds but not invested yet). This huge influx of money has driven up valuations. Many deals are being sold from PE fund to PE fund at ever increasing valuations. That’s why the Amundi CIO says it looks like a Ponzi scheme. Because returns are being generated by selling assets at ever increasing valuations to other private equity funds. This all works until it doesn’t, and when liquidity really dries up these assets will fall hard.

We’ve been skeptics of crypto for some time now, and when NFTs came into the scene we reached peak skepticism. NFT stands for non-fungible token, which in theory means that it is unique and cannot be copied. However, in the digital world it is very difficult to have something that is completely unique. Take for example one of the largest ever NFT sales, a painting called The First 5000 Days which was created by the artist Beeple. This NFT sold for $69 million, yes you read that right sixty-nine million. The painting was sold as an NFT, so essentially whoever bought it just got a simple jpeg. Since it is a digital painting it is infinitely reproducible at zero cost. In fact here is a copy of the $69M painting.

Why anyone would pay $69M for something which we can recreate infinite times online is beyond us. We always thought NFTs were a bubble and made absolutely no sense, since you could just copy the image! Same thing with the bored apes, and all the other nonsense that was being sold.

Well, now the whole NFT world is even dumber since a new project called Mimics can mimic your NFT. So, the whole non-fungibility is gone. Essentially every NFT has a line of code that points to where the actual image is. So, the NFT of the painting above doesn’t actually contain the image. Rather it contains a link to the image which is hosted somewhere else. Therefore, what the Mimic project does is create new NFTs that point to the same image as another NFT. So you can have 2 NFTs which point to the same thing, so much for non-fungibility…

We’ve talked about ESG several times before and have been skeptical about ESG investing in the public markets. We think that there are much more powerful ways to enact change than by not investing in Exxon for example. It seems that there is a disconnect if you divest from Exxon, Chevron, etc. but still drive your gas car every day. If you don’t agree with the labor policies of X company, then you’ll have a larger impact by not purchasing from them than by divesting from their stock. This is our view at least; others will of course disagree.

However, this article makes an interesting point. ESG is not only about the environment (although this seems to be the largest point everyone talks about). ESG relates to the environment, social policies, and governance. In the world of sovereign bond investing, governance is a big issue. If you invest in the debt of a country with poor governance, you run the risk of not being paid back if the government runs into trouble. Countries with better governance have stronger property rights and more legal recourse in case of a default.

Greed is a common trait in people. And it gets worse as things go well. When stock markets go up people tend to overestimate how much risk they can tolerate; only to realize they took on too much risk when markets fall. This makes sense, when things go up people feel better, they are wealthier and look like geniuses for investing in markets. This makes them overestimate their risk tolerance and invest in riskier stuff. This happens at the individual level and the institutional level. When things are going well hedge funds lever up to invest even more in what has been doing well. This is dangerous since things tend to mean revert. It gets even more dangerous when this leverage is used to invest in private assets which are much more illiquid than public market assets.

The latest fund to fall victim to this is D1. They started investing in private markets, when things were going well, they took out a $2 billion loan to invest even more in private markets. This works well when things are going up since leverage amplifies returns. However, when things turn (like they have done recently), the pain is even more extreme since leverage amplifies losses as well. And to make things worse they cannot liquidate their holdings quickly to repay the loan since it’s invested in private assets! People want to get rich quick, the promise of high returns in private assets and using leverage to increase those returns sounds enticing. However, people fail to realize the risks that this entails. Now they may be left holding the bag, since as we wrote above probably many investors will redeem after a period of bad returns.
Thanks for reading!

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