By Tamás Cser and Dániel Móricz, Sub-advising co-Portfolio Managers,
Budapest – Dec 4 2017
Recently, many people have shared with us their concerns about the disappointing YTD performance of the Concorde Columbus Fund. Indeed, despite an adjustment of the fund risk policy in Jan 2010 , which resulted in an annualized net return of 9.2% (in HUF), or 5.3% over the 3.9% Hungarian risk-free rate, investor criticism of our investment decisions is not totally groundless. 
Nevertheless, there is some merit in assessing Columbus’ performance over a period of only a few months rather than over its intended 3-5 year target horizon. Just for the period 2017 YTD, the Fund’s NAV has already dropped several percent, while global markets have been booming. On the other hand, as László Szabó (chairman of HOLD Fund Management and Platinum Pi’s Lead Portfolio Manager) frequently remind us, the most recent year always weighs double in the eye of actual fund investors.
So, in the case of an investment fund focusing on a single asset class (such as a stock fund or bond fund), investors may gain a comfortable sense of allocations in the fund, because the portfolio manager is expected to limit her investments to assets belonging to a specific asset class, thereby making the portfolio manager’s decisions feel more consistent or “predictable” and less prone to risky surprises. On the other hand, in a cross-asset fund like Columbus managed for absolute returns, the fund manager has many more degrees of freedom, hence, he/she can opt for positions in a broad range of instrument classes and direction (i.e., Long or Short). From this perspective, absolute return funds can be perceived as more complex and possibly even less transparent, somewhat more like black boxes to investors. It is therefore imperative for absolute return fund managers to communicate frequently their thoughts about markets and exposures to investors. Such letters should provide a periodic of investment style, strategy, assumptions or even trading assumptions (“bets”) under consideration by the PMs on investing clients behalf.
In this letter, we want to explain how we have analyzed and managed the Columbus fund and share the thought process that has informed our decisions throughout the year. We want also to demonstrate that our investment approach and Columbus’s management style has remained consistent from previous years. We have worked with the same diligence, passion, and relied on the same market research team that we used in the past, since this fund’s launch in 2007. Meanwhile, we constantly remind ourselves that we cannot always be right. (Hence the importance of always emphasizing that our strategies are optimized for long holding periods from 3-5 years).
In 2017, we found ourselves being wrong more often than right, in our analysis of global markets. Of course, we are not happy about this fact either, but in the world of investment this is not unusual. As they say, investment is about the future, which by its very nature is uncertain.
In 2017, for example, we came to the following conclusions:
- Almost all instruments, regardless of asset class, are expensive because central banks have dramatically boosted future cash returns for investors by artificially depressing the cost of money (i.e., interest rates). As a result, in absolute terms, attractive new investment opportunities have become very scarce.
- The global rise of stock markets (particularly in the USA) has already lasted nearly 8 years, which is one of the longest bull markets ever recorded. Concurrently, the global bond market rise has lasted for 35 years, with interest rates sinking to record lows.
- We were relatively bullish about the world economic outlook at the end of 2016, and were expecting further growth. However, due to pricey equity markets, we decided that rather than following consensus crowd and invest in equities, we would be better off betting on a rise of bond yields. There were several reasons for this:
- on one hand, we perceived that central bankers were already concerned about the risk of asset pricing bubbles caused by zero to negative interest rates;
- on the other hand, in the developed markets (and especially in the US), the labor market became tighter which implied that sooner or later, wage increases would provide a context for tightening monetary policies. We were expecting this to happen first in the US, because the US economy, which is one of the most flexible in the world, tends to lead monetary tightening cycles.
- In addition to raising interest rates, we felt also that another important risk factor was China. Indeed, the largest loan market in the world was rapidly growing into a bubble across China while the number of poor resource allocation policies, unsettled investments, non-performing loans, and the probability of a serious financial crisis seemed to accelerate..
Beside these thoughts, we had to remind ourselves of our core investment style, namely that we are value-based investors at the core. As a result, we love to buy things that are inexpensive while we believe strongly in mean reversions,e.g., after the price of stocks (or other assets) stops attracting a majority of investors following negative news or poor earnings announcements, share prices will rebound sooner or later from price levels reflecting excessive negative sentiment. In short: we love to buy instruments on the expectation that they will be worth more in the future. However, we refrain from buying securities that are already expensive, just because we expect to sell them in the future at a higher price. Though this strategy may be successful for others, it does not fit our style, and we avoid such bets because we are concerned that we might not be able to get out of a position in time. Because of our worldview and investment philosophy, we have been cutting back the following major exposures in 2017:
- We limited ourselves to small absolute (unidirectional) equity exposures, because we considered all stocks overpriced.
- On the other hand, we did open a few relative trades where each leg was expected to move in opposite directions, since there were stocks, bonds and markets that we considered cheap in relative terms. The most important of those were:
o We bought and held European stocks long while betting on a drop of US stock markets using the S&P500 as a proxy,
o We bought and held CEE stocks long, while shorting other emerging market shares boosted by a surge of post-crisis USD liquidity,
o Within equity exposures, “value” stocks were favored over more expensive (earnings) growth and momentum stocks,
o We bet on the rise of European interest rates and bond yields (as opposed to some in the emerging markets, and some US government securities, which we considered relatively more attractive),
o We bet on the appreciation of the USD by shorting some emerging market currencies (while not shorting the EUR).
- Overall, the Fund was positioned for the rise of global interest rates (thinking that central banks would start normalizing interest rates as a result of improved business cycles.
We can therefore assess now post-facto which of our 2017 bets have been contradicted by the market (or have not yet materialized, due to a misjudgment of their timing), thereby resulting in a weaker performance of Columbus than previously
- European stocks underperformed US stocks in their domestic currency and relative pricing spreads did not narrow. The main reason for this was the strengthening of the EUR vs USD. Although reluctantly optimistic about Europe, European share prices did not turn more attractive in local currencies.
- In addition, the EUR gained strength without support from interest rates. Despite the very strong level of economic activity, European interest rates remained depressed, while US short-term bond yields were increased steadily. Despite an increasing shortfall of interest rates, the EUR continues to strengthen against practically all other currencies.
- Interest rate levels remained depressed around the world, despite a global economy growing at its fastest pace in 5-years and all economic indicators achieving synchronized 10-year highs.
- China’s economic downturn has not materialized despite a steady increase of interest rates and capital outflows from one of the most indebted nations in the world, while the pace of monetary growth is slowing down.
- As a result, emerging market equities fluctuated, outperforming the CEE region with 3-4-5 % annualized GDP growth, while Romania is reaching a record 8% growth. (A significant part of the region’s returns can be linked to the appreciation of EUR-linked currencies against the USD). The Romanian and especially the Croatian stock market, which we consider to be the least expensive in the region, were significant underperformers this year. The latter is presumably held back by Agrokor’s bankruptcy, while the former is dragged down by a skyrocketing budget (with unorthodox suggestions for its implementation). As a result, the cheapest (value) shares in the region have become even cheaper.
- The under-performance of value shares in Western Europe is striking, with low interest rates pulling back the banking sector, while the technology, and even the result, is still a little productive, so the shares of companies that offer rotating technology, especially online services,
- The dollar, despite a steady increase in short-term yields, is not strengthening unfortunately against other currencies (flattening of US yield curve).
In 2017, these were the main events that depressed performance. However, we had a few good investments in Columbus, partially offsetting losing positions. For example, many of the regional stocks held by the Fund appreciated further and European government bonds approached the US 10 year while yields on the 2 year US bonds were raised significantly.
In 2017, market extremes were further heightened. Just to name a few examples:
- Expensive shares (and other securities) appreciated further: e.g., the S&P500 (based on many indicators) exceeded its previous heights in 1929 and 1999-2000.
- The low level of interest rates is even more remarkable in light of improving global business. There is a long list of countries with nominal economic growth rates of 5, 6 or 7 % GDP, where interest rates are essentially zero of negative.
- Developing market and China-linked assets have become more expensive, while global investors’ optimism is hyped further, while the old-new Chinese party leadership, reinforcing its political position, is openly curbing the unprecedented lending boom.
- Tech stocks are more expensive than any other sector. The gap between best and second best sector has not been as large since 1999.
- For each asset class, the volatility of options, i.e., the extent to which investors are exposed to risks, has dropped substantially to historical lows.
Of course, this does not mean that the above trends could not persist another 6-12 or even 18 months. However, the path of recovery for risky assets is becoming increasingly narrow. A strong economy lacking inflation would be required for the present conditions to be maintained (including low interest rates). However, current risks that are not negligible would mount significantly. (As noted by Kevin Warsh, former Fed governor, “risks are greatest when their metrics are at their lowest” ).
What should be the right course of action in such circumstances? For the last 15-20 years (including several periods of crises), we have remained value-oriented investors as managers of our clients’ wealth as well as our own assets. We believe that the right decision is to persevere in our investment style and market strategy, both successful in the past. When prices of more and more assets get overheated, it is worth holding more cash on the sidelines, which reduces our exposure to falling markets. Psychologically, it is also easier to use cash to re-enter a market rather than to have to agonize about what position to trim to finance a new investment. We are finding comfort and wisdom in sticking with our core principles, despite the call of sirens trying to lure us to more risky shores. Think about it!
- In the past few years, how many analyzes have been made that the tech revolution, the Amazon effect, would permanently eliminate inflation and remove forever the need to raise rates.
- How many opinions have we heard in recent years that social media, artificial intelligence and robots are completely changing the world? (Rímel’s words “no oil for the internet” at the end of the 1990s then called “Dotcom”, now any relation to AI would be a “doubling factor” in stock prices).
- How many have talked to us over the last month about how much they’ve been looking for Bitcoin and mining as the biggest business? (All of them may not be taxi drivers, but certainly there were more than a few.)
Under such circumstances, we do not feel comfortable unless we retain a moderate risk-taking and value-oriented attitude. In the long run, we believe in this philosophy, even if it does not necessarily work out well over shorter periods of time. It’s just the difficulty of this genre. As a renowned investor, Tobias Carlisle described this well: “The best time for value-based investments is when value-based investors seem to be the tallest.”  Value-based investment is a difficult strategy because it may sometimes be under-performing or even dropping, while markets rise. It is attractive and works out well in the long run, precisely because it is not attractive in the short term and most people therefore avoid it.
 Prior to 2010, Columbus had a more risky diversified investment policy, with a higher exposure to regional equities.
 Unfortunately, in the context of BTA’s Columbus (USD) fund in the Cayman Islands, the recent YTD result has a dominant negative impact on the computation of annualized performance, over a less than 3 year Inception To Date (ITD) period.
 “[…] macroeconomic risk may be the highest when market volatility measures are lowest.”
 “Value investing is a difficult strategy to follow because it regularly underperforms, and sometimes goes down while the market goes up. This phenomenon is called tracking error. And it’s the secret to return for value. The point in time that value investors look dumbest is the best time to be a value investor.”