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 funds 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 unlikely 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’.
I. Required Returns to Breakeven (%)
II. BREAKEVEN 'IMPLIED' ANNUAL RETURNS ASSUMING 3 YEARS TO RECOVER (%)
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 money. Ideally, 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 about a manager who makes one final, reckless all-or-nothing bet.
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.
HINDSIGHT is ALWAYS 20/20
Without having access and the full context of how investment decisions are made by the Managers, investors like ourselves are able to evaluate a Manager’s performance on an ex post basis, which means ‘after the fact’ in Latin. Any attempt to anticipate, or to second guess a Manager’s decision before the event may lead to losses which are attributable to our own mental blindspots (instead of the Manager's). For example, we might lean towards action bias, where we feel the need to take action even if the situation might be premature. To a certain degree, we must be willing to accept that losses are inevitable till such time when we can validate a fund’s death spiral; by the time that happens, we have likely taken… the road of no return.
Thus, the adage 'Never invest or allocate capital you're not prepared to lose' holds especially true for highly volatile investments such as ours.
Regards,
Stega Investment Team
HOW CAN WE HELP?
1. For Investors, we provide aligned, investment access with low minimums.
2. For Family Offices / Institutions, we offer capital introductions to our longest standing GP / hedge fund relationships.