As noted moments ago, the iconic $1.5 billion Nevsky Capital is calling it quits. What is surprising, is that unlike some "one hit wonder" hedge fund wannabe, Nevsky is actually a brand name in the hedge fund community, as demonstrated by the following performance charts.
And yet, despite its sterling performance, the fund is liquidating for all intents and purposes and returning outside money. Here is the full reason why, from the December letter to clients:
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Why have Nevsky Capital decided to cease managing the Nevsky Fund?
The decision to stop managing the Fund, after just over fifteen years, has been a very difficult one. This decision has been driven by a growing recent awareness that certain features of the current market environment, which we believe might persist for a considerable period of time, are inconsistent with the achievement of our goal of producing satisfactory risk adjusted absolute returns for you, our clients.
Over our twenty-one year investment career we have always invested using a broadly unchanged process. This process marries the top down forecasting of key macro-economic variables with the bottom up forecasting of company earnings; initially just in Eastern Europe, then across the Emerging World and finally on a global basis from 2003 onwards.
For this process to work we have consistently needed the following criteria to be met:
- Access to transparent and truthfully compiled data at both a macro and a company specific level, which is made available on a timely basis to all market participants. This allows us to construct and maintain detailed top down economic forecasts and bottom up company models.
- Logical decision making by macro-economic policy makers.
- An ability to achieve a clear understanding of the positioning of other investors in the market so as to be able to come to a view as to what is ‘in the price’ and what is ‘fair value’.
- A reasonable level of divergence in equity prices between different geographies and sectors and the existence of constantly evolving, but logical, inter-relationships between these different asset classes.
- Manageable ‘fat tail risk’
- A reasonable spread of uncorrelated potential investments across time zones.
Unfortunately, global trends over the past couple of years have begun to militate against these pre-conditions for successful fundamental investing. Namely:
Data quality has deteriorated
- Data releases have become much less transparent and truthful at both a macro and a micro level. At a macro level the key issue is the ever increasing importance of China and India. China is the world’s second largest economy, but already much larger than the US in a broad swathe of sectors. India will be the world’s third largest economy within a decade. Unfortunately their rise is increasing the global cost of capital because an ever growing share of the most important data they produce is simply not credible. Currently stated Chinese real GDP growth is 7.1% and India’s is 7.4%. Both are substantially over stated. This obfuscation and distortion of data, whether deliberate or inadvertent, makes it increasingly difficult to forecast macro and hence micro as well, for an ever growing share of our investment universe.
- At a micro level corporates have also responded to greater market scrutiny since the GFC to disclose less not more, on the basis that the less they reveal the less often they can be proved wrong by regulators, investors or law courts. This means the cost of capital relating to holding large company specific exposures has risen as the ‘headline’ risk of being proved wrong with regard our earnings projections is now commensurately higher.
The transparency of decision making has also declined
Assuming we can obtain trustworthy data we then apply logic to produce our forecasts. The validity of this process becomes questionable if economic policy makers do not themselves apply economic logic and in a transparent manner. Obviously we accept politics can trump economics and political analysis has always been a very big part of our process, but surely never has so much of the world been governed by leaders where the logic of that peculiarly parochial yet multi headed beast – nationalism - trumps all (China, India, Russia, Turkey, South Africa, Malaysia etc. etc.). Almost by definition the path of logic within nationalism is difficult for ‘outsiders’ to follow with any confidence, leading to highly unpredictable and potentially dysfunctional modelling outcomes.
- At the start of our careers we spent much time being forced to try and decipher the indecipherable – the moods and subsequent decisions of Boris Yeltsin. This ‘Kremlinology’ was truly the definition of banging your head against a proverbial brick wall. Fortunately this and similar masochistic macro-analytical tasks then gave way to the logical joy of the Washington Consensus which was adopted almost without exception across the Emerging World following the multiple devaluation crises in the mid-1990’s. Unfortunately though the Washington Consensus, having been severely wounded by the GFC is now stone dead. Kremlinology, with an additional nationalist twist, is back – and it is now the norm, not the exception, for most countries in the Emerging World. We are not convinced that knowingly continuing to bang our heads against these newly erected brick walls would be a sensible decision.
- Equity markets are also less transparent
- The unintended consequences of those new regulations introduced as a result of the GFC, which have largely removed the market making role of investment banks from global equity markets, has coincided with the recent massive increase in market share of both ‘dumb’ index funds and ‘black box’ algorithmic funds to create a situation where equity market volumes have fallen sharply and individual stock volatility has risen dramatically. An initially badly executed order can now inadvertently create a price trend (because there is no longer the cushion to price moves which was in the past provided by market maker inventories) that, as algorithmic funds feast on it, can create a market event even if the initial order was a simple innocent error. Truly – to mix metaphors – butterflies flapping their wings now regularly create hurricanes that stop out fundamentally driven investors who cannot remain solvent longer than the market can remain irrational.
- In such a world dominated by index and algorithmic funds historically logical correlations between different asset classes can remain in place long after they have ceased to be logical. More butterflies.
- Index and algorithmic fund manoeuvrings also make it very hard to ascertain what the markets ‘clean’ positioning is at any given time. All of which pushes up the cost of capital.
Fat tail risk has also increased
- Less disclosure means more event risk, while thin volumes coupled with trend seeking algorithmic trading mean the markets responses to such events have become much more violent. Instant downside risk on both longs and shorts has become immeasurably larger as a result.
Asia is becoming an increasingly dominant time zone
- If this wasn’t enough, the growing dominance of Asia, because of the growth of China and India and (happily) the resuscitation of Japan as a viable investment destination by Abenomics, also makes operating our all inclusive global equity process ever more difficult from a time management perspective. With the world ever more interlinked economically, gone are the days when one time zone (of Asia/Europe/the US) could be neglected at any given time to the benefit of the others. This has forced us, over the past two years, to resume the brutal hours we stepped back from in 2010, but which we now think are both unavoidable going forward and unsustainable.
In summary, all of the above factors now mean that it is more difficult than ever before for us to accurately forecast macroeconomic and corporate variables. This pushes up our cost of capital and substantially increases the risk of us suffering substantial capital loss on individual positions either because of a forecast error or simply because we could be caught up in an erroneous market trend, which could then persist for far longer than we could take the pain. This has made what we enjoy most – the thrill of analysing economic data releases and company accounts – no longer enjoyable. It is therefore time to accept that what we have done has worked brilliantly for twenty years but does not work anymore and move on. We are confident our process will eventually work again – for the laws of economics will never be repealed – but for now they are suspended and may be for some time; an indefinite period involving indeterminate levels of risk during which we think it would be wrong for us to be the stewards of your money.
The final reason we have decided to cease managing the Fund is our increasing concern with regard the health of the global economic cycle, which we describe in detail in section 3 (below). This view is relevant because, in our experience, periods of economic pressure and high market volatility will tend to make the issues that are already making it more difficult for our process to work (which we have discussed above) such as poor disclosure, the triumph of nationalism over economic logic, low market liquidity and heightened event risk, worse not better, thus potentially leading to a further deterioration in our risk adjusted returns.
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The full letter, which includes Martin Taylor's investment outlook, is below.