The World's Top Performing Hedge Fund Just Went Record Short, Explains Why

Tyler Durden's picture

Last month, in our latest profile of the $2.8 billion Horseman Capital, we said that not only has that fund which some have called the "most bearish in the world" generated tremendous returns almost every single year since inception (except for a 25% drop in 2009 after returning 31% during the cataclysmic 2008), but more notably, it has been net short - and quite bearish on - stocks ever since 2012. In that period it has consistently generated low double-digit returns, a feat virtually none of its competitors have managed to replicate. In fact, its performance has put it in the top percentile of all hedge funds in recent years.

Furthermore, in a year most other hedge funds would love to forget, the fund "crushed it", with a 20.45% return for 2015 and 5.6% in the tumultuous month of December. 

Today, we got Horseman's latest numbers and they are a doozy: in what was one of the worst Januarys in stock market history, the fund returned a whopping 8%, putting it in the 99%+ percentile of returns for the month (and the year).

 

Indeed, "crushing it" is hardly new to Horseman: it has been doing so for four years in a row, and not surprisingly, 2015 was its best year since 2008. 2016 is starting off just as good as the prior year.

How did Horseman generate another month of phenomenal returns? In its own words:

This month strong gains came from the short equity book, in particular from the automobile, real estate and EM financials sectors while the long portfolio incurred a loss.

This is what Horseman's sector allocation looks like as of this moment:

Headlines were made last year by the clampdown of the Chinese authorities on the Macau casinos, who had been allowing Chinese residents to move their winnings out of China. However, despite the clampdown and the following fall in casino revenues by some 34% in 2015 (source: Macau's Gaming Inspection and Coordination Bureau), capital outflows have continued via other channels.

 

Imports from Hong Kong to China jumped 64% year on year in December, but the same numbers released in Hong Kong showed a 0.9% increase (sources: China and Hong Kong customs data). This could be explained by the practice of over-invoicing of Chinese imports from Hong Kong with trading partners that agree to inflate the cost of goods before a letter of credit is issued.

 

Chinese companies were involved in foreign acquisitions worth a total of $656bn last year and already this year, four of the biggest cross-border deals have involved Chinese groups bidding for US and European assets worth $61.7bn in total (source: FT).

 

Over the past few years Chinese companies have issued a large amount of US dollar denominated debt (see Russell Clark’s market note entitled ‘Spotting property Bubbles in East Asia’), in 2015 they sold a total of $60.3 billion worth of dollar-denominated bonds, more than six times the 2010 figure (source: Thomson Reuters data). In August last year, as China’s monetary authorities gave the signal that the Renminbi was not immune to devaluations, companies started to reduce their dollar exposure. Recently China SCE Property Holdings Limited said that it would redeem its $350 million senior note due 2017, while another real estate company, SUNAC China Holdings Limited said it had completed the redemption of its dollar note due next year.

 

China’s currency reserves declined by $420bn over the past 6 months and in January they plunged by $99.5bn (source: PBOC). The fund maintains a short exposure to sectors exposed to a renminbi devaluation such as luxury brands and Chinese property developers, and to other Asian currencies that would also have to devalue, such as the Korean Won and Singapore dollar.

In other words, another adherent to the "China will blow up" philosophy, which it may, however unlike Kyle Bass and a cohort of other China-bearish hedge funds, Horseman is instead betting on select Chinese sector shorts, as well as China's currency devaluation although not by shorting the Yuan, and instead is bearish on the Won and the SGD.

What was the fund most bearish on? Pretty much everything, but a few sectors in particular:

However, what is most remarakable about the hedge fund, is that while it has maintained its gross exposure, as of January 31, the fund's net short exposure has risen to a whopping 76%, an all time high, even for one of the world's most bearish hedge funds.

 

Finally or those seeking to glean some wisdom from the Horseman's inimitable Chief Investment Manager, Russell Clark, here is his latest letter.

* * *

My wife and I went see to the “The Big Short” the other day. It was certainly very amusing, and explained difficult financial concepts well. I will put it up there in my top three finance based films, along with “Trading Places” and “Margin Call”. I found Margin Call to be the least appreciated of these films, and yet for me most closely matches up to life in an investment bank in the 21st century.

For those that have not seen it, the film centres on a junior risk analyst, who discovers that the potential losses on the bank’s holding of mortgage assets were larger than its market capitalisation. He immediately informs his colleagues, who then pass it onto senior management. One of the recurring themes of the movie, is that the junior low paid staff are all maths and excel spreadsheet gurus, and the upper management are luddites. The junior risk analyst shows his excel model to management, and is constantly told “You know I don’t like these spreadsheets, just tell me what’s going on”. The analyst is eventually introduced to the Chairman of the Board, who asks him to “please, speak as you might to a young child. Or a golden retriever. It wasn't brains that brought me here; I assure you that.”

If you were unfamiliar with the world of finance, you would think this grossly unfair. The brainboxes of the world toil endlessly, while their know-nothing bosses take home the big bucks. However, I think this is wrong. As the Chairman of the Board elaborates, the reason he earns the big bucks is, “I'm here for one reason and one reason alone. I'm here to guess what the music might do a week, a month, a year from now. That's it. Nothing more.” The music in this case would be market prices.

The crux of the matter is that anyone telling you what the market is doing now, what the value of something is now, is providing you a freely available commodity; even if, in the cases of some derivative products, you need to be a rocket scientist to be able to give a valuation today. The real value add in markets is to be able to see what future values might be; that is to live in the future, not in the present.

I spend most of my time, while looking at current prices, thinking about and trying to live six months to one year in the future. Thinking about what will be the reaction to what is happening now, and then thinking about what that means future prices might look like. Generally that has worked well for me.

What I can see now is that US growth is slowing, and that the market is likely to price in reduced monetary tightening.

This should lead to a weaker dollar. This makes shorting Europe and Japan very appealing. Theoretically, this should make commodities and emerging markets (‘EM’) attractive, particularly if you are of the view that US dollar strength is the reason emerging markets and commodities have been so weak. However, I think we have chronic oversupply of commodities, and real financial issues in China that cannot be resolved easily. This makes commodity related areas very unattractive, despite the prospect of renewed monetary easing by the Federal Reserve. Furthermore, the reaction to reduced tightening by the Federal Reserve, would almost certainly be more easing by every other central bank in the world. But as we have seen recently with both the ECB and BOJ, monetary activism is not always effective.

I also worry about the prospects of a trade war, as populism becomes the new normal in politics globally. The future for me is now more uncertain than at any time I can remember. Or to fully quote the Chairman of the Board from Margin Call, “I'm here to guess what the music might do a week, a month, a year from now. That's it. Nothing more. And standing here tonight, I'm afraid that I don't hear - a - thing. Just... silence.”

Your fund remains long bonds, short equities.