What to Do in this Market: Gotham Funds Update

So my posts about the perils of market timing and market valuation have led to some interesting discussions in the comments section.

Anyway, I wrote about the Gotham funds last year and since a little more time has passed, I thought I'd look at their performance to see what's going on.

But first, let me just say that if you *must* invest in some sort of hedged vehicle (in mutual funds), or something that mitigates stock market volatility, as I said in my original post (What To Do In This Market II), I would recommend one of the Gotham funds.

As I always say, I am not usually a big fan of long/short (unless they are run by people who have real track records like Loeb, Einhorn etc...).  I would definitely stay away from the long/short stuff that are put out by the mutual fund giants.

Why Gotham?  Well, we all know what a great manager Joel Greenblatt is.  He does have a long track record of outperformance.  OK, so it wasn't a long/short fund.  But he knows stocks and markets very well, and he has often spoken against the idea of long/short.  But he is doing it now.  What does this suggest?  It means that they have really dug in and figured out how to manage the risk inherent in a short book.  Otherwise he wouldn't do it.  He knows why long/short funds usually don't work out.

Plus, the funds will be operated according to the simple ideas laid out in his books, and I feel I do understand those well, and do have faith that they will continue to work over time.

He said on CNBC once (when the first Magic Formula book came out) that if he shorted the most expensive Magic Formula names against the long portfolio, the portfolio volatility would have been far greater than the long only portfolio, and I think he even said that the portfolio lost 90% or something like that at one point.  I'm not sure he said that, but I do remember him mentioning a huge drawdown with the long/short.

So I am sure he will not have a huge drawdown on the long/shorts like that as we know he is aware that is possible if you just bought the cheapest and shortest the dearest names.

Macro Based Mutual Funds
But first, let me get back to the macro, top-down mutual funds that I would caution people away from.  As I said in the comments section, my caution against market-timing funds is simply that there isn't any fund that I am aware of that has done it well over time and through cycles, never seen a newsletter or investment strategist that called things consistently over a long period of time (there are always stars, though, that have called the most recent correction, rally or both.  Maybe we can make a list of them).

As I said, for value investors, there is a Graham and Doddsville and the resident superinvestors.  Where is the Graham and Doddsville of market timers?

One thing you can do is subscribe to Hulbert's Financial Digest for a while and check out the long term performance of timers.  It is dreadful.  And many of them use the same things everyone else uses; P/E ratios etc...

So why do these funds come and go all the time?  And how can a fund like this, below, even exist?  Well, it barely does.  I think AUM is now $34 million.



To understand this, check out the performance figures below.  This is from the fact sheet for the fund from their website,  The above chart only starts at 1994.

So this fund started in 1985.  It is interesting to note that the arguments made back then are very similar to the arguments made today.  Especially going into 1987 and then after that throughout the early 1990's, the argument was about high stock prices, too much leverage (junk bond driven LBO mania), twin tower of deficits (budget and trade deficits), and there were no shortage of calls for another great depression to come.

In that environment, this fund came out and then nailed it in 1987.  Look at that.  They did OK in 1985 and 1986, and then absolutely hit it out of the park in 1987, no doubt due to their cautious stance.  That stance cost them in 1988, but it looked like things will be OK in 1989 (I don't know if that gain is due to the UAL crash, or from longs, but...).

And then from 1990 on, things start to go wrong, and then from 1994 on you can just look at the chart and things go horribly wrong forever after.

If you go to their website, there is a video of Charles Minter making some persuasively bearish statements in 2003.

The funny thing is, as is often the case, I totally agree with so many things the bears talk about.  They are right but I just tend to disagree on what to do about it (Buffett too often says things that are in agreement with the bears but acts totally differently so it's not that he is stupid and he doesn't see it, or that he is complacent.  He just has a time horizon long enough (and holdings solid enough to survive that long) for it not to matter.

These funds get very popular after a bear market because there are usually some people who absolutely nailed it.  Maybe they get the bear right and even get the turn correctly and rides up a rally.  Maybe they can even get the next bear etc.

But it is very hard to keep doing that and at some point, inevitably, your luck runs out and you can't keep calling the turns anymore.  This is true with newsletters and investment strategists too.

Cursed by Early Success
And their early success is the reason why they can't evolve or change.  When their best relative performance (and rise to fame) occurred during bear markets, it's only natural that these managers will almost always lean towards the bearish side.  Looking at the above table of Comstock's early success (1987), you can suspect that the management there has spent the next 27 years trying to replicate that success; kind of like Jay Gatsby trying to relive a summer of his youth.

I suspect other similar funds will do the same thing and if they fail, it will be because of the irresponsibility of the Fed.  In other words, it's won't be their fault.

Speaking of which, I remember in the 1980's and 1990's, the hedge funds and macro guys loved the central banks and governments because they were so inept.  It was very easy to trade against them and make tons of money.  So it's kind of ironic that many of them are now complaining that their bond market / interest rate manipulation is interfering with their ability to make money.  But that's another story for a different post.

And by the way, sometimes in the trading world, we say that making a killing on the very first trade can be the worst thing that can happen to you.  The thinking is that the trader will spend the rest of his career losing what he made and then some trying to replicate it.  (Imagine how much money has been wasted on S&P 500 index puts in the years following Black Monday?)

Value Funds
Of course, this inevitably leads to the argument, "gee, but value funds don't outperform the index either!".  Well, that's why Buffett says index investing (the S&P 500 index) is the right way to go for most people.

But I'll add that even if a value fund underperforms (hopefully they outperform over time, though) usually they end up making money.  You can still do pretty well.  I know someone who has become pretty wealthy just owning the Magellan fund for many years (I mean, many, many years!).

Why Do I Waste Time on This Topic?
Well, as I said in a response in the comments section, when people realize I am involved with the stock market, the discussion almost always ends up not being about stocks, but about what to do because the stock market is dangerous, dishonest and rigged, too expensive and bubbled up etc.

Also, I am not at all against the idea of market timing.  I don't write this stuff because I have something against them and I don't feel like I am trying to prove anything idealogically or anything like that at all.  In fact, I am very curious about these things and have always been.  True, I don't spend a whole lot of time on it, but I am curious about what others have to say about it and about attempts to do it.

If I find someone who can do it consistently and has a track record (or a group of such people), I would be very interested in what they do.

But the fact is that I just haven't found any yet.

In fact, early on in my career, I was very into this stuff and what lead me to value investing is that there was no Graham and Doddsville of market timers.  It turns out most market timers make the bulk of their money selling books / newsletters etc.  Every time I read a book about it, I couldn't verify the author's performance.  If they were newsletter writers, their letters performed horribly.

Back to Gotham Funds
OK, so back to Gotham.  Why am I OK with Gotham versus the others?  Because Gotham does not try to forecast the economy and structure a portfolio around it!  They don't get bearish and put on a hedge, and then get bullish and take off their hedge.  They simply buy the cheapest stocks and short the dearest stocks.

Here are the funds that they offer from their website (gothamfunds.com):

And here is how they've done:

These funds are still too young to really evaluate them, but so far it looks pretty good.

Check out how they have done versus the S&P 500 (Morningstar charts via Gotham's website):

Gotham Absolute Return

Gotham Absolute 500

Gotham Enhanced Return

Gotham Neutral

If I had to choose one to hold for the long haul (or recommend to, say, your sister or some non-market person), I would say Gotham Absolute Return.  Gotham Neutral is interesting, but that seems too cautious.  Also, the Enhanced Return looks exciting, but seems to have more leverage than I might be comfortable with to recommend someone who doesn't follow the markets. The Absolute Return long/short allocation is similar to how the typical long/short hedge fund operates.

Anyway, again, I would be very skeptical of the long/short funds coming out of the big fund families.  Think about how their funds tend to underperform most of the time anyway.  And add the risk of short-selling to that underperforming long portfolio.  Short-selling tends to be very tough, and in my experience, long-only managers suddenly being allowed to short have often lead to dreadful results.  It's just a lot harder to do.

If a stock is cheap you can buy it and if it goes down, you can just buy more.  But if you short a stock and it goes up, you can't just sell more.  If you try, you can really get killed.  And shorting wrong stocks can easily offset gains on longs.

Oh, and not to mention that the best short-sellers/stockpickers tend to go into hedge funds where the fees are higher (and therefore their own salaries/bonuses).

This Time it's Different
Over the years, when I get into this sort of discussion about the markets (and talking people out of market timing), they argue that the bulls are saying "this time it's different".

But it's never different.  Some things do differ, though.

For example, what's not different?

• Value still matters.  Cheap stocks will do better over time, and expensive stocks will do worse.  Gotham funds can exploit that.
• Asset values have always been valued against the U.S. treasury market.  Sure, there might not have been a close correlation in some periods in the past.  For long duration assets, U.S. long bond yields have always been the "risk-free" benchmark.  And against that, the U.S. stock market is not at all overvalued.  
• Even if the stock market is not overvalued versus bonds, it is expensive on an absolute basis which implies lower returns going forward.  This is a mathematical certainty that can't be denied.  But it doesn't necessarily follow that someone can earn a higher return than this projected low return by getting in and out of the market on a timely basis.  All evidence I have seen to date seems to suggest otherwise (most would have been better off in August 1987 to just hold on and ignore the headlines). 
• But having said all of that, even I wouldn't be comfortable if stocks got up to 50x or 100x P/E (to catch up to the bond market).  I think the stock market is acting prudently by not going there! 
• And, in general, people who try to time the market will get one, two or maybe even three turns right and will look good (and get a lot of face time on TV).  But the odds of that success continuing is very low.  This is not a judgement of anyone in particular.  Even Buffett has said that in his fifty+ years of life in the markets, he hasn't seen anyone do it. 

So most things don't change.  I think the world will go on as it always has in the above sense.

But what is different?

I was going to make a list, but I think the biggest difference is monetary policy.  In the old days, the Fed can just lower rates and things were hunky dory.  Now, all sorts of stimuli are having a much lower impact than in the past.  I think that's due to the amount of leverage already built into the system.  There is something going on that most of us don't understand; why are rates so low for so long?  I tend to believe it is not just about the Fed.  Why are rates still lower despite the end of QE?  We may be in a long term Japan scenario where deflationary pressures (and not Fed bond buying/manipulation) keep rates low.   This is sort of uncharted territory so old models may not work as they have in the past.

Conclusion
So maybe I sound like some idealogical extremist in terms of this stuff (anti-market-timing, pro-value investing) but there is a reason.  I have no horse in this race, really.  I don't sell a newsletter or book, don't own a value investing shop or anything like that.  And I have no relationship with Gotham, Greenblatt or anyone associated with either of them.

But I've been in the business a long time (well, maybe not as long as some of you!) and feel like I've seen it all.  I didn't experience Black Monday or any of the big bear markets before then, but I've been through all of the other crises, and they are all the same.

Heroes inevitably emerge from each of them (sometimes multiple heroes).  Some of them are wire-house investment strategist (that go out afterward to start a fund after making a great call), newsletter writers, economists etc.  And most of those guys that make their name in bear markets don't go on to make great long term track records.

Again, I exclude some of the really good trading oriented hedge funds (think traders in the Market Wizards book).  A lot of those guys are very good and have long, consistent records of profit.  But they are very different from the macro-based mutual funds (maybe that would be a topic of a future post).

So in a sense, no, this time is not different.

If you must invest in some hedged vehicle (again, I am only talking about mutual funds), then go with the Gotham funds.  They don't try to do the impossible (guess where the markets go) and they stick to fundamentals / valuation in stock selection.  It is a fund run by a successful manager with a great track record, great books with a method of picking stocks that have worked over time etc.

Of course, it may not work out at all.  Who really knows with these things.  But I can tell you that if you are going to do something in the long/short world, or 'hedged' world (to temper volatility), I can't think of anything (in the mutual fund world) I would feel more comfortable with.