Slow and steady

Martin Steward discusses how to win big from controlled risk with Majedie’s Tortoise fund

Majedie Asset Management launched its Tortoise Fund, a long/short UK equity strategy, in the teeth of the credit crunch. A paper portfolio started in April 2007, two months before the collapse of Bear Stearns’s structured credit funds; real money set to work in August, weeks before the run on Northern Rock. Two years later the £48m (€52m) fund is up more than 70%, outperforming the FTSE All-Share by 85%. With numbers like that, investors might wonder whether this is really a hare in tortoise’s clothing.

“The name hopefully suggests that we’re not the ‘alpha warriors’ chasing returns up in the good years on the way to the next massive blow-up,” says the fund’s manager, Matthew Smith. “We’ve had a much better start than we’d expected, but we still genuinely believe this strategy is good for 20-30 years. I certainly have all of my money that’s in the markets in this fund.”

Alongside him are nine institutional investors. Six were existing Majedie clients; of the three newcomers, one is a UK pension fund. No doubt they have been enjoying the returns. Are they worried about the risk?

Barra readings for total portfolio risk certainly spiked last winter, which looks like a tale of buying into the sell-off. “The returns generated this year should be considered in the context of valuation spreads that were at 70-year highs,” says Smith. “What we hope people see from the last two years is that we are pretty flexible.”

It is tempting to assume that the fund rode the beta waves up and down, while rationality took a holiday. That would be a mistake: Tortoise’s net exposure can range from -30% to +100%, but it has never been net-short (it has swung between +11% and +69%, averaging +39%). “One consultant looked at the portfolio in March and said: ‘You’re just taking a huge position on cyclicals versus defensives’,” Smith recalls. “You could look at it like that or, instead, you could say that we had a whole bunch of cheap stocks on the long side and a whole bunch of expensive ones on the short side.”

The source of the stellar returns and much of the limited downside risk is certainly an alpha, not a beta: asymmetrical, option-like exposures. “We try to think about the real upside and downside, not what we think a stock is going to do next week,” says Smith. “If margins fall, where might they fall to, what profit numbers does that give you? What valuation is the market going to put on those profits at the bottom of the market? On the upside, where might margins and revenue growth take profits to. And if people got really excited, what multiple could they reasonably put on that?”

Those questions form the heart of the research, forecasting a range of prices: Smith then looks for stocks at the extreme edges of those ranges. On top of these individual asymmetrical bets, volatility is also budgeted at portfolio level. At inception, the fund was dominated by global defensives with strong balance sheets, so risk was concentrated - “at one point we were only holding eight longs”, says Smith. As valuations on these defensive names got stretched and cyclicals collapsed in Q4 2008, some short positions were flipped into longs. “On the face of it we were buying risky companies - they’d gone down 90%, but could still halve again,” Smith recalls. “The potential upside was huge, and we focused on names that the banks would support and who could get through rights issues, but still, we significantly reduced concentration, going up to about 35 longs.”

Those portfolio rotations also highlight the importance of gradually sizing into positions: “The biggest mistake that you can make with this type of strategy is to go in too big, too early,” says Smith. The portfolio can take individual contrarian positions, but the long or short book never fights against momentum in aggregate. “As evidence for your scenario builds, you can scale up,” says Smith. “Eventually, momentum starts to roll over, confirming your valuation view, and you can be more aggressive.”

And if momentum doesn’t roll over? Liquidity is key. “Any fund manager is going to spend a lot of time being wrong, and yet people convince themselves they’re going to be right and build positions that are so large and illiquid they can’t get out of them,” says Smith. “Many of our mistakes don’t show up because we recognised them and shut them down early.”

Q4 2008, when the fund was building cyclical long positions, is a perfect example. Unsurprisingly, Smith was testing the bottom, but as systemic failure spread waves of forced selling some of his new longs were “waterfalling”, he recalls, straining his model’s momentum checks. Within a week he had retreated to the short side again: the losses from the beginning of October were all but corrected by the end of the month, and the longs were re-instated in January.

The fund is capped at £250m to preserve that kind of nimbleness. It’s not a trait associated with tortoises, but it lies at the heart of the Tortoise fund’s long-term objectives and profile: asymmetric opportunities and tight portfolio risk budgeting backed by abundant liquidity.

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