Summit View Fall 2012

SCC

Summit Creek Capital

summitVIEW |FALL 2012

What’s with Bacon?

“disaster economics” Better Beta

efficient allocation Re-Examining

risk and reward

Perhaps these

Maps & Legends

have been misunderstood.

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Louis Bacon &

our changing investment environment

“Markets are increasingly distorted by central banks’ attempts to squeeze drops of growth from an over-indebted private sector across much of the developed world,” through such practices as bond purchases and super-low interest rates...

The U.S. markets are hindered by a caustic political environment and an anti-business administration. U.S. banks have retreated from making markets in many securities because of the DoddFrank legislation, which limits them from trading for their own accounts.

Bacon added that “in some Kafkaesque absurdity,” the rule is “named after the two high protectors from regulatory oversight of perhaps the most egregious of U.S. financial miscreants, Fannie Mae and Freddie Mac. Bacon pulls no punches as he goes after inept regulators in Europe and the US, and describes the state of affairs as “Disaster Economics, where assets are valued based on their ability to withstand a lurking disaster as opposed to what they may yield or earn, is now the prism through which investors are pricing markets.” And perhaps most ‘distorted’ is the credit market where trading in individual corporate credits has also been ‘decimated’ he said. “I shudder to think of the stress that is going to occur during the new credit liquidation cycle.”

Bloomberg, August 1, 2012, quoting Louis Bacon, Founder, Moore Capital Management, as he announced the return of 25% of Moore’s assets under management (or $2.0B) to investors.

The announcement by Bacon is not so much the denouement of a long and successful career as much as it symbolizes the changing investment environment. As Reinhart and Rogoff point out in This Time is Different, working through credit cycle contractions requires many years and often brings unexpected events. So far, since the financial crisis, Ben Bernanke has formulated a floor value for credit while engineering an expansion for equity (at least in the United States). As global growth indicators and emerging equity market performance all point to a slowing global economy, an examination of suitable asset allocations and how one achieves those allocations is a worthy effort. The end does not always justify the means.

If performance goals are achieved in the near term, will the means to the risk and reward do not end withstand the align as they once did. dislocations that are likely to occur as the developed world works through a credit contraction?

Recently, Greek Prime Minister Antonis Samaras, responding to French President Francois Hollande’s concerns about Greece making good on its promises, said, “Of course we need to make an effort [to meet our obligations to France],” he said. “We can keep our promises and goals, reduce our deficit and debt, [and] accomplish structural reforms.” Certainly, meeting GDP growthcrushing obligations is easy when one maintains reliance on perpetual financial support from the European Central Bank (ECB) and cronyism from all other profligate European Union nations. Isn’t it? Certainly appears to be that way, right?

In light of Louis Bacon’s comments, finding the usual dislocations in the market proves difficult. The dislocations (mispricings) are what drive efficient allocation of capital. However, when central banks have an endless supply of capital (i.e., the printing presses), exposing assets to apparent dislocations can prove very painful as what was once typical for market behavior is replaced by central bank mandate. One can just as easily go with the flow, and entrust the central bankers to do the right thing to protect asset values (assuming you’re a blind faith type, of course), as one can choose not to participate in the gamesmanship.

Bacon has chosen to reduce his exposure to the game because the playing field has changed materially: risk and reward do not align as they once did. •

CAPITAL (IN)EFFICIENCY

Examining asset allocation in light of capital efficiency should open investors’ eyes to the inefficiencies of asset management: return reduction due to management fees, to taxes, and to poor performance by the manager. Remaining steadfast to long held views can prove trying when applying old thinking to new circumstances. As central banks around the globe work to stabilize capital markets, how best does one allocate assets to align with one’s tolerance for risk to achieve the highest return per unit of risk?

Opportunity comes in many forms and often arrives disguised, as opportunity changes over time. The opportunities for investors in our current socio-economic environment certainly do come in varying guises.

An examination of the current landscape prompts the following:

ONE The idea of active asset management is proving so difficult for the many that only the very few are capable of consistent long-term outperformance of indexes. As an investor one should ask why are large percentages of their portfolio entrusted to managers who either closely mimic their respective benchmarks or grossly underperform them. Why pay active management fees for a product that mimics a much less expensive alternative?

TWO

THREE

With computers automating so much of the investing world, is there a way to access performance generating models that are transparent and do not cost upwards of 30 percent of the profits (not to mention the fees just to have access to the computer model)?

The JOBS Act signed into law in April 2012 has provisions in it that allow for crowdfunding of business models. Robert Shiller, Yale professor, the name behind the Case Shiller housing index, and the source of the term ‘irrational exuberance’, said he sees crowdfunding as important to capital formation as the founding of the public stock exchanges at the turn of the 19th century.

We are more reliant on our politicians and central bankers to manipulate and shape markets and returns than perhaps ever before. These are not free markets.

Jim Reid, Strategist, Deutsche Bank, “A Journey into the Unknown,” September 3, 2012

Who’s your Beta?

Beta is one of the many financial terms tossed around by investment management practitioners. Beta is a Greek letter used to represent the “market.” The “market” is really very large1 . United States investors typically think the S&P 500 is the market, or the Dow Jones Industrial Average, even though it represents only thirty stocks. The number 1.0 is used to represent the market. In turn, stocks that comprise the market have betas as well, which represents their price movement relative to the movement of the market. A beta above one means the stock generally moves in greater percentages, both up and down, relative to the market, and vice versa if its beta is less than one.

The compositions of the two primary “market” indexes in the United States, the S&P 500 and the Dow Jones 30, are developed differently. The S&P 500 is a capitalization weighted index where each company represented in the index is weighted by its capitalization (total number of equity shares times the price of the stock). The Dow Jones 30 is a price weighted index, where the weighting of each company in the index is determined by the price of the stock times the total number of shares available. Understanding the composition of each index (or any index for that matter) is important for investors.

1

As of September 11, 2012 total global market capitalization of equities was $50.2 trillion versus the United States total capitalization of $16.9 trillion.

www.summitcreekcapital.com | 208-928-7500

Better Better Beta is an important development in this world of central bank controlled capital markets. Better Beta seeks to exploit the inefficiencies within the capital markets, namely the global equity markets.

The question SummitVIEW asks is why be subject to the aforementioned index (or market) weightings? Why do investors have to allocate their assets according to influences that often can become arbitrary or subject to a beauty contest or mania, for that matter? (See, the financial and housing stock bubble of the 2000s, the TMT (tech, media, telecom) bubble of the late 1990s where names like AOL, WorldCom, Enron could do no wrong, the Nifty Fifty of the 1960s, etc.) We believe investors should remove the behavioral tendencies of the broad markets by allocating capital more efficiently than can be done through traditional benchmarking.

As difficult as it is to go against the grain in times of euphoria and depression, utilizing Better Beta products will help to take advantage of the behavioral/ economic cycles so prone to human history. When euphoria and the markets are up, the smart thing to do is to sell or to reallocate. When markets are down, the right thing to do is to buy or to reallocate.

What are the best means to implement this contrarian strategy?

Discipline? Sure, easily said but very hard to implement when the

house appears to be cratering.

Better Beta is a concept that utilizes the power of computers to exploit the inherent flaws in broad indexes. If most active managers underperform or highly replicate the index, why pay their fees for that kind of work? If broad indexes are subject to periods of high, nerve wracking volatility that can impair portfolio performance, why not utilize methods that work to use the volatility as an advantage?

Better Beta provides a way to better spend your budget for risk.

An efficient spending of one’s risk budget rewards the investor with a higher return for the amount of risk taken. Better Beta is efficient capital allocation. If you are very averse to risk, where volatility of any kind makes you gag and reel towards a commode, you are not alone, especially if you’re in or are nearing retirement. Better Beta is an important development in this world of central bank controlled capital markets. Louis Bacon provided a product that exploited the inefficiencies among the global capital markets. Better Beta seeks to exploit the inefficiencies within the capital markets, namely the global equity markets.

“We can’t solve problems by using the same kind of thinking we used when we created them.”

Albert Einstein

Market Risk Factors

Historically, the universe of investments has been defined by silos: stocks; bonds; commodities; real estate; cash.

Further, the buckets were divided by geographic demarcation: US; International; Emerging Markets; etc. Expected returns of the asset silos were determined by the belief that returns were independently, identically distributed (i.i.d.).

To translate, i.i.d. implies that from one period of time to the next (say from one economic regime to another) the returns on assets are independently, identically distributed. With the advancement of computer modeling technologies, belief in i.i.d. becomes very difficult. Not all returns are independent, nor are return results identical from one period to the next. The market

goes through long periods of poor returns driven by existing socioeconomic factors just as it goes through boom periods.

Instead of allocating assets based upon the long term historical performance of an asset class, view the investment universe through a lens of market based factors, which allows investors to view the sources of returns that drive

The market based factors affecting all investments are: • Liquidity Risk • Sovereign Risk • Interest Rate Risk • Credit Risk • Equity Market Risk • Issuer Specific Risk

performance, not just the returns themselves.

Market based factors are the risks investors face when making any investment.

Ultimately, the portfolio is managed in terms of its overall market risk exposures from the various investment instruments held in the portfolio. Rather than examining the beta of an asset class and allocating the portfolio assets accordingly, market factor risk management allocates assets according to individual risk budgets and long term performance needs, where the portfolio is not divided among silos nor among regions. Instead, all investments are return distributions that provide the building blocks for portfolio construction, providing returns from market based factors.

www.summitcreekcapital.com | 208-928-7500

New Investment Paradigm & Personal Efficient Frontier The development of mankind has not been in a straight line and neither has the development of our economies.

If mankind and the economies that represent our development are historically subject to cycles of development and destruction, who believes that now we are in a “new� regime where those cycles are non-existent or are of less negative impact than past cycles? The Great Moderation was just not true. If, as an investor, you were able to build a better boat to sail the choppy seas of investing, would you do it? You certainly would.

Better Beta allows investors to personalize their portfolio, where the result is a personal efficient allocation of capital. In the parlance of the finance industry and academia, the efficient frontier is where everyone wants to be. Well, how nice would it be to

have your own, personalized efficient frontier? No more would investors be concerned with chasing performance.

SummitVIEW recommends focusing on three strategies for managing the overall investment portfolio. One, develop strategies that generate market directional returns; use the risk premiums to generate returns from exposure to market risk factors.

Two, develop strategies to use skill based arbitrage to indentify and to exploit market pricing dislocations.

Three, develop strategies for illiquid assets, as privately held assets are not subject to the gyrations of public markets and can provide consistent non-market correlated cash flows.

SCC

Summit Creek Capital www.summitcreekcapital.com | 208-928-7500