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AQR Style Premia Alternative I, AQR Style Premia Alternative LV I, September 2015

By Samuel Lee Objective and strategy AQR’s Style Premia Alternative, or SPA, strategy offers leveraged, market-neutral exposure to the four major investing “styles” AQR has identified: Value , the tendency for fundamentally cheap assets to beat expensive assets. Momentum , the tendency for relative performance in assets to persist over the short run (about one to twelve months). Carry , the tendency for high-yield assets to beat low-yield assets. Defensive , the tendency for low-volatility assets to offer higher volatility-adjusted returns than high-volatility assets. To make the cut as a bona fide style, a strategy has to be persistent, pervasive, dynamic, liquid, transparent and systematic. SPA offers pure exposure to these styles across virtually all major markets, including stocks, bonds, currencies, and commodities. It removes big, intentional directional bets by going long and short and hedging residual market exposure. As with all alternative investments, the goal is to create returns uncorrelated with conventional portfolio returns. SPA sizes its positions by volatility, not nominal dollars. In quant-speak, risk is often used as shorthand for volatility, a convention I will adopt. Of course, volatility is not risk (though they are awfully correlated in many situations). SPA’s strategic risk allocations to each style are as follows: 34% each to value and momentum, 18% to defensive, and 14% to carry. Its strategic risk allocations to each asset class are as follows: 30% to global stock selection, 20% each to equity markets and fixed income, and 15% each to currencies and commodities. There is a bias to the value and momentum styles, perhaps reflecting AQR’s greater confidence in and longer history with them. Risk allocations drift based on momentum and “style agreement,” where high-conviction positions are leveraged up relative to low-conviction positions. The strategy’s overall risk target falls in steps in the event of a drawdown and rises as losses are recouped. These overlays embody some of the hard-knock knowledge speculators have acquired over the decades: bet on your best ideas, cut losers and ride winners, and cut capital at risk when one is trading poorly. SPA targets a Sharpe ratio of 0.7 over a market cycle. AQR offers two flavors to the public: the 10% volatility-targeted AQR Style Premia Alternative Fund Inst (MUTF: QSPIX ) and the 5%-vol AQR Style Premia Alternative LV Fund Inst (MUTF: QSLIX ). Adviser AQR Capital Management, LLC, was founded in 1998 by a team of ex-Goldman Sachs quant investors led by Clifford S. Asness, David G. Kabiller, Robert J. Krail, and John M. Liew. AQR stands for Applied Quantitative Research. The firm’s bread and butter has long been trading value and momentum together, an idea Asness studied in his PhD dissertation at the University of Chicago. (Asness’s PhD advisor was none other than Eugene Fama, father of modern finance and one of the co-formulators of the efficient market hypothesis.) When the firm started up, it was hot. It had one of the biggest launches of any hedge fund up to that point. Then the dot-com bubble inflated. The widening gap in valuations between value and growth stocks almost sunk AQR. According to Asness , the firm was six months away from going out of business. When the bubble burst, the firm’s returns soared and so did its assets. The good times rolled until the financial crisis shredded its returns . Firm-wide assets from peak-to-trough went from $39.1 billion to $17.2 billion. The good times are back: As of June-end, AQR has $136.2 billion under management. The two near-death experiences have instilled in AQR a fear of concentrated business risks. In 2009, AQR began to diversify away from its flighty institutional clientele by launching mutual funds to entice stickier retail investors. The firm has also launched new strategies at a steady clip, including managed futures, risk parity, and global macro. AQR has a strong academic bent. Its leadership is sprinkled with economics and finance PhDs from top universities, particularly the University of Chicago. The firm has poached academics with strong publishing records, including Andrea Frazzini, Lasse Pedersen, and Tobias Moskowitz. Its researchers and leaders are still active in publishing papers. The firm’s principals are critical of hedge funds that charge high fees on strategies that are largely replicable. AQR’s business model is to offer up simplified quant versions of these strategies and charge relatively low fees. Managers Andrea Frazzini, Jacques A. Friedman, Ronen Israel, and Michael Katz. Frazzini was a finance professor at University of Chicago and a rising star before he joined AQR. He is now a principal on AQR’s Global Stock Selection team. Friedman is head of the Global Stock Selection team and worked at Goldman Sachs with the original founders prior to joining AQR. Israel is head of Global Alternative Premia and prior to AQR was a senior analyst at Quantitative Financial Strategies Inc. Katz leads AQR’s macro and fixed-income team. Frazzini is the most recognizable, as he has the fortune of having a last name that’s first in alphabetical order and publishing several influential studies in top finance journals, including ” Betting Against Beta ” with his colleague Lasse Pedersen. Unlisted is the intellectual godfather of SPA, Antti Ilmanen, a University of Chicago finance PhD who authored Expected Returns , an imposing but plainly-written tome that synthesizes the academic literature as it relates to money management. Though written years before SPA was conceived, Expected Returns can be read as an extended argument for an SPA-like strategy. Strategy capacity and closure AQR has a history of closing funds and ensuring its assets don’t overwhelm the capacity of its strategies. When the firm launched in 1998, it could have started with $2 billion but chose to manage only half of that, according to founding partner David Kabiller . Of its mutual funds, AQR has already closed its Multi-Strategy Alternative, Diversified Arbitrage and Risk Parity mutual funds. However, AQR will meet additional demand by launching additional funds that are tweaked to have more capacity. As of the end of 2014, AQR reported a little over $3 billion in its SPA composite return record. Given the strategy’s strong recent returns, assets have almost certainly grown through capital appreciation and inflows. Because AQR uses many of the same models or signals in different formats and even in different strategies, the effective amount of capital dedicated to at least some components of SPA’s strategy is higher than the amount reported by AQR. Management’s stake in the fund As of Dec. 31, 2014, the strategy’s managers had no assets in the low-volatility SPA fund and little in the standard-volatility SPA fund. One trustee had less than $50,000 in QSPIX. Collectively, the managers had $170,004 to $700,000 in the SPA mutual funds. Although these are piddling amounts compared to the millions the managers make every year, the SPA strategy is tax inefficient. If the managers wanted significant exposure to the strategies, they would probably do so through the partnerships AQR offers to high-net-worth investors. But would they do that? AQR, like most quant shops, attempts to scarf down as much as possible the “free lunch” of diversification. The managers are well aware that their human capital is tied to AQR’s success and so they would probably not want to concentrate too heavily in its potent leveraged strategies. Opening date QSPIX opened on October 30, 2013. QSLIX opened on September 17, 2014. The live performance composite began on September 1, 2012. Minimum investment The minimum investment varies depending on share class, broker-dealer and channel. For individual investors, a Fidelity IRA offers the lowest hurdle: a mere $2,500 for the I share class of the normal and low-volatility flavors of SPA. Or you can get access through an advisor. Otherwise, the hurdles are steep: $5 million for the I class, $1 million for the N class, and $50 million for the R6 class. Expense ratio The I class for the normal and low-volatility versions cost 1.50% and 0.85%, respectively. The N classes costs 0.25% more and the R6 classes costs 0.10% less. The per-unit price of exposure to SPA is lower the higher the volatility of the strategy. QSPIX targets 10% vol and costs 1.5%. QSLIX targets 5% vol and costs 0.85%. Anyone can replicate a position in QSLIX by simply halving the amount invested in QSPIX and putting the rest in cash. The effective expense ratio of a half QSPIX, half cash clone strategy is 0.75%. Comments Among right-thinking passive investors who count fees by the basis point, AQR’s SPA strategy elicits revulsion. It’s expensive, leveraged, complicated, hard to understand, and did I mention expensive? To make the strategy easier to swallow, some passive-investing advocates argue SPA is “passive” because it’s transparent, systematic, and involves no discretionary stock selection or market forecasting. This definition is not universally accepted by academics, or even by AQR. The purer, technical definition of passive investing is a strategy that replicates market weightings, and indeed this definition is used by the venerable William Sharpe in his famous essay, ” The Arithmetic of Active Management .” I do not think SPA is passive in any widely understood sense of the word. In fact, I think it’s about as active as you can get within a mutual fund. And I also happen to think SPA is a great fund. Regardless of my warm feelings for the strategy, I consider SPA suitable only for a rare kind of nerd, not the investing public. Though SPA is aggressively active, its intellectual roots dig deep into the foundations of financial theory that underpin what are commonly thought to be “passive” strategies, particularly value- and size-tilted stock portfolios (DFA has made a big business selling them). The nerds among you will have quickly caught on that what AQR calls a style is nothing more than a factor, a decades-old idea that sprung from academic finance. For the non-nerds: A factor, loosely speaking, is a fundamental building block that explains asset returns. Most stocks move together, as if their crescendos and diminuendos were orchestrated by the hand of some invisible conductor. This co-movement is attributed to the equity market factor. According to factor theory, a factor generates a positive excess return called a premium as reward for the distinct risk it represents. It is now widely agreed that two factors pervade virtually all markets: value and momentum (size has long been criticized as weak). AQR’s researchers – including some of the leading lights in finance – argue there are two more: carry and defensive. They’ve marshalled data and theoretical arguments that share an uncanny family resemblance with the data and arguments marshalled to justify the size and value factors. The SPA strategy is a potent distillation of the factor-theoretical approach to investing. If you believe the methods that produced the research demonstrating the value and size effects are sound, then you have to admit that those same tools applied to different data sets may yield more factors that can be harvested. OK, I’ve blasted you with theory. On to more practical matters. Who should invest in this fund? Investors who believe active management can produce market-beating results and are willing to run some unusual but controllable risks. How much capital should one dedicate to it? Depends on how much you trust the strategy, the managers, and so on. I personally would invest up to 30% of my personal money in the fund (and may do so soon!), but that’s only because I have a high taste for unconventionality, decades of earnings ahead of me, high conviction in the strategy and people, and a pessimistic view of competing options (other alternatives as well as conventional stocks and bonds). Swedroe, on the other hand, says he has 3% of his portfolio in it. How should it be assessed? At a minimum, an alternative has to produce positive excess returns that are uncorrelated to the returns of conventional portfolios to be worthwhile. However, AQR is making a rather bold claim: It has identified four distinct strategies that produce decent returns on a standalone basis and are both largely uncorrelated with each other and conventional portfolios. When combined and leveraged, the resulting portfolio is expected to produce a much steadier stream of positive returns, also uncorrelated with conventional portfolios. So far, the strategy is working as advertised. Returns have been good and uncorrelated. In back-tests, the strategy only really suffered during the dot-com bubble and the financial crisis. Even then, returns weren’t horrendous. Is AQR’s 0.7 Sharpe ratio target reasonable? I think so, but I would be ecstatic with 0.5. What are its major risks? Aside from leverage, counterparty, operational, credit, etc., I worry about a repeat of the quant meltdown of August 2007. It’s thought that a long-short hedge fund suddenly liquidated its positions then. Because many hedge funds dynamically adjust their positions based on recent volatility and returns, the sudden price movements induced by the liquidation set off a self-reinforcing cycle where more and more hedge funds cut the same positions. The stampede to the exits resulted in huge and sudden losses. However, the terror was short-lived. The funds that sold out lost a lot of money; the funds that held onto their positions looked fine by month-end. AQR is cognizant of this risk and so keeps its holdings liquid and doesn’t go overboard with the leverage. However, it is hard for outsiders to assess whether AQR is doing enough to mitigate this risk. I think they are, because I trust AQR’s people, but I’m well aware that I could be wrong. Bottom line One of the best alternative funds available to mutual-fund investors.

Misconceptions About Banks (And A Glance At Wells Fargo)

Summary The banking industry is very durable and predictable. Deposit growth tends to follow GDP growth. Over the last 20 years, total deposits of all FDIC-insured institutions compounded 6.2% annually. There aren’t many businesses that have high-single digit growth forever. But that’s very possible for good banks. The key for investors is to avoid banks that rely on borrowings other than deposits. Overall, banks that have stable funding sources and that make inherently lower risk loans can be very safe. By Quan Hoang I came to the U.S. in the fall of 2008. It was a turbulent time when I read about bankruptcies or about “too big to fail” banks almost every morning. As a new student of economics and value investing, I developed an ingrained prejudice against banks in this abnormal period. Like most casual observers, I thought that banking is a risky business because of high leverage. Business cycle is inevitable and a small mistake can be magnified into big losses. So, I’d better stay away from banks. Geoff asked me to look at several banks over the years. No bank was good enough to change my preconception. But some did recently. I spent the last 3 months researching banks. I realized that there are good banks and bad banks. Some have more stable funding sources than others. Some banks focus on inherently safe loans more than others. It’s not impossible to understand some banks. In this post, I will discuss why some banks can be a great long-term investment. I will also discuss what I like and don’t like about Wells Fargo. Good Banks Can Grow Profitably for Many Years The banking industry is very durable and predictable. Deposit growth tends to follow GDP growth. Over the last 20 years, total deposits of all FDIC-insured institutions compounded 6.2% annually. Good banks can do better than that. The long-term trend is that there are fewer and fewer banks. The total number of FDIC-insured institutions declined from 11,970 in 1995 to 6,509 in 2014. That means deposits per bank can grow faster than GDP growth. The group of banks with more than $10 billion in assets grew much faster than groups with fewer assets. That can be explained by acquisitions. But the fact is that in most local markets, the top 5, 10, or 15 banks as a group tend to increase total market share over time. So, a durable bank can have a high chance of growing more than 5-6% organically. There aren’t many businesses that have high-single digit growth forever. But that’s very possible for good banks. The banking industry has lower costs than other types of lenders. Banks get funding from noninterest-bearing deposits, interest-bearing deposits, and other interest-bearing liabilities. The rates banks pay for interest-bearing deposits and other liabilities is very stable as a fraction of the Federal Fund Rates (FFR). For example, the cost of interest-bearing deposits for most banks is between 60% and 90% of FFR. Some deposits are more expensive than others. For example, the cost of money market account can be 70% of FFR, and the cost of time deposits can be 90% of FFR. The total cost of funding for banks is usually lower than FFR. The estimated cost of funding as % of FFR for some banks I looked at is: Frost (NYSE: CFR ): 42% Commerce Bancshares (NASDAQ: CBSH ): 48% First Financial: 49% Prosperity Bancshares (NYSE: PB ): 53% BOK Financial (NASDAQ: BOKF ): 59% Wells Fargo (NYSE: WFC ): 64% U.S. Bancorp (NYSE: USB ): 67% The industry data isn’t available but these are banks with lower-than-average funding. We can assume that cost of funding for the industry isn’t far from 80% of FFR. So, if FFR is 3%, the cost of funding is 2.4%. The average net operating cost of banks with $1 billion to $10 billion in assets is 1.8%, and of banks with more than $10 billion in assets is 1.1%. These two groups are representative of the industry because banks with $1 billion to $10 billion of assets hold 10% of total industry deposit, and banks with more than $10 billion in assets hold 80% of total industry deposit. So, the industry’s average net operating cost is less than 1.5%. That means the industry’s total cost of money is less than 4% if FFR is 3%. That’s lower than risk-free rates and is surely lower than the required rate of return for most money market funds or bond funds. So, the banking industry has lower cost than other lenders. But strong rivalry among banks forces yields to go up and down along with the cost of funding. Therefore, the industry’s net interest spread, defined as yield minus cost of funding, was very stable at about 3.5%, as shown in the following graph: (click to enlarge) The U.S. banking industry’s net interest margin had a fairly stable tendency to be about 3.5% from 1999-2014. Good banks can make 15-20% after-tax ROE. For example, Wells Fargo’s total cost is about 2.5% of total asset assuming 3% FFR. That means a very modest yield of 4% can result in 1.5% pre-tax return on earning assets. With 10x leverage, ROE will be 15% pre-tax and 10% after-tax. A normal yield of 6% results in 3.5% pre-tax return on earning assets or 23% after-tax ROE. FFR can go up and down, but Wells Fargo tends to maintain at least 1% cost advantage over the industry. That means Wells Fargo’s ROA is always at least 1% more than the industry’s average ROA. That guarantees an above-average ROE. Some Banks Have Low Risk The main argument against banks is leverage. But not all liabilities are equal. Deposits are not debt. Deposits are more like insurance float. Even better, deposits tend to increase a lot in financial crises because people want to conserve cash. Some good banks are considered “safe havens” and thus gain deposit market share in bad times. Short-term liabilities are what cause liquidity problems. Many banks rely on commercial paper or repo. According to a McKinsey report, deposits were just 49% of liabilities of U.S. banks in 2012. Commercial paper, repo, senior debt, and other liabilities made up 39% of liabilities. So, these banks can have big trouble in renewing short-term borrowings in a crisis. That’s very different from a bank like Frost whose deposits represent 96% of total liabilities. So, the inherent risk in banking is liquidity. The key for investors is to avoid banks that rely on borrowings other than deposits. Regulators watch some capital ratios but banks with a lot of short-term borrowing could still face liquidity problems in a crisis even if they have a lot of tangible equity to assets. Quality of funding sources is more important than capital ratios. Banks that rely on deposits for most of their funding are very safe. They won’t have a liquidity problem even if they incur some loan losses. However, banks have to maintain regulatory capital ratios. So, it’s important to avoid loan losses. I found that loans have different risk profiles. For example, consumer loans tend to have more losses – offset by higher yield – than business loans. That’s perhaps because of government programs that encourage lending to home buyers or students. Among business loans, commercial real estate (CRE) loans tend to have more losses than commercial & industrial (C&I) loans. That’s because there is more speculation in real estate development than in other industry. So, the types of loans a bank makes are as important as a conservative culture in minimizing losses. For example, it’s widely accepted that Wells Fargo has conservative lending. Yet, its average net charge-offs over the last 20 years was 1.09%. That’s way higher than Frost’s 0.48% or BOK Financial’s 0.27%. Frost and BOK make much fewer consumer loans than Wells Fargo. Overall, banks that have stable funding sources and that make inherently lower risk loans can be very safe. I propose a checklist for good banks: 1. High deposits/liabilities ( 80% or more) 2. High noninterest-bearing deposits/total deposits ( 30% or more) 3. Low operating cost ( 1% or less) 4. High C&I loans/Total loans ( 60% or more) My View on Wells Fargo When I first looked at Wells Fargo, I thought that it can make $60 billion pre-tax earnings. The idea was simple. The median net interest income/earning asset from 1991 to 2014 was 4.45%. Net operating cost was 0.57% in 2014. Net operating cost has been declining over time, so it makes sense to use the latest number instead of the past median number. So, Wells Fargo can make 4.45% – 0.57% = 3.88% pre-tax return on earning assets (ROEA). As of the last quarter, Wells Fargo had $1.55 trillion in earning assets. $1.55 trillion times 3.88% equals to $60 billion. Another approach gives a similar result. Wells Fargo’s cost of interest-bearing liabilities as a % of FFR was stable at about 88% with a variation of 0.20. Wells Fargo’s net interest spread, defined as yield minus cost of interest-bearing liabilities, was very stable at about 4.52% with a variation of 0.13. So, at a normal 3% FFR, cost of interest-bearing liabilities would be 3% * 88% = 2.64% , and yield would be 2.64% + 4.52% = 7.16% . Free funding sources are 27% of total earning assets, so weighted average net interest spread is 5.23% (= 27% * 7.16% + 73% * 4.52%). Subtracting net interest spread by 0.84% average net charge-offs/earning assets and 0.57% net operating cost results in 3.82% pre-tax ROEA. That implies $59 billion pre-tax income. Wells Fargo’s current market cap is $275 billion. So, Wells Fargo is trading at only 4.6 times normal pre-tax earnings. That makes Wells Fargo the cheapest bank I’ve ever seen. Even if it takes 10 years for Wells Fargo to make a normal 3.82% ROEA, investors can still make 13% annual return based on today’s price. Assuming 5% growth, Wells Fargo would have $2,520 billion earning assets in 2025. Applying 3.82% ROEA results in $96 billion pre-tax earnings. That’s 10.6% annual growth from last year’s $35 billion pre-tax earnings. Adding 2.8% dividend yields results in 13.4% annual return. There can be also some multiple expansion and share buyback. Wells Fargo has characteristics that I like. It has a low cost of funding. Noninterest-bearing deposits are 32% of total deposits. Noninterest-bearing deposits are only 20-25% of total deposits at most banks. It has an extremely low net operating cost of 0.57%. That’s the lowest I’ve ever seen. I looked at about 50 publicly traded regional banks and most have between 1.6% and 3.3% net operating cost. Wells Fargo has low net operating costs, thanks to cross-selling. For example, its retail bank cross sells on average 6.17 products per household. That generates a lot of fee income. Wells Fargo has strong consumer brand awareness. All national banks have this advantage but Wells Fargo is better at cross-selling than any other bank. It’s likely that Wells Fargo can gain market share over time. In other words, it can grow deposits by more than 5% annually. Wells Fargo is conservative. For example, it exited subprime lending in 2004. Most of its problems during the Great Recession were related to the loans acquired from Wachovia. Its lowest pre-provision earnings before tax (2.43% in 2014) covers 1.4 times the highest net charge-offs (1.76% in 2010.) But there are things I don’t like about Wells Fargo. Wells Fargo is very big in mortgages. The mortgage origination business is okay. This business requires scale and Wells Fargo funds one out of every three home loans in the U.S. The problem is that it retains about 10% of the loans it makes. Mortgage loans are 21% of earning assets. I’m not comfortable with these loans. There are some adjustable-rate mortgages (ARM). Can customers afford interest expenses of these loans if interest rates increase? It’s likely that loans made after 2008 are very safe. Mortgage loans have been so restricted after The Great Recession. For example, total mortgage credit availability index was just 125.5 in July 2015 compared to almost 900 in July 2006. Regardless, a higher interest rate is still a concern for ARM. Fixed mortgage loan can limit upside. Consumers took advantage of the low interest rates to refinance mortgage loans. So, Wells Fargo may have to carry a low yield portfolio for a while. For example, the yield on 1-4 family first mortgages was 4.19% in 2014, which is way lower than 7.27% in 2006. The securities portfolio is another concern. Securities totaled $322 billion or about 21% of total earning assets. Mortgage-backed securities (MBS) totaled $124 billion. Wells Fargo expects the value of MBS to decline by $8.2 billion if interest rates increase by 2%. It doesn’t give the same expectation for the whole securities portfolio. But it can possibly lose over $35 billion if interest rates increase by 3%. This is just a paper loss. The weighted-average expected maturity of securities available for sale was just 6.6 years. So, Wells Fargo can hold these securities until maturity and incur no actual loss. This potential loss is only relevant because of regulatory capital ratios. Basel III requires banks with more than $250 billion assets to include marked-to-market gains or losses in the calculation of capital ratio. Assuming a $40 billion loss, tier I ratio would be 7.6%, which is well above the requirement of 6%. Supplementary leverage ratio, which takes into account off-balance sheet exposures, would be 5.9%, which is higher than the required 5%. So, Wells Fargo passed my stress test. My last concern is that Wells Fargo is a “too big to fail” bank. Even if it will never have a liquidity issue, it can be forced by regulators to get a cash injection, resulting in share dilution. The book “Too Big to Fail” by Andrew Ross Sorkin tells the story about the protest of Wells Fargo’s CEO Kovacevich against the TARP: Dick Kovacevich, for one, was obviously not pleased to have been given this ultimatum. He had had to get on a flight-a commercial flight, no less-to Washington, a place he had always found contemptible, only to be told he would have to take money he thought he didn’t need from the government, in some godforsaken effort to save all these other cowboys? “I’m not one of you New York guys with your fancy products. Why am I in this room, talking about bailing you out?” he asked derisively.” And Henry Paulson responded with a threat of a regulatory crackdown: You’re going to get a call tomorrow telling you you’re undercapitalized and that you won’t be able to raise money in the private markets.” Well Fargo is a good bank. It’s very cheap. But it’s too big. Its loan portfolio is too complicated. And it gets too much attention from regulators. Many people follow the stock. They may know things that I don’t know about Wells Fargo. So, I prefer smaller banks that have a simpler balance sheet.

TCW/Gargoyle Hedged Value, September 2015

By David Objective and strategy TCW/Gargoyle Hedged Value seeks long-term capital appreciation while exposing investors to less risk than broad stock market indices. The strategy is to hold a diversified portfolio mid- to large-cap value stocks, mostly domestic, and to hedge part of the stock market risk by selling a blend of index call options. In theory, the mix will allow investors to enjoy most of the market’s upside while being buffered for a fair chunk of its downside. Adviser TCW. TCW, based in Los Angeles, was founded in 1971 as Trust Company of the West. About $140 billion of that are in fixed income assets. The Carlyle Group owns about 60% of the adviser while TCW’s employees own the remainder. They advise 22 TCW funds, as well as nine Metropolitan West funds with a new series of TCW Alternative funds in registration. As of June 30, 2015, the firm had about $180 billion in AUM; of that, $18 billion resides in TCW funds and $76 billion in the mostly fixed-income MetWest funds. Manager Joshua B. Parker and Alan Salzbank. Messrs. Parker and Salzbank are the Managing Partners of Gargoyle Investment Advisor, LLC. They were the architects of the combined strategy and managed the hedge fund which became RiverPark/Gargoyle, and now TCW/Gargoyle, and also oversee about a half billion in separate accounts. Mr. Parker, a securities lawyer by training is also an internationally competitive bridge player (Gates, Buffett, Parker…) and there’s some reason to believe that the habits of mind that make for successful bridge play also makes for successful options trading. They both have over three decades of experience and all of the investment folks who support them at Gargoyle have at least 20 years of experience in the industry. Strategy capacity and closure The managers estimate that they could manage about $2 billion in the stock portion of the portfolio and a vastly greater sum in the large, liquid options market. TCW appears not to have any clear standards controlling fund closures. Active share “Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. Gargoyle has calculated the active share of the equity portion of the portfolio but is legally constrained from making that information public. Given the portfolio’s distinctive construction, it’s apt to be reasonably high. Management’s stake in the fund As of January 2014, the managers had $5 million invested in the strategy (including $500,000 in this fund). Gargoyle Partners and employees have over $10 million invested in the strategy. Opening date The strategy was originally embodied in a hedge fund which launched December 31, 1999. The hedge fund converted to a mutual fund on April 30, 2012. TCW adopted the RiverPark fund on June 26, 2015. Minimum investment $5000, reduced to $1000 for retirement accounts. There’s also an institutional share class (MUTF: TFHIX ) with a $1 million minimum and 1.25% expense ratio. Expense ratio 1.50%, after waivers, on assets of $74.5 million, as of July 2015. Comments Shakespeare was right. Juliet, the world’s most famously confused 13-year-old, decries the harm that a name can do: ‘Tis but thy name that is my enemy; Thou art thyself, though not a Montague. What’s Montague? it is nor hand, nor foot, Nor arm, nor face, nor any other part Belonging to a man. O, be some other name! What’s in a name? that which we call a rose By any other name would smell as sweet; So Romeo would, were he not Romeo call’d, Retain that dear perfection which he owes Without that title. Her point is clear: people react to the name, no matter how little sense that makes. In many ways, they make the same mistake with this fund. The word “hedged” as the first significant term of the name leads many people to think “low volatility,” “mild-mannered,” “market neutral” or something comparable. Those who understand the fund’s strategy recognize that it isn’t any of those things. The Gargoyle fund has two components. The fund combines an unleveraged long portfolio and a 50% short portfolio, for a steady market exposure of 50%. The portfolio rebalances between those strategies monthly, but monitors and trades its options portfolio “in real time” throughout the month. The long portfolio is 80-120 stocks, and stock selection is algorithmic. They screen the 1000 largest US stocks on four valuation criteria (price to book, earnings, cash flow and sales) and then assign a “J score” to each stock based on how its current valuation compares with (1) its historic valuation and (2) its industry peers’ valuation. They then buy the hundred most undervalued stocks, but maintain sector weightings that are close to the S&P 500’s. The options portfolio is index call options. At base, they’re selling insurance policies to nervous investors. Those policies pay an average premium of 2% per month and rise in value as the market falls. That 2% is a long-term average, during the market panic in the fall of 2008, their options were generating 8% per month in premiums. Why index calls? Two reasons: (1) they are systematically mispriced, and so they generate more profit (or suffer less of a loss) than they theoretically should. Apparently, anxious investors are not as price sensitive as they should be. In particular, these options are overpriced by about 35 basis points per month 88% of the time. For sellers such as Gargoyle, that means something like a 35 bps free lunch. Moreover, (2) selling calls on their individual stocks – that is, betting that the stocks in their long portfolio will fall – would reduce returns. They believe that their long portfolio is a collection of stocks superior to any index and so they don’t want to hedge away any of their stock-specific upside. By managing their options overlay, the team can react to changes in the extent to which their investors are exposed to the stock markets movements. At base, as they sell more index options, they reduce the degree to which the fund is exposed to the market. Their plan is to keep net market exposure somewhere in the range of 35-65%, with a 50% average and a healthy amount of income. On whole, the strategy works. The entire strategy has outperformed the S&P. Since inception, its returns have roughly doubled those of the S&P 500. It’s done so with modestly less volatility. Throughout, it has sort of clubbed its actively-managed long-short peers. More significantly, it has substantially outperformed the gargantuan Gateway Fund (MUTF: GATEX ). At $7.8 billion, Gateway is – for many institutions and advisors – the automatic go-to fund for an options-hedged portfolio. It’s not clear to me that it should be. Here’s the long-term performance of Gateway (green) versus Gargoyle (blue): Two things stand out: an initial investment in Gargoyle fifteen years ago would have returned more than twice as much as the same investment at the same time in Gateway (or the S&P 500). That outperformance is neither a fluke nor a one-time occurrence: Gargoyle leads Gateway over the past one, three, five, seven and ten-year periods as well. The second thing that stands out is Gargoyle’s weak performance in the 2008 crash. The fund’s maximum drawdown was 48%, between 10/07 and 03/09. The managers attribute that loss to the nature of the fund’s long portfolio: it buys stocks in badly dented companies when the price of the stock is even lower than the company’s dents would warrant. Unfortunately in the meltdown, those were the stocks people least wanted to own so they got killed. The fund’s discipline kept them from wavering: they stayed 100% invested and rebalanced monthly to buy more of the stocks that were cratering. The payback came in 2009 when they posted a 42% return against the S&P’s 26% and again in 2010 when they made 18% to the index’s 15%. The managers believe that ’08 was exceptional, and note that the strategy actually made money from 2000-02 when the market suffered from the bursting of the dot-com bubble. Morty Schaja, president of River Park Funds, notes that “We are going to have meltdowns in the future, but it is unlikely that they will play out the same way as it did 2008 . . . a market decline that is substantial but lasts a long time, would play better for Gargoyle that sells 1-2% option premium and therefore has that as a cushion every month as compared to a sudden drop in one quarter where they are more exposed. Similarly, a market decline that experiences movement from growth stocks to value stocks would benefit a Gargoyle, as compared to a 2008.” I concur. Just as the French obsession with avoiding a repeat of WW1 led to the disastrous decision to build the Maginot Line in the 1930s, so an investor’s obsession with avoiding “another ’08” will lead him badly astray. What about the ETF option? Josh and Alan anticipate clubbing the emerging bevy of buy-write ETFs. The guys identify two structural advantages they have over an ETF: (1) they buy stocks superior to those in broad indexes and (2) they manage their options portfolio moment by moment, while the ETF just sits and takes hits for 29 out of 30 days each month. There’s evidence that they’re right. The ETFs are largely based on the CBOE S&P Buy-Write Index (BXM). Between 2000 and 2012, the S&P 500 returned 24% and the BXM returned 52%; the options portion of the Gargoyle portfolio returned 110% while the long portfolio crushed the S&P. Nonetheless, investors need to know that returns are lumpy; it’s quite capable of beating the S&P 500 for three or four years in a row, and then trailing it for the next three or four. The fund’s returns are not highly correlated with the returns of the S&P 500; the fund may lose money when the index makes money, and vice versa. That’s true in the short term – it beat the S&P 500 during August’s turbulence but substantially trailed during the quieter July – as well as the long-term. All of that is driven by the fact that this is a fairly aggressive value portfolio. In years when value investing is out of favor and momentum rules the day, the fund will lag. Bottom line On average and over time, a value-oriented portfolio works. It outperforms growth-oriented portfolios and generally does so with lower volatility. On average and over time, an options overlay works and an actively-managed one works better. It generates substantial income and effectively buffers market volatility with modest loss of upside potential. There will always be periods, such as the rapidly rising market of the past several years, where their performance is merely solid rather than spectacular. That said, Messrs. Parker and Salzbank have been doing this and doing this well for decades. What’s the role of the fund in a portfolio? For the guys, it’s virtually 100% of their US equity exposure. In talking with investors, they discuss it as a substitute for a large-cap value investment; so if your asset allocation plan is 20% LCV, then you could profitably invest up to 20% of your portfolio in Gargoyle. Indeed, the record suggests “very profitably.”