Waratah Performance - A hedge fund that is only semi-crappy

Does Waratah Capital Advisors add any value?

Waratah Capital Advisors is a $1.5 billion investment firm with 34 staff dedicated to underperforming the S&P 500. The reason for this is, of course, the pursuit of "risk-adjusted returns", ie hedge fund strategies designed to lower volatility in order to cater to emotionally under-developed investors. I can empathize: for many years, I was also terrified of downturns and could not accept them as a necessary evil. Their flagship fund is Waratah Performance, I will focus my analysis on that.

Starting as I always do with an open mind, I have wavered between calling Waratah Performance semi-respectable and semi-crappy. As far as hedge funds go, Waratah Performance is not especially bad. I do believe its clients can do better, but they're not making a catastrophic mistake (of the type I described in my own story from two posts ago). What tipped the balance is that Waratah Performance ("WP") is failing by the standard it freely set for itself, which to me, signals a lot of things. At inception and for years afterward, the fund stated a performance objective of 15% annualized over five and ten year investment periods. Six months away from its 10 year anniversary, the fund is compounding at 10%. The fund now has changed its tune to "targeting 10% returns" - still an unsafe objective, in my view. If it did 10% in the conditions of the past 10 years, it seems unrealistic to aim for that going forward. Even though WP is a fund with relatively low market exposure, it nevertheless benefits from beta. I would venture to guess there will be less beta in the next 10 years.

I would be curious to find out how the goal-post shifting from 15% to 10% was explained to clients. Was there a lot of self-flagellation or was the change swept under the carpet? Stating an absolute return objective also betrays less than watertight thinking. What rational basis is there for coming up with such a return objective? Wouldn't it have to change as market conjunctures change? Are they saying they will deliver 10% annualized even if the market flatlines for the next 5 years? WP has no control over things like interest rates or market multiples, among other economic conditions, so how can it tie itself to a specific return target?

The reason I call WP only semi-crappy (by my standards, high praise) is that I think the track record since inception is defensible. The fund's other objective is "market-like returns with less volatility". The lower vol part is accomplished through a short book averaging around 34% since inception. The fund's 10% CAGR compares to 11.4% for a 50/50 blend of the S&P 500 and TSX Composite. I believe a long-term investor's benchmark should always be the S&P 500, but let's leave that aside. To make the comparison fairer for Waratah, I would risk-adjust the benchmark return for volatility. To adjust the volatility I will use worst drawdowns as weights. WP's worst drawdown was 13.1%. The benchmark's worst drawdown was 15.9%. An investor in the benchmark could have experienced the same drawdown as WP by putting 82% of his money in the benchmark (13.1/15.9). Such an investor would have gotten 9.35% returns instead of the full 11.4% returns. In addition, the benchmark investor would have had the option to invest the unallocated 18% in a risk-free asset, picking up some extra yield. Using this method, I calculate that WP has added 0.39% per year in value over the benchmark since inception, on a risk-adjusted basis. If standard deviation is your preferred vol measure, then WP's value add is around 1.2%. The reason I prefer drawdown as the measure is that it's the lived experience of volatility. People say: "I put $10k in this position and now it's worth $9k". I have never heard anyone say: "I put $10k in this position and I have experienced 12% standard deviation". The emotion comes from drawdowns. The fund's worst month was -7% vs -7.8% for the benchmark, which again shows that the downside profile of the fund is not that far from the benchmark.

Bottom line, the fund appears to add some value, if we adopt their suggested benchmark. The use of the TSX benchmark is problematic because it has lumpy components such as banks or materials and energy. But in any event, the alpha margin is too small for me to consider this a good product. With more assets and more competition, this alpha margin is also likely to deteriorate in future. This is, of course, a net of fees analysis. The fund charges typical 2 and 20 fees. This means that before fees, WP does appear to have added some more meaningful value. So clients bear the risk but get some crumbs of outperformance. If WP drops fees to a more reasonable 1%, then I would revise my opinion. Let's see how much clout I have accrued so far.

Investors experience other emotions in relation to their fund investments. This fund had a strong first 6 months to start (up 22.5% in the 2nd half of 2010). How would you have felt about then spending 9 years compounding at 8%? Not only was this below the fund's stated objective (then or now) in fairly bullish conditions, but it's a significant opportunity cost vs the S&P 500's compound rate of 13% (with dividends reinvested). The last 5 years, the compound rate is 6.8%. So you would have to spend all this time having faith that this sacrifice will be worthwhile, when the market eventually experiences a serious downturn. I still prefer the long-only investor's plan to make hay while the sun shines and to use the excess hay to absorb any losses during bear markets.

I can sense that WP is prepared for a bear market, whether from portfolio manager Brad Dunkley's thoughts on Twitter or the fact that the fund was up 1.7% in 2018, a losing year for most long investors. But I think gambling that years of underperformance (vs a simple long-only portfolio) will be heroically made up during a bear market is a bad bet. Undeterred by their original funds routinely falling short of stated performance objectives, the firm has expanded into new strategies, including lithium mining royalties and land. They have launched an "Alternative Mutual Fund" product (aka liquid alts), so that the retail investor may benefit from all this talent. But that fund seems to have only attracted about $5m in assets. Yet another sign that the retail investor is getting wiser and leaving these "sophisticated" products to the Yorkville crowd. I might have more to say about Waratah later on.

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