Thoughts of an Investment Advisor - 2nd Quarter 2015 - Part 2

Looking back on the year so far, two of our funds come to mind.  T Rowe Price Capital Appreciation, a balanced fund that owns stocks and bonds is running on all cylinders.  Gotham Neutral Institutional, a long-short fund is having serious difficulties.  Capital Appreciation is one of the best balanced funds around.  It is in the top 1% of balanced funds for the 1 year, 3 year, 5 year and 10 year periods.  Its 10 year annualized return is 9%, which is higher than the category average by 2.44% per year and higher than the S&P 500 return by over 1% per year.  Through 6/30, the fund is up 3.71% versus the S&P 500 which is up 1.23% and the bond market overall which is down 0.3%.  The manager of the fund, David Giroux, is a whiz kid who is only 38 years old but has run the fund for nine years.  He is currently very cautious of the equity markets and is holding 10% cash and a large weighting of short-term bonds.

Gotham Neutral uses a strategy that balances long positions with short positions so that the fund is “market neutral”.  (When you short a stock, you make money if the stock declines in value.)  If its long positions perform better than its short positions, the fund makes money.  Most market neutral funds make big bets on a few stocks on both the long and short side.  Gotham, however, is long around 300 stocks and short around 300 stocks.  They use a disciplined approach to sector selection so that no sector is over represented.  The strategy was first used by Gotham in a hedge fund and then a mutual fund was created in September 2013.  Here are historical returns from combining the history of the hedge fund and the mutual fund:

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The managers of this fund, Joel Greenblatt and Robert Goldstein have many years of experience managing both hedge funds and mutual funds and an excellent record of performance.  So, what explains this year’s terrible returns?  In discussions with the fund, the basic problem is that the short positions, which should be going down, are instead rising in value.  The managers attribute this to the fact that the market is overvalued and continues to reward lower quality companies with higher and higher prices.  (From my meetings with the fund companies, Goldman, Blackrock and T Rowe Price all feel the same way about valuations.)

So, now I have to make a decision about Gotham Neutral.  Do I continue to hold it for my clients or do I sell it?  This is one of those questions that has no obvious right or wrong answer.  On the one hand, if there is a correction or the market becomes less overvalued, the fund should increase in value and act as a hedge against other investments that might decline.  On the other hand, it is possible that the strategy itself is broken and what has worked in the past will no longer work.  I have not made a final decision yet.  There is a conference call in a couple of weeks and I will learn more about the managers’ thoughts.  Feel free to email me your opinion.