Many of our clients hold two funds managed by Gotham funds – Gotham Enhanced Return (GENIX) and Gotham Neutral (GONIX). Both funds lost money in 2015, and in prior blog posts I discussed my thought process for continuing to hold the funds. Recently, one of my brightest clients posed this question to me regarding these funds, “Why am I still invested in funds that are losing money when the overall market is up”? After realizing that this was not a rhetorical question, I thought I would try to provide an answer in this blog post.
Review of Strategy
In my post titled “Thoughts of an Investment Advisor – 2nd Quarter 2015 Part 3”, I described Gotham’s methodology and strategy in detail. To summarize, Gotham values the largest 3,000 US stocks and ranks them from most overvalued to most undervalued. In their valuation analysis, they consider free cash flow (cash left in the company after paying for operations, asset purchases, loan payments and dividends), relative value to other stocks and historic value.
GONIX is structured as a market neutral fund. The managers buy the 300 stocks that are most undervalued and sell short the 300 stocks that are most overvalued. The theory of the fund is that over time the market will reward the undervalued stocks which will increase in value and punish the overvalued stocks which will decrease in value.
GENIX is structured as a "net long" fund. Part of the fund holds undervalued stocks and part of the fund uses the market neutral strategy.
Looking in the Rear View Mirror
Both GONIX and GENIX began their investing careers as hedge funds in July 2009. The hedge funds were converted to mutual funds in June of 2013. We have the historical monthly returns of the strategies since inception. The charts below were created by combining the returns for the hedge fund years with the returns since GONIX and GENIX became mutual funds. We compared GENIX returns with the S&P 500 and GONIX returns with the bond market, as represented by the Vanguard Total Bond Market ETF, BND.
Even with the losses from 2015, each fund has handily outperformed its benchmark since mid-2009. Most actively managed mutual funds outperform or underperform based on the manager’s stock picking ability. Gotham’s performance, however, is much more tied to its methodology described above. It is possible that the methodology has quit working after six and a half years and it is time to move on. We need to explore what went wrong in 2015 and then make a judgement call on what the future might hold.
The Gotham Hedged Value 140/40 hedge fund was introduced in July 2009. In June of 2013, the fund closed and was reopened as Gotham Enhanced Return mutual fund (GENIX). The chart above includes monthly total returns from the Hedge Value 140/40 from July 2009 – June 2013.
The Gotham Neutral strategies hedge fund was introduced in July 2009. In June of 2013, the fund closed and was reopened as Gotham Market Neutral mutual fund (GONIX). The chart above includes monthly total returns from the Market Neutral Strategies from July 2009 – June 2013.
What Happened in 2015?
Every fund and investment style can do poorly when certain conditions are present. For example, in 1998, large-cap tech stocks (Dell, Microsoft, AOL) were dominating the markets. The S&P 500, which represents large stocks, increased 28.58% that year while the Russell 2000, which represents small-cap stocks, lost 2.54%. At any given time, between its long and short positions, Gotham is dealing with 600 stocks with roughly equal weighting. If most of the return in the market is generated by only a few stocks, Gotham’s broad based style could be a negative factor regarding its returns. In addition, Gotham is long deep value stocks and short speculative momentum stocks. If speculative stocks do well (Netflix, Amazon) and value stocks do poorly (oil stocks, industrial stocks), Gotham’s returns could be weak.
The Russell Company has created indexes for small-cap, mid-cap and large-cap stocks in many different flavors. They have indexes that are capitalization weighted (more weight is given to larger stocks in each size category), equal weighted (each stock in a size category has an equal weighting), and style segregated (“pure growth” stocks and “pure value” stocks in each size category). Using these indexes we can measure the factors that could cause Gotham to lose money. I calculated the difference in returns for each size category and marked the years where the cap-weighted returns exceeded the equal weighted returns by more than 20% and the pure growth returns exceeded the pure value returns by more than 20%.
As you can see, 2015 was the only year in the last ten years where all the negative factors affecting Gotham's methodology were present. In every size category, speculative stocks greatly outperformed value stocks and returns were skewed to the few larger stocks versus the majority of stocks.
Back to the Future
The Gotham team has spent years developing their valuation methodology. Their strategy of buying undervalued, cash rich companies and selling short speculative, cash poor companies has worked well in the past. The results from 2015 were an aberration caused by a market environment that existed one year out of the past ten. I believe that diversification goes beyond owning different types of investments. I think owning different investment approaches is also important. Gotham’s approach differs significantly from most “long only” mutual funds. In down markets their strategy acts as a hedge against the losses of other investments in an allocation. While the losses in the Gotham funds in 2015 were painful, I expect their outperformance of the past to resume in future years.
I encourage you to read Joel Greenblatt and Robert Goldstein’s most recent letter to investors. Please click on the following link: https://www.gothamfunds.com/uploadfiles/703cc3ee-c.pdf