MY INTERVIEW WITH MICHAEL JARZYNA
OF STONE TORO INVESTMENT ADVISERS, LLC, AN ASSET MANAGER PARTNER OF ELYSIAN CAPITAL MARKETS GROUP, LLC
By John Harline | March 19, 2015
Everyday appears to be anyone’s guess. The capital markets around the world seem to be reaching for the light, as they have been blinded by data that has guided them for decades. The state of our current economy leaves us asking even more questions. When will the six-year bull market end? When will the Federal Reserve decide to raise interest rates? Are the increasing international and emerging markets destined for a fall? Is it just a time to lock-in wealth and play defense for a while?
Whatever the event, or cause, there could be a correction that could affect investors worldwide. The real question on the minds of these investors is how they can reduce the impact of such a correction. There has been a growing interest in alternative strategies, especially those that have been derived from hedge funds, and their potential protection against dramatic downturns in equity and fixed income markets.
We had a recent conversation with Michael Jarzyna, CFA, the Chief Investment Officer and a founding member of Stone Toro Investment Advisers, LLC. Mike manages the Stone Toro Long/Short Fund, a mutual fund registered under Investment Company Act of 1940. In the discussion below, Mike gives us an in-depth look at the value of alternative strategies in the current capital market environment, what we could possibly expect from a return standpoint, and the effect of the documented 7-year cycle on Growth and Value stocks, which could be utilized to help diversify a portfolio within Stone Toro’s Long/Short Investment Strategy.
Question: Given the changing nature of capital markets, how might alternative strategies help meet a portfolios goal?
Mike: This is a question I get most often from advisors and investors alike. My answer remains primarily the same and starts with basic portfolio construction and how it is enhanced when non-correlated assets are added to a portfolio. What I mean technically is that when the total portfolio standard deviation (Standard deviation is the up and down movement of an investments return also known as return volatility)is reduced, by potentially adding non-correlated assets, the expected return of a portfolio can be enhanced, especially during periods of market downturns.
This is typically described through the Markowitz Framework, or Modern Portfolio Theory, or the MPT Framework. The MPT plots the return, per unit of risk, in a portfolio. Thus, by adding the alternative non-correlated assets, the return per unit of risk tend to increase.
Source: StoneToro Investment Management. The above hypothetical example is being provided for illustrative purposes only. There is no guarantee of future results. Benchmarks include the MSCI All Country World Index (ACWI), S&P 500 and the CRSP US 10 Year Treasury Constant Maturity Index(Center for Research in Security Prices index based on the average yield of a range of Treasury securities, all adjusted to the equivalent of a 10-year maturity.). The blend of each benchmark is as follows:
Conservative: 20% S&P 500, 20% MSCI and 60% CRSP US 10 Year Treasury Constant Maturity Index
Moderate: 37.5% S&P 500, 37.5% MSCI and 25% CRSP US 10 Year Treasury Constant Maturity Index
The next question then becomes, how much of a portfolio should be allocated to alternatives, for optimal benefit? This is where we get into a little bit of history. Traditionally, pure alternative strategies have not been available to the retail client. They have only been available to the institutional client, like pensions and endowments for example. If you look at their allocations to alternatives, particularly within endowments, about 10 to 15 years ago, they start at 50% of the portfolio. That percentage has increased, even through the financial crisis of 2008/2009. They understand the power of non-correlated assets. The best way to display this is an analysis within the Markowitz Framework. Markowitz is considered one of the early authors of Modern Portfolio Theory which is sometimes referred to as Markowitz portfolio theory (MPT).Markowitz Portfolio Theory is the theory of finance that attempts to maximize a portfolios expected return for a given amount of portfolio risk. (See graph above.)
The endowment, moving to a 60% allocation, on average, over the past couple of years, really speaks to the power of portfolio construction with alternative inclusion. The big issue, of course, has been the retail investor.
So how does the retail investor get non-correlated assets into their portfolio? The retail investor can get thousands of different flavors of beta,(Beta describes market or systematic risk) but historically, they could not get something that is not correlated to beta. This, for the most part, has only been available within a limited partnership, and in order to be eligible for this investment strategy, an investor needed to have a specific net worth, which eluded most retail investors.
Thus, over the past several years, you have seen the commoditization of hedge fund strategies; that is, the transitioning of non-correlated investment strategies into the ’40-Act retail world. It is the classic business cycle, where profitability decreases in a specialized population, as the idea is spread to the mass market, and we are at this point right now with these investment strategies.
However, there are some issues. The ‘40 Act rules and regulations have some restrictions, which apply to the amount of leverage that can be used, and regarding the use of illiquid assets, which are difficult to price daily. Therefore, highly-levered strategies which are greater than 300% gross, will not be appropriate, or fall within the regulations of the ‘40-Act world. The use of illiquid asset strategies will be minimized or eliminated altogether.
Certainly, there are those strategies that can fit into the ’40-Act world. Most of the Long/Short, Market Neutral and Global Macro strategies can be modified on the margin in order to fit into the ’40-Act regulatory rules. This is what we have done here at Stone Toro, taking a traditional hedge fund strategy and putting it into the ’40-Act structure, essentially a mirror from limited partnership strategies into a ’40 Act. This unique approach provides an investor with what we call a diversified and non-correlated investment premise. Over time, we believe this type of diversification could enhance the risk return characteristics of a portfolio, especially during times of negative markets.
Question: With respect to your unique approach to “ diversification,” how does Stone Toro’s Long/Short Investment Strategy differ from other Long/Short and 130/30 strategies and what are its advantages?
Mike: With respect to the population of Long/Short funds in the universe right now, the average Long/Short fund was likely created sometime in 2002, 2003 or 2004, as 130/30 funds. A 130/30 fund means that you are 130% long by 30% short, but you are still 100% net exposed to the market. Typically, shorting an index satisfies the 30% short. Thus, you don’t short actual stocks. The net result is that your correlation (Correlation is the tendency for two values or variables to change together) to the overall market is still very high and the only thing you’ve really done is levered your alpha-generating (Alpha, the excess return of the fund relative to the return of the benchmark or index) capabilities within a long portfolio. If you want to think about it that way, then most likely, your standard deviation is increased by the actual structure, which reduces your ultimate hedge during downturns. Thus, a 130/30 fund, with a 100% net exposure and a very high correlation to the market, for example 0.9, is not what anyone should or would call a true hedge fund. Anything that moves that closely to the market should really go in your beta basket. That is the legacy of the Long/Short mutual fund group today. Most of the funds come from the beta environment and behave like you would expect those funds to behave. For example, in 2012, the market was up 30%. These types of funds were, on average with a 0.9 net beta, up 27% or so. Ergo, no hedging there, whatsoever.
We have created an investment strategy to behave very differently than that group of 130/30 strategies and one that diversifies an investor’s portfolio. First off, the biggest difference for us is that we only run at 25% net exposure, instead of running at something close to 100%. Thus, we get to 25% net exposure by going 110% long by 85% short. The key is that our short exposure is generated by actually shorting individual stocks, instead of shorting an index. Thus, there is the ability to create positive alpha on the short side, as well as on the long side. When both sides are moving in the right way, or even when only one side is moving in the right way, the alpha generation can be quite significant.
Because our strategy is so different from the group, and because we only have 25% net exposure, and because our beta of the portfolio is essentially zero, we rarely get disturbed, frightened, or rattled by a market that can potentially be down by 2%, or 10% or even 20%, for that matter. On the flipside, when equity markets are soaring, we will not see similar upside returns. We believe this could be a real advantage for our investors because we rarely see any significant downward movement during these challenging market conditions. It is simply what a Long/Short strategy should be doing.
Question: What are some factors that go into your Long and Short selection process?
Mike: Great question. On the long side, we select stocks that are trading within the lower 20% of their historical relative valuation range and that pay a dividend, somewhere in the general neighborhood of 2%. On the short side, we select stocks that are trading in the upper 20% of their historical relative valuation range and that do not pay a dividend. There are a lot of other factors that go into the selection process, but that is a very quick overview.
It is important to have an understanding of the selection process which is illustrated above. There are factors and inherent biases that come out as a result of our selection process with the long and the short side. This type of investment approach can generally be called buying value. There are a whole host of factors. There are Value Factors, Capitalization Factors and Sector Factors. However, our bias on the long side is the Value Factor. Conversely, on the short side, our bias is a Growth Factor. As much as portfolio managers don’t want to admit that they have any factor biases within their portfolios, there inherent investment approach results in a typical long and short position, and these similar characteristics can be described as factors.
Question: How are these factor bets relevant with respect to Value and Growth?
Mike: If we take a 25-year look back at Growth v. Value, what you notice are 7-year cycles, more or less. In the very early 90’s, you have the tail end of a value cycle. Then the growth cycle begins to occur, culminating in the Internet Bubble. Thereafter, in early-2000 that is from the burst of the Internet Bubble through about the second quarter of 2007, you have a value cycle bias in the market for those seven years. Then, from about the second or third quarter of 2007 until today, you have a Pro-Growth Environment in the market. What we know is that these things have, over the past 25 years or so, run in approximately 7-year segments.
At the tail end of the 7-year cycle, which began in 1993 and ended in 2000, Growth outperformed Value by an approximate difference of 138. (138 is the difference between the S&P Growth and S&P Value indices as shown above) The Growth Cycle that we are currently experiencing is exactly as large as the previous pinnacle of the cycle, right around a difference of 138. I have done a lot of work studying the cause of these inflections, and although much of the cycle is driven by behavior, the magnitude of the difference likely signals a mean reversion.
Question: And the magnitude of the difference remains the same?
Mike: Yes, the magnitude of the move is the same. That is precisely the way to think about it. The difference between the 90’s Pro-Growth Cycle and today’s Pro-Growth Cycle is that when the 90’s Pro-Growth Cycle exploded in 1998 and 1999, we were able to achieve that 138 magnitude in a two-year time period. The current Growth Cycle has been much more moderate in terms of its rate of change. Even though the magnitude is the same between the two cycles, today’s rate of change is much less. Therefore, there has been a movement toward Growth and the rate of change has only really increased over the last 10 to12 months or so. As I said before, I have tried to do a lot of research into what causes movement from one to the other, and I have talked to a lot of clients and strategists on the sell side, and I actually don’t think anyone has an answer. I don’t believe anyone knows why institutional investors move from Growth to Value, or from Value to Growth. It is likely that a lot of it has to do with valuations, yield implications and risk aversion, one group appearing to be far too expensive relative to the other. Once institutions figure that out, there is a “herd” mentality. It is simply a pattern of behavior.
Question: If we shift to Stone Toro specifically, can you speak to the current performance of the Long / Short Investment Strategy?
Mike: From a timing standpoint, we launched to retail investors at the worst possible time for a “true” Long / Short Investment Strategy. The only other time period that would have been worse for a launch, would have been in the last quarter or two of 1999, which would have yielded the same Growth v. Value environment that we are currently experiencing. That being said, we feel really positive about where we are right now. We know, from a historical perspective, that once we hit the bottom of the Growth v. Value trade in March, 2000, a typical long/short strategy achieved solid returns during the next four years. In particular, the strategy averaged 35% per annum, on a net basis, as Value came in favor to Growth.
For us to have weathered these last 10 months, which was the second worst possible time period over the previous 25 years, and to be down where we are, is actually not bad at all.
The summer swoon was caused by our implicit factor bets, namely long yield and short momentum. In July, 2014, yield underperformed by the biggest gap than in the previous ten years. Unfortunately, it is difficult to choose a launch date that will always favor a strategy in its infancy.
Unlike the summer, this time period had two sharp negative market moves, one in October and the other in December. In October, the fund preserved capital as the market corrected over 5%. Such performance can again be seen in December as the market again corrected over 5%.
We will not be able to call with certainty when Growth vs. Value will reverse, but when the mean reversion trade occurs, we are poised to take advantage of it.
Question: With respect to the current Pro-Growth Cycle, how much longer can it continue at this pace?
Mike: Let’s be clear, our Long/Short strategy could perform well in growth cycles, but in a rapidly accelerating growth cycle like we are experiencing today or back in 1999, we tend to not do as well.
Speaking to this current growth cycle, it really is anybody’s guess at this point to when it will mean revert. One thing is evident, it cannot continue indefinitely, but no one knows for sure when it will revert. It’s quite a quandary for those of us watching intently. However, what I do know is that all of the earmarks for a Value Market are right here in front of us. For example, with respect to valuation, this market is very expensive. Stocks are more expensive today than in any time over the previous 10 years. They are definitely more expensive than they were in 2007, and we all know what happened in 2008. So, that is certainly one concern of ours.
The other thing is that the Fed, as we heard recently, could be ready to raise rates at some point in the future. I think the normalization of monetary policy could force a lot more rational capital investments among corporations. This risk on future capital investments may no longer look as appealing because corporations will soon have to pay higher interest rates in order to get the leverage that they need. This may impact the way investors and institutional investors, in particular, see the aspects of growth.
In a lot of ways, this feels a lot like 1999. Depending on what you are analyzing, stock valuations are within 20% of their relative highs. Once you strip out the technology piece, valuations today are very similar to 1999. As an example, just look at Blue Chip types of stocks. The valuation today is the same as it was in 1999.
This is clearly a warning. If we note that money is going to get a lot more expensive in the future, and that the environment over the past seven years is looking more artificial in nature, then it can be argued that the signs of concern are real. This is not the way the market is supposed to work. But, we had an unusual circumstance. We had a seven standard deviation event. The Fed did what it had to do in order to save the economy and stabilize the market. Although, it appears the time is approaching where both will need to stand on their own.
So, we see all of these factors in the future that suggest the market is going to get rational again. This supports a position where Value should be moving back into favor.
Question: The end of the 1990’s saw a surge in technological valuations and artificially elevated market levels, so much that when the bubble burst, the downside effect was dramatic, and not simply the result of a quantitative easing event. If we fast-forward to the present cycle, from 2009 to 2015, money has again been dramatically pumped in the financial economy, which has inflated valuations once more. Comparatively speaking, is it fair to assume that when something occurs to burst the current bubble (rising interest rates, perhaps), will the downside effect be as dramatic? Is this a fair comparison?
Mike: We think it is a fair comparison. We were inflated artificially in the early 1990’s, not because of a quantitative easing program, but because of a new paradigm, so to speak. The analysts back at that time told us that the old valuation metrics didn’t matter anymore — that nobody cared about earnings, and nobody cared about relative valuation / price to sales, etcetera. This new paradigm dictated that this new economy was to be inflated artificially through exuberance. Thus, we agree with you, what we have seen over the last seven years is artificial as well. In particular, if we just look over the last three years, capital markets and stocks and bonds have behaved unconventionally. When you take a look at what the equity markets have done on an annualized basis, we are on average 25% or so net return over the last three years.
We are historians, and if you look at the equity market historically, the average annual return is somewhere in the neighborhood of 8.5%. If you do the math, in order to get to that 8.5% average annual return, you are probably going to have to post something significantly less than 25% over the next couple of years in order to rebalance.
If you think about this in terms of a pendulum, which swings back and forth, its weight in gravity always pulls it back to its mean, just as in the normal distribution of a curve. Thus, as the law of averages would suggest, eventually the pendulum will fall back to the mean and the universe will rebalance. Likewise, there has to be some sort of dramatic event, given the current imbalance, which means the pendulum will eventually swing back in the opposite direction in order to pull the universe back to its mean. It’s just common sense.
Question: In the spirit of protecting portfolios from downside risk, what type of position should an investor have in a Long/Short Investment Strategy if they were going to look at reducing correlations within their portfolio? Do they need a 10% or 15% allocation to have an effective impact?
Mike: This is a great question. First of all, when we are talking about alternative investments, specifically non-correlated investments, in theory we are not talking about a single fund. We are talking about a host of funds that behave in a similar fashion. What is the proper allocation for that group of strategies? We have done a tremendous amount of work to try to answer that question. In order to get any real benefit, (decreased draw-downs of the portfolio, decreased standard deviation and increased return), we believe you may want to be allocated closer to 20%. If you only dip a toe in the water at 5% or 10%, it will likely be insignificant, and will not impact the downside effectively. I know that it can be a difficult answer for investors to digest, because it sounds like a big commitment. However, the closer the allocation gets to 20%, the effects of a lower exposure and correlation to equities may result in lower draw downs during corrections, which at this point in time, could be significant.
Question: If we parlay the recommended allocation back to the comments on endowments, which are 50% or 60% investment in alternatives, what is the breakdown of that 50%, between illiquid alternative investments and liquid alternative strategies?
Mike: That is another really good question. Unfortunately, a lot of the data that we have is not that granular. A good point of reference would be 35% as alternative strategy-related and the remaining 15% as illiquid alternative investments. This sounds about right in terms of the proportion of the hedge fund universe. However, aside from the illiquid alternative investments, most retail investors have the opportunity to mimic the alternative strategies utilized by endowments and institutions with what is available in the ’40 Act space. But to be clear, the decision to use alternative strategies depends on the level of risk an investor feels comfortable with.
Question: So, where appropriate, as a retail investor, you can get to 35% alternative strategies through ’40-Act funds?
Mike: Correct. However, it is important for an investor to perform their due diligence on each mutual fund to make certain that the objective of the fund meets their need. We have taken great care at Stone Toro to bring the closest transition of a hedge fund strategy to a ’40 Act mutual fund. We believe our strategies, if allocated appropriately, could give retail investors the potential for portfolio diversity benefits afforded to endowments, institutional and high net worth investors alike.
Mike is a founding member of Stone Toro and brings significant asset management experience to the firm. He serves as the Chief Investment Officer for Stone Toro and is the portfolio manager for the Stone Toro Long Short Fund, a mutual fund registered under Investment Company Act of 1940. Prior to Stone Toro, Mike co-led the management of several billion dollars of mutual fund assets as a Director and Associate Portfolio Manager for Blackrock and its predecessor, Merrill Lynch Investment Managers (MLIM). Additionally, he was appointed as Team Leader of Blackrock’s internal Technology Research Group. From 2002 to 2008, Mike had sole discretion on the technology sector portion of two funds at Merrill Lynch. Mike began his portfolio management experience in 1998 as an analyst with the Merrill Lynch Special Value Fund, one of the largest small-cap mutual funds in the nation, at that time. Prior to his analyst and portfolio management duties, Mike held technology and investment modeling positions at Merrill Lynch. Mike is a graduate of Rutgers College and received his MBA, with a concentration in Finance, from Syracuse University.
Before investing you should carefully consider the Stone Toro Long Short Fund’s investment objectives, risks, charges and expenses. This and other Fund information is in the Prospectus and Summary Prospectus, a copy of which may be obtained by calling 1-855-4ST-TORO (1-855-478-8676), or by visiting the Fund’s website at www.stonetoro.com. Please read the Fund’s prospectus and summary prospectus carefully
RISK AND OTHER DISCLOSURES:
An investment in the Fund is subject to risk, including the possible loss of principal. Investment in small and mid-cap companies poses greater risks than those associated with larger, more established companies. Short sales involve the sale of a security that is not owned by the seller or that the seller has borrowed; and has the potential of unlimited loss. Exchange traded funds (ETFs) typically trade on securities exchanges and their shares may, at times, trade at a premium or discount to their net asset values. Foreign investing involves certain risks and increased volatility not associated with investing solely in the U.S., including currency fluctuations, economic and social conditions, different accounting standards, and unfavorable political and legal developments. ADRs (American Depository Receipts) are also subject to foreign investment risk. There can be no guarantee that the Fund will achieve its investment objective. The Fund may not be suitable for all investors. The Fund is newly organized and has limited operating history. As a result, prospective investors have a limited track record on which to base their investment decisions.
MSCI All Country World Index (Net) is an unmanaged index consisting of developed and emerging market country indices and is calculated with dividends reinvested after deduction of withholding tax.
The S&P 500 Index is a broad based, unmanaged measurement of changes in stock market conditions based on the average of 500 widely held stocks.
CRSP US 10 year Treasury Constant Maturity Index index based on the average yield of a range of Treasury securities, all adjusted to the equivalent of a 10-year maturity. One cannot invest directly in an index.
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