The Arcus team, consisting of Robert Macrae, Peter Tasker and Mark Pearson, discusses its new long fund, Arcus Japan Fund (AJF).
AJF has returned 15% since inception in March 2005, with an annualised return of 24% and annualised volatility of 14%. The fund currently has US$90 million in assets.
- Why are you launching a long Japan fund?
Because we believe there is significant upside in the Japanese market. We have just come to the end of one of the longest, most brutal bear markets in modern times. Quite naturally the domestic investment base is very suspicious of equities. Cash and bond holdings are extremely high. Equities are off the bottom, but they have by no means kept pace with the improvement in corporate fundamentals. Companies have dramatically cut leverage; management has got the cost-cutting religion big-time and profitability is at an all-time high. Also – and this is very important – a group of buccaneering takeover-artists have appeared on the scene, just as was in the case in the US in the early 1980s. It's a very interesting time to be in Japan.
- You run three hedge funds and AJVF, an absolute return fund. All are closed. How does AJF fit in?
We have always managed long-only funds alongside hedge funds; we see them as complementary products. Recently some of our hedge fund investors have been asking for a longer bias to our hedged products, and AJF will allow these investors to take a more aggressive Japan exposure than we want to take the hedged vehicles.
We dislike the idea that investors might be in a vehicle that evolves away from its original concept and longer suits their requirements. This makes us reluctant to change a fund mandate once it has been launched, and we prefer to launch new funds. For example, we launched Zenkei to exploit capacity in large-cap and international trades without diluting the small-cap holdings in Zensen. This is why we are launching a new long fund with a specific long mandate, rather than morph AJVF away from its absolute return concept.
We have a substantial track record in managing long funds. This table shows the outperformance after fees for all the long assets we have managed or advised, inception to close or to date. To us the track record suggests reasonably consistent performance through both strong and weak markets. AJF will be very similar to Leaders in mandate.
AVF PSJEF ANCF Meta Leaders AJVF AJF Start Jan-99 Mar-99 Dec-99 Jun-00 Sep-00 Dec-03 Mar-05 End Jan-04 Sep-03 Jun-03 Sep-02 - - - Outperformance 84% 86% 116% 46% 77% 35% -3% Annualised 13% 15% 24% 19% 12% 18% -7% AJVF – Arcus Japan Value Fund ANCF – Arcus Neo-Capitalist Fund AVF – Arcus Value Fund Leaders – Arcus Leaders Fund Meta – Arcus Meta Fund PSJEF – Prime Series Japan Equity Fund
Fees are 1% flat and 20% of outperformance over Topix. This is intended essentially to match our hedge funds, which pay 2+20 but use leverage. Performance fee are equal because alpha costs an equal amount of work hedged or long, but flat fees are reduced because we are running fewer positions per dollar of NAV.
Based on preliminary discussions so far, we anticipate considerable demand both from existing Arcus clients and from a number of institutions looking for skill-based exposure to Japan.
- Can you explain your investment process?
Process has changed very little over the last seven years. We are value investors. The fund will seek out a wide range of undervalued stocks, from classic deep discount value stocks and low P/Es through to GARP stocks and undervalued new economy stocks. What is cheap is always changing, and that is why a value approach is useful. At present we are finding major companies trading well below the value of their strong franchises. It is not that these stocks are unfamiliar to investors, but just they would rather pay up for riskier recovery names. This preference is unlikely to persist for very long, and the numbers suggest that good returns will be available during any reversion towards a more normal preference for quality.
Looking back to the launch of AJVF in 2003, the big change is in the kind of stocks that are missing from the list. Back then we highlighted small, distressed and leveraged companies, and the kind of net-net that makes a natural target for activist. In a few cases these still offer opportunities, but as a group such stocks no longer offer exceptional value, and in fact their rise is the primary reason for the +35% outperformance of AJVF. These stocks have given us great returns in the past but they no longer look like the right place to be.
In fact, these considerations apply to all our funds. Mandates differ, but all funds are managed by the same people using the same skill sets and historically all funds have had a high degree of correlation in their active returns. AJF differs from AJVF more in where we will focus our search, than in how we will search.
- What are your targeted returns and your approach to risk?
We are always a little uncomfortable talking about target returns, because whatever we say, we know the reality will be different. We have typically had double-digit outperformance on our long funds, but while this perhaps gives a general indication of scale we can't say whether the future will offer as favourable an environment as we have seen over the last five years.
It is a lot easier to talk about risk. We don't use stoplosses (See../1138/The_Hidden_Cost_of_the_Stoploss
for our article on "The Hidden Cost of the Stoploss"). We use the same proprietary process for all our funds, which attempts to make robust forecasts of the marginal contribution that each stock in our universe makes to fund risk. In other words, it forecasts how many cents we add to our risk budget if we put one more dollar into the stock.
This lets us set reasonable targets for the funds' risk exposure. In the hedge funds, we target an absolute volatility budget, 10-12% for Zenkei. In AJF we are more concerned with tracking error, because we are offering exposure to Japan Inc and the fund should do well if, as we expect, the market is strong. We anticipate that we will track Topix to within 8%, the level that we have achieved in Leaders over the last six years. Despite its tracking objective Leaders has historically had considerable room for outperformance.
In addition to this portfolio-level target, we aim to avoid excessively lumpy positions because of the "event risk" exposure that they create. As a guide to scale it is reasonable to think in terms of most stock positions being within 3 percentage points of their index weights and most sectors being within 10 points. It is always expensive to be forced onto the back foot in risk control, so we focus on making robust forecasts and avoiding excessive concentration.
- For a long time you based all investment activity in London, but last year you opened a research office in Tokyo. Why the change, and how do you see it affecting your investment approach?
Investment management has always been based in London, but Peter has always been in Tokyo and Mark spent a substantial part of each year there so this is not a major change of approach. Mark moved to Yokohama mainly so that his younger children would experience both educational systems – it's basically a personal move. Its primary advantage for Arcus is allowing us to set up a research office, where Mark works closely with Takaaki Haruki. We hope that Takaaki will make a significant contribution to our coverage, and having both of them over there should put us a little closer to the companies.
Robert remains in London, and our objective is to combine the immediacy of a presence on the ground with the advantages given by distance and an international perspective. All our funds are based on Mark picking stocks, Robert looking at the portfolio and Peter looking at Japan Inc.
- How flexible is your strategy? Would you consider moving into small caps if these again start to look interesting?
AJF has a reasonably unrestricted mandate and can hold small caps, but because it offers monthly liquidity it is unlikely to be a good vehicle for major small-cap exposure. If we once again feel that the best opportunities are in small caps – unlikely unless they underperform large caps – we will probably offer AJF investors the opportunity to transfer into AJVF. We always aim to give existing investors priority on new capacity as it becomes available.
- When you launched AJVF, you gave a qualified but positive view on Japan. How do you feel the situation has evolved?
Back in December 2003, Topix was at 1043. As we suggested it has moved significantly higher. This move has been supported by some gradual but very positive developments: the near end of deflation; the bottoming of real estate; the nascent improvement in unemployment. The big potential bugbears we mentioned – weak earnings momentum, weak industrial production, weak world markets and weak export demand – have not appeared.
That doesn't necessarily mean that they won't. Our longstanding view that US demand may weaken is now becoming uncomfortably close to consensus; despite this it remains a possibility. The apparent peaking of US real estate is ominous. We have really encouraging indications that a domestic demand recovery may bail out Japan even if US demand fades, but this is not certain. The Japanese consumer is cautious and conservative, and unlikely to start a wild spending spree overnight.
So, as in 2003, we are positive on the environment, but in a qualified manner. We are positive on Japan relative to most other world markets and think it offers interesting opportunities for investors with an international orientation. The market is still trading at a fraction of the levels achieved in the 1990s, though profitability has been transformed. This clearly suggests room for a further rise in the market.
- What are the advantages of running a long-only strategy as compared to a long/short strategy?
Long/short is a good model, but if you push any model far enough you will find its limits. To us it feels as if that may be happening in the hedge fund industry. A few years ago we were comfortable buying small caps and selling large caps in a high-liquidity vehicle because we were confident that we could get out of positions. Now, with the likelihood that there is substantial hedge fund money trading along side you on both sides of the trade, we aren't really comfortable with doing either in larger size.
We have always been concerned on capacity and have always closed funds as they reach a level at which we think performance may be impacted by further scale. These concerns have dictated the nature of all our launches ever since the close of Zensen: first AJVF, with its extremely tight redemption terms; then Zenkei with its large-cap focus; now AJF.
One advantage of AJF is that capacity is much less constrained than in any of the other products. While we will pause at around US$500 million to check whether any problems are emerging, the ultimate limit on size might be a few times this amount.
- Looking forward, do you think that the trend of hedge fund managers launching long funds will continue?
This does seem to be something of a trend, and from our perspective it makes sense. Any hedge fund manager who can control risk and generate alpha has the tools to manage long money.
The main limitation is a kind of "branding" problem; active long management has done such a poor job for so long that skill-based long funds are quite a hard sell. However, now that capacity is becoming such an issue in the hedge fund space, it looks to us as if managers who take capacity seriously will have to make this move. We may be too conservative, but we are not comfortable with the idea of running billions of long/short dollars even in a market as liquid as Japan. To us skill-based long funds look a sensible development.
Arcus Investment Ltd
+44 20 7861 9660