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 http://www.eurekahedge.com/news/Arcus_The_Hidden_Cost_of_the_
Stoploss.asp 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.
