The Arcus team, consisting of Robert Macrae, Peter Tasker and Mark Pearson, discuss their latest product with Eurekahedge.
- Looking forward, how do you envisage absolute return investment strategies or styles evolving over time?
We can't really say much about the way in which the industry will evolve, but we don't expect to make major changes within Arcus. The real driver is always bottom-up stock analysis, which is Mark's key contribution: is it cheap, and why? Peter's macro view provides context. In a year or so we may want to sell this stock; what will the market be talking about then? Should we be looking for companies that will be the stars of the coming recovery, or those that will survive the coming crunch? Robert's tools provide the glue that lets us handle large portfolios and answer the perennial favourite, why did we lose money?
It is a recipe that seems to work. AJVF is just about applying our established approach to the stocks we love best.
- You have two successful Japanese hedge funds. What made you decide to launch a long only fund?
Arcus has always managed long only funds alongside its hedge funds and, like the hedge funds, these have been very successful. All of the funds have outperformed Topix substantially. However, until now the long funds have been available only to Japanese investors; the Arcus Japan Value Fund ("AJVF") will be the first Arcus long fund open to international investors.
We reckon that outstanding value is available in Japanese small/micro caps and stocks with limited liquidity. By way of illustration, one of our more conservative long funds recently had the following profile: an average PER of 9x, an average PBR of 1x, and average growth of 8%. That's an attractive value-to-growth ratio by any standard.
We hold lots of positions like this in our hedge funds, but in many cases we can't expand them because they are constrained by risk control and liquidity. Now that the hedge funds are closed we see AJVF as the ideal vehicle to make these exposures available in concentrated form.
- Can you explain your investment process for this fund?
The fund will seek out a range of different kinds of undervalued stocks - classic deep discount value stocks, net nets and extremely low P/Es and some quasi-distressed companies, but we will also hold GARP stocks, undervalued new economy stocks and some undervalued major companies if they look compelling enough. Our industry knowledge, quantitative tools and screening are used to highlight candidates that are then selected on the basis of fundamental analysis.
This is the process that we have used for the last decade and in all our funds.
With a strong emphasis on fundamental research and 3500 companies to cover in Japan, why do you prefer to be based in London rather than Tokyo?
London is a great base for regulatory reasons and for convenience, but it's a little misleading to see us as based solely over here. Peter, our strategist, is based full time in Tokyo and Mark, the fund manager, spent three months there last year. Most of his time was spent visiting companies and we visit well over one hundred companies a year in Japan, as well as the several hundred we meet in London.
It is certainly important to be firmly grounded in Tokyo. It tends to be the big, well-known, foreigner-friendly - in other words, "expensive" - companies that visit London. On balance our longs come from visits in Japan and our shorts from London. However, there is also a big advantage to distance - it gives you perspective. Our style is highly contrarian and it's important to us to avoid being caught up in the latest fad or fear.
- Is your strategy flexible? Would you consider large cap stocks if you uncover some sudden turnaround in 'living dead' companies?
Until recently investors hated zombies so much that few of them are large caps any more! Peter and Robert wrote an article on this for Swisshedge a few months back, laying out our perspective on the impact of the bear market on equity valuations. There is a price at which zombies are a buy, and there is enormous upside for the ones that survive. Resona is a classic example.
Of course, since the Resona rescue such stocks have performed strongly and it is no longer obvious that one is being paid for the risk, but the time may well return… That is why we have made the mandate flexible. Right now we don't know what will be cheapest in a year or two, but that is where AJVF will be.
- Your capacity is quite low at $100m. Is this purely determined by liquidity and if so how would you go about increasing capacity with increased investor demand?
Capacity is constrained by the AJVF's objective of maximising performance. Many of the best investment opportunities are in stocks with rather low liquidity. AJVF has been structured to allow it to invest in such stocks, with a tight gate for redemptions, but there is always a limit to the size of investment that can be made without hitting price. Our objective is to provide a significant exposure to the best investment opportunities in Japan and, as with our hedge funds, we are not going to let size get in the way of this.
It is possible that the fund will close below $100m, depending on market conditions, but I don't think any increase in this limit is at all likely. If we are right about the attractiveness of these assets they will be marked up significantly - in some cases by a factor of two or three - over the next few years. Of course they will then become more liquid, but I do not think it would make much sense to increase the fund size after the best returns had been made.
What are the advantages of running a long only strategy as compared to a long/short strategy?
AJVF grew out of a kind of frustration with long/short. We have set up the hedge funds with tight risk and liquidity parameters. These are constraints that restrict our ability to increase some of the very best positions. There are great stocks out there that we would love to leverage into, but can't because it would blow Zensen's volatility budget of 12-15% a year, or just be unmanageable if we face a substantial redemption some month.
That is where AJVF comes in. It is going to be a high-volatility fund. We want investors who want to take risk and who have a long-term vision on this asset class. That is why we have tight redemption terms. We can take more exposure because investors are less focussed on the short term.
- What is your fee structure?
We charge 2% fixed and 20% performance - a hedge fund structure. Investors will have the choice of an absolute performance fee or one relative to Topix.
- Generally long-only absolute return funds tend to charge lower fees than hedge funds. How do you justify your fees?
Arcus has a strong track record of managing long only funds.
PSJEF $25m 4.50 57% -18% +91% +15% AVF $45m 4.75 62% -8% +76% +13% Leaders $70m 3.00 9% -31% +58% +17% Neo $5m 3.50 21% -44% +116% +24% Returns are for funds and managed accounts for which Arcus is investment advisor and are quoted net of all fees, from inception to September 2003 or to fund closure. Past performance is not necessarily indicative of future returns
PSJEF is probably the most comparable to AJVF in terms of mandate, but our relative returns on all these long funds are comparable to the absolute returns normally seen on hedge funds so we don't see any reason to be shy on fees.
We are not a commodity manager. We can't take $1 billion and continue to deliver this kind of performance, so we prefer to keep the funds small and make money when we do a good job for our clients.
What would be the difference in investor appetite for this fund as opposed to your long/short strategy?We see AJVF and Zensen as fulfilling quite different roles in clients' portfolios. AJVF will appeal to investors who want unhedged long exposure to what we think is the most exciting part of Japan Inc, and who want it for the long term. Zensen is a cash-relative product taking significantly less risk.
Due to the success of your long/short strategy do you expect to raise assets from investors who have allocated to the Arcus Zensen Fund and the Arcus Japan Long / Short Fund?We have strong indications of interest from investors in our hedge funds, and also significant commitments from new investors. Though it is still early days - Launch is 1 December - we think the fund will open with well over $30 million.
In fact the strong appetite for this kind of exposure is one of the reasons we like this class of stocks. They haven't really moved yet, but with the levels of interest we are seeing it is possible that they will move rather soon. We want to be invested when they do.
Do you feel that Japan markets have finally recovered?Topix is currently up +36% from its March low, which leaves it down -40% below its peak in early 2000. Is it half way, or just the beginning? In every past cycle, the problem for Japan is that the market recovery has allowed the authorities to back-pedal the ongoing reform. It could be the same story again.
On the other hand - as Peter noted in a strategy comment to our investors earlier this year - this time it is different. This time, the usual flurry of spring market support was muted. The bounce dates not from administrative manoeuvres, but from Resona's bankruptcy, and there is a good case that this is healthier. At least the market now sees a way out; the banks may have capital adequacy problems but the government is now following a pragmatic damage-minimising strategy, and monetary policy is very supportive. This gives reasonable prospects of exiting deflation.
At the moment earnings momentum is strong, industrial production is strong, world markets are strong, export demand is strong and policy is supportive. We can't say how long this will persist, but while it does there is certainly room for a further rise in the market.
What are your targeted returns and how do you plan to minimise your volatility? What risk procedures are in place to do this?We are always a little uncomfortable talking about target returns, because whatever we say we know the reality will be different. On average we have had double-digit outperformance on our long funds, so I guess that gives an indication of scale.
Maybe it is better to talk about risk. We actually use the same process for all our funds. We have developed a proprietary system that gives robust forecasts of the marginal contribution that each stock in the universe - both our positions and all possible candidates - 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 the fund's risk exposure where we want it.
In Zensen, we use this to set a budget of 12-15%. The risk system is actively telling us to limit positions to stay within this range. In AJVF we use the same system so that we can see where our risk is, but it does not really constrain positions in the same way. Both volatility and tracking to Topix are going to be on the general scale of 20%.
Perhaps it is repeating an earlier point, but this fund is only for people who really want this exposure. Zensen aims to control risk, AJVF aims to take it.
Arcus Investment Ltd
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