Waratah Capital Performance – An almost satisfactory hedge fund with underwhelming results

Is Waratah Capital Advisors useful?

Waratah Capital Performance

Waratah Capital Advisors is a $1.5 billion investment firm with 34 employees who are committed to outperforming the S&P 500. The reason for this is, of course, the pursuit of “risk-adjusted returns,” which are hedge fund strategies designed to reduce volatility in order to appeal to emotionally underdeveloped investors. I can empathize: for many years, I was also terrified of downturns and could not accept them as a necessary evil. Waratah Performance is their flagship fund, so I’ll concentrate my analysis on that.

I began with an open mind, as I always do, and have wavered between calling Waratah Performance semi-respectable and semi-crappy. As far as hedge funds go, Waratah Performance is not especially bad. I believe its clients can do better, but they are not making a fatal error (of the type I described in my own story from two posts ago).

What tipped the scales is that Waratah Performance (“WP”) is failing by the standard it freely set for itself, which, to me, indicates a lot. The fund stated a performance objective of 15% annualized over five and ten year investment periods at its inception and for many years after.

The fund is compounding at 10% six months before its tenth anniversary. The fund has now changed its tune to “targeting 10% returns,” which is still a risky goal in my opinion. If it did 10% in the previous ten years, aiming for 10% in the future appears unrealistic. Despite the fact that WP is a fund with a low market exposure, it benefits from beta. I’m guessing there will be less beta in the next ten years.

I would be curious to find out how the goal-post shifting from 15% to 10% was explained to clients. Was there a lot of self-flagellation, or was the change ignored? Stating an absolute return goal also demonstrates sloppy thinking.

What rational basis exists for establishing such a return objective? Wouldn’t it have to change as market conjunctures change? Are they claiming that they will deliver 10% annualized even if the market remains flat for the next five years? WP has no control over interest rates, market multiples, or other economic conditions, so how can it commit to a specific return target?

The reason I only rate WP as semi-crappy (by my standards, this is high praise) is that I believe the track record since its inception is defendable. The fund’s secondary goal is to achieve “market-like returns with less volatility.” The lower vol part is achieved through a short book that has averaged around 34% since its inception.

The fund’s 10% CAGR compares to a 11.4% CAGR for a 50/50 mix of the S&P 500 and the TSX Composite. Let’s ignore the fact that I believe the S&P 500 should always be a long-term investor’s benchmark. To make the comparison fairer for Waratah, I would risk-adjust the benchmark return for volatility. I’ll use the worst drawdowns as weights to adjust the volatility. WP’s worst loss was 13.1%. The worst drawdown in the benchmark was 15.9%.

An investor in the benchmark could have experienced the same drawdown as WP by putting 82% of his money in the benchmark (13.1/15.9). Such an investor would have gotten 9.35% returns instead of the full 11.4% returns. Furthermore, the benchmark investor could have invested the unallocated 18% in a risk-free asset, earning a higher yield.

Using this method, I calculate that WP has added 0.39% per year in value over the benchmark since its inception. If standard deviation is your preferred measure of volatility, WP’s value add is approximately 1.2%. I prefer drawdown as a measure because it represents the lived experience of volatility. People say, “I put $10,000 into this position, and it’s now worth $9,000.”

I’ve never heard anyone say, “I invested $10,000 in this position and experienced a 12% standard deviation.” The emotion is caused by drawdowns. The fund’s worst month was -7% compared to -7.8% for the benchmark, demonstrating that the fund’s downside profile is not that different from the benchmark.

Bottom line, if we use their suggested benchmark, the fund appears to add some value. The TSX is a difficult benchmark to use because it contains lumpy components such as banks, materials, and energy. However, the alpha margin is too low for me to consider this a good product.

This alpha margin is likely to deteriorate in the future as assets and competition increase. Of course, this is a net of fees analysis. The fund charges the standard 2 and 20 fees. This means that, prior to fees, WP appears to have added some more significant value. Clients bear the risk in exchange for crumbs of outperformance. If WP reduces its fees to a more reasonable 1%, I will reconsider my position. Let’s see how much clout I’ve accumulated thus far.

Investors experience other emotions in relation to their fund investments. This fund had a strong first six months, rising 22.5% in the second half of 2010. How would you have felt about investing at 8% for 9 years? Not only was this below the fund’s stated objective (then or now) in fairly bullish conditions, but it also represents a significant opportunity cost compared to the S&P 500’s compound rate of 13%. (with dividends reinvested).

The compound rate over the last five years has been 6.8%. So you’d have to spend all of this time hoping that your sacrifice will be worthwhile when the market eventually collapses. I continue to prefer the long-only investor’s strategy of making hay while the sun shines and using the excess hay to absorb losses during bear markets.

I get the impression that WP is bracing for a bear market from portfolio manager Brad Dunkley’s tweets or the fact that the fund gained 1.7% in 2018, a losing year for most long investors. However, I believe that betting that years of underperformance (in comparison to a simple long-only portfolio) will be heroically made up during a bear market is a bad bet.

Undaunted by the fact that their initial funds consistently fell short of stated performance objectives, the firm has expanded into new strategies such as lithium mining royalties and land. They’ve launched a “Alternative Mutual Fund” product (aka liquid alts) to take advantage of all this talent.

However, that fund appears to have only attracted about $5 million in assets. Another indication that the retail investor is maturing and leaving these “sophisticated” products to the Yorkville set. Later on, I may have more to say about Waratah.

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