Mathews Capital – Are they really skilled or just lucky risk takers?

How do you assess whether a money manager is truly skilled or just lucky?

There is only one answer to this question – time. Lucky money managers will eventually fall by the wayside, just give them enough time and their initially impressive returns will revert to the mean or worse.

Money mangers with long track records of impressive returns are truly skilled. Think of Warren Buffett, Seth Klarman, Ed Thorpe, Ken Griffin, Paul Tudor Jones, Jim Simons and so on. Money managers with short track records of impressive returns are either skilled or lucky but you won’t know which until sufficient time has passed.

As I have previously written here, I once thought that Kerr Neilson was a truly skilled investor. I no longer believe that. I believe Kerr simply got lucky early on (with the help of one of the longest bull markets in financial history) and has been able to “dine out” on those earlier returns for a long time. As soon as 2008 came along, Platinum Asset Management’s funds started to struggle – they are still struggling.

Which brings me to Mathews Capital. A Sydney based outfit founded by Phil Mathews in 2001.

Phil Mathews, like so many others who have started funds management businesses in this country had a menagerie of former employers before going into business for himself (County Natwest, Ord Minnett, SPAL, Armstrong Jones, Jardine Fleming and Bell Potter).

Until 2010, Mathews Capital enjoyed spectacular success. Most of which was based on investing in smaller to medium sized resource companies. However, the wheels fell off in 2011 and 2012 is shaping up as another very poor year for the firm (between March and July of 2012 approximately 60% of the value of the Velocity Fund has been wiped out - it’s hard to understand how this could have happened).

One of the things that stands out you when you look at the monthly returns of Mathews Capital’s Velocity Fund is the volatility of those returns. Wild swings from month to month are the norm. This in turn indicates to me that the firm has taken significant risks to achieve their returns and their risk management techniques are not particularly effective.

It is known that Mathews Capital hedges equity positions with short positions over indexes. However, as any novice student of quantitative finance would know, the correlation (or indeed the cointegration) between the types of equities that fill the Mathews Capital fund portfolios and the indexes are very low, indicating that short positions in those indexes are not at all effective hedges for those long positions in equities.

My concerns with the Mathews Capital funds are as follows:

1. The firm attempts to pick the “winners” amongst hundreds of smaller resources companies, this provides spectacular returns if you get it right and appalling returns if you get it wrong. Mathews Capital got it right between 2002-2010 and is now getting it wrong;
2. The portfolios are highly concentrated – there is no room for error with such a strategy;
3. The firm seems comfortable with this level of risk – I don’t believe that they should feel comfortable;
4. The firm’s fees (while normal for most hedge funds) are high for a firm that at present only has funds with very short-term records open for investment and a history of very high volatility;
5. The inability to hang on to most of the spectacular returns achieved between 2006-2010 in the Velocity Fund are very worrying;
6. The firm’s practice of visiting vast numbers of companies is dangerous – most chief executives are optimistic, ego-maniac sales people. Plenty of them will lead you astray;
7. The firm’s investment in Elders a few years ago may be an example of point 5. It has been well known for a long time that Elders is experiencing significant financial problems and yet Mathews Capital were buying the shares;
8. The firm is still clinging tightly to the resources boom theme – but the boom seems to be over for now.

I would expect that the return from Mathews Capital’s funds will continue to decline towards index returns and if they do not get their risk management under control, returns may well eventually go below the index.

Please note that as always, none of the above constitutes financial advice. You need to do your own research and consult appropriately qualified people for advice (where necessary).