Watermark Funds Management – Have they still got what it takes?

Watermark is a Sydney based funds manager that specialises in “hedged” strategies through both listed and unlisted vehicles. Watermark has approximately $A700 million under management.

The listed vehicles are the Australian Leaders Fund (ALF.AX), Watermark Market Neutral Fund (WMK.AX) and the Watermark Global Leaders Fund (WGF.AX). 

The Watermark Global Leaders Fund listed late in 2016 at $1.10 per share and now trades at around $0.92 (a 16.4% loss for investors in under one year).

While the above listed companies have slightly different strategies, they are all essentially variations on the same theme, i.e. to have a long portfolio which is more or less identical in size to the short portfolio.

Let’s say a fund manager employing this strategy has $100 million in capital to invest. He first deposits that capital with a prime broker and then he sells short $100 million of equities that he thinks will fall in value. As a result of his short sale, he receives $100 million which he then takes and invests in equities he thinks will rise in value. He now has $100 million short and the same amount long which means (in theory) he has no exposure to the movement in the equities market.

If the long portfolio were to rise by 6% and the short portfolio fell by 2%, the total portfolio would be up by 8%. The manager can now either retain that 8% or pay some (or all) of it out as a dividend to his investors. Of course, if the opposite were to happen, the long portfolio declined by 6% and the short portfolio rose by 2%, he would lose 8%.

Unlike in a long only listed investment company (LIC), there is virtually no scope for the manager in the above strategy to simply pass on dividends received to investors because those dividends that he receives on his long portfolio will be used to pay the dividends of the investors whose stock he has borrowed to sell short. This means that the manager can only generate positive results from superior stock picking.

As we all know, over time, stock markets rise, and because of this, it is more often than not a sound strategy to keep the long portfolio larger than the short portfolio (so that you capture some of the returns of rising markets over time).

If you are running a completely market neutral strategy, (the longs and shorts are equal), if your stock picking is average, you will not make any money. This is the exact situation that Watermark has found itself in over the last 18 months or so. 

Watermark has made no money (after fees, it has lost money for investors) and that in turn has opened a substantial gap in the share prices of the listed vehicles to the net asset backing of the shares. In effect, the market is saying that it doesn’t have much faith in Watermark to recapture their results of previous years.

One unfortunate result of Watermark’s poor performance is that the “dividend” from the Australian Leaders Fund now comprises of a capital return, or in other words, giving investors their own money back under the guise of a dividend. (Incidentally, the Magellan Global Trust which listed in October 2017 will almost certainly end up doing this as well - something that I don’t think subscribers to that float understood at all). 

Some of my observations on Watermark are:

1.    I don’t think their investment team is as good as the Chief Investment Officer Justin Braitling believes – great teams don’t deliver the poor results that Watermark has had over the last 18 months or so. The team is also quite young and therefore not as experienced as one would ideally like;

2.    They seem to have had a reasonable amount of staff turnover in recent times – not usually a good sign;

3.    They have almost certainly made some execution mistakes in attempting to deliver their strategies (which is worrying and a sign of inexperience);

4.    For the average stock picker, running completely market neutral funds is a mistake as the long-term appreciation of equities over time is just thrown away through the short portfolio – yes, you will be a genius once every 5-10 years (and a fool the rest of the time). Better to take that part of your money and put it in a bank for a guaranteed 2.5% or so, rather than pay someone fees to make no money at all!

5.    The fondness of Australian fund managers for short positions over specific stocks rather than the use of put options over an index is a strategic mistake in my view. Over the years, I’ve seen very few Australian fund managers who can successfully short companies over time, but there has always been a misplaced confidence in their abilities to do just that;

6.    As with almost all of the newer listed investment companies, the fees are too high for the performance that has been achieved in recent times.

Fortunately for Watermark, most of their funds under management are in the closed end listed vehicles, had they been in unlisted vehicles, Watermark would have lost significant funds through redemptions.

Let’s keep watching and see if they can turn it around, I hope they can.

The VGI Partners Global Investments IPO – Why I’m giving it a miss

VGI Partners Global Investments is a global long/short equity fund that is floating as a listed investment company (LIC) on the ASX. The float hopes to raise between $100 to $300 million.

I was initially quite interested in the upcoming float and thought it was admirable that VGI was absorbing the costs of the float so that the LIC’s net asset value (NAV) per share would be the same as what subscribers to the float paid for their shares. However, my admiration soon evaporated when I read the fee structure detailed in the prospectus.

VGI will charge a management fee of 1.5% (plus GST) on the value of the fund – this is par for the course and I have no major issues with this. What I do have major issues with is the performance fee. VGI will charge a 15% performance fee (plus GST) on any positive performance (less management fee).

What this means is that there is no benchmark performance hurdle that VGI Partners Global Investments has to exceed before it pays performance fees. It will pay performance fees on any positive performance.

This is highly unusual. I can’t think of any other similar type of fund that does not have to exceed a performance hurdle (usually the return on a benchmark index such as the MSCI World Net Total Return Index) prior to being charged performance fees.

Performance fees should only be paid to managers who generate “alpha”, i.e. performance which is above a relevant benchmark index. The fee structure for VGI Partners Global Investments allows the LIC to be charged “performance” fees for under-performance of a benchmark index!

To understand what this means, the following table estimates what the results will be for shareholders over a 10 year period based on different annual average compound rates of return for the LIC (assuming that the LIC’s shares trade at NAV). It also shows the estimated dollar value of fees that VGI will charge based on those rates of return:

 You can begin to see how lucrative this fund will be for the proprietors.

The very unfavourable terms for shareholders are that the performance fee is calculated on a “high water mark” which is the initial value of the fund, when in fact the high water mark should be the initial value of the fund plus the return on whatever benchmark index is comparable.

For example, if VGI raises $300 million and earns a return of 8% in its first year, it will have earned $24 million (pre-tax). The management fee of 1.5% will be charged (it will be more than $4.5 million, but let’s say it’s $4.5 million for simplicity). That $4.5 million is then subtracted from the $24 million to arrive at $19.5 million and the 15% performance fee is then charged on $19.5 million which equates to $2.925 million (exclusive of GST).

Ok, so of that $24 million return, investors share in approximately $16.575 million (pre-tax) after fees. And if the benchmark index has returned say 10%, the investors (in aggregate) could have put their money in a low cost index fund and received the equivalent of close to $30 million for the year.

The total fee in the above example represents just shy of 31% of the fund’s return.

Nothing that VGI Partners does is rocket science. I would happily pay Renaissance Technologies their incredibly high fees for what they do. I would also pay someone like Manoj Narang (now at Mana Partners) for what he does, because what they do is absolutely impossible for the average investor to replicate and they have outstanding records. What VGI Partners do is very simple for many retail investors to replicate. 

Here are all of VGI Partners US holdings as at 30 June 2017 – think you can replicate that portfolio?

Of course you can, and at vastly lower cost than what VGI charges.

The VGI Partners Master Fund also holds short positions (as can the LIC), but the Master Fund has rarely been much more than 25% short, which means that over time it has definitely had a long bias in a very concentrated portfolio. This, in my opinion, means that there is very limited downside protection in a market crash.

The VGI Partners Master Fund is also a unit trust, so it pays no income tax and as such, its reported returns are pre-tax. If you factor in the tax that is paid to investors on distributions from that fund, the returns do not look anywhere near as good in comparison to the MSCI World Net Total Return Index.

So in summary, I’m giving this IPO a miss. The fees are way too high and not at all justifiable for an outfit that only has nine years of performance history.

Note: None of the above constitutes investment advice, it represents the opinions of the author only. You should seek appropriate professional or financial advice regarding the appropriateness of investing in any securities.

TPG Telecom’s big gamble

TPG’s announcement on 12 April that it plans to build a mobile network to compete with Telstra, Optus and Vodafone should be more than a little worrying for TPG shareholders.

The salient points were:

•  TPG paid an extremely high price ($1.26 billion) for 2x10 MHz (for just under 11 years) in the government’s 700 MHz spectrum auction (twice what Telstra had paid in a 2013 auction);

•  TPG’s forecast maintenance spend of $600 million over three years (for a mobile network with a supposed 80% reach of the Australian population) was widely viewed as ridiculously low by many commentators; and

• To part fund the spectrum purchase, TPG is conducting a non-renounceable pro-rata entitlement offer to existing shareholders at $5.25(!) per share, a 20% discount to the closing price on 11 April and a price the shares have not traded at since July 2014.

It should also be noted that TPG (TPM.AX) is attempting to become the 4^th mobile player in the Singapore market at the same time as its adventure into the Australian mobile market. 

When TPG announced its foray into the Singaporean market, I asked a friend who knows a great deal about the telecommunications market in Singapore (and happens to be a Singaporean national) what he thought of TPG’s ambitions in Singapore. He recounted all the past failures of those who tried to compete against the incumbent players in that market and concluded by stating that there was no reason to believe that TPG would have any different experience.

What TPG is essentially doing is taking on very high levels of debt, vastly increasing its interest and amortisation expenses and therefore, significantly reducing its return on equity for what is at best a marginally profitable exercise. It also assumes that the established players will simply allow TPG to just walk away with their mobile customers! It’s a classic case of growth for growth’s sake.

It is completely illogical for anyone to think that a company that has paid twice as much for its spectrum licence than its competitors and does not have an existing (complete) network in place can price its products to achieve sound profits against incumbent players.

After initially being very successful, TPG has struggled in recent times. The share price peaked at $12.93 in July 2016 and will have declined by 59% once it comes out of its current trading halt.

At the $5.25 capital raising price, major TPG shareholder Washington H. Soul Pattinson (SOL.AX) will have seen it’s shareholding in TPG decline by approximately $1.6 billion since that peak in July 2016. And yes, Soul Pattinson did purchase that shareholding at a mere pittance of what it’s now worth, but to sit on your hands while $1.6 billion evaporates isn’t the best management in my book.

The market price of TPG’s shares indicates that there is little confidence in the company’s strategies. I have to say that on this occasion, I agree with the market.