In this webcast transcript Troy Gayeski, Senior Portfolio Manager, and Ray Nolte, Chief Investment Officer of SkyBridge Capital discuss how the shifts of market and economic background have driven the decision making on the flagship SkyBridge Multi-Advisor Hedge Fund Portfolios (Series G).
1. Q2 Portfolio Review: How much did the portfolio shift?
Troy Gayeski: We were very active in the 2nd quarter. We had reduced risk quite substantially in the back half. For the following reasons: the first is that we believed that as QE was coming to an end it would be harder for risk assets and overall assets classes to perform well. It would take more good news for things to go better than people expected and would take less bad news to drive risk assets down or cause a correction. So that was point one. Point two is when you looked at where risk was priced generally in broader asset classes, people weren’t being paid a lot to take risk so implied volatility was very low, credit spreads were very tight, absolute yields on credit products were at all time lows, equity multiples were at their highest since the crisis. So we felt since QE was ending, combined with the fact that you weren’t getting paid a lot to take risk, it made sense to reduce our overall exposures.
Now the way we did that was we reduced our long/short equity exposure – we cut that in half from basically 6 percent to 3 percent; we swapped a lot of our exposures from higher octane event drive equity managers that had a lot of upside capture if things turned out extremely well to more market neutral exposures and we also ramped up things that don’t have much beta like pre-payment sensitive RMBS, credit-sensitive RMBS and also Basel III bank recapitalization. So ytd through August it is right around 44 percent. So that was the main changes we made primarily in the back half of the second quarter.
2. Q2 Portfolio Review: What impact has the de-risking of the portfolio had on performance?
Ray Nolte: We think that as markets begin to go through kind of a corrective phase – we don’t think they are going to go back into a recession where we are going to see a major sell-off – but we do think we are going to see some pullback in market activity. What we would rather be is in a position of strength where we have less risk on the portfolio so we can redeploy that capital into any weakness.
If we are wrong and we don’t get the weakness and things continue to march higher, we are going to capture plenty of that upside, but we felt it was the right thing to do. Remove some of that potential upside capture to protect against draw-downs or sell-offs in the markets. And I think July is a very good example of that. If we hadn’t made the changes that we did in the second quarter, the portfolio would have been down an incremental 50 basis points, so we did save a fair amount of the value of the portfolio by making those de-risking positions given the down trades that we saw coming into the start of the third quarter.
3. Q2 Portfolio Review: Did US GDP contraction impact the portfolio?
Troy Gayeski: Fortunately markets digested soft Q1 growth rather well and we think the primary reason again gets back into quantitative easing being in play. If there was no QE in play and we had a 2.1, initially reported 2.9 percent contraction, we think markets would have reacted more violently. With abundant liquidity in the system, markets shrugged it off and rallied to all time highs in the 2nd quarter. And that was fortunate for us because if you remember the first half of the year we had our max risk level we were comfortable having on so it didn’t impact the portfolio directly, but it reinforced to us that given the fact that this will be another subpar year of growth, cutting risk towards the back half of the second quarter with equities at all time highs, with volatility at or near all time lows, with credit spreads at or near all time tights, it was a great exit point to take risk off and we have the Fed and quantitative easing to thank for that.
4. Q3 Portfolio Positioning: How much of the portfolio is allocated to mortgage-backed securities?
Ray Nolte: One of the things that we look at is the fixed income arb space, specifically around mortgages. That was the very large theme that we had on for a number of years, really up until the end of 2012 coming into 2013 where we scaled back the prepayment sensitive managers. We took that from 40 percent down to 20 percent and it drifted further down into the mid teens. As we were starting to make this decision to begin to de-risk the portfolio, we looked at that space, it had cheapened up a fair amount from when we got out and we decided to increase some of the cash-flow generative strategies. So we took them up to around 21, 22 percent where we are at currently. Certainly not back to 40 percent – I do not think the strategy is as robust as it was then, but I think it is a very attractive strategy and more importantly I think it has very low correlations to the other things that we do in the portfolio, so it is very helpful from a portfolio construction standpoint.
5. Q3 Portfolio Positioning: For how long may event driven equity remain an attractive theme?
Troy Gayeski: We think event driven equity will be with us as an attractive them for at least the next 6 to 12 months. Most of these M&A cycles last two to three years. This one really didn’t kick off until the beginning of this year. We ramped up the exposure in anticipation of that happening. It started. Additionally as you move through these cycles you start to see a variety of signs of them getting tired and old and we really haven’t seen any of those signs yet. Some of those signs are management teams, instead of doing accretive, strategic transactions, like for consolidating their industry, for instance, they start to just borrow debt and pay special dividends or they start to do other types of shenanigans that benefit their balance sheets. We have seen no evidence of that thus far. In the last cycle too the LBO players, the PE guys, were in full swing. We have see no sign of them coming back and taking companies out at ridiculous premiums. So there are certainly no signs so far that the cycle is getting tired, which gives us confidence it will last at least another six to 12 months.
6. Q3 Portfolio Positioning: When do you plan to ramp risk in the portfolio back up?
Troy Gayeski: We think at some point over the next 12 to 24 months, from a probability standpoint you almost have to have a correction. There’s no law that says you will, but it’s highly probable with QE ending and the fact that we have gone multiple years without having a true correction that we have one. When that occurs, since we have already reduced risk, we will be in a great position to ramp risk back up. We can use a variety of tools, we can use long-bias/long-short equity managers, we’re going to swap some of our lower beta event driven equity guys back into their higher beta or higher risk profile underlying funds. We’ve been looking very actively at various ETFs or mutual funds to use as well.
The key here now is to kind of keep your head down, wait for something bad to happen, which is almost inevitable, and then swoop in and buy a bunch of stuff that’s cheaper than it would been otherwise. What you don’t want to do is fall prey to a short term rally back from the recent selling pressure we’ve seen or another collapse in volatility and say “hey the coast is clear, you saved 50 basis points, now we’re going to ramp things back up.” We are going to wait to ramp risk back up until after we have a more meaningful dislocation in the markets.
7. Macroeconomic Outlook: What is your view on current Fed policy under Yellen’s leadership?
Ray Nolte: So far I think Yellen is doing a very good job monitoring, or running, monetary policy. She inherited what’s going to be a very difficult process of how to exit and unwind the volume of QE that’s gone through. I think she will continue with the taper. I think they’ll finish their purchasing program late third, early fourth quarter. I don’t see a move toward starting to raise rates probably until late first, early second quarter of 2015, but I do think there is one thing that the market is not focused on and that is the size of the Fed’s balance sheet. All of the QE that they have done has built a balance sheet that is in excess of $4 trillion.
To date, the Fed has said that they are going to reinvest the principle and interest on that balance sheet. And just the interest that $4 trillion or $4.5 trillion book of bonds generates is quite significant and is simulative in itself if they continue to roll over and reinvest the interest. Obviously that is another tool that the Fed has and to unwind or to tighten. They could choose not to roll over the interest and simply use that to pay down the debt. They could use the interest payments to offset wind down of principle and again shrink the book. And, ultimately, they could begin selling securities which is really a major tightening move and I don’t think they would do. That would become a very significant issue for the market to deal with if the Fed talked about selling down their balance sheet.
8. Macroeconomic Outlook: What is your view on the current state of Europe’s economy?
Ray Nolte: Europe continues to be anaemic. We thought that Europe would be anaemic for quite some time. To date, Europe really has not addressed their banking problems and their banking crisis. They have kind of chosen to turn a blind eye to it. They have allowed the banks to continue to hold onto the assets that they have. They have not been forced to recapitalize. I think we will continue to see Europe kind of flat line.
You’ve got Italy back into recession. You saw problems with one of the Portuguese banks that ultimately needed to be bailed out. I think Greece and certainly Ireland have started to get their act together. France looks like it’s going in the wrong direction. Germany is flat-lining after coming out with roughly one percent GDP – that’s fallen off.
I think the single biggest factor right now that we are focused on is what is happening in Ukraine with Russia. That’s a major concern for the region. It certainly has some economic implications for the region. It probably has more economic implications for Russia than it does for Europe, but it’s definitely a negative. It will weigh on the market. The fact that this is happening at this time of the year when it’s warm is probably a better thing than if it was happening in the winter in the heating season where Europe is a large consumer of Russian energy and natural gas. So I think if this becomes extended and isn’t worked out you may see further weakness in Europe come the winter months.