January 2016
Ivan Obolensky

Nevsky Capital is a Hedge Fund that has returned some 1,216% since its inception in 2000. To put this return in perspective, if you invested $100,000 when it opened its doors, today that investment would be worth over a million dollars.

The fund has over 1.5 billion dollars under management.

In spite of this success, Nevsky Capital is returning all money to investors¹. How come?

A “Hedge Fund” is a managed pool of money that invests in whatever the manager thinks will create a substantial return.

For instance, they might use your cash investment as collateral to borrow five times that amount. If the fund invests in something that pays 10%, the return on the capital invested is 50%, or five times more, less the cost of borrowing (cost of capital). Hedge funds invest in almost any financial product from ordinary stocks to the most sophisticated and arcane derivatives. These are relatively recent investment vehicles.

The first hedge fund was started by Alfred Jones in 1948. While working as an editorial writer for Fortune magazine, he decided to manage money instead. He started with $100,000 of which he personally contributed $40,000. His objective was to reduce the risk in holding long term stock investments by short selling (betting that a specific stock would go down in price). This strategy offset large declines in the portfolio value and made returns less volatile and more consistent.²

Today there are many hedge funds, but recently, a number of these funds have closed their doors.

Nevsky Capital cites the rising cost of capital and the uncertain investment environment the fund managers see going forward. Its letter to investors (see footnote) is instructive. By reviewing some basics and their reasoning behind the decision, perhaps we can learn something about today’s economic climate.

“Cost of Capital” is a fundamental concept. For an investment to be worthwhile, the return must be greater than the cost required to make it. When we buy a house and don’t pay cash, we borrow from the bank often at a fixed rate of interest. The interest paid is the cost of capital. Twenty years ago mortgage interest was around 10%. Buying a million-dollar home with twenty percent down meant paying $80,000 per year (almost $7,000 per month) on interest alone. Today at 3%, the interest would be $24,000 or only $2,000 per month. Many more people can afford larger mortgages and bigger homes because the cost of capital is lower. That interest rates remained low for so long has had an enormous impact across all strata of society in terms of quality of life and living standards. Many more people can afford to own their homes rather than rent.

Another economic term is “Opportunity Cost”. It is the cost of choosing the next best alternative. As an example, suppose you are a farmer and must choose between planting carrots or potatoes. Our choice is mutually exclusive, we can only choose one, not both. We have to forego other alternatives. Let us suppose that carrots are selling today for three dollars a bushel and one dollar a bushel for potatoes. You can expect to sell 1,500 bushels of either one. At three dollars, the carrots are expected to return $4,500 while potatoes will return only $1,500. You decide to go with carrots. The opportunity cost, if you planted potatoes and prices stayed the same, is the difference between the two: $3,000 dollars.

The term implies there is an opportunity available compared to what you could be doing with your time, or your money. If you choose the lesser alternative, it will cost you. This also applies in a more abstract sense.

If a friend says he or she wants to go out with you, when normally you would stay home and watch TV, you might consider it an opportunity because of the pleasure you would experience when compared to the same old same old. The opportunity cost of staying home is the potential pleasure and satisfaction you would not experience if you decided not to accept.

As with much economic theory, it sounds neat and logical. In reality, one can never know the opportunity cost until after the fact. At the time we must choose, calculating the opportunity cost is often simply our best guess as to which path leads to the most desirable outcome. We never have the benefit of hindsight. All we have are our own ideas about possible futures. This adds complications. Much of the structure of markets is due to this one fact.

Going back to our example, suppose every farmer in your area also decides to plant carrots having looked at the same numbers. At harvest time, the price of carrots drops to one dollar a bushel while potatoes are few and far between. Potatoes rise to three dollars a bushel. Many other farmers wished they had planted potatoes, but you were smarter and thankfully did something different. You considered the idea that others might also want to plant carrots which would drop the price at harvest and in anticipation, made the decision to pre-sell your entire crop of carrots to a wholesaler before you planted at the then price of 3 dollars. This is called a “forward contract”, or simply a “forward”. The agreement was for you to supply 1,500 bushels of carrots at harvest time. In exchange, the wholesaler wrote you a check for $4,500 today. You are happy. You wisely hedged the sale price of your crop by offsetting it with a forward and were successful. This is the original meaning of the term “hedge” in hedge fund. The first of its kind hedged, or limited, the downside risk inherent in the investments it held.

If carrots were a major commodity such as gold, oil, or steel, then there might be many such agreements; so many in fact that it would be worthwhile creating a set of standardized contracts that could be traded continuously. Thus was born the concept of an exchange whose function is/was to match buyer with seller and seller with buyer. This is the fundamental beneath all futures and commodity markets which now encompass many different products including financial instruments such as government debt and baskets of stocks such as the S&P 500.

The example also points out another element in the money, economics, and the financial arena: the importance of what others are doing and thinking of doing.

If you were the only carrot producer, then what other participants did would hardly matter, but we are rarely the only players and thus, we have to constantly make choices based on what we know, and just as importantly, what we think others know and will do.

This process applies even to a simple activity such as hosting a party. If you want to have guests, you have to invite them, and they have to accept. Each invitation when it arrives implies an opportunity cost to the receiver. The potential guest has to decide between accepting, or doing something else. Not knowing that there is another party happening the same day can crimp your plans. Successful party people scope out what else is scheduled on their party day. This is called “discovery”.

Price discovery is also a fundamental part of markets. What is the current price of an item and is it correct? This concept has important ramifications.

If store A is selling the same product for half the price compared to store B, which store has the correct price?

From a buyer perspective, it is simple: the lower one is correct. From the seller’s point of view, it may be different. What if the sales person in store A mislabeled the product? By the time management of store A discovers the error, the store has sold hundreds of items and lost thousands of dollars on every sale. They are out of business while outselling their competition. In spite of getting a good deal, it is worth thinking about the following: is it possible that the consumer was actually harmed because of this pricing error? There is now only one option: store B, who can now raise prices because they can. Maybe it wasn’t such a good deal after all for the consumer.

In a slightly different scenario, imagine that store A slashed their prices deliberately, having enough reserves to cover the costs. Over time it drives store B, as well as many others, out of business. This allows store A to eventually raise prices. Imagine A standing for Amazon. Is that a possibility?

In our carrot-potato example, the correct current price of carrots and potatoes was key to the decision process of what to plant and how to hedge. Price discovery is vital for markets and all decision makers. It presupposes transparency. But what if there is a growing trend in the opposite direction, toward deliberate opaqueness?

With these basics in mind, let’s review Nevsky Capital’s decision:

To be successful in their approach they required the following:

• Access to transparent and accurate macro and company specific financial data.
• Logical decision processes by global policy makers.
• Clear information on the positions of other players in the markets to get an accurate picture of pricing (price discovery).
• Markets that move in different directions at different times.
• Manageable risk procedures for long-tail risk.

[Note about long-tail risk: Most readers are familiar with the normal bell-shaped curve. The curve is most obvious in observational measurements. If one measured the length of a steel rod a thousand times to a certain level of accuracy (say to the nearest .001 of an inch) and plotted all these observations, the graph of them would bunch around a central point with some observations higher and some lower. The graph would assume the classic bell shape. Mathematicians, such as Gauss and Adrain, developed formulas that duplicated the observed curves precisely. Most of elementary statistics has to do with using the characteristics of this curve to make probability decisions. Unfortunately, markets are not so simple. Real market data shows that the tails on both the upside and the downside are much longer and thicker than those of the normal curve implying that there are many more large events (crashes and blow-offs) than would be expected using the normal curve. This concept is shortened to Fat Tail or Long Tail risk: the possibility of a large unpredicted good or bad event.]

Nevsky Capital pointed out in its announcement that it was unable follow its procedures. Some of the reasons it listed were:

China is the world’s 2^nd largest economy with India becoming the 3^rd in the next ten years. China has reported GDP growth of 7.1% and India reported theirs at 7.4%. Their numbers, whether deliberately or otherwise, are inaccurate and probably much smaller, but the main point is that they are wrong. To base investment decisions on obviously incorrect information is not a wise course. Even if one adds a fudge factor, what are the real numbers? Further, if those numbers are wrong, what else is?

The Global Financial Crisis occurred in 2008. Since that time there has been a growing trend for corporations to withhold information rather than be forthcoming. Much of this inclination is the result of the possibility of having this information proved wrong in the eyes of courts and regulators. In the corporate world of today, less disclosure is better business. Unfortunately, this behavior heightens the likelihood of headline risk or unpredicted disasters that are not anticipated in terms of earnings and other key metrics.

In addition, politics has entered the economic arena and political expediency usually wins out over sound logic in the short-term. Unfortunately, the “short-term” can continue for quite a long period in the context of the economy.

Active investment management has been shunned in favor of index investing simply because no manager can survive the periodic under-performance that active-management can yield, hence the move toward investing only in indexes which has in effect reduced the diversity of investors, methodologies, and volume.

Past regulation changes have made High Frequency Trading possible and this has affected liquidity and precipitated price movements that seem to have no logical basis. (See Computer Games). Logical correlations between asset classes are also becoming difficult to discern for investors dealing with fundamental data.

The US Federal Reserve may have to raise rates more quickly than anticipated causing other interest rates to follow at a pace much faster than the market currently believes, as reflected in the current level of prices.

They concluded as follows:

“In summary, all of the above factors now mean that it is more difficult than ever before for us to accurately forecast macroeconomic and corporate variables. This pushes up our cost of capital and substantially increases the risk of us suffering substantial capital loss on individual positions either because of forecast error or simply because we got caught up in an erroneous market trend, which could then persist for far longer than we could take the pain. This has made what we enjoy most – the thrill of analyzing economic data releases and company accounts – no longer enjoyable. It is therefore time to accept that what we have done has worked brilliantly for twenty years but does not work anymore and move on. We are confident our process will eventually work again – for the laws of economics will never be repealed – but for now they are suspended and may be for some time; an indefinite period involving indeterminate levels of risk during which we think it would be wrong for us to be the steward of your money.”³

If one of the better money managers in the world feels this way, how should we feel in comparison?

Ultimately each of us must weigh the opportunity costs and do the best we can with the information we have both economically and intellectually. We will always have to make decisions based on incomplete information however we choose. It is important to be aware of what others are doing and thinking of doing, perhaps now more than ever. It is also essential that each of us do our research and that we demand and get accurate information, not just financial, in order to make the best decision possible.

Times may be tough in the markets, but they don’t last forever. In the meantime, we have to make decisions regardless. Knowing the current state of the game helps.

 

---

1. Durden T. (2015) Why $1.5 Billion Nevsky Capital Is Shutting Down: The Full Letter, Zero Hedge. Retrieved January 6, 2016 from http://www.zerohedge.com/news/2016-01-05/why-15-billion-nevsky-capital-shutting-down-full-letter.
2. McWhinney, J. E. (2005) A Brief History of Hedge Funds. Retrieved January 6, 2016 from http://www.investopedia.com/articles/mutualfund/05/hedgefundhist.asp.
3. N.A. (2015, December) Nevsky Fund Quarterly Performance, page 3. Retrieved January 6, 2016 from https://www.scribd.com/fullscreen/294654490?access_key=key-xfqKH8QC2LsXN87EW4uk&allow_share=true&escape=false&show_recommendations=false&view_mode=scroll

---

If you would like to sign up for our monthly articles, please click here.

Interested in reprinting our articles? Please see our reprint requirements.

© 2016 Ivan Obolensky. All rights reserved. No part of this publication can be reproduced without the written permission from the author.