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A Top Performing Hedge Fund Just Went Record Short: Here's Why

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When we last looked at the $2.9 billion Horseman Capital, we reported that not only has the fund which many have called the "most bearish in the world" generated tremendous returns almost every single year since inception (except for a 25% drop in 2009 after returning 31% during the cataclysmic 2008), but more notably, it has achieved that return while been net short - and quite bearish on - stocks ever since 2012.


In that period it has consistently generated low double-digit returns, a feat virtually none of its competitors have managed to replicate. Its performance has put it in the top percentile of all hedge funds in recent years.


Furthermore, in a year most other hedge funds would love to forget, the fund "crushed it", with a 20.45% return for 2015 and 5.6% in the tumultuous month of December.


Today, we received Horseman's latest February numbers and the fund's outperformance has continued: in a very volatile month, in which many hedge funds were stopped out in both directions, Horseman returned a respectable 1.5%, after 8% the month before, and with a 9.6% YTD tally, it remains in the 99%+ percentile of returns for the year.




Outperforming the market is hardly new to Horseman: it has been doing so for four years in a row, and not surprisingly, 2015 was its best year since 2008. 2016 is starting off just as good as the prior year.




What was the source of Horseman's February outperformance? Recall that in January it was all about short Chinese exposure. This is what the fund was shorting in February:


This month both the long and short equity portfolios incurred small losses while gains came from the long positions in government bonds and the currency positions. Losses came primarily from the small remaining long positions in European banks and from the short positions in the automobile sector. Gains were made in discount retailers in the long portfolio and in financials in the short portfolio.




In the airline industry, the decision to operate a new or an old aircraft has nothing to do with safety or reliability as routinely airliners fly 100,000 hours or more before they are retired out of service. According to Aviation Consultants 360, the Federal Aviation Administration does not disqualify an aircraft based on its chronological age when determining a jet aircraft's condition or safety. What counts is the aircraft's current maintenance status, its maintenance history, current required upgrades and engines.




Manufacturers have made significant improvements in engine efficiency, but it only matters when fuel prices are high. Improvements have been made in avionics and communication but these are separate safety issues beyond the safety and reliability of the aircraft's airframe, and the equipment can be updated. Consequently, for all practical purposes, a well maintained 30 year old aircraft with 10,000 hours on its airframe is as safe and dependable as any new aircraft but costs only a fraction. According to Aviation Consultants 360, in many ways, the older aircraft is safer; it has history and is known to be safe, a huge benefit.




Although Boeing and Airbus revealed record production figures for 2015, net new orders fell by almost half at Boeing and a third at Airbus. An analyst at Citigroup recently pointed that in the aviation cycle before 2008, around 70% of demand for new airplanes was from airlines and leasing companies planning to add capacity, and that since then, demand from customers seeking to replace old planes with new more fuel efficient ones has risen to more than half of deliveries. In our opinion, as fuel prices have fallen, the replacement market is likely to shrink as fuel efficiency is no longer a top priority.




A large part of Boeing and Airbus' order books has been driven by demand from emerging countries' low cost airlines (sources: Boeing; Airbus), who in our opinion, may cancel orders in the event of further emerging markets currency devaluations versus the US dollar. During the month we built a short position to aircraft manufacturers and aircraft leasing companies of about 10%.


So while being bearish China was the flavor of last month, this time it is all about shorting airplane manufacturers.


This is what Horseman's sector allocation looks like as of this moment:




However, what remains most remarakable about Horseman Capital is that even as it modestly boosted its gross exposure to 59%, as of February the fund's net short exposure has risen from what was a previous record of 76%, to a whopping -88%, an unprecedented record even for one of the world's most bearish hedge funds!




Finally or those seeking to glean some wisdom from the Horseman's inimitable Chief Investment Manager, Russell Clark, here is his latest letter.


* * *


Your fund made 1.47% net last month mainly on the back of its Japan related positions.


The fund has had a good move from its last drawdown in October of last year, and is probably overdue for a pullback. The first few days of March are bearing this out. However in many ways the drawdown in the fund began in February, as consensus short positions in the market began to rally furiously. Good examples are stocks such as Glencore, which the market was pricing for bankruptcy in January, has now seen its stock price rise 58% year to date. The 10 best performing stocks in the S&P this year, were down last year on average 40%. The reality is no one likes it when loser stocks rally. It makes everyone look bad. Short sellers get crushed, best performing long managers from last year start underperforming the market, and investors wonder why they even bother with active managers!


Sadly, I am all too familiar with markets like these. A significant and surprising move in the market, for example yen strength in February, can cause significant losses in a large macro fund. This macro fund will then seek to reduce risk, and will sell long positions and buy back short positions. This can cause a short counter trend rally, which is painfully, but usually short lived.


My view is that when indices have broken down and are trading as a bear market the best thing to do is to try and reduce the long book as much as possible. There is a strong temptation to find "safe" long positions to own that will reduce the net short position of your fund. I have found this to be the worst possible thing to do as almost every other market participant is trying to crowd into these same safe positions. When the inevitable redemptions come, long positions get sold and short positions get covered, and your "safe" longs end up causing as much damage as your short book.


For that reason over the last year as the bear market has become more and more apparent, I have been continually adding to the short book and selling the long book. I have also been moving the fund to less consensual bearish ideas, such as long yen and short Japanese and European exporters. This strategy has paid dividends in February, which was a very tough month for many other short sellers. The big rally in the yen, helped our currency book, bond book (our JGBs have had a significant move) and short Japanese stocks positions.


I have always felt that having these type of non-consensual trades on are very important as they give you time to observe the market before making a change to the strategy. The equity and commodity markets are sending signals that perhaps the bear market in commodities and the related bear market in emerging markets is over. This however seems very unlikely to me, as many of the indicators for commodity supply are still flashing red, and the issue of excessive capacity has not really been adequately addressed. Big moves in commodity prices could be suggestive of government policies finally becoming effective in creating inflation and above trend growth. However what we are also seeing is a strong yen and falling bond yields, which is not consistent with accelerating growth or inflation.


More likely the yen rally in February has been extremely painful for a number of large macro funds, and has caused these funds to cut risk from the long and short book, which given consensual positioning in markets is causing a great deal more pain. If history is a guide, I would assume that we are nearly through this mean reversion trade.


Your fund remains short equities, long bonds.















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