To date I have been avoiding commenting on Michael Burry of Scion Capital. The Vanity Fair article in which he served as protagonist is an amazing read, but my goal of this blog is to produce value added insights relatively free of outright unsubstantiated opinion or speculation. That is, in this blog I strive to synthesize information (which I define as taking information from multiple sources to infer relationships and draw conclusions) to produce unique and fresh insights that add to (ie are not currently found in) the body of knowledge of the investing community, particularly the semi professional and professional communities. So, to date, in regards to Michael burry, I have had very little to add to what is already out there. It is fortunate, however, that Burry, today, is published in the New York Times complaining about the actions and inactions of the various participants of the credit crisis (see below from Scribd as well). His various indictments are sure to get lots of press, but what I find particularly interesting, and what few discuss, are his experiences in running a firm involved in investing other people’s money. He was an incredibly successful investor but was unable to maintain an investment management firm.
He states:
“During 2007, under constant pressure from my investors, I liquidated most of our credit default swaps at a substantial profit. By early 2008, I feared the effects of government intervention and exited all our remaining credit default positions — by auctioning them to the many Wall Street banks that were themselves by then desperate to buy protection against default. This was well in advance of the government bailouts. Because I had been operating in the face of strong opposition from both my investors and the Wall Street community, it took everything I had to see these trades through to completion. Disheartened on many fronts, I shut down Scion Capital in 2008.”
Indeed, Michael Burry, according to Michael Lewis in Vanity Fair, eventually returned a 5x return (“489.34 percent” actually) which under almost any time horizon is a great IRR, but still he failed as a money manager to the extent that, by his own admission, he alienated his own investors and lost his business (even if by his own choice).
What happened? This brings me to the interesting grouping in the graphic at the top of the page. We can gain some insights by looking at the fund raising experiences of other questionable investors- a fraud (Fairfield Sentry – Bernard Madoff) and an alleged fraud (Stanford Financial Group – Allen Stanford), and comparing them to a (ex-post) well regarded/successful investment firm (Scion Capital – Michael Burry). The first two (questionable investors) raised tremendous assets while the third (highly successful investor) struggled – even after years of great returns. All three operated in the private wealth space. A quick recap:
Fairfield Greenwich (FG) was invested in Bernard Madoff and at its peak apparently managed over $15bb. One of FG’s funds, Fairfield Sentry (left), alone, was able to raise $7bb of assets under management by showing ~10.9% return with a ~2.5% volatility. We now know (based on Madoff’s allocution) that these returns were fraudulent, but what is useful to know is that the fund was able to draw and maintain $7bb of assets under the assumption that this performance would continue. So presumably, the lesson is at least $7bb of demand exists at the risk preference of 10.9% return with 2.5% volatility. If FG’s other funds (besides Sentry) exhibited similar return profiles, then we can say at least $15bb of demand existed at this risk/return point.
Next, the Stanford Financial Group (SFG) was seized by the US for allegedly perpetrating a ponzi scheme that attracted $8bb of assets. Not commenting on the merits of the case, what we do know (at least from this WSJ article on the SEC’s accusations) is that “from 1992 to 2006, Stanford International Bank reported steady returns of from 6% to 10% annually on its certificates of deposit, according to the SEC” and based on these “steady returns” SFG was able to draw and maintain $8bb of assets. I remember reading in Bloomberg (though unfortunately I can’t find the source) that much of the returns promised were around 8% per year which checks with WSJ’s statement. So from this we can surmise that another $8bb (at least) of demand existed at low/no risk and 8% return.
Lastly, not much is public about Burry’s Scion Capital, but from the Vanity Fair article, we can surmise that assets peaked at $1bb after a 5x gain and after shoving a significant portion of assets into side-pockets (as discussed in Burry’s 2006 letter to investors) which was so poorly received as to eventually merit shutting down the firm as noted in the above quote in Burry’s New York Times Op-Ed. If we assume that 5x was garnered in 3 years, then we can estimate that the yearly return was 70%. Based on Burry’s other writings and letters we can make a rough guess that his fund had a volatility of 30% annualized. Reducing the $1bb to the original investment and adding a factor to make it comparable to FG, perhaps it’s fair to say that Burry eventually raised $300mm and was able to grow it, though he was not able to hold on to it even after significant gains. So from this it’s perhaps fair to say that very little demand exists in the private wealth space at 30% risk with lock-ups (side-pockets) even if the return is exceptional.
Insights and Conclusions
* So what seems to be a common theme is that private wealth investors are more sensitive to risk (or perceived risk) than return. In short investors prefer low risk – low return strategies.
* Along this line, FG and SFG were able to raise a combined $23bb of assets by showing returns of at most 11% per year but possessing very low volatility.
* Additionally, Scion was not able to keep assets after requiring lockups and demonstrating significant volatility even if over time exceptional returns were generated.
* So investor behavior seems to indicate that investors prefer to delegate total wealth management to an asset manager – low risk / low return strategies tend to have an easier time raising assets, even after correcting for risk that presumably the investors could do themselves.
* Yet, investment managers tend to offer only a one-size-fits-all product (medium to high risk with high returns) even when the investment market clearly rewards more de-levered products (like a low risk CD returning high single digits or a fund consistently giving a 10% return at low vol).
* Therefore there is an opportunity to offer a menu of products – ie a menu of risk – to investors and allow them to indicate their own risk tolerance. At least offer a “capital preservation” strategy that has a volatility of no greater than 8% per year.
* If this were done, many managers would likely find that they need to de-lever their portfolios but would be able to buy more of the same risk assets over a much larger asset base.
So even though investors claim to want 20+% per year, the general risk tolerance seems to be more at the 8% vol level. Assuming a sharpe ratio of 1 and a 2% alpha, 8% vol gets you to 10% return. Therefore returning 10% (net after fees) at 8% vol (roughly half of the S&P) should raise significant assets.
Consider the implications. A fund that has a strategy that yields 15% per year net at 10% vol on its investment style, would be much better suited taking the same style and de-levering it roughly by a third (ie putting 1/3rd of assets into cash or something similarly low risk) and reducing vol to 7-8% and return to 10% and could probably then raise 50% to 100% or more in assets.
So in Burry’s case, I actually sympathize more with the investors. They thought they were getting a more liquid strategy than they ultimately discovered they had. Yes, Burry was spectacularly right on his investments, but investors did not want to take that level of volatility. Presumably he could have exercised the same strategy, but much less concentrated, and would keep his firm. Alternatively he could have solicited a side pocket strategy (much as Paulson did) and been clearer with the liquidity. If he had done either, likely he’d be running/managing billions now. His choice, however, was to produce a 500% return – great for him personally as incentive fees yielded $100mm and the story led to a book but at the cost of the business.
It’s a questionable choice, professionally. Consider that a firm producing 10% net of fees is probably making 13% before fees and extracting 3% in fees. If 10% net raises $2bb in assets, then fees on those assets amount to $60mm per year. In two years, the $100mm payout is surpassed. Such is the asset management business. In the end, profits are more sensitive to time than returns.
Feliz Páscoa,
Arthur O’Keefe, São Paulo Value
The above is the FXE Euro Trust Currency Shares vs the S&P Trust
