Lee Ainslie & Maverick Capital's 2011 Letter On Lessons Learned & The Investment Environment ~ market folly

Tuesday, March 20, 2012

Lee Ainslie & Maverick Capital's 2011 Letter On Lessons Learned & The Investment Environment

Lee Ainslie's hedge fund firm Maverick Capital finished 2011 with their flagship Maverick Fund down 14.7% for the year. Their Levered Fund was down 30.7% for the year while their Long Fund was down 17.5%.

Today we present excerpts from Maverick's year-end letter where they outline how they've learned from their mistakes and how increased volatility and high correlations have affected them.

On Risk Management

Ainslie said that it was the firm's darkest year. The reason for the underperformance? He writes,

"While the environment for fundamental investing was certainly unfavorable last year, such factors do not fully account for our results. Maverick's poor performance was primarily driven by a handful of individual mistakes and insufficient risk constraints."

In order to address risk management, they've implemented MavRank, a quantitative system driven by fundamental inputs that helps make recommendations for position sizing. While Ainslie stressed that all decisions will still be made by humans, the full implementation of quant tools is interesting.

Lessons Learned

Ainslie turned then turned his focus to volatility, highlighting some interesting datapoints:

"In late October last year the trailing 60 day volatility of the S&P 500 index exceeded 37% for only the fourth time since 1938. The alarming aspect to me is the increasing frequency with which the equity markets have displayed this level of volatility since 1938:

Years that Volatility Exceeded 37%: 1988, 2002, 2008, 2011
Years Since Prior Occurrence: 50, 14, 6, 3

The fact that recent volatility surpassed anything seen in a fifty year period is staggering - especially when one considers that during that time the world suffered through World War II, the Cuban missile crisis, a Presidential assassination, the dollar going off the gold standard, New York City on the verge of bankruptcy, the OPEC oil embargo, US 10 year treasuries yielding over 15%, and the S&L crisis - just to name a few of the events that today's markets might find a tad unsettling.

So why do the markets appear less resilient to such developments today? There are many factors, but I believe globalization, high levels of debt, uncertain regulatory environments, extreme monetary policies, unsustainable fiscal policies and the resulting currency uncertainties all play major roles. The more important question, in my mind, is 'will it continue?' Given that the aforementioned factors are all likely to persist, and in some cases further deteriorate, it is hard to believe the answer is 'no.'

This leads to our conclusion that volatility spikes are likely to continue to occur more frequently, and, therefore, future levels of equity volatility are likely to be higher than those seen in the past. As a result, going forward we will seek to continue to maintain volatility in the 10-12% range in our core funds, even though we expect this level of volatility is likely to be less than half of the equity market's volatility. To help achieve this objective, we have lowered our long-held gross exposure target to 225% from 250%(our long-term average gross exposure has been 248%), among other steps. (We have also decided to maintain our 1.5:1 long/short ratio, which translates to a slight reduction in our target net exposure from 50% to 45%.)"

On the Investment Environment

Ainslie also touched on a subject that many investors have been fixated on: correlation. He writes,

"Last year intra-stock correlations reached all-time highs, surpassing even the levels seen in 1929 and 2008. In other words, stocks moved in tandem with one another to a degree never before seen and were less responsive to idiosyncratic risks, such as fundamental factors, than ever before.

Such an environment is clearly challenging for long/short investors who rely upon stock prices being responsive to fundamental differences among companies. These challenges were evidenced in the small number of positions that generated significant returns for us last year."

Ainslie goes on to point out that January 2012 marked a break in high correlations. However, he still points out that, "equities have maintained correlation above the long-term average for almost six years now, creating a sustained, unfavorable headwind for fundamental investors."

For more from this hedge fund, we've also posted up Ainslie on the impact of fund size on returns.

To read more hedge fund letters, be sure to check out Dan Loeb & Third Point's year end letter, as well as excerpts from Passport Capital's letter.

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