The Appian Fund returned 0.22% in August as Equity and Fixed Income markets rebounded from July’s global selloff. Tactical Currency, Global Macro and Relative Value Arbitrage strategies performed well during the month, while Event Driven and U.S. Long/Short Equity were the leading detractors. The VIX averaged 13.49 over the course of the month, up 9.8% versus July, yet remains below the 2013 VIX closing average of 14.54 and well below its long term average.
We are bypassing the Market Commentary section this month in order to direct your attention to a few important changes we are making to the portfolio. Performance attribution for August was as follows:
|Attribution by Strategy|
|Relative Value Arbitrage||0.12%|
|U.S. Long/Short Equity||-0.16%|
|Event Driven – Special Situations||-0.42%|
Appian Fund Portfolio and Positioning
Having been unsatisfied with the performance of the Fund as a whole through the spring and summer months, we are significantly repositioning the Appian Fund (Fund) portfolio as of November 1st. This follows several months of iterative analysis between us and the research staff at Wilshire, with the process further complicated by the fact that there is no single culprit responsible for the underperformance. Manager performance has been erratic, and the resulting Fund performance has been muted and unspectacular.
It has always been our view that the Wilshire platform avails us a complete set of alternative strategies with which to manage the Appian Fund. Our investment philosophy and process has not changed. However, our opinions about managers do change, particularly as we see their performance daily and compare it to what we know and to what happened in their respective markets. Additionally, our views on the markets evolve just as the markets evolve. When we launched the Fund in July 2012, the markets were trading headline-to-headline. That behavior receded as 2013 progressed and risk assets lurched forward, but headline-to-headline trading seems to be making a comeback as of late.
Geopolitical risks are on the rise globally, and the markets have taken notice. We are concerned that the U.S. equity market (and perhaps other developed equity markets) faces a heightened risk of a correction. While volatility has remained low, the end of the Federal Reserve’s third quantitative easing program (“QE3”) and, perhaps more importantly, the potential for rising interest rates through the end of the year and into 2015 may have a major impact on markets and require comprehensive consideration as we manage the portfolio into Q4. In sum, disappointing recent performance combined with a few prospective concerns caused us to thoroughly examine the portfolio with an eye on a substantial rebalancing. Let us now discuss our approach.
In constructing the portfolio, we consistently subject each manager and the portfolio as a whole to the following tests:
- On a standalone basis, would the manager contribute to achieving the Appian Fund’s objectives?
- Does the manager habitually produce strong returns relative to the risks they are taking?
- Is the Appian Fund portfolio useful to investors’ overall portfolios (i.e. does it reduce risk and/or enhance return of a traditional portfolio) and what could make it more so?
- Does the overall portfolio reflect our views on the current market environment?
- How would we allocate the capital if we were launching the fund today?
With that as a basis, we conducted an analysis of a variety of different prospective portfolios. One of the many advantages of managing the entire fund on the Wilshire Platform, with its numerous analytical resources at our disposal, is that we are able to stress-test a wide variety of portfolios against an even wider variety of scenarios. Some of those scenarios include the 2007 Sub-prime crisis, S&P 500 +/- 15%, 1999 Fed tightening and Interest rate parallel shift +100 basis points, among many others. In conducting this most recent analysis, we were searching for portfolios that exhibit asymmetric upside in the majority of events (i.e., a portfolio that returns +1.5% when the S&P rises 15% and suffers only a 30 basis point loss when the S&P is down 15%).
After reviewing the current and numerous prospective portfolios, a couple facts became clear to us. First, there are two managers on the platform who stand out as superior when assessed by the five standards listed above. Second, the presence of too many strategies in the portfolio reduces the likelihood of the Fund meeting its goals.
As a result of our analysis and considerable consultation with Wilshire, we are making significant changes to the portfolio as of November 1st. The new allocations are listed below, but let us first discuss the rationale underlying these changes:
- We are completely exiting Structured Credit. Although the manager has produced consistent returns since inception, we believe that the opportunity set faced by structured credit managers is waning now that the housing market has nearly fully recovered. Additionally, we are concerned with this manager’s downside exposure as they are highly correlated to high yield bond markets. As such, we felt that the opportunity cost of having them in the portfolio is simply too high and that the capital could be better deployed elsewhere.
- We are increasing our already substantial allocation to Market Neutral European REIT. As we have often commented, this manager produces consistent positive returns while running a portfolio with no (or extremely low) net exposure to their underlying market. That is an indicator of manager skill and is extremely valuable in the portfolio. The target long term allocation to this manager is 30% of the Appian Fund.
- We are significantly increasing our exposure to Tactical Currency, which is also a market neutral strategy. This manager has been present in the Appian Fund since inception and, although month-to-month returns have been volatile, their calendar-year performance has been strong (9- 13% annually). While there may be some volatility along the way, generally the manager’s investment thesis proves correct over time. Additionally, a double-digit return with no net underlying market exposure is the definition of true alpha.
As you can see, we are effectively anchoring the portfolio with two managers that will constitute approximately 45-55% of the Appian Fund. One exhibits very low volatility, and one very high. They are completely uncorrelated to each other and, again, they are both market neutral. Our analysis suggests that these two managers will work well alongside each other in the Fund. Increasing the Tactical Currency exposure should increase the volatility of the Appian Fund, which we are keen to do. The current volatility of the Appian Fund since inception is 2.3%, while the target volatility is 5-7%. It is difficult to imagine the confluence of events that would produce double digit returns in a portfolio with a volatility of 2.3%. Therefore, as of November 1st we are: establishing the two aforementioned managers as anchors in the portfolio; eliminating certain strategies (Structured Credit and Global Macro/CTA, which has already been exited); and sizing others to newly established medium term targets.
Additionally, with the onset of the official end of QE3, we are maintaining the long-volatility bias of the Fund. Volatility has been so low, for so long, that market participants (especially traders) are starting to wonder if it has been permanently dampened. Some believe that may be the case as the markets have been overrun by algorithmic and high frequency traders, but we are not of that opinion. With the end of QE3, as well as new guidance on interest rates, we will maintain our long-volatility positioning and see if these events re-introduce persistent volatility into the markets. Following is table of strategy allocations:
|Strategy||Curent Allocation||11/1 Allocation||Medium Term Target1|
|Market Neutral REIT||18.53%||26.88%||30%|
|Relative Value Arbitrage||16.23%||16.23%||10%|
|Long Short Equity||11.44%||15%||15%|
|Event Driven – Special Situations||12.25%||10%||10%|
The net effect of these changes should be an increase in the overall volatility of the Fund while maintaining a low correlation to equity and fixed income markets. By bringing the Fund’s volatility into its target range the potential for the Fund to achieve its target returns is correspondingly increased. We appreciate your interest in the Appian Fund and invite you to contact us at any time.