The Appian Fund returned –1.67% in September as the market pulled back from its August rally. U.S. and International Equities and U.S. High Yield indices were negative for the month as investors sought haven in U.S. Treasuries in the face of rising geopolitical tensions.
Economic and Financial Market Overview
The market gave up ground in September, and the Wilshire 5000 Total Market Index returned -2.03% for the month. As investor sentiment shifted to risk off, higher beta segments of the markets were hit hard, and the Wilshire Small Cap Growth Index returned -5.78% for the month. All styles and segments of the U.S. equity market were negative for the month; however, investors expressed a preference for more defensive stocks with the Wilshire U.S. Large Cap Value Index faring the best, finishing down -1.35%. Non-U.S. equities also suffered in September as fiscal woes continued in Europe and emerging markets were rattled by fears that the Federal Reserve will begin to normalize rates in the near term. Developed international equities, as represented by the MSCI EAFE Index, were down -3.84% for the month, while emerging markets sold off nearly twice as much with the MSCI Emerging Markets Index off -7.41%.
Demand has increased for U.S. Treasuries as geopolitical tension has escalated and investors have fled for quality, a shift that has been detrimental to segments of the bond market perceived as higher risk, such as high yield and emerging market debt. The Barclays U.S. Corporate High Yield Index and the Barclays Global EM Local Currency Government Universal Index ended the month down -2.09% and -2.33%, respectively. The spike in demand for Treasuries, coupled with speculation about the timing of the Fed raising rates, pressured yields, and the 10-year U.S. Treasury ended the month at 2.49%. Bill Gross’s abrupt departure from PIMCO on September 26th further rattled global debt markets as investors became skittish about liquidity.
Appian Fund Performance and Positioning
The Appian Fund’s September loss was driven primarily by drawdowns in two of the Fund’s underlying managers: Relative Value Arbitrage and Event Driven – Special Situations. Both managers drew down in excess of 4.0%, which overwhelmed profits in Structured Credit and Market Neutral. Tactical Currency and U.S. Long Short Equity were both flat for the month.
The loss in Relative Value Arbitrage, while troubling, is likely temporary in our opinion. The strategy draws down in periods of serial correlation, defined simply as the market moving in the same direction day after day. Serial correlation is nearly always immediately followed by a reversal in direction and an increase in volatility. The manager’s strategy is akin to stretching a rubber band: when the band stretches, the strategy draws down; but simultaneously the likelihood of the band snapping back is increasing. From the onset of our relationship with this manager, they have told us “the best time for clients to add to their accounts is when we are drawing down”. True to their prediction, early October witnessed spikes in volatility and a few VIX closes above 25. You may recall that we are rebalancing the Appian Fund portfolio considerably as of November 1st. Although our long term target allocation to this manager is 10%, we left them unchanged at 16% as of and beyond November 1st. We believe the end of the Federal Reserve’s QE3 program, combined with an increase in geopolitical tensions, will lead to price discovery and increased volatility in the markets. As we have written previously, this strategy is one that profits in medium to high volatility markets (i.e. VIX greater than 20).
The loss by the Event Driven – Special Situations manager provides cause for further analysis. Deep value, special situations and post-reorganization equities are indeed volatile strategies; however, concurrent losses of a noticeable magnitude calls the manager’s hedging and downside protection strategies into question. That said, event-driven strategies such as this frequently experience temporary losses until a particular catalyst (or event) comes to fruition and produces a positive return. We will continue to monitor this manager with an eye on how successful they are at identifying and profiting from these catalysts.
Attribution for September is as follows:
|Attribution by Strategy|
|U.S. Long/Short Equity||-0.02%|
|Relative Value Arbitrage||-0.72%|
|Event Driven – Special Situations||-0.84%|
As a reminder, the portfolio will be substantially rebalanced as of November 1st. We are shifting the exposures in the portfolio further away from broad market dependent-strategies and further towards non-correlated strategies. We are anchoring the Appian Fund portfolio with two managers whose strategies are completely non-dependent on the performance of an underlying index. Importantly, they are also non-correlated to each other. In doing so we are exposing the portfolio more directly to the skill and expertise of these two managers. Furthermore, we are also reducing the overall number of strategies present in the Fund towards a goal of simplifying the portfolio and reducing the number of favorable market conditions which must occur in order for the Fund to consistently perform well. Going forward, the Appian Fund will be anchored by Market Neutral –European REIT and Tactical Currency. Finally, the Fund will maintain its long volatility positioning as the wind-down of the Fed’s QE3 program, as well as multiple geopolitical uncertainties, are fully absorbed by the markets.
We appreciate your interest in the Appian Fund, and invite you to contact us at any time.