I want to discuss part two of my Investment Philosophy series, Portfolio Concentration and Diversification. Although this is not the most important part of my philosophy (that was discussed in part 1), it is still very important for you as a potential investor in the Fund to understand how I think about such matters like diversification and the concentration of my portfolio.
If you are a reader of my investment blog, which is more or less an extension
of these letters I send to you, you might have picked up on the amount of holdings I may have at any given point in the Fund. I often say that I like to stick to roughly 8 – 12 positions at any given time. Now you may ask, ‘Why 8 – 12?’, and that is a great question. The honest answer is this: Anything above 8 – 12 I start to have a hard time really concentrating on each position and making the best decisions for each position. This is why, as your Fund Manager, you will never see the Fund hold 50 or 100 positions. To me this is both insane and stupid.
Ray Dalio, who is one of the most respected investors in the world, and CEO of the largest hedge fund in the world, wrote a great piece on diversification, and I would like to put a snippet of that piece in this letter. Here it is:
“All investment assets are priced to be exchanges of lump-sum payments for future cash flows; i.e., when assessing their value the market estimates the present values of those cash flows. And they all compete with each other, with investors trying to buy those that are cheap and sell those that are expensive. Because so many people put so much effort into doing this well, markets are generally pretty efficient—i.e., there aren’t many no-brainers that allow one to buy one thing and sell another to confidently make a favorable return spread. Trying to do that is trying to create alpha, which we do in our Pure Alpha accounts. In our All Weather account, we assume that we don’t know what investment assets will be better and worse than others, so we try to buy all sorts of stocks, bonds and commodities in the right proportions to produce good diversification.”
On this topic, it is known statistically that after 20 individual positions, the
diversification benefit from that additional position is nothing, zero. This means that a portfolio with 100 different positions is more or less equally diversified when compared to a portfolio with 20 positions. The key to this though is to find zero correlated bets. However, we live in a world where everything seems to be connected, so achieving a zero correlation bet is near impossible, but it is the benchmark to strive for. It is precisely for this reason that I don’t see the benefit of holding more than 20 positions at any given time.
The other reason I am not a huge believer in the classical diversification
methods is because I believe it can diminish returns by being too wide spread.
In other words, think about the diversification dichotomy in two ways via a
horse race betting story: 1) Rockvue Capital Diversification – Casting no more
than 8 – 12 bets on horses with the best risk reward ratios of payout, not the
horse with the greatest chance. 2) Traditional Diversification – Place equal
sized bets on every single horse in the race, guaranteeing you don’t lose
money.
As you can see, the second option offers the best protection in terms of
downside risk. No matter what were to happen in the horse race, the bettor
would’ve broke even. However, this is a terrible investment strategy when
capital is being risked. Sadly, that is what so many individuals do. They go to a
financial advisor who then puts their capital into a broad range of mutual funds
and ETFs. The problem with that is a mutual fund is already supposed to be a
diversified investment. So, when you combine multiple mutual funds, you end
up owning the same thing in different places, thus actually increasing your risk
exposure.
I believe that that is both a lazy and not fiduciarily responsible maneuver for
most advisors, and it is detrimental to partner capital. That is not Rockvue
Capital, and that will never be Rockvue Capital. We will never invest in any
mutual fund. Why would we when we believe our fund is better than the
alternative?
Diversification Example in Voyager Fund
With all that being said, the portfolio current has 19 positions. Now I
know you might be thinking to yourself, “Why talk about diversification
and 8 – 12 position limits when you currently have almost double what
you recommend for the Fund? That is a great question. The answer is
quite simple: The increase in positions is due to a “basket” style trade
that I have experimented with over the last couple of months.
This “basket” trade is similar to buying an ETF of such industries or
theses, but with a basket of my own creation, I have much more control
over how I express my bullish thesis. Let’s take a look at a real – time example in the Voyager Fund.
When I did my long oil thesis, I wanted to
express it in a basket. I went long four equity positions: WTI, CVE, ESV,
and BTE. That basket of four equities I consider one large basket trade.
I hope this makes sense to you as a potential investor. This means that
those four trades I personally consider as one trade, and I advise you to
do the same.
Diversification is something that is important to me, but not too
important. Too much emphasis on diversification puts caps on returns.
With proper risk management and capital allocation, diversification is
more of an afterthought for the Fund. That being said, it is important to
construct a portfolio where each trade is as lowly correlated with one
another as possible. This goes for the “basket” trades as well. I do not
want two basket trades of the same thesis.
Fund Updates as of 25 September 2017
Voyager Fund Update
Lastly, I want to update you on the Voyager and SteadFast Fund. The
Voyager Fund is doing extremely well since we have positioned the
Fund for a long oil, commodity, and agriculture plays, while adding
some short exposure. Out of the 19 positions, two of them are shorts,
with the latest addition being short Apple, Inc. My short position in
Apple is working in my favor and I quickly moved my stop loss to get to
break – even; that is the MO. Of the 19 positions, only two of them are in
the red, GNC and an Irish company Irish Continental Group.
With regards to the Voyager Fund, Total Capital Risk is -186bps. This
means that if every position were to hit my stop loss targets, the
Voyager Fund would be up 1.86%. This is where I like to be, and where I
expect to be with the Voyager Fund. By aggressively moving up stop
loss targets and cutting my losses quickly, you can see the power of
positive risk asymmetry.
SteadFast Fund Update
The SteadFast Fund is up 6.85% since February 1st. Since the first of
September, the Fund has increased 80bps. I do not expect this to be
the norm for the SteadFast Fund, but it is nice to see risk parity working.
Once again, I ask each of you to consider the SteadFast Fund as an
option for an initial investment into Rockvue Capital. The SteadFast
Fund is the more conservative investment vehicle within Rockvue
Capital, but it would prove better to those that are more on the fence
with my investment philosophy, or with those that are not fully
convinced or entrusting of my trading style and philosophies.
The Market Plunger 