Through the first half of the year the Absolute Capital Opportunities Fund (the “Fund”) declined 2.89%. By comparison, the HFRX Equity Hedge Index gained 7.86% over the same period.

Over longer time periods the Fund’s performance continues to meet goals and objectives. Since inception in 2015, CAPOX has averaged a 5.10% annual return while also generating a positive return in Q4 2018 and Q1 2020 – the two significant drawdown periods for broad financial markets (see chart).

It is worth noting that the Fund has been very well hedged since inception in 2015 and dating back to 2013 in how the strategy is managed in private accounts. The reason is that since the Great Financial Crisis of 2008, we have been navigating a market environment defined by interest rates hovering near zero. Investment decision-making in a world where interest rates are near zero (or negative in Europe and Japan) changes equity investing in a significant way.

Historically when we purchased a stock, we did so because we thought the security was mispriced and could potentially yield a return somewhere in the 15% per year range. We understand that there is risk inherent every time you invest in a company, and that sometimes the negative case will play out. Therefore, we would spend significant effort estimating the value of the company if things went poorly. If the probabilities were 70% good outcome, and 30% bad outcome, and the potential return was worth the risk, we’d initiate a position. All of this remains true today.

What has changed is that historically we could diversify a good deal of the portfolio risk by owning 30-40 companies each with its company-specific risks that did not necessarily overlap with each other. While a recession could cause a highly correlated temporary decline in values, the odds of a permanent loss were reduced through diversification. However, because interest rates are so very low, all equity investments today face the risk of a permanent impairment of value.

We are acutely aware of this risk, and yet, we believe our company-specific work is valid even in an interest rate environment with ten-year US Treasury bonds yield rising to a more normal 2.5-3%. If rates stay well below that level, it’s quite possible the company- specific valuation estimates we are using could prove to be too low. It is our belief that ten-year US Treasury yields increasing above 4% may cause a permanent reduction in business values across the entire stock market.

Since there is no way for us to guard against this risk through valuation or diversification work, we are guarding against it using our hedging strategy.

CAPOX has historically achieved a profit in three ways:

1. 1. Relative stock selection
   2. Sudden large stock market movements (up or down)
   3.  Increases in stock market volatility

The Fund benefits from having three sources of return, and the interaction between the three goes a long way in explaining the low correlation return stream produced by the fund.

That said, here is what has transpired over the first half of the year:

1. 1. Relative stock selection (+) : Relative stock performance has been extremely strong this year with the long stock portion of our portfolio out-performing the S&P 500 Index by approximately 5%.
   2. Sudden large stock market movements (up or down) (-): While the market is up nearly 15% this year, the moves have been generally very small and steadily upward. This pattern is not conducive to the funds hedging strategy adding value.
   3. Shocks up in volatility (-): Dwindling stock market volatility has been the largest detractor. The VIX index has reversed course this year and is down about 25% YTD.

While we are never pleased with negative performance, the outcome for the first half of the year is well within our range of expectations given the underlying circumstances. Interestingly, this period’s resemblance to 2015 is striking. As markets have marched steadily higher, volatility has fallen significantly. This has caused the cost of future hedging to have become much cheaper. The longer this environment continues (historically high stock market valuations coupled with declining stock market volatility), the better positioned the Fund becomes.

We expect our hedging to be very profitable from time to time, but certainly not every time – once or twice a year should be sufficient based on how we are managing the strategy. We expect this will happen most, but not all years. We are okay with this cost as long as we continue to improve the positioning along the way. In our opinion, the mismatch of timing is what makes this such an attractive vehicle. Just as we rebalance from low-risk assets to higher risk during times of crisis, the longer the current risk-taking environment persists, we believe the Fund becomes even more attractive.

– Kovitz Investment Group

KOVITZ INVESTMENT GROUP is based in Chicago, IL. and is the Portfolio Manager of the Absolute Capital Opportunities Fund