Why $1.5 Billion Nevsky Capital Is Shutting Down: The Full Letter

 

As noted moments ago, the iconic $1.5 billion Nevsky Capital is calling it quits. What is surprising, is that unlike some "one hit wonder" hedge fund wannabe, Nevsky is actually a brand name in the hedge fund community, as demonstrated by the following performance charts.

 

And yet, despite its sterling performance, the fund is liquidating for all intents and purposes and returning outside money. Here is the full reason why, from the December letter to clients:

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Why have Nevsky Capital decided to cease managing the Nevsky Fund?

The decision to stop managing the Fund, after just over fifteen years, has been a very difficult one. This decision has been driven by a growing recent awareness that certain features of the current market environment, which we believe might persist for a considerable period of time, are inconsistent with the achievement of our goal of producing satisfactory risk adjusted absolute returns for you, our clients.

Over our twenty-one year investment career we have always invested using a broadly unchanged process. This process marries the top down forecasting of key macro-economic variables with the bottom up forecasting of company earnings; initially just in Eastern Europe, then across the Emerging World and finally on a global basis from 2003 onwards.

For this process to work we have consistently needed the following criteria to be met:

• Access to transparent and truthfully compiled data at both a macro and a company specific level, which is made available on a timely basis to all market participants. This allows us to construct and maintain detailed top down economic forecasts and bottom up company models.
• Logical decision making by macro-economic policy makers.
• An ability to achieve a clear understanding of the positioning of other investors in the market so as to be able to come to a view as to what is ‘in the price’ and what is ‘fair value’.
• A reasonable level of divergence in equity prices between different geographies and sectors and the existence of constantly evolving, but logical, inter-relationships between these different asset classes.
• Manageable ‘fat tail risk’
• A reasonable spread of uncorrelated potential investments across time zones.

Unfortunately, global trends over the past couple of years have begun to militate against these pre-conditions for successful fundamental investing. Namely:

Data quality has deteriorated

• Data releases have become much less transparent and truthful at both a macro and a micro level. At a macro level the key issue is the ever increasing importance of China and India. China is the world’s second largest economy, but already much larger than the US in a broad swathe of sectors. India will be the world’s third largest economy within a decade. Unfortunately their rise is increasing the global cost of capital because an ever growing share of the most important data they produce is simply not credible. Currently stated Chinese real GDP growth is 7.1% and India’s is 7.4%. Both are substantially over stated. This obfuscation and distortion of data, whether deliberate or inadvertent, makes it increasingly difficult to forecast macro and hence micro as well, for an ever growing share of our investment universe.
• At a micro level corporates have also responded to greater market scrutiny since the GFC to disclose less not more, on the basis that the less they reveal the less often they can be proved wrong by regulators, investors or law courts. This means the cost of capital relating to holding large company specific exposures has risen as the ‘headline’ risk of being proved wrong with regard our earnings projections is now commensurately higher.

The transparency of decision making has also declined

Assuming we can obtain trustworthy data we then apply logic to produce our forecasts. The validity of this process becomes questionable if economic policy makers do not themselves apply economic logic and in a transparent manner. Obviously we accept politics can trump economics and political analysis has always been a very big part of our process, but surely never has so much of the world been governed by leaders where the logic of that peculiarly parochial yet multi headed beast – nationalism - trumps all (China, India, Russia, Turkey, South Africa, Malaysia etc. etc.). Almost by definition the path of logic within nationalism is difficult for ‘outsiders’ to follow with any confidence, leading to highly unpredictable and potentially dysfunctional modelling outcomes.

• At the start of our careers we spent much time being forced to try and decipher the indecipherable – the moods and subsequent decisions of Boris Yeltsin. This ‘Kremlinology’ was truly the definition of banging your head against a proverbial brick wall. Fortunately this and similar masochistic macro-analytical tasks then gave way to the logical joy of the Washington Consensus which was adopted almost without exception across the Emerging World following the multiple devaluation crises in the mid-1990’s. Unfortunately though the Washington Consensus, having been severely wounded by the GFC is now stone dead. Kremlinology, with an additional nationalist twist, is back – and it is now the norm, not the exception, for most countries in the Emerging World. We are not convinced that knowingly continuing to bang our heads against these newly erected brick walls would be a sensible decision.
• Equity markets are also less transparent
• The unintended consequences of those new regulations introduced as a result of the GFC, which have largely removed the market making role of investment banks from global equity markets, has coincided with the recent massive increase in market share of both ‘dumb’ index funds and ‘black box’ algorithmic funds to create a situation where equity market volumes have fallen sharply and individual stock volatility has risen dramatically. An initially badly executed order can now inadvertently create a price trend (because there is no longer the cushion to price moves which was in the past provided by market maker inventories) that, as algorithmic funds feast on it, can create a market event even if the initial order was a simple innocent error. Truly – to mix metaphors – butterflies flapping their wings now regularly create hurricanes that stop out fundamentally driven investors who cannot remain solvent longer than the market can remain irrational.
• In such a world dominated by index and algorithmic funds historically logical correlations between different asset classes can remain in place long after they have ceased to be logical. More butterflies.
• Index and algorithmic fund manoeuvrings also make it very hard to ascertain what the markets ‘clean’ positioning is at any given time. All of which pushes up the cost of capital.

Fat tail risk has also increased

• Less disclosure means more event risk, while thin volumes coupled with trend seeking algorithmic trading mean the markets responses to such events have become much more violent. Instant downside risk on both longs and shorts has become immeasurably larger as a result.

Asia is becoming an increasingly dominant time zone

• If this wasn’t enough, the growing dominance of Asia, because of the growth of China and India and (happily) the resuscitation of Japan as a viable investment destination by Abenomics, also makes operating our all inclusive global equity process ever more difficult from a time management perspective. With the world ever more interlinked economically, gone are the days when one time zone (of Asia/Europe/the US) could be neglected at any given time to the benefit of the others. This has forced us, over the past two years, to resume the brutal hours we stepped back from in 2010, but which we now think are both unavoidable going forward and unsustainable.

In summary, all of the above factors now mean that it is more difficult than ever before for us to accurately forecast macroeconomic and corporate variables. This pushes up our cost of capital and substantially increases the risk of us suffering substantial capital loss on individual positions either because of a forecast error or simply because we could be caught up in an erroneous market trend, which could then persist for far longer than we could take the pain. This has made what we enjoy most – the thrill of analysing economic data releases and company accounts – no longer enjoyable. It is therefore time to accept that what we have done has worked brilliantly for twenty years but does not work anymore and move on. We are confident our process will eventually work again – for the laws of economics will never be repealed – but for now they are suspended and may be for some time; an indefinite period involving indeterminate levels of risk during which we think it would be wrong for us to be the stewards of your money.

The final reason we have decided to cease managing the Fund is our increasing concern with regard the health of the global economic cycle, which we describe in detail in section 3 (below). This view is relevant because, in our experience, periods of economic pressure and high market volatility will tend to make the issues that are already making it more difficult for our process to work (which we have discussed above) such as poor disclosure, the triumph of nationalism over economic logic, low market liquidity and heightened event risk, worse not better, thus potentially leading to a further deterioration in our risk adjusted returns.

Link to full letter https://www.scribd.com/fullscreen/294654490?access_key=key-xfqKH8QC2LsXN87EW4uk&allow_share=true&escape=false&show_recommendations=false&view_mode=scroll

Worth a look. What's happened? China A and H corrected 7% and 3% on the first day of trading in 2016, the worst start of a new calendar year in the history of the Chinese equity markets. The 7% drop in CSI300 triggered the new circuit breaker mechanism which was implemented for the first day today. CNY fixing and CNH also weakened 0.15% and 0.95% vs. the USD on Jan 4 (to 6.50 and 6.63 respectively), extending the 5.77% and 5.36% depreciation in 2015. What triggered the selloff? The commonly cited explanations for the selloffs include: 1) a marginally weaker than expected Caixin PMI for December, which came in at 49.7 vs. Bloomberg consensus of 49.8, below 50 for the 10th consecutive month; 2) market concerns over near-term liquidity conditions, notably the expiry of selling ban (on Jan 8) from major shareholders, the resumption of IPOs, and the confirmation of IPO reform in A shares; 3) the continuing weakness of the CNY/CNH and the related concerns regarding capital (out)flows, domestic monetary tightening, and corporate earnings; and 4) concerns about policy stimulus inaction (or lower intensity) as the government begins to emphasize supply-side reforms. 10FAQs about Chinese equity markets at the start of a new year. 1. How does the new circuit breaker(CB) work in A shares? Exhibit 1 summarizes the key features of the CB in A shares and how it compares with CBs in major markets globally. Simply put, the whole market will suspend trading for 15mins when the CSI300 index moves +/- 5% from the previous day's close, and will halt trading for the whole day when the index moves +/-7%. It is noteworthy that the 10% price limits remain valid at the stock level and the new rules only apply to the CSI300 index (that's why ChiNext was down 8.2% today). We reiterate our view that the new CB doesn't fundamentally change the volatility profile of the A-share market as it is inherently driven by the investor mix (dominated by retail investors) and their investment philosophy (strong growth/momentum bias vs. value). The lower price limits of the new CB also suggest that today's price actions may not reflect a market clearing price, as history shows the A-share market only managed to rebound 0.9% on average on the subsequent day post the previous 13 large, one-day corrections over the past decade. Exhibit 1: How does the new circuit breaker mechanism work in A shares? And how did market fare historically after a significant 1-day drop? Download attachment-1 Sources: Bloomberg, SSE SEC, NYSE, NASDAQ, IIROC, SEBI, NSE, BSE, JPX, KRX, Bursa, SGX, TWSE, SET. 2. How muchcould major shareholders be selling? As a background, on July 8, the CSRC banned company shareholders with stakes of more than 5% from selling for the next 6 months as a part of the regulator’s effort to provide an external stabilizer (reduce supply) to smooth out volatility during the sharp market correction in July 2015. These bans will expire on Jan 8 and we estimate that major individual shareholders with over Rmb1.1tn of stock holdings, representing 5.8% of total A-share free-float market cap, could be incentivized to sell given the 13% market rally since July 8, although the actual selling could be considerably smaller. On Jan 4 after market close, according to SINA.com, there were news reports suggesting that major shareholders won’t be able to sell even after Jan 8 subject to further clarifications from the CSRC. If these reports prove to be true, we think they may help alleviate liquidity concerns in the short term, but they would not change our core view that the A-share market will face several market liquidity headwinds in 1Q/1H16. See China Strategy: 2016 Outlook: A nuanced story; alpha markets, Dec 3. Exhibit 2: We estimate that major individual shareholders with over Rmb1.1tn of stock holdings could be incentivized to sell post the expiry of the selling bans Download attachment-2 Source: Wind. 3. What's thepotential market impact of the resumption of IPOs? On November 6, the CSRC reactivated the IPO window after freezing it since early July. So far, 28 companies have listed on the main, SME, and ChiNext boards, raising Rmb11bn (US$1.7bn) in total. According to the CSRC, 600+ companies are currently in the pipeline, although we believe the regulators will carefully manage the pipeline according to market conditions to avoid unnecessary liquidity squeeze/shocks. From a tactical standpoint, history suggests the A-share market tends to trade sideways to slightly down shortly after resumptions became effective but it doesn't seem to fully explain the selloff today, at least in that magnitude. We think investors may be more concerned about the confirmation from the State Council/NPC of IPO reform (from approval-based to registration-based), which will start on March 1, but implementation details are not yet available. As detailed in our 2016 China A-share outlook report, we estimated that around Rmb1.2 tn of A-share equity financing may come to the market this year, representing a 20% increase from 2015, 2.9% of A-share free-float market cap, but still lower than the historical average of 5.5% during 2000-2015. Exhibit 3: History suggests that resumption of IPOs has had only short-lived impact on the market, and next year's total equity financing is likely below historical average, based on our estimate Download attachment-3 Source: Bloomberg, FactSet, Wind, Xinhua News, Goldman Sachs Global Investment Research. 4. What'sa down day in the 1st trading day mean for the rest of the year? While we don't form our views based on technical indicators and episodic analysis, the selloff in the first calendar year's trading day has sparked questions on what a poor start could mean for full-year returns. Empirical evidence suggests that a down day on the first trading day in a calendar year is usually followed by a tough trading environment for the rest of the year, with the offshore markets registering 80%, 100%, and 60% probability to return negatively in the ensuing 1, 3, and 12 months respectively. Exhibit 4: A down day on the first trading day in a calendar year tends to suggest a tough trading environment for the rest of the year Download attachment-4 Source: FactSet, MSCI, Wind, Goldman Sachs Global Investment Research. 5.What are the key policy changes and announcements that have been made in the past 1 month? And what are the key events ahead? The international and domestic event calendar was very active when investors were away for holidays in December. Externally, the ECB announced to extend its QE program in early Dec and followed by the 25bps policy rate hike by the Fed, the first hike since 2005. In China, the Central Economic Working Conference (CEWC) was held on Dec 21 after which the concept of 'supply side' reform was prominently highlighted. The Rmb was admitted to the SDR basket on Nov 30 but the CNY/CNH has lost 1.6%/3.1% since then, which partly prompted the authorities to tighten restrictions on capital flows. In the equity market, 14 ADRs were added to the MSCI universe on Dec 1, the NPC approved the long-awaited IPO reform in late Dec after the CSRC re-opened the IPO window in Nov. At the company level, PetroChina and China Merchants Group/Sinotrans announced their respective SOE reform plans in late Dec, while China Vanke filed for suspension due to pending corporate action. Looking ahead, we expect 2016 to be another eventful year as it will be the maiden year of the implementation of the 13th Five Year Plan, and SZ-HK Connect will likely be announced and implemented in 1H16, followed by the discussion of A shares potentially going into MSCI benchmarks. Additionally, market liquidity events (such as the 'exit' from the National team), and the development regarding the anticorruption campaign could have far-reaching macro and investment/trading implications, in our view. Exhibit 5: Quite a number of important policy changes have been made last month, and we expect the policy/event calendar to stay active in 2016 Download attachment-5 Source: Bloomberg, Reuters, Xinhua news, PBOC, Goldman Sachs Global Investment Research. 6.What are our key views on the core macro drivers (growth, liquidity, reforms)? Our economists forecast China's GDP to grow 6.4% in 2016 (from 6.9% in 2015), with a tough 1Q in terms of sequential growth momentum (5.8%). The growth orientation is clearly changing (more services, less FAI and exports) but we believe the skepticism around the ‘true’ growth state of China, and the associated leverage/bad debt concerns, will remain elevated as our alternative growth measure suggests that China’s growth may be 1-2pp weaker than official GDP statistics may indicate. Domestic policy/liquidity is likely to stay easy to support growth and to facilitate reforms—we expect monetary and fiscal policies to further loosen. However, the Fed's policy normalization cycle, and the risks regarding a significant Rmb depreciation, have weakened the macro liquidity arguments somewhat. Reform should remain a topical issue in China as 2016 is the maiden year of the 13th FYP. While we may see acceleration of reform implementation in areas including SOE and capital markets, we think the bar for reforms to single-handedly re-rate Chinese equities is much higher than before given the policy surprises investors witnessed (and hence the questions on policy efficacy) in the equity and FX markets last year. Additionally, we also expect more corporate (SOE) defaults to surface, which could sporadically provoke systemic concerns and market volatility. Exhibit 6: We expect macro growth to decelerate, policy to stay easy, and more corporate defaults in 2016 Download attachment-6 Source: Bloomberg, CEIC, Wind, Goldman Sachs Global Investment Research. 7.How do we position China in a regional context to start 2016? In our 2016 outlook published on Dec 3, we lowered China (MSCI China) to Marketweight from Overweight on slowing sequential macro growth and A-share liquidity risks in 1Q as discussed above. Specifically, we forecast only mid-single-digit EPS growth for H and A shares in 2016, but limited room for multiple expansion as valuations appear fair benchmarking against our macro forecasts, with both MXCN and CSI300 trading at mid-cycle valuations. While our end-16 index targets currently imply 13% and 15% price return for MXCN and CSI300 after the two indexes have fallen 4% and 3% since Dec 15 (vs. 6% for MXAPJ), our envisaged short-term macro and liquidity headwinds lead us to believe that it's too early to turn aggressive on Chinese equities. Also see Asia Pacific Strategy: 2016 Outlook: Muted returns, targeted opportunities, Dec 3. Exhibit 7: In our 2016 outlook report, we lowered China to MW on slowing growth and A-share liquidity risks in 1Q Download attachment-7 Source: FactSet, CEIC, Goldman Sachs Global Investment Research. 8. Sector allocation? Top- and bottom-3 performing sectors have yielded 37% long-short returns in 2015 on significant rotations, meaning that investors need to embrace a nimble investment approach to seek alpha. We are Overweight Tech, Telecom, Healthcare, and Property to start the year, reflecting our ‘New China’ bias and defensive orientation. Exhibit 8: We are OW Tech, Telecoms, Healthcare, and Property to start the year to reflect our 'New China' bias and defensive orientation Download attachment-8 Source: FactSet, Bloomberg, MSCI, I/B/E/S, Goldman Sachs Global Investment Research. 9. Themes? Growth scarcity, risk/reward, and Rmb risks are the key axes in our thematic thinking. We would build core positions around ‘New China’ stocks, which managed to grow top-/bottom-line by 37%/45% in 1H15, with ADRs currently being our top idea in that space given the MSCI inclusion catalyst. In ‘Old China’, select SOE reform beneficiaries and ‘bottomed out’ old economy stocks, notably telcos and energy-related companies, look attractive given where they are traded in terms of valuations and profitability expectations. To hedge the Rmb deval risks in the equity space, we like fundamentally sound companies which may benefit when the Rmb weakens, paired against those which may lose out. Exhibit 9: Key themes: ‘New’ vs ‘Old’ China; 'Old China' revengers; Rmb hedges Download attachment-9 Source: Bloomberg, FactSet, Wind, Goldman Sachs Global Investment Research. 10. What's the key concern that most investors are concerned about?CNY. The topic of Rmb devaluation risks came up in virtually all of our investor meetings in December. To express our view that there could be non-trivial risks for a one-off Rmb devaluation and to position for the potential market ramifications, besides options strategy, we highlight a group of stocks which may fundamentally benefit in a Rmb depreciation scenario based on our analysts’ bottom-up estimates. In a similar vein, we have put together a list of companies which may lose out when the currency weakens. In fundamental terms, every 10% Rmb depreciation (vs. the USD) could on average boost/reduce 2015 earnings by 41%/81% for the beneficiaries/losers group, respectively. Exhibit 10: These stocks may disproportionately benefit or lose out in a Rmb weakening environment, based on our analysts’ estimates Download attachment-10 Source: FactSet, I/B/E/S, Gao Hua Investment Research, Goldman Sachs Global Investment Research.