Objective and strategy
The fund seeks long-term growth of capital independent of stock market direction. The managers balance long and short positions in domestic large cap stocks within the S&P 500 universe. They calculate a company’s Return on Tangible Assets (ROTA) and Return on Market Value of Equity (ROME). The former is a measure of a firm’s value; the latter measures its stock valuation. They buy good businesses as measured by ROTA and significantly undervalued firms as measured by ROME. Their short positions are made up of poor businesses that are significantly overvalued. As a risk-management measure and to achieve beta neutrality, their individual short positions are generally a lower dollar amount, but constitute more names than the long portfolio.
Cognios Capital LLC. Cognios, headquartered near Kansas City was founded in 2008. It’s an independent quantitative investment management firm that pursues both long-only and hedged strategies. As of December 31, 2015, they had $388 million in assets under management. They manage a hedge fund and accounts for individual and institutional clients as well as the mutual fund. The senior folks at Cognios are deeply involved with charitable organizations in the Kansas City area.
Jonathan Angrist, Brian Machtley and Francisco Bido. Mr. Angrist, Cognios’s cofounder, president and chief investment officer, has co-managed the fund since its inception. He co-owned and was a portfolio manager at Helzberg Angrist Capital, an alternative asset manager that was the predecessor firm to Cognios. He helped launch, and briefly managed, Buffalo Micro Cap fund. Mr. Machtley, Cognios’ chief operating officer, has co-managed the fund since its inception. Previously, Mr. Machtley served as an associate portfolio manager at a Chicago-based hedge fund manager focused on micro-capitalization equities. Mr. Bido is Cognios’ head of quantitative research. Prior to joining Cognios in 2013, Mr. Bido was a senior quantitative researcher with American Century Investments.
Strategy capacity and closure
At $3 billion, the managers would need to consider closing the fund. The strategy capacity is limited primarily by its short portfolio, which has more numerous but smaller positions than the long portfolio.
Management’s stake in the fund
Messrs. Angrist and Machtley have between $100,000 – 500,000 each in the fund. Mr. Bido has between $10,000 – 50,000. One of the fund’s trustees has an investment of $10,000 – $50,000 in the fund. The vast majority of the fund’s shares – 98% of investor shares and 64% of institutional ones, as of the last Statement of Additional Information – were owned by the A. Joseph Brandmeyer Trust. Mr. Brandmeyer founded the medical supplies company Enturia and is the father of one of the Cognios founders.
31 December 2012
$1,000 for the individual shares and $100,000 for the institutional shares (COGIX).
Excluding dividend expenses, borrowing costs and brokerage expenses on securities sold short, the expense ratio is 1.95% on assets of $31 million, as of January 2016. Once the “excluded” expenses are factored-in, the expense ratio bounces to 3.96% on the retail shares and 3.71% for the institutional ones.
Market neutral funds, mostly, are a waste of time. In general, they invest $1 long in what they consider to be a great stock and $1 short in what they consider to be an awful one. Because there are equal long and short positions, the general movement of the stock market should be neutralized. At that point, the fund’s return is driven by the difference in performance between a great stock and an awful one: if the great stock goes up 10% and the awful one goes up 5%, the fund makes 5%. If the great stock drops 5% and the awful one drops 10%, the fund makes 5%.
Sadly, practice badly lags the theory. The average market neutral fund has made barely 1% annually over the past three and five year periods. On average, they lost money in the turbulent January 2016 with about 60% of the category in the red. Only two market neutral funds have managed to earn 5% or more over the past five years while two others have lost 5% or more. No matter how low you set the bar, the great majority of market neutral funds cannot clear it. In short, they charge hedge fund-like fees for the prospect of cash-like returns.
The short answer is, because we need risk mitigation and our traditional tool for it – investing in bonds – is likely to fail us. Bonds are generating very little income, with interest rates at or near zero there’s very little room for price appreciation (the price of bonds rise when interest rates fall), there are looming questions about liquidity in the bond market and central bankers have few resources left to boost markets.
Fortunately, a few market neutral funds seem to have gotten the discipline right. Cognios is one of them. The fund has returned 7.6% annually over the three years of its existence, while its peers made 1.2%. In January 2016, the fund returned 4.3% while the stock market dropped 5% and its peers lost a fraction of a percent. That record places it in the top 4% of its peer group in the company of two titans: BlackRock and Vanguard.
What has Cognios gotten right?
- Their portfolio is beta neutral, rather than dollar neutral. In a typical dollar-neutral portfolio, there’s $1 long for $1 short. That can be a serious problem if the beta characteristics of the short portfolio don’t match those of the long portfolio; a bunch of high beta shorts paired with low beta long positions is a recipe for instability and under-performance. Cognios focuses on keeping the portfolio beta-neutral: if the beta of the short portfolio is high relative to the long, they reduce the size of the short portfolio. That more completely cancels the effects of market movements on the fund’s return.
- Their long positions are in high-quality value stocks, rather than growth ones. They use a quantitative screen called ROTA/ROME ™. ROTA (Return on Tangible Assets) is a way of identifying high-quality businesses. At base, it measures a sort of capital efficiency: a company that generates $300 million in returns on a $1 billion in assets is doing better than a company that generates $150 million in returns on those same assets. Cognios research shows ROTA to be a stable identifier of high quality firms; that is, firms that use capital well in one period tend to continue doing so in the future. As Mr. Buffett has said, “A good business is one that earns high return on tangible assets. That’s pretty simple. The very best businesses are the ones that earn a high return on tangible assets and grow.” The combined quality and value screens skew the portfolio toward value. They also only invest in S&P 500 stocks – no use of derivatives, futures or swaps.
- They target equity-like returns. Most market neutral managers strive for returns in the low single-digits, to which Mr. Angrist echoes the question: “why bother?” He believes that with a more concentrated portfolio – perhaps 50 long positions and 100 short ones – he’s able to find and exploit enough mispriced securities to generate substantially better returns.
- They don’t second-guess their decisions. Their strategy is mechanical and repeatable. They don’t make top-down calls about what sectors are attractive, nor do they worry about the direction of the market, terrorism, interest rates, oil prices or the Chinese banking system. If they’ve managed to neutralize the effect of market movements on the portfolio, they’ve also made fretting about such things irrelevant. So they don’t.
- They focus. This is their flagship product and their only mutual fund.
A market neutral strategy isn’t designed to thrive in a bull market, where even bad companies are assigned ever-rising prices. These funds are designed to serve you in uncertain or falling markets. It’s unclear, with the prospect that both stocks and bonds might be volatile and falling, that traditional strategies will fully protect you. GMO’s December 2015 asset class returns suggest that a traditional 60/40 hybrid fund will lose 1.4% annually in real terms over the next five to seven years. Of the three market neutral funds with the best records (Vanguard Market Neutral VMNFX with a $250,000 minimum and BlackRock Event Driven Equity BALPX with a 5.75% load are the other two), Cognios is by far the smallest, most accessible and most interesting. You might want to learn more about it.