While the U.S. Presidential Election came as a shock to many, our team was prepared for a surprise victory and positioned the ACE Fund accordingly.  We also explain the concept of ‘Emerging Managers’ and the relationship between outperformance and size.
    

On the earnings front, we were encouraged with the broad tone of reports out of U.S. companies (Canada is currently in the thick of earnings season).  Per share earnings for the aggregate S&P 500 in Q3 has come in at +2.5% growth year over year, which brings the “earnings recession” of the past 18 months to a close and relaxes a major headwind for the equity markets.

It may feel as though America took a sharp right turn last week, but the reality is that the White House was the last, sole liberal holdout in what has become a dominantly conservative U.S. legislative landscape.  Come January, Republicans will hold the oval office, majorities in the Senate and House of Representatives, 32 of the 50 state Governorships, and control a majority of the state legislatures. This is a historically one-sided tilting of the map and its ripples are likely to be felt far into the future as the GOP will also appoint the next Fed Chair, at least one and perhaps as many as three Supreme Court Justices, and be well set up for the next Congressional redistricting in 2020.  So much for those shifting demographics sweeping a wave of blue across the electoral map.

Election night itself felt eerily similar to the UK referendum back in June and the overnight trading session saw “limit-down” moves in several currency, bond and equity markets.  In investor meetings over the past few weeks we had been highlighting our view that a surprise Trump victory would likely create a buyable correction.  Going into election night we had scaled our risk exposure down to 80% and as the outcome took shape, our team corresponded throughout the evening.  The plan was to buy stocks at the open, unfortunately by the time the market opened for trading, futures had regained nearly all of the overnight nosedive and we didn’t get a chance to do as much buying as we would have liked.  Still, we eliminated a majority of our shorts (based on the reduced uncertainty), and added to specific longs that reflected (1) our views on the improved earnings trends and (2) expectations for reduced taxes and regulation under the Republicans.

Why is this important? The significance of Emerging Managers is simple: there is a discernible correlation in asset managers between outperformance and size.  Taking this a bit further, the optimal window to be invested with a young and performing asset manager tends to be between roughly years 3 and 8, when total assets under management are above $100 million, but below $500 million.  Several factors align during this window, some organizational, some structural, which helps to make it a more reliable predictor of success.

Organizationally, the compensation structure of an Emerging Manager is much more conducive to alpha generation than at a mature fund company.  For starters, a Portfolio Manager on a billion-dollar fund is making a pretty good living, almost certainly seven figures.  This individual is not very likely to risk their career for a few extra basis points of performance and their employer, probably a public company, is tolerant of failure so long as it is conventional.  A big decision for a manager like this is whether to have a 6% weight in Royal Bank or a 7% weight.  By contrast, the Emerging Manager builds its business on the back of superior performance and risk control, and is hungry to identify exploitable discrepancies in securities prices.  The Emerging Manager seeks compelling opportunities across all sectors and market caps, irrespective of benchmarks, and views being different as a necessary precursor, not a career risk.

Over time, a successful Emerging Manager will grow in scale through a combination of performance and new investors, until such time as its activities become constrained by its shrinking investable universe.  The chart below illustrates this nicely.  If a Canadian Equity Fund manager is restricted from buying more than 10% of a company (the threshold to become an insider), the chart below shows how quickly one’s investable universe in Canadian Equities drops off as fund size grows.  Up to this point, a key asset of the Emerging Manager has been its ability to buy and sell securities with minimal price impact, and to take meaningful weights in small companies doing big things.  As the manager grows, these advantages diminish and the ability to capitalize on market inefficiencies in smaller market cap companies erodes.

The below chart comes from Eurekahedge, a Singapore-based manager research firm which tracks monthly performance on a database of over 22,000 global funds for institutional clients.  This specific chart looks at 16,000 managers in its US-focused database, plotting their annualized 5 year trailing returns against their average assets under management.  While there is a lot going on in this chart, the quality that stands out to us is the positively skewed dispersion of returns for managers with between $100mm and $500mm in assets under management, and how the median manager performance peaks around the high end of this range.

Investment consultants often focus on trying to identify if a manager has an “edge” before greenlighting their allocation to any new strategy.  If the best degree of edge is one that is tangible, explainable and repeatable then a true edge is extremely difficult to find, because if it is tangible and explainable then it’s rarely repeatable (due to market forces exploiting it).  However investors and capital allocators can rely on the Emerging Manager performance edge as a phenomenon that replays over and over with consistency, within the parameters outlined above.

If you have any questions about Emerging Manager performance trends or would be interested in learning more about the implementation of such a strategy in your broader asset portfolio, we’d be happy to speak with you.

Thanks as always for your interest in the ACE Fund. We deeply appreciate your continued support and hope you will remain satisfied investors for years to come.