A Micro-Bubble Is Popped

February 14, 2018 - John Osbon (3 mins to read)

It’s been 20 days since the Dow peaked at 26,400.  After a wild ride, the index is back within a few percentage points of that level. While very little has changed in the diversified portfolio of long-term investors, some casualties of the market flip-flops have floated to the surface. One is LJMIX. Here’s the story of a fund that took a few bad days and turned it into a bona fide disaster.  What can we learn from its mistakes?

Monday, February 5th

The LJM Preservation & Growth fund has a name that denotes safety and discipline, but you’d never know it based on recent results. Monday, February 5th was the day of destruction for LJMIX. The Dow sank 1100 points. More to the point, the VIX, a volatility measure, sprinted from 14 to 38. LJMIX was shorting the VIX, betting that it would go down. Instead, the VIX went up enough to erase $400 million or 80% from the investors in LJMIX. So much for Preservation and Growth. After the fall, LJM founder and chairman Tony Caine said “our goal is to preserve as much capital as possible.” But that horse had left the barn. Lawsuits against LJM are now in progress.

How to avoid the next LJMIX

For years LJMIX had flown more red flags than the former Soviet Union. Any reasonable person who spent the time and energy to investigate could see that LJMIX was an accident waiting to happen. Here’s what to look for:

First and foremost, know the risk and return profile of the investment. Can the investment go to $0 or close to it? You have to understand what is under the hood to answer this question – it’s not as obvious as it may seem.
Next, identify allowable derivatives. This fund was shorting volatility, a derivate trading strategy. Derivatives can act like leverage, accelerating losses when markets are tested.

Finally, know the rules surrounding investment strategy. If it’s an actively managed fund, what are the guidelines for its manager?  Don’t just trust the name. Even self-described “passive,” “growth,” or “value” funds are often mislabeled.

We’ve seen this episode before

If you have been investing for 20 years or more you may remember other misleading fund names like Long-Term Capital Management which was wiped out with a $4.4B loss on $4.7B in 1998, because it was leveraged 100 to 1. Or the Ruane, Cunniff Sequoia Fund (SEQUX) debacle where — despite a brand and reputation centered on value investing — a third of its assets were invested in Valeant shortly before that stock tanked. (See chart above). Both funds strayed wildly from their investment charters, broke their own rules and paid a steep price. So did their investors.

The point I am making here is to remain ever-vigilant about where your money is actually invested. You or your advisor can perform the task. Don’t stop with fund names, performance history or the pedigree of fund managers. Do the research and get into the weeds. There’s a lot to be gained in investing by avoiding mistakes that don’t need to happen.

Where to go from here

It is possible to navigate successfully through volatile markets like the ones we are experiencing now. For starters, realize that volatility does not necessarily mean loss nor gain. US stock market investors are back to flat for the year 2018. Furthermore, diversifying your assets to include allocations to bonds, commodities, real estate and others generally reduces swings in portfolio value.

Here’s the best news: Recent events provide a great opportunity to understand what you own. Have your advisor do some homework on your portfolio since the beginning of the year. Did your portfolio go up or down by more than 10%?  If it did, why? Are you holding assets that accelerate your risk in turbulent times?

If you would like to know what Osbon Capital has done in 2018 please email us.



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