Portfolio of a successful hedge fund Master Capital Management:
Mike Masters: The making of a maverick
01 SEP 2011 –
By Kit R. Roane
Mike Masters: I have a
Mike Masters, a six-and-a-half-foot former all-American swimmer, is used to pushing against the current. Over the past four years, he has repeatedly bucked his hedge fund brethren by calling for financial reforms and has laid into both investment banks and institutional investors for piling into commodity derivatives, which he believes have spiked prices and hammered the poor.
“I have a Christian worldview,” Masters says unapologetically of his Capitol Hill activities. “Investing is not just about efficiency, and not everything is an investment, even if it is theoretically uncorrelated. There are bigger ideas out there.”
But these days he’s battling a turbulent current of a different sort: declining hedge fund returns. The roughly $200 million he runs through Masters Capital Management has fallen by more than 12% through July 2011, compared with a gain of 2.20% in the AR U.S. Equity Index and a gain of 2.75% in the S&P 500.
Masters is by no means alone in what has been a tough year for even the most storied hedge fund managers. But the loss stands out for the Texas-born money manager, because over the past 16 years his financial prowess has generally matched his fine-tuned sense of social justice. Masters has produced annualized returns over the past 24 months of more than 80%, according to investors, compared with an S&P return of about 28% during the same period. Longtime investors have enjoyed a compound annual growth rate of about 29% since 1995. More remarkably, they have experienced only three down years.
Although Masters refuses to discuss fund returns, noting that Masters Capital Management works only with accredited investors, he admits that nothing comes easy. “It is not about home runs for us, as much as sometimes I wish it would be. It’s more about approach, and making singles and doubles, and repetition,” he explains. “To a certain extent, I think this business is a lot like the insurance business and other businesses that have to do with risk. If you are making high-probability decisions, you will make mistakes, but you will be successful over time. The trick is to make enough of these high-probability decisions.”
Masters, 45, doesn’t fit the mold of either a legislative firebrand or a hedge fund titan. He is a devout Catholic who is active in several charities. Cordial, if informal, he has an affinity for sockless loafers and eschews wearing a tie. Although a senator once called him “the most powerful guy in Washington” following one round of his testimony on Capitol Hill, he seems the antithesis of that as he politely excuses himself to return to his trading screens one hot Atlanta afternoon, a towering plate of Kentucky Fried Chicken balanced precariously in one hand.
His fund, the Marlin fund, is equally difficult to pin down. Run out of a well- appointed office suite across from a Johnny Rockets burger joint and named after a feisty sport fish, it focuses on what Masters calls catalyst trades.
In general, this means he looks for triggers that will move mispriced securities, usually highly liquid midcap and large-cap stocks and their options. But to do that successfully, Masters has gone far off the beaten path, digging deeply into behavioral finance. He once hired a former Central Intelligence Agency spook to help him understand competitive intelligence, and brought in three philosophy graduate students to suggest new ways of conceptualizing and organizing his trading system.
Mike Masters: We needed to evolve
Masters sees such pursuits as critical to his success. “Some funds spend a lot of their time on marketing and other aspects of the business, but for better or worse, we spend an inordinate amount of time on trying to understand why we do the things we do,” he says. “I think that has been the core of our success.”
The portfolio tends to be concentrated in 25 to 40 names, with no single name representing more than 10% of the total and no sector representing more than 30%. Masters generally turns over about 70% of the book within six months or less, with positions often being held only a matter of days. More than half of it is usually placed in listed options (long both puts and calls), so the portfolio can look quite different over time. For instance, Marathon Oil showed up among Masters’ largest holdings in March 2011 but was nowhere to be found in December 2010.
Trades can have a fundamental element, but nearly all of them are heavily influenced by Masters’ judgment about how other groups of market players (mutual funds, pension funds, hedge funds and the like) invest and how their movements in the market will affect securities.
This can be as simple as understanding that value investors tend to be less aggressive when buying securities than growth investors. “When you see that value-to-growth transition or growth-to-value transition, it will affect the price action,” Masters says.
But the trade is generally tied to how such homogeneous groups will react to some apparent or not-so-apparent event, from earnings announcements, updates and road shows, to end-of-quarter window dressing or signs of distress. In 2003, for instance, Masters made a slew of buys on what he calls the uncertainty trade. President George W. Bush was threatening war in Iraq, infecting the financial markets and the real economy with doubt. Masters’ view was that once the war started, whether or not the U.S. won, the uncertainty that was holding back everything from stock prices to business expansion would be removed. More precisely, he figured defensive stock groups would do poorly compared with more volatile names.
“We decided to make a pretty big bet, which actually worked well,” he says. Securities and Exchange Commission filings from the start of 2003 show Masters holding large option positions in the Amex Japan Index, Goldman Sachs, Intel, J.P. Morgan and United Parcel Service, among others. The S&P 500 index, after declining or flatlining through February of that year, took off after the U.S. declared war in March and gained more than 18% over the next six months.
Masters made a similar call toward the end of the credit crisis in 2009, buying airlines, financials and other beaten-down sectors, with the portfolio at the time showing a heavy slug of American Express, Bank of America, Wells Fargo, FedEx, MetLife, Prudential Financial, US Airways, Delta Air Lines, UAL, and iShares MSCI Emerging Markets Index Fund. It also contained other unloved companies, such as Temple-Inland, Louisiana-Pacific, MBIA, General Motors and Eastman Kodak.
This June, the fund followed a more typical behavioral trade, purchasing stocks in the belief that manager mandates would force mutual funds to put cash to work. That would drive a rally toward the end of the month, which underinvested hedge funds would chase. Quantitative programs, the theory went, would then add fuel to the fire. Masters says such situations are akin to one person buying a block of Exxon, causing others to scramble, and “then suddenly the market is up 10%.” The idea appears to have panned out, with the S&P 500 rising a little more than 3% over the last 10 days of June.
In 2010, such maneuvers helped Masters Capital return greater than 41%. However, Masters wasn’t crowing much in his midyear update to clients this time around. In the firm’s June 13 investor letter, Masters and his team noted their disappointment in the performance, saying the European debt crisis, continued fighting in Libya, and weakened domestic economic data had contributed to volatility in the stock market and led to both “weak trading results and negative attribution from our core portfolio positions.”
Masters responded by reducing his position in some longer-term holdings, such as Swift Transportation, because of concerns about the broader economy. That stock had been highlighted the previous quarter for improving business dynamics and fits within a general move by Masters, as he again brings in a few new investors, to find more core trades that take advantage of industrial shifts. He notes that such shifts have occurred in the railroad industry and are now occurring in the airline industry, as companies in both have cut back supply and realized “that a dollar in price is worth more than a dollar in volume.”
Performance-measuring schemes, he says, have turned too many hedge funds into short-term momentum investors, which may create new opportunities for his firm. “We have always had a sort of trading orientation,” he adds. “But if you want to know where most of the real alpha is, it is out a year or two.”
While that belief didn’t stop Masters from selling a bit of Swift and focusing on strategies to trade around second-quarter earnings reports, his investment letter made it clear that the fund would continue to watch that company’s progress “and allocate capital accordingly.”
This year is just a hiccup for Masters when compared with the volatility he and his investors navigated in 2008. The credit crisis and ensuing equity swoon, he says, “tested everybody’s belief that there was some objective value in the marketplace.”
According to Masters, his fund was flat through much of 2008, and he didn’t begin putting significant capital to work until October. But Masters was still early.
“What we missed in 2008 and 2009 was the aftermath of Madoff and what that would do to the fund-of-funds industry. We didn’t know it would be that severe in terms of the unwinds, and that really hurt us,” he says. “We stayed in our positions, although it was very painful.”
This led to pointed questions on investor calls. “He was in a lot of airline stocks at the time,” says John Kuck, who was Masters’ college roommate and an initial investor in his fund. “These things went from $4 to $2, so you can’t help but do a little armchair quarterbacking.”
But Masters didn’t shirk from his trades, say two investors. He got on the call, apologized for the volatility and noted that as the biggest shareholder, he was hurting more than anyone. Then he said that despite being early, the trades were solid and he was going to ride them out.
“As an investor, you might have doubted where he was going and his judgment. But he was able to trust his instinct and stick with some bets that were really hard,” says Kuck. “It got ugly. We went down about 50%. I think that his character led him through that. And the experience of going down 50% to—within 12 months—being up 90%, or net 70%, told me a lot about him. I had a lot of respect for Mike, not that I didn’t have it before, but his convictions were unquestionable.”
All of Masters’ losing years were followed by sharp upward reversals, with data showing him roaring back from a 2002 loss of 14.65% to an 80.57% gain in 2003. He answered the 2008 loss of 22.59% with a 69.21% gain in 2009. In each case he handily outstripped stock market rebounds.
“Mike has had some bad quarters, but he’s had a lot of good ones too,” notes Neal Allen, a co-founder of Invesco Capital Management, who placed part of his IRA with Masters in 1999 and says he’s always been impressed by Masters’ discipline and flexible approach. “There have been a lot of changes in the market, and Mike seems to have been able to adapt to the changes that have come along.”
Although investors say Masters started out charging no management fee, he now takes the standard 2% of assets under management. He charges a 20% performance fee on the first 35% return, 25% on any gain from 35% to 70%, and 30% of any gains over 70%. The fund carries a high-water mark and a hurdle rate of Libor (30-day, 12-month average). There is no gate; however, there is a one-year soft lockup, carrying a 2% penalty. Investors can redeem monthly with 30 days’ notice.
Masters grew up in Marietta, Ga., in a family where stock trading was a fluid conversation. His maternal grandmother, Cleo, had a margin account. His father, Burt, traded professionally for five years before obtaining an MBA from Emory University. He then worked as a consultant and entrepreneur in the food service industry and a variety of other fields.
Both Masters’ uncle Louie and uncle Larry were avid investors of the Graham and Dodd variety. While they favored a diversified portfolio of classics—such as Dixie Bearings and U. S. Steel—Masters’ father loved the short side, always telling his son that knowing when to sell was just as important as knowing when to buy.
The lesson stuck with Masters, who recalls that good-natured arguments about investing philosophy were common at the dinner table whenever one of his uncles was around. “My dad would always say my uncle was too conservative,” recalls Masters, “and my uncle would say my dad was too aggressive.”
The young Masters wasn’t destined to run a hedge fund, however. Growing up, he was interested most in athletics, and when he arrived at the University of Tennessee on a swimming scholarship, his ultimate goal was to become a physician.
The rigor required to attain that childhood dream became apparent a few years into college, and he ended up majoring in business. But swimming stayed with Masters. An all-American in the freestyle sprint for four years, Masters’ Olympic bid was cut short when he contracted mumps the summer before the Olympic trials.
By the time his Olympic hopes were dashed, Masters had begun seriously dating the woman who would later become his wife, Suzanne, whom he had met at a fraternity party. He decided to apply to Emory to get an MBA. When the school told him he needed some relevant work experience first, he used a neighborhood connection to get a job as a broker trainee. It was a bad fit. Masters and the brokerage parted ways shortly after he tried to unilaterally lower the commission structure for his clients so they could trade more actively without prohibitive cost. “I guess I was pretty naive,” he says.
The one thing Masters had enjoyed about the job was trading, and he says he was fairly good at it. So, in 1994, after discussing his situation with his father and Suzanne, the 28-year-old Masters decided to try to do it full-time. He wrote his initial approach on a Lotus spreadsheet, had his father help him come up with a prospectus, and built a piece of furniture in the garage designed to hold enough cathode-ray-tube trading screens to track about 200 stocks at a time. At first, Masters planned to trade stocks using a combination of market triggers and fundamental variables, such as cash flow, book value and the like. But “the ultimate conclusion I came to was, on the shorter time horizon, the only thing that matters is the catalyst, and that was the solution,” he says.
Masters’ timing was good. He launched at the cusp of a great bull market that would, by 2000, lead technology shares to dizzying heights. But he still needed to persuade investors that his strategy was predictable and sound. He was working with about $25,000 in personal capital at the time, had no track record and no fund. Undaunted, he began knocking on doors, pitching former customers and acquaintances. “Most folks would say, I’ll give you $25,000 or $50,000. The biggest single investment was $200,000,” he says, adding that most of the capital came from family members or wealthy individuals who probably gave him less money than they were likely to lose “playing golf on a Saturday.”
Rod Chamberlain, a retired salesman and builder of supercomputers, was introduced to Masters by some early investors from a Georgia moving company. He is among those who fondly recall Masters giving him the nascent pitch. “Right from the beginning, I felt like this guy could really accomplish what he said, that he wasn’t BS-ing,” says Chamberlain, 74, who invested $100,000 in June 1995.
By that time, Masters had raised $700,000 to start his fund. Trading out of a 100-square-foot room owned by a local brokerage, he quickly began posting eye-popping returns. In 1996, Masters returned just over 79%. He followed with a greater than 57% return in 1997, the year he moved his operation into its own 2,000-square-foot office just upstairs. Meanwhile, Masters’ winning streak continued to gain notice. By 1999, he had attracted about $300 million. In 2000, fund assets reached $500 million, and Jack Schwager came calling to interview Masters for his investment book series, Market Wizards, describing the hedge fund manager as so focused that he would physically lock himself in his trading room during market hours.
About the same time, with money pouring in, particularly from European funds of funds, Masters decided to pull up stakes and follow several other hedge funds to the Virgin Islands, attracted by the beneficial IRS tax treatment. (He relocated the fund back to Atlanta in the summer of 2010.)
The rapid fund inflows, which peaked in December 2001 at about $650 million, were a mixed blessing, because many of Masters’ new backers seemed to be chasing returns, with little interest in understanding his philosophy or his style of investing. “I felt like I was riding a rocket ship as assets were coming in, and the ride was fast enough for me,” says Masters, who was by then one of the largest traders of single-company stock options. “I was trying not to go crazy.”
The ride ended abruptly with the market cascade that began in March 2002. The hot money, says Adam Cooper, a partner in the firm, “pulled the rip cord.” By 2003, funds under management were down to just above $200 million. Masters stopped seeking new investors, and assets under management have remained south of $300 million pretty much ever since.
“Certainly one of the reasons why I have not been enthusiastic about raising capital is that most investors don’t have a high tolerance for pain, and when they should be investing, they often go the other way,” Masters says, adding that during this period, he was also wrestling with his underlying strategy of catalyst trading.
“We knew that things had changed. We could see it in our performance and in the fact that some things we were doing weren’t working the same way,” he says. “My view was that we needed to evolve, and I thought it would be good to hire some experts in epistemology to look at our process and our thought construction.”
Cooper called up Harvard, then Yale. Nobody returned his calls. At Columbia, they “thought I was selling insurance,” says Cooper. Then he reached out to NYU. He explained to the dean of the philosophy department that his firm was working on a trading strategy and wanted help with the philosophical underpinning first. Masters ended up hiring three graduate students from NYU for an initial six-month stint at the hedge fund’s St. Croix offices.
“We weren’t searching so much for answers about how one ought to trade, but were more focused on seeking clarification on what general principles underwrote Michael Masters’ trading strategies,” says Dr. Michael J. Raven, who was one of those graduate students and now teaches philosophy at the University of Victoria in Canada. He added that during the process, Masters showed a “raw curiosity” and “a sincere enthusiasm for reflecting critically on trading strategy.”
Masters also brought a greater behavioral bent to his work, sending Cooper off for months to cull and summarize research on sometimes arcane subjects such as cognitive bias and the effect of news on buying behavior. An offshoot of Masters’ research in this area led him to Capitol Hill in 2008.
After looking at fund flows and doing some calculations on oil demand, Masters wrote a note to Warren Mosler, an old friend and fellow hedge fund manager who runs III Offshore Advisors from the Virgin Islands, saying he believed pension funds and other “index speculators” were having an outsize effect on rising commodity prices. Cooper says Mosler passed the note to Connecticut senator Joseph Lieberman, who invited Masters to testify before the Senate.
Masters told the Senate that hundreds of billions in investment dollars entering the commodities futures markets had turned speculators into virtual hoarders, that this money was squeezing millions of U.S. consumers and could end up starving millions more of the world’s poor.
Many lawmakers struggling with rising commodity prices welcomed his testimony. At one hearing, Missouri senator Claire McCaskill even thanked Masters for providing a simple road map for puncturing oil prices, which she said lawmakers were under “incredible pressure” to reduce.
Since then, the effect of speculation on the price of commodities has been widely debated. While many experts think that speculation plays a role in creating excessive short-term price volatility, there is little consensus over whether an increase in speculation has altered longer-term price trends.
Masters was particularly effective in arguing for position limits and other regulatory changes to the commodities market because of his status in the financial community. “He had high ideals, and you don’t often associate such high ideals with hedge fund folk,” says Dave Andrews, a Holy Cross brother and a senior representative of Food & Water Watch, who calls Masters’ continuing leadership in the area “significant.”
However, not everyone thought Masters was being purely altruistic, with some critics noting that his fund held many airline and other stocks being battered by rising oil prices. (As of March 2011, Masters continued to hold several such positions.)
Others just blasted the economic reasoning underpinning his testimony. Paul Krugman, the Nobel Prize–winning economist and New York Times columnist, called it “just stupid,” while Michael Dunn, the outgoing Commodities Futures Trading commissioner, said recently that the position limits Masters advocated may be, at best, “a cure for a disease that does not exist or at worst, a placebo for one that does.”
Told of the criticism, Masters just shrugs as though he’s heard it all before, then leans back in his chair and patiently lays out his reasoning again. It is clear Masters sees little wisdom in the crowd, whether in Washington or on Wall Street, and he plans to keep making his bets accordingly. “It’s important to understand that the market is not God,” he says. “It isn’t perfect, and prices do get out of whack.” AR