Anticipate Before You Participate: Part 2 Understanding Market Volatility is Key to Managing Expectations |
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Due to last quarter's market volatility, we hosted a webcast in June titled "Anticipate Before You Participate" to educate our investors about volatility in commodities and emerging markets. We explained then why we had such a large cash position going into the correction. We are now going through the second leg of the correction after a nice rally during July and August, so it's timely to communicate with you again as this quarter ends.
Last week's implosion of Amaranth Advisors' $9 billion hedge fund has called into question a popular hedge-fund strategy of using excessive margin/borrowings to generate hefty returns.
For our shareholders, it is important to point out that we do not use any form of margin debt or borrowing to leverage an exposure to any asset class. In fact, in particular for the gold funds, we have had relatively high cash balances as a defensive position before the corrections in June and September as a result of our quantitative models. For the past six months, our single largest investment has been cash.
With the Amaranth Advisors blow-up and the widely watched CRB commodity index having the worst performance for any three-month period for the past 10 years, the market sentiment is excessively bearish.
Now there is a lot of guessing about where the next blow-up might be. Another hedge fund or other asset manager? Or perhaps mortgage lenders overextended in the declining real-estate market? Or could it be that the worst is over?
When it comes to housing, for instance, there are conflicting signals in the marketplace, as one can see in the following charts from Societe General. On the following chart, it's clear that homebuilders are very pessimistic in their outlook about new-home sales in the coming six months.
But in the next chart, it's equally clear that there's been a significant upswing in the number of people who plan to buy a new home in the next six months.
Both housing and commodities are now extremely oversold. To be a contrarian investor requires courage, an appreciation for history and a matrix of investment processes to recognize relative value in order to make risk-adjusted investment decisions. We believe our fundamental and statistical models have helped us make risk-adjusted decisions.
A recent Barron's story regarding the Amaranth implosion suggested that hedge-fund investors ask money managers four questions when above average returns are generated:
- How were the returns generated?
- What kind of leverage is being used?
- How are the securities being valued?
- Are the securities liquid or illiquid?
We thought it would be timely to apply these questions towards our resources funds, which have demonstrated consistent leadership for the past one-, three- and five-year periods.
The U.S. Global Investors team has posted strong returns for our investors in 2006. Part of the reason is that our key market sectors – commodities and emerging markets - have performed well. The other part is how we approach our job as active money managers.
We apply both fundamental and statistical models to manage our investment decisions. We travel extensively to emerging-market countries and remote regions to take a look at what we might be buying. Our natural-resources analysts attend courses at the Colorado School of Mines to learn better how to value mineral deposits. We publish research on a regular basis that objectively analyzes current strengths and weaknesses and identifies future opportunities and threats.
Over the past five years, we have been a leader in fund performance, so we believe our innovative approach has benefited our shareholders.
During this secular bull market for commodities, we have focused on the companies that are generating the highest return on capital and those that have the potential to do so over the next 12 months. For exploration and developing companies, we have applied the optionality concept to value reserves in the ground and have invested in those companies that offer the highest potential for return with rising commodity prices. We have used long-term warrants combined with higher cash levels to maintain a highly liquid portfolio and at the same time participate in a rising market and still be able to buy attractive securities during corrections.
Finally, we made a strategic investment decision five years ago to focus on overweighting copper/gold producers that are unhedged, such as Northern Orion, Freeport McMoran, Goldcorp and Bema Gold.
We cannot provide all the details behind our strategy for proprietary reasons, but we do offer detailed educational webcasts and shareholder letters explaining our thoughts. This would be a good opportunity to explain a bit more about how warrants fit into our strategy.
Warrants are securities that offer leverage without borrowing, so in a rising market, they have helped our risk-adjusted performance, measured as alpha. In a falling market, they can fall faster and hurt performance. As a defensive measure, we have increased our cash levels after big price runs, which de-leverages these warrants and at the same time allows us to create a portfolio with exposure to the best investment ideas.
Warrants differ from options in that they are issued by a company, and usually they have a longer life than options. Most warrants are exchange-traded, and they can be attractive for medium-term or long-term strategies.
The key investment factors for warrants are (1) the underlying fundamentals of the stock and (2) the time remaining on the warrant. Warrants have rights that options don't have, such as voting rights and anti-dilution rights. In addition, they are generally long-lived when issued, which can make them more desirable than an option.
We use quantitative models to manage our warrant positions. At this time the majority of our warrant positions are "in the money" – that is, the stock and warrants have appreciated above the exercise price. In-the-money warrants attract a broader community of investors, so the liquidity of the warrants expands.
Out-of-the-money warrants tend to have different price behaviors than in-the-money warrants. As an example, for an out-of-the-money warrant with a long time to exercise, its value generally declines less when the underlying stock price drops because most of its value comes from the time component.
We believe we have developed competency in using exchange-listed, long-term warrants over the past 15 years, and that competency is one way we distinguish ourselves from other money managers.
While we have positions in the listed warrants of gold producers, the two critical drivers for fund performance are the price of gold and the fundamentals of gold-mining companies owned by the fund. Our key metrics focus on return on capital: growth in production, reserves and cash flow. Our research has shown that shares in gold companies with higher relative ROC outperform their peers.
Our largest equity investment has been Goldcorp because we believe it has the best fundamentals in the industry and it has generated robust returns on capital. Our investment in Goldcorp is made up of common shares and long-term warrants that are traded on the Toronto and New York stock exchanges.
The risk-adjusted return for our gold funds, as measured by the Sharpe ratio, is considerably higher than their peers over the one-, three- and five-year averages. For the three-year period, the Sharpe ratio for the World Precious Minerals Fund is 44.5 percent above the peer average and the Gold Shares Fund is 26 percent higher.
Gold stocks are well-known for being risky, but it might surprise you to learn that the volatility of gold stocks, as measured by beta, is about the same as the volatility of Internet and biotech stocks, according to Bloomberg. There is a community of analysts, writers and others who love tech stocks and at the same time are anti-commodities despite the comparable volatilities.
Our natural-resource funds are classified in their prospectus as "non-diversified," so we are allowed to make concentrated investments in specific companies. As for illiquid securities, we follow the SEC rule that a minimum of 85 percent of each fund's assets be invested in liquid securities.
We closely monitor each fund's liquidity and the fund board of trustees have adopted processes for addressing liquidity and fair valuation. Being mutual fund managers, we have many additional layers of compliance and review procedures compared to the hedge fund world.
As we said earlier, we are active money managers. We will at times have a large defensive cash position combined with exchange-listed warrant positions as a way to manage risks and volatility and to capture opportunities.
We urge you to read our fund prospectuses and our Statement of Additional Information for more disclosure about the risks associated with investing in natural resources funds. And we'd like to repeat our recommendation that investors limit their gold-related investments to a maximum of 5 percent of their portfolio and that they rebalance each year.
Our consistently strong performance has attracted the attention of investors, and we go to great lengths to regularly update them about risk and the factors that drive performance.
Please consider carefully the fund’s investment objectives, risks, charges and expenses. For this and other important information, obtain a fund prospectus by visiting www.usfunds.com or by calling 1-800-US-FUNDS (1-800-873-8637). Read it carefully before investing. Distributed by U.S. Global Brokerage, Inc.
Performance data quoted above is historical. Past performance is no guarantee of future results. Current performance may be higher or lower than the performance data quoted. The principal value and investment return of an investment will fluctuate so that your shares, when redeemed, may be worth more or less than their original cost. Performance does not include the effect of any fees described in the fund’s prospectus (e.g. short-term trading fees) which, if applicable, would lower your total returns. Obtain performance data current to the most recent month-end at www.usfunds.com or 1-800-US-FUNDS, option 5.
Please keep in mind that high double-digit and triple-digit returns are highly unusual and cannot be sustained. Recent returns were achieved during favorable market conditions, especially within the (name of sector) sector.
All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor.
Foreign and emerging market investing involves special risks such as currency fluctuation and less public disclosure, as well as economic and political risk. Diversification does not protect an investor from market risks and does not assure a profit.
Gold funds may be susceptible to adverse economic, political or regulatory developments due to concentrating in a single theme. The price of gold is subject to substantial price fluctuations over short periods of time and may be affected by unpredicted international monetary and political policies. We suggest investing no more than 5% to 10% of your portfolio in gold or gold stocks.
The CRB/Reuters Futures Price Index is an unweighted geometric average of commodity price levels relative to the base year average price.
Holdings as a percentage of net assets as of 6-30-06:
Northern Orion: Gold Shares Fund (5.55%), World Precious Minerals Fund (5.52%), Holmes Growth Fund (1.70%), Global Resources Fund (1.26%)
Freeport McMoRan Copper and Gold: Gold Shares Fund (3.17%), World Precious Minerals Fund (0.74%)
Goldcorp: Gold Shares Fund (23.82%), World Precious Minerals Fund (18.05%), All-American Equity Fund (9.61%), Global Resources Fund (3.10%), Holmes Growth Fund (1.35%)
Bema Gold: Gold Shares Fund (2.67%), World Precious Minerals Fund (1.45%), All-American Equity Fund (0.42%), Global Resources Fund (0.21%)
Toronto Stock Exchange: (0.0%)
New York Stock Exchange: (0.0%)