Economic Dislocation To Play Out For Years

US financial woes mean ‘all weather’ fund is needed

Originally published in the January 2010 issue

At Fractal, we publish a monthly economic outlook for all our clients and prospects helping us to remind them of the importance of having versatile investments in their portfolios. It is common for investors to flee to the best performing markets and to then get hit when that bubble bursts, but through this economic analysis, our clients are constantly reminded of the benefits an ‘all weather’ function and the returns that can be delivered in all market conditions.

As an example of the value of these monthly reports, there has been much talk about the huge amount of money created from nothing by the US Treasury to fend off the current economic crisis and how this action will quickly help stimulate a return to inflation in our domestic economy. We believe this logic is foolish. Housing prices are plummeting and will continue to do so. Furthermore, when you go to the mall, most merchandise is on sale and will continue to be for an extended period of time. Chinese products, a good portion of which are imported by the US, keep getting cheaper and, while import tariffs are low, we will carry on encouraging emerging economies to produce goods for us rather than supporting our domestic manufacturing sector and further increasing unemployment in the States. These factors point more towards deflation than inflation.

With over 130 bank failures in the US in 2009 alone, more banks have failed this year than any year since 1992 (see Fig.1). Although the market is currently showing signs of stabilization, such dreary numbers suggest that the market is still unhealthy and we may not be out of the woods yet. Experts unanimously agree that the current crisis is much worse than the Savings and Loan crisis of the 1980s and 1990s was and we anticipate that there will be many more bank failures before this crisis is over (see Fig.1).


One of the major parts of the current crisis is the difficulty people are having receiving loans and mortgages. The collapse of many regional and local banks as well as major mortgage lenders will just make it that much more difficult to find a reasonable loan or mortgage, which will further depress the housing market.

Eventually the US government will come to its senses and start to introduce policies to encourage employment, increase the barriers to entry for imported goods, incentivize our domestic manufacturing and housing sectors, and return our economy to health. It is then, and only then, that inflation will begin to take over. But governments the world over are always slow to react and in the US we anticipate that these policies will come into effect only as emergency solutions and in years hence, once Obama is out of office and a new President inherits a disaster so enormous that it requires immediate and very radical action in terms of government policy.

Oh well, it’s important to keep a sense of perspective! Even if the US unemployment rate keeps growing, European countries have historically had (and currently have) higher rates of unemployment than the US. Although we currently have the highest rate of unemployment that the US has seen since the Great Depression, we are still comparatively better off that most other industrialized nations. As an absolute number, the US still has more people employed than other countries, thus we still have more consumers who continue to be able to afford to consume, even if at a lower level than in the past. Unlike those in other countries, the social programs for the unemployed in the US do not encourage long-term unemployment. We believe these programs are stringent enough to encourage the population to seek work. The main problem right now is that policies to encourage industry to begin hiring again have not been put into place, so the government has been extending the term for which people can collect unemployment ‘benefits’. Instead of extending more welfare cover to the unemployed, the government needs to institute policies that encourage industry to become more competitive and begin hiring again. In doing so, they will help get people back into jobs, which will allow them to have disposable income with which they can consume at higher levels again.

We believe there are other elements that will need to be addressed in order to solve our current economic problems. The first of these comes as the Government has spent three to four months trying to pass a health bill. As the debate goes back and forth on these issues, it becomes ever more evident that the government seems focused on fixing the country’s problems with a band aid instead of stitches.

Rather than worrying about health care, we believe the Government should begin to draft regulation to address the IRS required withdrawals of money from IRAs, called Required Minimum Distributions (RMD). These RMD obligations begin at the age of 70.5 years and must happen annually. Baby Boomers begin hitting 70.5 years in 2016. The amount of the RMD is contingent on a difficult formula decided upon by the IRS, but year after year a portion of retired people’s portfolio IRAs will have to be redeemed or face a 50% excise tax. These RMDs will cause a huge pileup of obligatory redemptions, which will cause a large amount of selling to occur in the market. If this requirement isn’t fixed soon, between 2016 and 2026, Baby Boomers in mass will have to begin liquidating part of their portfolios or suffer tax consequences, again causing depreciation in the market. Although this is more of a long-term problem, it could cause calamity. If the government, slow to react, does not begin working on ways to resolve the tremendous number of obligatory redemptions in the portfolios of Baby Boomers, there will be little hope for the market to recover for a period even somewhat resembling the 15-year rally we had between 1983 and 1999.

The third important change we foresee is that gold will gather more importance as the only tool to preserve value alongside cash. China, which holds about 40% of its reserves in US dollars, is accumulating gold because it is losing faith in the US dollar, which is the traditional ‘home’ for most sovereign investment. Other governments are following China’s lead in shifting from the US dollar to gold. Yet while most governments are buying into gold, the majority of individual investors will shy away from gold and put their money into short-term US Treasury Bills. T-bills are of course denominated in US dollars and for this reason, whilst most governments and evidently their advisors believe the value of the US dollar will further erode, we remain bullish about the US dollar.

So what does this have to do with Fractal? We tell you this because our aim is to deliver absolute returns, in US dollars, with returns that are competitive to gold, even if gold continues in its current bullish trend, and returns that are much better than those of T-bills. We use T-bills for our cash position and US Treasury notes, bonds and derivatives for our monthly duration, yield curve and momentum decisions. On top of this, because we can use only T-bills, T-note and T-bond positions, our liquidity is our best friend because the positions can be easily bought and sold in one of the most liquid markets in the world.

At Fractal, we aim to provide absolute returns in any kind of environment. Deflationary and inflationary periods; bear and bull markets; rising and falling interest rates – these conditions should not tend to alter our performance. In every sense, Fractal aims to be an ‘all weather’ fund. We achieve our absolute returns by following strict guidelines on the way we place trades and allocate among the various managers. Similarly stringent guidelines apply to the way we delete, maintain or add variables in our main trading model, in which we place 12 trades per year and take advantage of the movements in the market placing the majority of our assets either long for 30 days or short for 30 days without necessarily moving our position every month of the year. The shift in tactical positions every 30 days permits us to take advantage of the cyclical trends within every secular trend. We have a hit ratio of over 70%, meaning we have only three or four negative months and eight or nine positive months per year.

Fractals are the self-repeating patterns found in nature and we chose this name for our Fund (after a great deal of brainstorming) because in 2002 whilst working at a major bank, my founding partner, Alain Bibliowicz, and I were faced with the decision of either diversifying our clients’ portfolio or focusing on a single high quality product that would produce absolute returns. We opted for the latter. Seven years later, and four years since the founding of Fractal Fund Management in 2005, we have altered the proprietary model we use to generate absolute returns and complemented it with other non-correlated trading strategies to create the Fractal product offered today. But the guiding principles behind our trading strategies have not changed and we like the fact that our proprietary trading model and the research and decision making processes are constant month-in and month-out. The new path that we took back in 2002 and that we remain on to this day are very closely aligned with the definition of a fractal. Our investment process is straight-forward, repetitive and unemotional and this is what allows us to deliver consistent absolute returns for our clients.

Fractal has a mix of 50% institutional money and 50% high net worth individual investments both directly into the fund and through the Swiss banks, where our funds can easily be bought or sold. For institutional clients, we now offer our product as an overlay for their portfolio through a separately managed account, which appeals to the need for transparency that the current crisis has precipitated. Because the account is in the name of the client (not through our usual fund structure) and all we have is a limited authority to trade in the account, the client has daily liquidity. For our private clients, even though technically their liquidity has the same attributes, the PPMs for our funds stipulate monthly redemptions.

Our clients realize that our ability to take both long and short positions using primarily US Treasury bonds and derivatives distinguishes our fund from the traditional bond fund that performs well only during falling rate markets. This differentiation and our addition of other managers with complimentary yet uncorrelated trading strategies are what allow us to continue gathering assets despite the havoc the current crisis has wreaked on so many portfolios. With the underlying being US Treasury bonds and derivatives, we can easily provide the transparency and liquidity so desperately needed by market participants right now. Be it deflationary storms, inflationary earthquakes, secular bear market tsunamis or secular bull markets that usually only attract investors in large numbers during their latter stages, Fractal tends to perform well in all conditions and this is the true test of an ‘all weather’ fund.

Jorge Zighelboim is a Managing Director of Fractal Advisors with responsibility for advisory on both the management and marketing of Fractal Fund and its subsidiaries. From 2002 to 2005 he advised both clients and institutions for UBS. From 1998 to 2002 he served as Financial Consultant at Merrill Lynch’s International Private Client Group.