Lower volatility versions of the strategy

Between 1997 and 2006, Okumus ran a fund annualizing near 30%, which had an anchor investment from the late great value investor, Sir John Templeton, and made money every year, including the three bear market years of 2000, 2001 and 2002, albeit with substantial volatility in some months. The new RPD Opportunity Fund (RPDOF), launched in 2021, has been generating very similar returns, compounding at 27%, but with lower volatility and a higher hit ratio. Investors receive a transparency report on realized trades, of which 171/173 have been profitable. Even taking account of unrealized trades, there have only been four losers out of 183 trades, as of July 2023. 

Though the strategy always had a high hit rate of around 90% profitable trades, Okumus carried out a post-mortem on the 10% of losing trades before relaunching the strategy under RPD. This led to the proprietary Precision Targeting Methodology which, along with stricter investment guidelines and the investment committee vetoes, aims to further ramp up the hit rate and reduce drawdowns. “We went over every trade, idea by idea, trade by trade, and determined that we could run the strategy in a much less volatile format,” explains Okumus. RPDOF launched in 2021 with $88 million of internal capital that has now more than doubled to $215 million through performance, and there is $270 million of external capital as of August 2023, taking total strategy assets to just below $500 million. 

Investors who want to further dial down the risk profile can opt for a lower volatility version of the strategy; the Fortress Fund, launched in February 2023, and open to external investors only since August 2023, targets a steadier return profile of 1 to 2% per month with less downside risk. The philosophy behind the two funds is the same but the trade implementation and portfolio construction is calibrated differently to their risk and return targets. “Generally, the two funds sell options on the same names, but Fortress may do so at different strike prices. Fortress is targeting an IRR of at least 13% while RPDOF is aiming for at least 20% from option selling, based on options’ notional value exposure. And Fortress cannot go net short or use leverage,” explains Okumus. Fortress targets 0 to 30% net exposure and since inception has had no down months, an annualized volatility of less than 3%, and an annualized Sharpe of 4.0. Fortress has already attracted two separately managed accounts of $50 and $75 million from institutional investors.

Option centric strategies

Fortress only trades options whereas RPDOF can also trade stocks, both in the first instance and by hanging onto stocks assigned because of options. On the rare occasions when Fortress is assigned stock, it will swiftly neutralize the delta with options, rarely hanging on to the position for any significant period. The carveout of RPDOF’s option portfolio, which is almost identical to Fortress’ strategy, has made positive returns in 29 out of 30 months. Since January 2023, RPDOF has also become more options centric and less equity centric, with an annualized volatility of less than 5% in 2023. RPDOF will still however be inclined to switch into more outright equity positions after a substantial market drop in a short period.

Neither strategy is an options strategy per se. They are fundamental equity strategies, using options as instruments to optimize risk reward, with the goal of getting paid while awaiting more attractive entry prices. There is perhaps a paradox here: “Nearly all the options have expired worthless, but the base case for RPDOF when entering positions is that we would be happy to have options exercised and be assigned stock; going long if short puts levels are hit and going short if short call levels are triggered, unless our intrinsic value and margin of safety assessments change based on fundamentals. Therefore, the notional exposure of the options is sized so that we would feel comfortable with the position size if they were exercised,” explains Okumus. For both strategies, the options are “cash covered”, meaning that their notional at the money strike exposure is covered by the fund NAV, (but are not covered by the underlying stock). The delta-adjusted exposure is of course much lower at inception since the options sold are out of the money.

On the rare occasions when the options have been exercised (only 8% of the time since inception), and stock was assigned to RPDOF, profits have subsequently been three or four times higher than from the expiries of options (excluding two losing positions).

Option premium and interest income

The options are plain vanilla, exchange traded, and usually only one strike is sold per strategy. Given average option maturities of 1 to 2 months, portfolio turnover is at least 6 to 12 times per year on the options books and can be much higher when weekly options are used. The turnover of underlying names is somewhat lower because some options are repeatedly sold over multiple weeks or months. Turnover is also much lower, at 1 to 2 times per year, on the small number of outright equities in RPDOF.

One inefficiency exploited is that Okumus finds option traders may be adept at managing their “Greeks”, but do not care to understand the underlying business fundamentals. Some 92% of the options RPDOF sold have expired worthless, generating an average IRR of 20% on notional; this level of return is likely to vary through the cycle with option valuations and assignments amongst others.

The option strategy is capital light. In most instances when the fund is fully invested notionally, some 80% of RPDOF, and even more for Fortress, is sitting in a risk-free money market fund, which is currently earning around 5%, adding another return driver.

Long and short investment universe

Okumus does deep fundamental analysis to get comfortable with companies’ business and competitive environment. “We talk to management and competitors, read regulatory filings, analyse industry trends and consult expert networks, especially for technology. We form a view on the intrinsic value of the business,” says Okumus. Accounting analysis looks at cashflows, which would have weeded out optically cheap companies such as Parmalat that turned out to be frauds; Okumus has been short of alleged fraud Nikola. In contrast, insider share purchases and sales have in fact become a less important indicator over the past 30 years. Sell side research is not a major factor in the decision-making process, but RPD does read everything as it is important for them to understand consensus thinking before any trade. A monthly transparency report lists the five key bullet points for each stock.

“We have built a huge research database with detailed company models on over 1,300 US names,” says McAlea. The investment universe at any point in time is at least 900 long and 400 short names. Longs normally need a market capitalization of at least $500 million while shorts must have a much higher minimum of $15 billion. Typically, positions have a market cap between $3 to $50 billion. Examples of long positions that have meaningfully contributed to RPDOF’s 2023 performance are Twilio, a leading customer engagement platform, and The Carlyle Group, a multinational private equity and asset management corporation. Each was trading at or near all-time low valuation multiples, giving Okumus a window of opportunity to sell cash covered puts at a strike price with excellent risk/reward. On the short side, a short call position in Axon Enterprise, a technology leader in global public safety, at its highest all-time normalized EV/EBITDA multiple meaningfully contributed to the fund’s return.

Some sectors are largely excluded. “We do not understand biotech or healthcare business models and avoid commodities. We stick to our circle of competence. On the long side, we are seeking growth in intrinsic value,” says Okumus. Some countries can also be excluded: Okumus has never felt comfortable with Russia, even though some Russian stocks in 2021 and 2022 did show up on quantitative deep value screens. “Anytime a market sells off like Russia did in early 2022, we are interested. In fact, we made a quick trade for a nice profit in 2015 in Russia. But when the facts change, we change, and it was an easy pass for us in 2022,” says Okumus.

Deep value Chinese tech and internet

RPD owns longs at least 50% below its own estimate of their fair value and in the cheapest 1% of the stock’s trading history on a cash flow basis, which often have net cash on their balance sheets. “Being down 70%, 80% or 90% means that expectations are low, and these sorts of stocks can easily perform well even when they miss earnings estimates (which has happened about 25% of the time),” says Okumus. 

Chinese technology and internet stocks have been a big, long book exposure, all based on bottom-up stock picks. All China exposure has been via US-listed ADRs. RPD has been long of China’s Twitter, Weibo. “It is much more successful than Twitter ever wanted to be or ever could be. It is also very cheap, with net cash, 30-35% EBITDA margins, low capital intensity and trading on 3x EBIT, with a good dividend,” says Okumus. The fund has also owned China’s Google, Baidu. And a new cars portal called Autohome is viewed as a very high-quality business. “It is a market leader, larger than the next two combined, with $3 billion of net cash on the balance sheet, a good-sized buyback program, low capex, and 35% EBITDA margins. It is possible to sell very richly priced puts on this stock at a strike price where you are essentially buying the business for free,” says Okumus. 

Political, geopolitical, delisting and Covid related risks were all factored into the Chinese exposures. Though Okumus judges Chinese politics is now back to business as usual, he accepts that Chinese tech should trade at some sort of discount to the US, but at a reasonable discount given the good quality management teams and businesses. “We know the management teams, business fundamentals and the quality of the business. We understand the company culture.”

Since August 2021, RPD has made money from its exposures to long Chinese internet related stocks, despite the KWEB ETF being down 65% over this period. Chinese exposure was as high as 45% in 2022 of which 40% was in Weibo and Baidu together, but a 25% cap on overall China exposure, and a 15% cap per position, was introduced after the RPDOF performance drawdown of October 2022. 

Directional wagers

RPDOF can be net long or net short. The average net long was higher in 2022 than 2021 given the focus on deep value in China.  RPDOF has been net short for three months over the past 30 months: February and March 2021, and July 2023. In July 2023, the RPD strategy is net short in both notional, and delta-adjusted, terms. “We cannot find any deep value in the US market and have not been able to since Q3 2022. We nearly became active during the SVB crisis in March 2023, selling some puts that expired, but did not get assigned,” says Srinivasan. In July 2023, the strategy was running at low levels of exposure with a notional long of 30% and short of 40%, both of which are much lower in delta-adjusted terms. “We wait for the opportunities to come,” says Okumus.

Risk controls

RPDOF returned nearly 50% in 2021, of which 70% came from the short side. This seems almost uncanny given that the style is to be long deep value and short overvalued growth and momentum names, which were inflated by a mania bubble in 2021. Even in 2023, with value stocks in the doldrums and a low VIX reducing option premiums, returns are 11% to July. This is not inconsistent with the prior fund track record: in 1999, Okumus Capital even made a triple digit return.

The manager chooses companies and options very carefully. RPD defines risk as permanent loss of capital, rather than volatility, and therefore seeks a huge margin of safety in terms of valuations on the long book.

RPD touts its extremely disciplined investment process and risk guidelines, which include strict individual, sector and geographic limits along with portfolio level stop loss. “We are not interested in investing even 1% of our capital if the criteria are not met,” says Okumus. 

Safeguards on the short side include the minimum market capitalization of $15 billion. “As an unprofitable company with a $50 billion market cap Symbotic seemed like a good candidate, but we are common sense investors and do not want to risk it on a low free float,” says Srinivasan, who along with McAlea has exercised their veto for around 20% of proposed trades.

Shorts should also be valued at least multiple times above the RPD estimate of their fair value, plus trading in the highest percentile of their trading history based on sales and EBITDA multiples. The precision targeting methodology is homing in on the most bifurcated valuations in years or decades, based on peaks and troughs over long lookback periods, including 2020, 2014 and the GFC. “We buy at GFC low multiples and short at 2021 peak valuations. If we don’t find those ideas we are disciplined enough to stay in cash, which is the reason our hit ratio is around 98%,” says Okumus.

The only two realized losers have been “longs”: short puts on Groupon and Ring Central. “Groupon was a mistake,” says Okumus. “Ring Central was a different situation, where puts were covered too early and if we had waited it would have been profitable,” he adds.

Selling calls on glamour and meme stocks

Some hedge fund managers have blown up through outright shorts on the most fashionable growth and meme stocks, but RPD has profited in both categories from its nimble approach and trading acumen.

It seems highly improbable, but RPD has consistently profited from short calls on Nvidia eight times in 2023, even though Nvidia has tripled in price. “Valuation wise the juicy premiums make perfect sense. Last week, we shorted August 21st expiry date Nvidia calls with a strike price of 570. This would equate to a $1.4 trillion market cap at which we would happily be short. We are nimble and price sensitive. An outright short would have been dangerous. We usually sell a 20-25% out of the money call, sometimes even higher, expiring in one month or less. We are very tactical. We do not always take earnings risk. We look for maximum euphoria and look for very well priced options. We pick our spots very carefully, and we will sometimes close positions before expiry and take profits,” reveals Srinivasan.

Similarly, with GameStop, RPD was very patient in waiting for the right timing. Back in 2019, the family office even sold puts on GameStop at a strike of $4 as a potential long but covered the puts at a profit. The first ten-bagging of GameStop was ignored, because its market cap at a share price of 40 was still only $3 billion. GameStop’s share price needed to multiply by roughly factor fifty before it even reached RPD’s minimum market capitalization threshold. 

RPD started selling calls on GameStop at an astonishing implied volatility of 800 – the highest the manager has ever observed on a single stock – and at a strike price that would equate to a market capitalization of $64 billion. And once again the trade has been profitable every time.

This option valuation was exceptional: “In general, we are selling options on implied volatilities between 80 and 200, which are 20% out of the money. These are still very expensive options. By way of comparison, the typical name has implied volatility of 20-25 for large caps, and 30-40 for mid-caps, as of July 2023,” says Srinivasan.

Long term investors 

RPD is now able to execute all trades electronically, having historically sometimes had to call brokers. The old fund assets peaked at $1.2 billion but the two new strategies could run multiples of that. Both strategies are liquid, so do not need a one year lock up, but Okumus is looking to attract longer term investors and avoid “hot money”.