Bob Treue is the founder and manager of a hedge fund that has generated annualized returns of more than 15% since its 2001 inception. Those results rank it among the best, but the fund manages a relatively humdrum $700 million with half a dozen employees, scanning global markets for unusual events that have created temporary pricing anomalies.
Treue, 51, is an outlier and genuine outsider. He doesn’t actively market, instead focusing his time on investing and research. His fees are among the lowest around and he turns away capital when he can’t put it to good use.
The manager has no need for a fancy Midtown Manhattan address, opting for a simple townhouse across the Hudson in Hoboken, N.J. to be close to his family. And he candidly offers potential investors a bunch of reasons as to why they should not invest in Barnegat.
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Treue’s stellar performance, no-frills approach, and commitment to rock-bottom costs may resonate with RIAs as they increasingly consider alternative investments and recognize that the independent nature of hedge fund management can help them generate more consistent performance. Because vetting hedge funds is not something that comes naturally to many advisors, determining the “right” managers can be challenging.
Starting with the basics can get advisors on the right track. This includes fund longevity, repeatable investment process and returns, moderate to low volatility, a focus on performance over asset gathering, and alignment of manager and investor interests. It also includes top-tier service providers that help ensure the integrity of what managers say they are doing, and a stable asset base that won’t bolt when times get dicey.
A number of these managers can be found in the past 17 hedge fund surveys I’ve managed for The Financial Times, Barron’s, The Wall Street Journal, and last year for SALT— the annual alternative investment conference. (The pandemic pre-empted the event, but BarclayHedge — a leading industry database that has been a key resource for my work, ended up hosting my study, along with a review of how the Top 50 funds, selected based on historic returns through 2019, fared in 2020.)
One fund that has perennially made my list has a most unusual story.
Treue started the Barnegat Fund in the shadow of the 1998 collapse of Long Term Capital Management, which until the Financial Crisis of 2008, was the poster child of financial hubris.
The Federal Reserve orchestrated the rescue package that enabled the orderly shutdown of the fund, having kept it from slamming into the economy. The Fed’s own history offers a brief look into the fund. “Led by a team of market experts including two Nobel laureates, LTCM was a hedge fund well known for using sophisticated mathematical models to make impressive profits. Founded by former Salomon Brothers Vice Chairman John Meriwether in February 1994, LTCM exploited temporary price differences between similar types of securities. Its “market-neutral” design meant it expected to make profits regardless of whether prices were heading up or down. LTCM generated above-normal returns of 20 percent in 1994, 43 percent in 1995, 41 percent in 1996, and 17 percent in 1997.”
Then something happened.
An emerging market financial crisis that started in Southeast Asia in 1997 metastasized across the globe, uncovering the fund’s Achilles Heel.
Treue recalled, “it wasn’t that LTCM’s relative value trades were wrong; management simply was not keeping sufficient reserves to meet margin calls when its trades moved against them.”
This was a major risk considering the fund was running a ton of leverage, with some estimates having cited a number as high as 100 times NAV. When the financial crisis abated and dust settled around LTCM’s book, most of the fund’s positions actually played out according to plan.
Having been a head trader at the London-based fixed income relative value shop Paloma Partners, this got Treue thinking.
In 2001, while living in a friend’s apartment in Greenwich Village and working out of the NY Public Library, Treue started Barnegat, believing in the underlying merits of fixed income relative value trading. Simply put, this strategy seeks out pairs of securities that should trade in-line with one another, but for various reasons have diverged — one trading cheap, the other trading expensive. Treue goes long the underpriced security (expecting it to rally) and shorts the overvalued security (expecting its price to fall).
Treue doesn’t run an arcane secret black box to generate trades, but depends on common sense observations to identify potential investments.
“I’m not trying to anticipate unexpected events or catalysts that other relative value managers look for,” he explains. “They have already happened in creating such pricing divergence. I’m simply betting that rationality will ultimately prevail.”
Treue doesn’t look at massive mispricing that may reflect systemic events that don’t bode well for things to come. He looks for when the market has temporarily gotten things wrong. In absolute terms, it may involve just 20 to 80 basis points. He then uses a good dose of leverage to help his trade generate a reasonable return.
While the fund hedges certain risks, Treue recognizes that the market can stay irrational longer than one can stay solvent, and acts accordingly.
“That’s why I typically keep more than half my assets liquid and unencumbered,” explains Treue, “to meet margin calls in case the spread, which I expect will close, widens further. This is something LTCM failed to do.”
Since Treue can never know when a trade gap has maxed out, he will dollar-cost average into positions, adding to them if the price differential widens — assuming his underlying thesis remains intact. His average investment horizon for trades range from two to four years.
What has Treue’s approach accomplished in over 20 years? Annualized returns of more than 15%, more than double those of the S&P 500. Barnegat has delivered this outperformance with far less annualized volatility: 12.5% versus the market’s 17.6%. Highlighting the fund’s independent performance: returns that are virtually uncorrelated to the market. This is the ideal of what a hedge fund ought to do.
Minimum investment into the fund is $1 million. RIAs can pool client capital and access the fund’s offshore fund. Barnegat does not maintain an onshore vehicle. This helps keep expenses low, with a 1% management fee and 15% performance fee — both well below industry averages.
Treue made believers out of early investors, including two funds of hedge funds and one global pension fund, which together had seeded him $25 million in early 2001. That year, when the S&P 500 was in the throes of the Tech Wreck and fell by more than 16%, Treue gained 13.5%.
Then in 2002, when stocks lost nearly one-quarter of their value, Barnegat gained more than 50%. He kept a winning record every year until 2008, when the fund declined by more than one-third. This was the fund’s only down year in 20. “At the time, I was convinced the problem wasn’t my positions,” explains Treue, “but that liquidity had dried up and pricing had collapsed.”
It was the only time he ever sold out of positions before realizing a gain. He did this to control risk as volatility was going off the charts – not because his investments lost their perceived value. The following year, Barnegat gained more than 130% as Treue’s convictions were borne out.
A classic Barnegat trade occurred during the Financial Crisis involving U.S. Treasurys — those that were inflation protected (TIPS) and nominal Treasurys, both with the same maturity. There was a massive selloff in TIPS in the fall of 2008 because Lehman Brothers had excessively relied on these securities for collateral in its repo trades. This sudden liquidation sent their prices lower and yields higher. Yields on 6-year TIPS hit 5% while the nominal Treasurys were yielding half that. (Note: Annual US inflation between 2009 and 2014 was 1.6%.)
Barnegat bet that the price of 6-year TIPS would rise and 6-year nominal Treasury prices would fall as their yields normalized, which they did.
Another anomaly Treue identified around the same time was when the Bank of England initiated quantitative easing in 2009 in response to the Great Recession. Instead of broadly buying British Gilts, the Bank announced it was buying maturities ranging from 5 to 25 years. This purchasing demand produced a kink in the yield curve: 4 3/4-year gilts were yielding 3% where 5-year gilts were paying 2.8%. Treue bought the slightly shorter maturities and shorted the slightly longer maturities. A year later in March 2010, when the Bank started to pull back on quantitative easing, yields had realigned and Barnegat profited.
Of course not all of Barnegat’s trades have worked out.
Five years ago, Treue saw 30-year U.K. Gilts trading irrationally. “Government bond yields should be above inflation,” explains Treue. “But the Gilt was yielding 1.95% and the equivalently termed inflation swap was paying 3.53%.”
So he shorted the long-term Gilt, believing its yield would rise and price would fall, and went long the inflation swap, believing it would rise in value. Based on the way he structured the financing of the investment, as the trade moved against him (creating a paper loss), he started enjoying carry income. But if and when the trade rebounds in his favor, that positive carry will turn negative.
Certainly the pandemic hasn’t helped matters, forcing the British Central Bank to restart quantitative easing. Treue concedes it’s unclear when this trade might pay off. Certainly it has taken much longer than anticipated.
A new trade Barnegat initiated this past April involves the yield and pricing gap between Japanese Treasuries (JGB) and their inflation-protected versions (JGBi). Buying the same maturities of both bonds (with identical coupons of 0.1% and both due in March 2029), he bought JGBi at 99.756, which was yielding 0.129%. He shorted the nominal Treasurys at a price of 101.747. This has produced a negative yield of -0.095%, which Treue actually receives being short the JGB.
“In effect,” Treue explains, “the market is paying us 0.224% a year and offering a free option on Japanese inflation being greater than 0. There is no more to this trade. It is that simple.”
“Given we repo both bonds,” adds Treue, “there is no upfront cost. As time passes, we would incur a repo cost to borrow and lend these bonds, but that cost in Japan is just a few basis points and can occasionally be a positive.”
The manager plans on holding this trade through early 2029 when both bonds will mature at 100, producing an additional 2% return.
The manager explains when assets and liabilities are matched, these kind of relative value trades can cancel out interest rate and currency risk to U.S. investors.
So how does Barnegat turn small securities mispricing into 15% annualized returns?
The manager relies on significant gross leverage to establish meaningful positions in these trades, which typically ranges between 15 to 25 times his net assets. Treue says this risk is managed through two basic techniques. One, the leverage is applied to both sides of his trades, which means the leverage risk can (but not always) largely cancel out each other.
Secondly, in keeping more than half of his assets in cash, he can continually meet margin calls that are required to keep him in positions and not forced to sell at inopportune times that would trigger real losses. (The lowest his cash position has ever fallen to was during 2008 when it reached 37% as he met margin calls.)
So what does Treue tell perspective investors that may blunt their interest in the fund?
He has no floor or limits to the amount of leverage he may apply in a trade. It’s all up to the manager’s discretion and his belief in a trade.
He doesn’t apply tail-risk options to protect his positions because over time, he doesn’t believe they pay off.
Barnegat doesn’t apply stop-losses to staunch paper losses being accrued when trades move against him. He’s more likely to add to positions when this occurs.
This means that potential investors who are cautious about headline risk shouldn’t invest in the fund. Treue will more likely be investing when bad news is being reported rather than ratcheting back exposure.
It can take investors approximately 10 months to fully redeem their money.
Barnegat is clearly not for the faint of heart. Bob Treue is the fund, and therefore Barnegat has a key-man risk. He worries markets might suffer from protracted mispricing, forcing him to drawdown his cash reserves. And being a small fund that trades sparingly, he is concerned about having only one prime brokerage account — albeit a first-tier one in Barclays Bank.
Treue clearly marches to his own drumbeat that’s very different from most of his hedge fund colleagues working across the river in Manhattan. But the fund is a fascinating example of what a manager who truly believes in his own strategy and methods has achieved over the past 20 years and across three seismic market events.
Eric Uhlfelder has covered global capital markets for 25 years, wrote the first book on the advent of the euro post currency unification, and has earned a National Press Club award.