Eminence Capital saw changes in stock market – so hedge fund shifted, too

Ricky Sandler, CIO of $6.4 billion Eminence Capital, says the stock market has changed — and his firm is changing with it.

Eminence has a 25-year history of investing in the long/short arena. The firm has three funds, the flagship long/short fund launched in 1999, a long-only fund launched in 2012 and an alpha extension vehicle launched last year called a 150/50 strategy.

The new strategy incorporates what Sandler believes are fundamental changes in the structure of the stock market.

“The market is not broken. It is changing,” he told Pensions & Investments. Fifteen years ago, 75% of the stock market was actively managed assets, whereas today that’s dropped to 40%. The other roughly 60% is now controlled by passive index funds, algorithmic and quantitative funds, hedge fund trading “pod shops” and thematic investors, according to Eminence data.

In the short run of between three to nine months, “stock prices are not being driven by bottom-up fundamentals,” he said. Individual stocks are exhibiting much greater price volatility, and that is a poor signal for fundamental investors. The firm’s typical holding period is two to three years, he added.

The dynamics of shorting also changed after 2021, and the firm has evolved its portfolio construction and management. The flagship fund was down 11% in January 2021 as a result of retail investors squeezing short positions, but ended up for the year.

“We see how markets have changed and allocators have changed. They used to prefer long/short strategies with a better Sharpe ratio and now that has changed.”

“In the first half of Eminence’s existence, mispricing (of stocks) were largely coming from bad judgments by bottom-up investors. Whereas today, they are still mispriced for that reason, in addition to mispricings that are driven from trading from quants, pod shops and hedge funds.”

As a result of the new volatility, Sandler and his team changed the way they short now. Scale is required for single-name short portfolios, and they manage short portfolios with smaller position sizes (a 2% limit for one short position, and roughly 115 shorts). The firm has a dedicated short research team and collaborates with the quantitative research team.

Eminence Capital's 150/50 strategy, which is 150% long and 50% short, with $700 million in assets under management, was set up to appeal to institutional investors.

“This is a substitute for investors’ long bucket with leverage,” he said. Institutional investors in the new strategy include the Virginia Retirement System, Richmond, and the investors “like the potential alpha and fit into the allocator models. Plus, we only get paid if there’s alpha.”

In Eminence's alpha extension strategy, the firm charges a 0.5% management fee and no performance fee unless the fund outperforms the market. Above that hurdle rate, Eminence keeps 30% of the outperformance as its fee.

Eminence Partners was up 6.1% through February (flagship hedge fund), and 13.4% in 2023, for an annualized return of 11.4% over 25 years; Eminence Partners' long-only fund was up 5.6% through February and 30.2% in 2023, for an annualized return of 12.6% over 10 years; Eminence's alpha extension strategy was up 7.5% through February, and 21.5% in 2023, according to people familiar with the funds.

Activism

Sandler personally has taken board seats on companies such as Entain, in which Eminence holds a 4% to 5% stake.

“Activism is a tool in the toolkit. But we never go in to an investment expecting to be an influencer," Sandler said. "We engage constructively to help improve outcomes and get needed change. If constructive engagement doesn’t work, our choice is a more public and traditional form of activism or (to) sell.

"On rare occasions, it’s an attractive enough business and situation where activism is a better choice. Entain is on that spectrum. It is a strong business that has been poorly run for the last 3½ years. I went on the board a few months ago. The search for the new CEO is ongoing. It needed a shakeup.”