Tuesday, September 13, 2011

Hedge Funds versus Managed Futures

If you follow our publications at all, you have likely seen how we usually separate managed futures and hedge funds. But not everyone follows this practice. Dow Jones Credit Suisse, for one, lists managed futures as merely a subset of their hedge fund index. The financial press often fall into the same trap, portraying managed futures as a hedge fund strategy instead of its own asset class.
So, are they the same?  Are managed futures a type of hedge fund?  We generally believe that managed futures is an asset class on its own, not part of the hedge fund landscape. However, given the continued mix up on the subject, we thought it might be time to compare the two investments to clarify matters.
To start to bring some clarity to this – a necessary first step is reviewing just what a hedge fund is.  Our 2006 newsletter ‘Hedge Funds Explained’ defined them as such:
So what is a hedge fund? The American Heritage Dictionary defines a hedge fund as: "An investment company that uses high-risk techniques, such as borrowing money and selling short, in an effort to make extraordinary capital gains."
…an investment company is merely a partnership, LLC, or similar legal entity formed for the purpose of investing. The money of multiple investors is pooled together in order for those investors to realize the benefits of a larger total pool of capital (such as more diversification) and allowing the same strategy to be employed simultaneously for all of the company members. The most well known investment companies are mutual funds….
A hedge fund is nearly identical to a mutual fund in its general premise of pooling the money of multiple investors, but unlike mutual funds, hedge funds purposely keep the number of investors in the company(fund) under 100 people (usually entities). This allows hedge funds to qualify for an exemption…by which they do not have to register as an investment company… While the laws require a company investing on behalf of greater than 100 people to be registered, there is no restriction on the total amount of money that is pooled together, thus hedge funds usually set their minimums at $1 Million and higher so they can still manage a significant amount of money while staying under the 100 investor limit.
Because of this exemption, hedge funds are not required to redeem investor's money within 7 days or report their positions like mutual funds must. As practically unregulated entities, they have much greater freedom in their investments and how they fund those investments. They can borrow money, do short sales, invest in complex derivatives, and more in their search for higher returns.
[Finally]… the regulations prohibit unregistered firms from advertising or soliciting new clients. That is why you don't see advertisements for big hedge funds right next to the Fidelity and Vanguard ads in the Wall Street Journal, and one of the reasons hedge funds are surrounded by so much mystique.
Commodity Pools = Funds = Sort-of-Hedge-Funds
Now that we have that out of the way, let’s now look at the various ways one goes about gaining access to the managed futures space:  1. Individually managed accounts, 2. A Commodity Pool, or 3. the newly launched, publically offered mutual fund or ETF route.
Item number 2 above, a commodity pool, is why many people get confused on managed futures being part of the hedge fund world. You see, commodity pools are technically the same thing as hedge funds. They are investment companies (LLCs or partnerships), or funds, which ‘pool’ investor money together for the purpose of investing.
To see why these commodity pools (or funds), instead of individually managed accounts, became synonymous with managed futures, one can look back in the infancy of managed futures, before there were places such as Attain dedicated to the space. Back in those days, those in the managed futures space with commodity pools were forced to submit their performance to the various hedge fund databases in order to get people looking at their performance.  They were technically funds, and there were no managed futures specific reporting platforms – so it made for a good fit.
Before you know it, managed futures funds were right there alongside hedge funds, and it seemed logical to say that managed futures was a type of hedge fund strategy.
To solidify this, you had both managed futures and hedge funds marketed as alternative investments which could provide absolute returns not correlated with stock and bond investments (even though hedge funds didn’t live up to that in 2008). You also have the very real link between global macro style hedge funds (think George Soros’ famous bet against the British Pound) which tend to take longer term positions which have a long volatility type return profile, and managed futures – which many times end up riding those same ‘macro’ level trends (not because they analyzed the situation and thought it was going to happen, but because the price action dictated such). Finally, they often have the same fee structure of a 2% management fee and 20% incentive fee.
BUT…..when considering Individually Managed Accounts…..
So, while managed futures were lumped together with hedge funds for simplicity’s sake, and while there are technically managed futures funds which are set up the same as hedge funds – calling managed futures a type of hedge fund strategy does it a great disservice.
For starters, one of the biggest points of managed futures is that they can be invested in through individually managed accounts. You cannot get more unlike a hedge fund than an individually managed account. In fact, the characteristics of an individually managed account are almost as if they were set up for the specific purpose of being diametrically opposed to a fund structure.
When looking at managed futures through Individually Managed Account lenses, we see they are quite different than hedge funds.  Let us count the ways:
1. Custody of Funds (fraud risk) - When you invest in a hedge fund (or commodity pool) – you are handing over your money to that fund, and putting your money in the name of the fund. Your money becomes part of the assets of the fund, with you owning a part of those overall assets.
With an individually managed account, you don’t hand over your money to a fund, you keep your money in your name, and your money does not become part of the assets of the manager you invest in (and in fact, it does not even become part of the assets of the clearing firm/prime broker used by the manger). Your money stays in a segregated account in your name, with the manager only having authority and access to the account to place trades. More on that here.
2. Registration - Managed futures has an extra check on potential fraud through registration requirements. If you're a CTA offering a managed futures program to investors, you must be registered with the CFTC and NFA as such. This subjects them to a wide variety of communication restrictions and performance reporting requirements that may not protect investors 100%, but still serves as a confidence booster, in our opinion.
Hedge funds, on the other hand, are not required to register with any such body. Though the Dodd-Frank regulations are attempting to require the big boys in the space to register, we're quickly learning just how rapidly regulators are putting the new rules into place, so we'll see when that one goes into effect.
3. Exchange Traded vs Over the Counter - Managed futures trade exchange listed futures, like Corn futures,  Crude Oil futures, or US 30 Year Bond futures. These contracts are carefully monitored, and are typically perceived to carry less risk than over-the-counter (or OTC) derivatives traded by many hedge funds – because there is no counterparty risk (the CME guarantees the trades and acts as the sole counterparty). OTC derivatives are often considered to be riskier because the trade is only as good as the credit and sustainability of the entity on the other side (the counterparty). Given the bank failures in 2008 and now Greece – the problems with this should be obvious.
4. Liquidity - Managed futures are often lauded for their liquidity, and with good reason. Technically, if you wanted to, you could liquidate your managed futures investment within one to two days. And because the account is in your name and under your control – liquidation can be initiated by you, without input from the manager. In the hedge fund world – liquidity is a known issue. Most funds will work some form of lock-up into the process, meaning you will be required to keep your money invested for a specified amount of time. Have to get to your money right away? Prepare to pay a hefty fee to do so.  Moreover, that kind of liquidation can only happen through the manager of the hedge fund, since, as we mentioned above, your money would be under their discretion prior to action taken.
5. Transparency- Managed futures investors in individual accounts are able to see their positions at the close of every day (and often even in real time). The trading process is made as transparent as possible. In hedge funds, the opposite is often true, with many hedge funds quite secretive about what positions they hold, even with their clients. Their fear is that they will be front run or other hedge funds will see them in a weak position and try and take advantage of it somehow.  Others are afraid of giving away too much of their "secret sauce." No matter what excuse they use, hedge funds are known for a lack of transparency (although many are trying to improve this), while managed futures are known for one of the highest levels of transparency available.
6. Leverage- One of the reasons managed futures is often portrayed as "risky" is because it trades futures contracts, which have built in leverage via the commodity futures contracts they trade (you can put up $8k to trade $80K worth of Crude Oil in futures trading, for example) . Hedge funds often have this same leverage (those that trade futures and other derivatives sure do), but are also leveraged in another way. Hedge funds can (and frequently do) borrow money to leverage up their returns in addition to any leverage that may be built into the contracts they trade.  Using our example above, a hedge fund may take $4,000, and borrow another $4,000 to put up the $8K needed to control $80K worth of Crude Oil via futures.  This leverage obviously increases risk, but the more nuanced ways it affects hedge funds are the bigger deal. Those include the possibility of margin calls where they must offset other positions to meet margin calls against borrowed money, and credit market risk, whereby a freezing up of credit (like in 2008) can impact returns of hedge funds as they won’t be able to borrow the money they need to put on the trades they want to. A managed futures manager can not borrow money against your individually managed account and increase their bet size with that borrowed money. There is simply no function or structure allowing such.
And more...
While many of the differences between hedge funds and managed futures are a result of the fund versus individually managed account structural difference – there are other differences which are more of how they trade than how they are structured:
7. Losses beget losses – One lesson learned in 2008 was that investor outflow can have a substantial impact on the performance of hedge funds, especially those funds with illiquid stocks, derivatives or swap positions. The general idea is that a move down in something a hedge fund owns causes losses for the fund. Then those losses cause investors to request redemptions. To meet the redemptions, the fund must sell some of what they own in that losing position, which drives it down further, thus causing more losses, and more redemptions, and so on.   The good folks at nearly every failed hedge fund (including Long Term Capital Mgmt, Amaranth, and even the Bear Stearns fund which acted as the canary in the coal mine for the credit crisis) blame just this sort of action on their failures – with quotes such as once the run on our positions started, there was no stopping the losses.
While this is technically possible in managed futures, it is highly unlikely. For one, managed futures typically risk less than 1% per trade, meaning that any one losing position would leave the managed futures investment down just 1%, which is unlikely to cause losses. But likely more relevant is that managed futures programs are usually just a very small percentage of the open interest in whatever markets they are engaging (less than 1%), meaning that even if they had to cover all of their position, it would likely not move the market substantially.
8. Hedge Funds like a rising stock market
Whether it be so called private equity, arbitrage between a company’s public debt and stock, the trading of stock pairs (i.e. long Home Depot, short Loews), investing in a beaten down company, or loading up on the stock or bonds of a high flying tech company or emerging market player – many hedge funds are involved with the fate of public companies in one way or another (the exception being Global Macro). When something affects the whole corporate stock/bond ecosystem, such as credit freezing up hurting corporate America in 2008 – hedge funds are likely to struggle,  despite their alternative investment moniker.
And this isn’t just us saying this, the data backs it up as well, as was referenced in the white paper by Welton Investment Corp. back in February:
eight out of 10 hedge fund strategy types, including private equity, event driven, and even fixed income arbitrage, behaved more like stock markets than we would expect them to under the alternatives moniker; and so called real assets like infrastructure and real estate again tied closer to equity market returns than one would expect from their marketing as non correlated to the stock market asset classes. If you are in any of the strategy types just mentioned thinking that you are diversifying your risk – these finding should keep you up at night. 
9. The DNA test came back negative
Some of you may be saying – enough of all the talk, what do the numbers say? And, as luck would have it for this article, the numbers back up the argument that managed futures is not part of the hedge fund universe, with the average correlation between managed futures and the other hedge fund strategies 0.02. And when excluding Global Macro, it comes out to an average of 0.00 – you can’t get more non-correlated than that, my friends.
Managed Futures Correlation to Hedge Fund Strategies

Fixed Income Arbitrage
Event Driven Risk Arbitrage
Event Driven Distressed
Emerging Markets
Event Driven
Event Driven Multi-Strategy
Equity Market Neutral
Dedicated Short Bias
Long/Short Equity
Global Macro
The bottom line here is that while managed futures in their commodity pool/fund form may have some similar traits to their hedge fund cousins - at the end of the day, the vague resemblance does not make a direct relation. They're more like 5th or 6th cousins, if you must go with the familial analogy.
We would love to see the financial press realize that all managed futures are not funds and talk about the individual managed account structure, but we won’t hold our breath.  Managed futures are likely to continue to be referred to as a hedge fund strategy, with articles defining managed futures as funds which invest in commodities.
Please don’t be fooled.  This is a logic problem you may have seen in Intro to Logic freshman year in college. If all managed futures funds are hedge funds, but not all managed futures programs are funds, are all managed futures program hedge funds?  We'll give you a hint: the answer is decidedly NO.  There are real benefits like liquidity, transparency, and more which simply aren’t there on the hedge fund side.

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Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.