Tuesday, September 03, 2013

CTAs: Diamonds during the rough

Global investors had a wake-up call in 2008. As asset classes from equities and corporate bonds to commodities and real estate simultaneously suffered record losses, it seemed diversification as a strategy had failed. In short, these diverse asset classes experienced drawdowns as deep as 66% of their value. Some types of hedge funds, such as convertible bond arbitrage or long-short equity, experienced losses of 32%. It seemed that there was nowhere to hide from the global, panic-induced selling that resulted from the market turmoil that culminated in the demise of Lehman Brothers. Even after the markets started to recover, losses were significant, with losses ranging from -15.9% to -19.4% to the S&P 500, the MSCI world equity index, and the S&P GSCI commodity index for the three years ending December 2009 (see “Diamonds in the rough,” below).
Although these “risk on” assets earn high returns over time, they can suffer during times of increased systemic risk. In 2008, a decline in liquidity and credit availability led to forced liquidations and bid-ask spreads as wide as 30% of the value of secondary trading of hedge funds and private equity limited partnerships. 
Gates were erected, meaning that investors who had fulfilled their lock-up period wrongly assumed that they would be able to redeem their interests in hedge fund or real estate holdings. Formerly liquid assets, such as money market funds or stock index funds, faced restricted redemptions given holdings in the massive debt of Lehman Brothers or securities lending programs.  
And elsewhere…
While many investors were discussing the end of the financial world as we know it, business as usual proceeded in the world of macro and managed futures. As these funds take long or short positions in “macro” markets, such as interest rates, stock market indexes, and physical commodities, and trade on the futures markets, which offer liquidity, real-time pricing and reduced levels of counterparty risk, most of these funds continued to offer liquidity to their investors throughout the crisis. However, despite positive returns in 2008, many managed futures funds had lower assets under management (AUM) at the end of 2008 than at the beginning. Why? Because investors sought liquidity in one of the few places where cash was readily accessible. Redeeming interests in these funds between the fall 2008 and the spring 2009 offered opportunities to pick up other assets at fire-sale prices.  
Over the three-year period ended December 2009, managed futures funds had positive returns of 17.2%, while macro funds profited by nearly 25%. This wasn’t a fluke, as macro and managed futures funds historically have provided safe harbor during stormy markets. Consider the 51 months between January 1994 and March 2013 in which the S&P 500 index posted losses of greater than 2%. During these crisis months in the U.S. equity markets, stocks declined an average of 5.5% per month, while macro funds returned -0.2% and managed futures profited by 1.2%. In the 74 months when stocks boomed by greater than 3% per month, macro funds averaged returns of 1.7% and managed futures earned 0.7% per month.  
How can these funds profit during times of crisis? Discretionary macro funds are managed by investors who specialize in making top-down calls that profit during times of crisis. Macro managers search for trades with skewed risk-reward situations. The most extreme example is that of a fixed-rate currency: Being short the currency may cost a few percent per year in negative carry, but profit as much as 50% in weeks when the currency becomes unpegged. After the quant meltdown in 2007 and the Bear Stearns “incident” in 2008, many macro managers correctly surmised that more downside risk was coming.  
Many commodity trading advisors (CTAs) have systematic trend-following at the core of their strategies. It’s easy to see how a trend-following strategy could produce profits that averaged more than 10% from September to December 2008, a time when stocks fell more than 30%. With well-established trends in place, most CTAs had short positions in “risk on” assets, such as commodities and equities, and long positions in “risk off” assets, such as sovereign debt and the U.S. dollar.  
Historically, to reduce losses during times of crisis, investors have allocated assets to cash and sovereign debt or long positions in equity put options. While these strategies can be effective at reducing portfolio drawdowns, they also serve to reduce long-term portfolio returns, because lower risk assets typically have lower returns and rolling long positions in equity put options may have negative returns over time. However, an equally-weighted portfolio of macro and managed futures indexes had a return similar to the S&P 500 Index since January 1994 with substantially lower volatility and drawdown statistics. With low correlations to equities and superior returns during turbulent markets, macro and managed futures funds are taking portfolio share when investors are seeking to hedge tail risk. Another important consideration is liquidity, as investors were allowed to withdraw cash from macro and managed futures during 2008 and 2009, even when withdrawals were constrained.
From 2007 to 2009, a 60/40 portfolio invested in global stocks and bonds posted break-even performance with a maximum drawdown of more than 36%. Investing 20% in macro and managed futures indexes, while allocating 50% to global equities and 30% to global bonds earned 1.3% higher annual returns, while reducing drawdowns to 30%. (see “The right mix,” below). Since 1994, the addition of macro and managed futures to the previously 60/40 portfolio added 0.7% to annual returns while reducing annual volatility by 1.4 percentage points. 
The industry’s ability to provide positive or break-even returns in a time of crisis and the willingness to return cash to investors when cash was dear was richly rewarded by investors in the post-2008 era. An analysis of data from Hedge Fund Research, Inc. shows that systematic diversified macro funds grew from 4.9% of a $1.41 trillion global hedge fund market at the end of 2008 to 9.5% of a $2.25 trillion market at the end of 2012. CTAs, then, grew from $63 billion to more than $214 billion AUM in just four years as a result of their ability to serve the role as a tail hedge for investor portfolios. Barclay Hedge notes AUM of systematic traders at $266.3 billion and total managed futures AUM of $329.6 billion, which includes managers that exclusively trade currencies or financial futures.  
So how has the managed futures industry changed over time in response to increased AUM and interest from institutional investors? First, institutional investors are relatively adverse to large drawdowns, even when long-term returns compensate for the short-term risk. As a result, managers have diversified models and markets to reduce the weight on long-term trend-following, which had historically higher volatility and larger drawdowns. From 1993 to 2004, managed futures indexes averaged a volatility of 10.16%. Since then, volatility has declined to 8.4%, even when equity market volatility has increased. Let’s hear from the managers on how they’ve changed:
  • Justin Dew, senior managing director of the Welton Investment Corp., a 25-year-old, alternative investment manager with more than $700 million AUM, says “research never stops,” as managers are looking to add trading tools to their heritage of pure trend-following. In addition to the core strategies of long-term trend-following, managers are diversifying by adding shorter-term models that may catch different portions of the trend in a given market. Countertrend models are increasing, as are the use of inventory data in commodities and carry strategies in currency markets.  
  • Dew further explains how institutional investors differ from individual investors.Historically, individuals have had shorter-term relationships with their CTAs, often choosing to redeem after drawdowns and add to allocations after times of strong performance, which has reduced their and returns relative to the buy-and-hold investor. Institutional investors tend to commit funds for longer holding periods, seeking to earn performance over the manager’s full return cycle.  
  • Jason Gerlach, principal and managing director of Sunrise Capital Partners, a $375 million manager that was founded in 1980, notes that after the 2008 Madoff debacle, institutional investors have increased the due diligence process substantially, taking a much deeper look at both the investment process as well as the operational risk factors. The risk management and compliance requirements of institutional investors can cause managers to add staff and systems, which can make it more expensive to run a managed futures shop. Given that only the largest management firms can afford to make these investments, the AUM of the managed futures industry is becoming more concentrated at the large firms that have taken the effort to ensure their compliance meets the demands of institutional investors.  
  • Barry Goodman, executive director of trading and EVP of $1.8 billion AUM Millburn Ridgefield Corp., a CTA with a 36-year track record, thinks investors should ask questions about the potential impact of size on a manager’s ability to allocate meaningful risk to some of the less liquid or unique futures markets. As managers grow, allocating to these markets in a way that will actually have an impact on returns of the portfolio as a whole becomes more difficult, and portfolios may be forced toward concentration. And just as firms that are too large may run into difficulties on the investment side, firms that are too small won’t always be able to effectively negotiate with counterparties, attract talent, invest in research and development, and keep up with the relentless and increasing pace of technological innovation. Simply put, barriers to entry in the industry have risen and are getting higher every day. Goodman sees institutionalization of the business as one of its most important developments. As firms focus on the development of well-defined operational procedures and departmental responsibilities, a strong compliance framework, and technologies and trading strategies designed to scale, they can be better prepared for the due diligence process of institutional investors and their consultants and to overcome the challenges of growing AUM. 
To reduce operational risks, CTAs are moving to build relationships with multiple FCMs and prime brokers, which avoids the situation of having all of the firm’s assets in limbo upon the demise of a counterparty. The relative risk perception of managed futures compared to over-the-counter products has increased in recent years, as the problems at MF Global and Peregrine at least temporarily impaired the assets of investors (see “We’ve been wronged,” May 2013).
While the cost of doing business is increasing, Gerlach comments that institutional investors are seeking to reduce fees, often in exchange for longer lock-up periods or larger investment commitments. He also appreciates the long-term commitment and more sophisticated discussion with institutional investors. 
However, the environment of quantitative easing and reduction of market volatility has challenged CTAs the last three years. But this is the environment that can favor discretionary macro managers. Rather than redeeming from CTAs for earning lower profits than equity markets, institutions are maintaining their CTA investments while diversifying their exposure with discretionary managers.  
Finally, Gerlach notes that changes in the regulatory environment are causing uncertainty for both managers and investors. Dodd-Frank in the United States and the ever-evolving UCITS regulations in Europe are raising questions about what strategies are allowed in the new regime. Specifically, investors are concerned about position limits on energy, metals and agricultural commodities, and whether those trades have different tax or regulatory status than trades in financial futures. With the rise of ETFs and 40 Act funds in the United States, managers are modifying fee structures, as incentive fees are an area of concern within the 40 Act regulatory regime.  
The bottom line is CTAs are getting a new-found respect after 2008 and 2009, even though outperformance in down markets has a strong historical precedent for these managers. The ability to provide liquidity in any type of market, and the willingness to offer managed accounts where investors keep the custody of their assets, are increasingly prized by investors in this (hopefully) post-crisis era. The next time someone tells you that “in a crisis, all correlations move toward one,” please remind them that there is an underappreciated asset class that has historically provided value in a down market. Your friendly neighborhood managed futures manager will thank you for the referral.  

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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.