EM Stock Markets – Destabilized by Currency Sell-offs and Capital Outflows

Developed market equities are attempting to stabilize based on some more talk from Eurozone leaders who are meeting with the IMF and reported to be discussing items such as expanding the size of the EFSF, creating a TARP-EU, and recapitalizing more of the European financials. Developed market investors are attempting to look ahead during scary times. This contrasts to the overnight session in Asia, which saw another spiral into panic selling towards the Asian close. Most markets were down 3-6% again, and for a short period last night the S&P futures were down 15 points (2.5% lower than 8:00am NY time). There are a number of signs that this round of selling is liquidation with little regard to fundamentals in the region. The selling is indiscriminant when you look across individual stocks across emerging markets in Asia and breadth in the markets is extremely negative. The cause of this selling is temporal in my view, as intrinsic value will support these markets going forward so long as a global financial crisis is avoided. The small cap sector in EM had numerous double digit % stock price declines last night.
The IMF recently came out with updated estimates that emerging markets will be driving 80% of real global GDP growth in 2011 and 76% in 2012. There is simply no way that emerging markets can drive the vast majority of global GDP growth and not see another strong year of growth in corporate sector profits. Developed market companies in the US and Europe continue to point to emerging markets as a growth engine. Companies like Nike haven’t seen any slowdown in emerging market demand recently. It is simply implausible that US companies will continue to see strong growth in the region while the local companies go into decline. So the region will bottom based on improved sentiment which is impossible to forecast and when valuations are stretched to the downside. I believe that we at least have the second condition in place now:
EM currency declines from highs in the past month:

• Brazilian Real:                  17%
• Mexican Peso:                 17%
• Russian Ruble:                 18%
• Indian Rupee:                   13%
• Turkish Lira                     9%
• Indonesia Rupiah:              8%
• Malaysian Ringgit:             8%
• Thai Baht:                        5%

In conjunction with the currency market sell-off, BRIC stock markets have declined and valuations have contracted sharply. Here are the major EM equity markets:










In destabilized markets, the valuations can get stretched to extremes. There needs to be selling fatigue as you run out of sellers before the markets can really turn. Savvy buyers will attempt to jump in at the first signs that the selling pressure is exhausted. This will be very difficult to time just right, but an approach of scaling into emerging market weakness at this point, without using leverage is a sensible strategy. I prefer overweights in China and Brazil as these markets have declined more, have lower valuations, and the most solid dividend yield support. When one thinks about how the world economy will evolve over the next number of years it is implausible to envision an environment without growth being driven by the BRICs and frontier markets within EM. Investing in EM after a period of a sudden dislocation and liquidity withdrawal has led to numerous instances of outsized returns. With valuations providing strong medium-term support to the markets (when panic subsides) I think it is reasonable to expect 100% returns over the next 2-3 years for investors who scale-in buy from here, without leverage, and can hold their positions while taking advantage of near term volatility and not reacting to the volatility.

Residential Remodeling Index at new high in July

The BuildFax Residential Remodeling Index was at 130.4 in July, up from 129.5 in June. This is based on the number of properties pulling residential construction permits in a given month.

From BuildFax:

The Residential BuildFax Remodeling Index rose 24% year-over-year--and for the twenty-first straight month--in July to 130.4, the highest number in the index to date. Residential remodels in July were up month-over-month almost a single point (.6%) from the June value of 129.5, and up year-over-year 25.6 points (24.5%) from the July 2010 value of 104.7.
...
In July, the West (3.4 points; 3%) and Midwest (4.9 points; 5%) all had month-over-month gains, while the South (3.3 points; 3%) and Northeast (2.7 points; 3.4%) saw a decline.
...
"As millions of Americans believe that they will not be able to secure a new home due to a variety of factors including tight credit, limited buyers and challenging job prospects, they are more and more turning to renovating and remodeling their current properties, sending remodeling activity to record levels," said Joe Emison, Vice President of Research and Development at BuildFax.

Click on graph for larger image in graph gallery.

This is the highest level for the index (started in 2004) - even above the levels from 2004 through 2006 during the home equity ("home ATM") withdrawal boom.

Note: Permits are not adjusted by value, so this doesn't mean there is more money being spent, just more permit activity. Also some smaller remodeling projects are done without permits and the index will miss that activity.

Since there is a strong seasonal pattern for remodeling, the second graph shows the year-over-year change from the same month of the previous year.

The remodeling index is up 24.5% from July 2010.

Even though new home construction is still moving sideways, it appears that two other components of residential investment will increase in 2011: multi-family construction and home improvement.

Data Source: BuildFax, Courtesy of Index.BuildFax.com

Grantham: ‘No market for young men’ (Buy EM, Japan, & Europe)

Hey, Young Turks on trading desks, up-and-coming money managers and Wall Street stock jockeys: You want the truth about the global markets today?

Listen to Jeremy Grantham, chairman of Boston-based investment manager GMO LLC: You can’t handle the truth.

Jeremy Grantham.

“This is no market for young men,” Grantham said. “At least us old men remember what a real bear market is like, and the young men haven’t got a clue.”

Women, too, for that matter. And at 72, after 40-plus years in the investment business, Grantham can make this claim unchallenged, but his point is more about the lessons of experience than the limitations of age, and an investor’s ability to build on the former and overcome the latter.

With Greece on the verge of default, and economic growth in even the healthiest developed markets stuck in slow gear, Grantham reserves his harshest words for the leaders of central banks, big money-center banks and governments. The fittest global companies, meanwhile, are getting his firm’s client’s money.

Policymakers and politicians have acted like “children at play,” Grantham has said. As he sees it, they’ve created a tower of debt and an illusion of wealth, and have not been held responsible for their frivolous actions.

“No one has been prepared to make tough decisions,” Grantham said in a recent telephone interview. “Where have the Europeans been for 10 years? None of these things came out of the woodwork two weeks ago. No one attempted to blow the whistle and make tough decisions in a timely fashion.” 

Targeting income inequality

“Kicking the can” on deficits and spending delays the reckoning, but only makes it more painful when it comes. Had “grown-ups” been supervising the financial system, the problem might not have gotten out of hand, Grantham noted. 

To put the debt crisis in perspective, Grantham suggested imagining multiple stacks of building blocks, “fairly precarious and fairly tall,” each set uncomfortably close to the other. If one falls, it could either take down several others or fall neatly between them. The trouble, Grantham said, is that there’s really no way to know.

Financial markets nowadays are faced with this hit-or-miss scenario, and buyers don’t like the odds. Said Grantham: “We have these basically distinct problems joined only by a general fragility of the financial system. So you can’t know for sure that if China stumbled it wouldn’t set off something else, or if the U.S. goes into a double-dip [recession], it won’t set off a European bank failure.”

Especially worrisome to Grantham is the gulf between wage earners in the U.S. The top 10% of U.S. workers currently receive about half of the nation’s total income, with half of that going to the top 1%. The last time this country saw a wage gap so extreme was just before the 1929 stock-market crash and the Great Depression. By comparison, in the late 1970s the top 1% garnered about 9% of all earnings.

“You can’t run the economy on BMWs alone,” Grantham said. “If the average person is in a pickle, how do you have a healthy economy?”

For starters, he said, you tax the richest more than they’re paying now. Said Grantham: “We have actually made the tax structure friendlier to the top 10%.”

Grantham contends that income inequality at these levels takes a real toll on ordinary workers and society as a whole. To bridge this gap and give average workers a bigger slice of the pie, Grantham advocates investing in education, training, and to “change the tax structure to make it equitable.”

Value stocks, rich market

Grantham also doesn’t approve of Federal Reserve Chairman Ben Bernanke taking steps that he said essentially have put savers in a box. Keeping interest rates low, and stating that rates will remain in the cellar for at least a couple of years, forces people to take more risk with their money if they want yield and capital appreciation.

“You’re transferring money away from retirees” who must either delve into stocks, gold or some other higher-stakes investment, or languish in savings accounts and low-yielding bonds, Grantham said. “They could use that money. They would spend every penny.”

Instead, Grantham said the Fed’s policy puts money “in the hands of people who aren’t spending it — people who only buy BMWs and don’t support Wal-Mart.” This creates a vicious cycle in which, Grantham said, individual savers are penalized and restrain spending, while the beneficiaries are “bankers and corporations that can build factories all over the place — except they won’t because consumption is too weak.”

Accordingly, Grantham sees this path coming to no good end over the short-term. He said he expects another leg down for the U.S. stock market, one where shares could stay low-priced for years while U.S. economic growth plods along at maybe 2% annually instead of the relatively more robust historical average of around 3.4%.

But Grantham is an investor, not a politician, so his job is to hunt down opportunities in bull or bear markets. Nowadays, he’s finding more stocks that fit GMO’s strict value-investing discipline.

“If we adjust earnings to normal and apply an average P/E, you can finally build a decent portfolio today of global equities at a respectable long-term return,” he said.

The potential for gains is “modestly higher” outside of the U.S., he added, other than “high-quality blue-chips.” Mostly, he said he prefers discounted plays that are surfacing in Europe and emerging markets.

“In stocks you will eventually do OK at these prices,” Grantham said.

“The real danger is one or two of these building blocks falling over,” Grantham said. “You can buy a whole portfolio of slightly cheap global stocks, and the risk you take is that you get sandbagged by some of these major problems.”

Indeed, Grantham said that since there’s a “decent chance” of stocks becoming even cheaper, GMO is positioned slightly below normal in equities “because the risk profile of the world is way over normal.”

At the same time, he’s not jumping on the long-term-bond bandwagon. “One day we will have more inflation and our bonds will bleed like a pig,” Grantham said. “The only reason for buying long bonds is short-term or as a desperate haven for terrorized investors. But the potential to make longer-term real money is naught.”

Grantham runs a personal, non-profit foundation dedicated to the protection of the environment. For the foundation he has invested heavily in agriculture, commodities and natural resources. Timber is a favorite, as are fertilizer companies. He’s not a big fan of gold. “I own some myself as a pure speculation,” Grantham said — “just enough to mute the irritation of watching gold [prices] rise.”

For others, Grantham advised taking a page from GMO and buying shares in companies with strong finances and which produce goods that people need, as opposed to luxury items. Look for dividend-paying opportunities in emerging markets especially. “I would own emerging and EAFE (the MSCI Europe, Australasia, and Far East Index), including Japan,” Grantham said.

“In the end everything comes down to value, and they have suffered a lot more recently,” he said of non-U.S. markets. “Yes, it can get whacked in the next 18 months if the wheels come off, and the possibilities are likely, but if you hang in anyway you’ll make a respectable return.”

Beware the market spam

In light of the news that Goldman Sachs’ Global Alpha — le quant fund extraordinaire –  has started “liquidating” its holdings, and that other algorithmically minded unwinds have probably been stalking the markets, we bring you the following chart from Nanex’s Eric Scott Hunsader:

What it shows is the incremental build-up over the last few years of superfluous quote traffic over the course of the day. That is to say, quotes which are entered into markets systems but are never actually transacted. Spam.
The more red, the more recent the data.
As Hunsader notes:

The chart shows how many quotes it takes to get $10,000 worth of stock traded in the U.S. for any point in time during the trading day over the last 4.5 years. Higher numbers indicate a less efficient market: it takes more information to transact the same dollar volume of trading. Quote traffic, like spam, is virtually free for the sender, but not free to the recipient. The cost of storing, transmitting and analyzing data, increases much faster than the rate of growth: that is, doubling the amount of data will result in much more than a doubling of the cost. For example, a gigabit network card costs $100, while a 10 gigabit network card costs over $2,000. A gigabit switch, $200; a 10 gigabit switch, $10,000. This October, anyone processing CQS (stock quotes) will have to upgrade all their equipment from gigabit to 10 gigabit. Which would be fine if this was due to an increase in meaningful data.
We think that a 10-fold increase in costs without any benefits would be considered “detrimental” by most business people.
This explosion of quote traffic relative to its economic value is accelerating. Data for September 14, 2011 is the thicker red line that snakes near the high. There is simply no justification for the type of quote data that underlies this growth. Only the computers spamming these bogus quotes benefit when they successfully trick other computers or humans into revealing information, or executing trades. This is not progress. Progress is almost always accompanied by an increase in efficiencies. This is completely backwards.

This needless to say produces a huge information burden, not only on anyone trying to trade the market, but also any regulatory systems trying to monitor and analyse what’s going on.
Back of an envelope guesstimates from our resident exchange sleuths regarding the data produced by US markets alone run into several hundred terabytes a year. That said, the higher the volatility the higher the data burden. In peak August volatility US markets supposedly generated as much as 1 terabyte of data per day, while previous peaks had been around 600 gigabytes. Add data from Europe and Asia and we could be hitting a figure of several petabytes a year.
It’s worth noting scientists at CERN in Switzerland faced a similar problem when building the Large Haron Collider. Though in their case they were faced with having to analyse roughly 15 petabytes (15m gigabytes) worth of data annually.
That’s the equivalent 1.7m dual-layer DVDs a year, they say.
Being scientists, they opted to get creative. A brand new computer network called “the grid” was the result, designed specifically to cope with information overload. Though to this day, even Cern doesn’t have the capacity to store all the data it produces and regularly chucks as much as it receives back into the abyss forever.
From a regulatory point of view, of course, chucking data away is not really the ideal solution for market data.
Meanwhile, it’s worth wondering how close we are to peak capacity right now.

Jury renders split decision in TCW-Jeffrey Gundlach case

Star bond fund manager Jeffrey Gundlach was found liable Friday for breaching his fiduciary duty to his former employer, asset management giant TCW Group Inc., which fired him in December 2009.
But in what essentially can be viewed as a win for Gundlach, a Los Angeles jury found no harm to TCW in that breach and awarded the firm no financial compensation.
Further, the  jury found that TCW must pay $66.7 million to Gundlach and his three co-defendants for failure to pay wages owed them before leaving the money-management firm to set up a rival company in 2009.
[Updated at 9:51 a.m.: After the jury was dismissed, a smiling Gundlach was asked how he felt about the decision. "Great," he said. "It's 67-to-zero," he added, referring to the wages owed to him and his co-defendants.
[TCW's general counsel, Michael Cahill, said in a statement that the firm was "gratified by the jury's verdict, which speaks directly to the principles at the heart of this case -- integrity, honesty and trust."]
On a separate issue, the jury of five women and seven men agreed with TCW’s claim that Gundlach had misappropriated the company’s trade secrets in setting up a rival firm in 2009, causing harm to TCW. Any damages on that claim will be decided by Judge Carl J. West. TCW is asking for $89 million.
The verdicts were read in a packed courtroom, with Gundlach and many of TCW’s top officers present. The six-week civil trial in Los Angeles County Superior Court had wrapped up on Tuesday afternoon. Jurors took just two days to decide on 37 separate issues on the verdict form.
TCW, which manages about $120 billion in assets for clients, fired Gundlach in December 2009 in a shakeup that rocked the mutual-fund world. One month later the company sued Gundlach, alleging that he and key aides conspired against the firm and stole TCW proprietary information to set up a new  fund-management business, DoubleLine Capital, almost overnight.
Gundlach, 51, then countersued and accused TCW, the parent of Trust Co. of the West, of ousting him after 24 years at the firm to cheat him out of a huge chunk of promised income.
The two lawsuits were combined into one trial, which began in late July and has been closely watched on Wall Street.
The trial was an unusual airing of the financial industry's dirty laundry. Most such disputes are settled quietly to prevent potentially embarrassing or damaging information from becoming public. But in this one there was so much bad blood between the two sides that they were unable to reach an out-of-court deal.

TCW alleged that Gundlach, a bond-market genius who had managed more than 60% of TCW's total assets, was secretly planning all through 2009 to abandon the company. He allegedly wanted to take his entire bond team with him to another firm, or one that he created, and leave TCW in the lurch. If he had succeeded, he "likely would have destroyed TCW," TCW attorney John Quinn said Tuesday in closing arguments. Instead, TCW said it used the element of surprise to strike first, firing Gundlach and acquiring another bond firm on the same day to take over the assets Gundlach had managed.
Gundlach denied that he wanted to leave TCW, and alleged that Chief Executive Marc Stern and the company's French parent, banking firm Societe Generale, were plotting in 2009 to oust him in a cost-saving move. Gundlach's attorneys pointed repeatedly during the trial to notes taken at a meeting of TCW executives in August 2009 referring to the idea of firing him.
Gundlach wanted nearly $500 million in damages from TCW, claiming that he would have earned that much through this year based on his contract with the company at the time of his ouster. As one of Wall Street's most acclaimed investors in mortgage bonds, Gundlach had attracted tens of billions of client dollars to TCW over the last two decades. He and TCW had shared management fees earned on the assets. TCW calculated that Gundlach’s compensation since 1991 had totaled $239 million.
During the trial, Gundlach estimated his personal net worth at about $90 million, some of which he has sunk into an extensive collection of modern art.
For much of the six weeks of testimony Gundlach found his personality on trial. TCW lawyers and witnesses described him as arrogant, disloyal and even a “disease” on the company. The jury was told that Gundlach encouraged his staff to refer to him as "the Pope" and "the Godfather."
Gundlach has acknowledged his large ego, but has said his investment results spoke for themselves.
His new company, DoubleLine Capital, has attracted $15 billion in assets in less than two years, despite TCW’s legal onslaught against him. The DoubleLine Total Return Bond fund, Gundlach’s flagship mutual fund, has risen 11.7% over the last 12 months, beating 99% of its peer funds, including the one he left behind at TCW.
Barron's magazine earlier this year crowned Gundlach "King of Bonds." During the trial he estimated his personal net worth at about $90 million, some of which he has sunk into an extensive collection of modern art.
Before the trial, Gundlach and his attorneys accused TCW of engineering a public smear campaign against him. When TCW filed suit against Gundlach in 2010, it included allegations that hard-core pornographic magazines and DVDs and drug paraphernalia were found in his TCW offices downtown and in Santa Monica.
Gundlach said at the time that TCW was resorting to "gutter tactics." Later, he said that whatever the company found in his offices were "vestiges of closed chapters of my life."
TCW wanted to have the jury hear about the alleged porn and drugs, but presiding Judge Carl J. West ruled in July that those accusations weren't relevant to the case, which he said was complex enough.

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
Arbitrage	-0.07
Fixed Income Arbitrage	-0.06
Event Driven Risk Arbitrage	-0.05
Event Driven Distressed	-0.04
Emerging Markets	-0.03
Event Driven	-0.02
Event Driven Multi-Strategy	-0.01
Equity Market Neutral	0.01
Multi-Strategy	0.06
Dedicated Short Bias	0.07
Long/Short Equity	0.09
Global Macro	0.31

Conclusion

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.

Stock Returns by Debt Rating

Above are annual returns for portfolios formed every July 1, based on the Senior rating of the company. I only used non-financial companies because financial companies tend to be only with investment grade, and they are very different from a debt rating perspective (when I modeled default at Moody's, there was a clear non-financial focus because financial companies are very different).

The annual data are as follows for this period (Jul1975-Jun2011):

	StockReturns(%)	beta	Volatility(%)
AAA	12.4	0.78	17.1
AA	13.9	0.81	16.1
A	14.3	0.81	16.5
BBB	14.2	0.82	17.9
BB	15.0	1.04	23.4
B	8.6	1.43	32.0
C	-12.7	1.18	44.9

It appears there's a reasonable story one could tell about returns from AAA to BB: higher returns, and higher intuitive measures of risk: beta, volatility. But for B and C rated stocks, the returns make no sense to standard asset pricing theory, because these are obviously risky stocks. I remember presenting this chart to an NBER conference around 2000, and the esteemed audience told me I was wrong; my data had to be incorrect. I was working at Moody's, so my ratings data was as good as it got. Anyway, I wrote it up and sent it to Journal of Portfolio Management, and the editor, Peter Bernstein, wrote back they weren't accepting submissions at that time. I thought that was an odd response. This avenue wasn't part of my day job, so I let it go, but I keep updating my data for fun.

The result is really corroborated by Campbell, Hilscher and Szilagyi (2005), who found distress risk to be negatively correlated with stock returns, which makes sense because volatility and leverage is inversely correlated with future returns, and cash-flow is positively correlated with future returns, so those are the main drivers of default risk.

Reality is that which, when you don't believe it, doesn't go away, so I don't really mind when people tell me I'm wrong on facts like this.

Buy, hold, regret

IT IS a truth universally acknowledged that equities outperform over the long term, so that the best strategy is to buy and hold. But as Deutsche Bank's long-term asset study (the subject of yesterday's post) makes clear, this has not been true for all markets. Over the last 50 years, the real returns from equities have been lower than those from bonds in Germany, Japan and Italy. In the Italian case, the gap is almost three percentage points, and that is despite the recent bond sell-off (actually, as Deutsche points out, a 5-6% yield on Italian debt is quite low by historical standards.)
The buy and hold mantra was developed in the US where real equity returns have generally been positive over long periods. But the US was history's winner in the 20th century; enjoying 100 years of political stability while its European rivals destroyed themselves in two world wars and Russia followed the dead end path of communism. The US equity market, in other words, displays distinct survivorship bias. In turn, that bias leads to greater confidence and thus higher valuations; eventually the valuations become so high (as in 2000) that they doom future returns to be disappointing.
Indeed, there is nothing so catastrophic for an asset class as the conviction that its price can only go up. It was the belief that borrowing to buy an house was "free money" - a source of income that beat working for a living - that helped fuel the subprime bubble. The mantra was that US house prices never fell at the national level; it proved mistaken. A blind belief in "buy and hold" is a similar mistake.
Nor does Deutsche offer much comfort going forward. The likely real returns from equities over the next five years are -2.6% (annualised) or (more optimistically) 0.6% over 10 years. That is largely because profits and high relative to trend and will mean revert. Valuations are better than they were in 2000 but are still not cheap (speaking of which, I have been sent an attack on the Shiller p/e that I will address in a later post). The likely returns from 10-year Treasury bonds will be worse (-2% a year over 10 years) and one can also expect negative real returns from property, gold and commodities. Only in corporate bonds (particularly high-yield) is there scope for positive returns.
Of course, the alternative to buy and hold is to try to trade your way through the cycle, a very difficult process that by definition cannot be achieved by the average investor. But this is the inevitable hangover after the debt-fuelled party of 1982-2007.

Pimco’s Gross Raised Credit Risk for Fund’s Worst Run on Record

Pimco Total Return Fund (PTTRX), the world’s largest mutual fund, is having its worst year versus rivals based on records going back to 1995, and Bill Gross’s decision to dump Treasuries isn’t the only reason.
Gross bet almost $11 billion in the second quarter on an index of U.S. corporate credit risk, raised the amount of insurance the fund provides on sovereign debt and put $1.3 billion into Italian Treasury bonds linked to inflation, according to an August regulatory filing.
Since June 2010, Gross has been reducing the $245 billion fund’s vulnerability to interest-rate swings and increasing its reliance on credit quality by shifting from Treasuries to corporate and non-U.S. sovereign debt, a strategy that backfired last month. As the U.S. economy slowed and Europe’s debt crisis worsened, investors sought the safety of Treasuries and sold the bonds Pimco had bet on, leaving the fund trailing 89 percent of competitors in August and 67 percent this year through Sept. 8, according to data compiled by Bloomberg.
“People are focusing on the Treasuries, but the real issue is that the other credit instruments didn’t do as well,” A. Michael Lipper, head of Lipper Advisory Services Inc., a Summit, New Jersey, firm that advises institutions on investing in mutual funds, said in a telephone interview. “They had way too much, short term, of the underperformers.”
The amount of protection issued by Pimco Total Return on debt tied to corporate borrowers, municipalities and sovereign governments outside the U.S. rose to $43.6 billion as of June 30 from $19.6 billion a year earlier, the filing shows.

Navigating ‘New Normal’

This year is shaping up to be Gross’s worst against U.S. total-return funds in data going back to 1995, the earliest year for which Bloomberg has rankings for Pimco’s flagship, which opened in May 1987. Gross hasn’t lost money in any year since 1999, when Pimco Total Return declined 0.3 percent, including dividends, and trailed 59 percent of the competition, according to data compiled by Bloomberg. In 2010, the fund returned 8.8 percent to beat 82 percent of its peers.
Gross today disclosed that he raised his holdings in U.S. Treasuries to the highest level since December 2010 as the fund trailed rivals. The fund increased its holdings of Treasury debt to 16 percent as of Aug. 31 from 10 percent at the end of July, according to data posted on Pimco’s website. Gross raised his investments in non-U.S. developed markets such as Europe to 18 percent from 13 percent in the prior month, while mortgage holdings climbed to 32 percent from 25 percent.

‘Bouts of Volatility’

Selling Treasuries and buying corporate debt is a sound long-term strategy that will cause short-term weakness when investors are seeking havens, said Ed Goard, chief investment officer for fixed income at Birmingham, Michigan-based Munder Capital Management, and Michael Krushena, one of the firm’s senior portfolio managers.
“There will still be some bouts of volatility with the uncertainty going on in Europe and the unresolved lawsuit issues surrounding mortgages in the banking sector,” Krushena said in a telephone interview. “But looking further out than the next two or three months, we think corporate bonds are better investments.”
Pimco is seeking to navigate what Gross, the firm’s co- chief investment officer, and Mohamed El-Erian, its chief executive officer and co-CIO, called the “new normal,” a future marked by slower growth in developed markets, higher unemployment and more regulation. Gross last year forecast the end of the three-decade rally in bonds, a move that creates strategic challenges for Pimco, whose assets, totaling $1.34 trillion as of June 30, are mostly in fixed-income securities.

Manager of Decade

Pimco Total Return gained 3.9 percent this year through Sept. 8, with dividends, trailing the 6.6 percent advance by its benchmark, the BarCap U.S. Aggregate Total Return Value Index. The fund generated an average annual gain of 7.2 percent in the 10 years ended March 31, 2010, compared with 6.3 percent for the BarCap index, helping Gross earn Morningstar Inc.’s award as fixed-income fund manager of the decade.
Mark Porterfield, a spokesman for Pacific Investment Management Co. in Newport Beach, California, declined to comment.
The main factor in this year’s slump was Gross’s decision to sell Treasuries, according to Eric Jacobson, a Morningstar analyst. Treasury holdings fell to zero as of February and climbed back to 10 percent as of July 31, according to Pimco’s website, compared with 33 percent for the BarCap index. When demand for Treasuries soared last month, Pimco Total Return fell 0.8 percent as the BarCap Index rose 1.5 percent.

‘Rare Deviation’

Current yields on 10-year government bonds don’t adequately compensate investors for inflation risk, Gross has said publicly. Government efforts to stoke the economy through quantitative easing, including the Federal Reserve’s purchase of $600 billion in Treasuries over eight months, artificially repressed U.S. rates, leaving investors with negative real returns when inflation was factored in, he said in a June investment outlook posted on Pimco’s website.
“Gross’s bearish call on Treasuries was an extremely rare deviation from the Pimco script of a lower-than-consensus forecast” for gross domestic product, inflation and household spending, said William Powers, a former Pimco portfolio manager who now runs Strand Partners, a family office in Los Angeles, and helps manage two real estate funds.
Pimco’s solution, as Gross described in his commentary, was to replace Treasuries with corporate debt as well as emerging- market and non-agency mortgage securities. The bonds are less sensitive to interest-rate changes, and thus less affected by quantitative easing, Gross said. That made the debt perceived as riskier a relative bargain, according to Pimco.

‘Safer Spread’

“The credit piece,” Gross wrote, “is a safer spread than the duration piece.”
Rather than buy actual bonds, Gross used credit-default swaps, derivative contracts that are similar to providing insurance on debt securities. Under the terms of a credit- default swap, Pimco receives annual premiums in return for agreeing to pay the insured an amount equaling the face value of the bond, minus any residual value, should the issuer of the debt fail to meet its obligations.
The amount of protection sold by the fund on debt issued by individual companies, municipalities and non-U.S. sovereign governments increased to $22 billion as of June 30 from $13.9 billion a year earlier, according to a quarterly report filed Aug. 26 with the U.S. Securities and Exchange Commission.

Rising Insurance Cost

The 2011 figures included swaps covering $6.9 billion of debt issued by emerging-market countries Brazil, China, Mexico and Indonesia, compared with $2.8 billion a year earlier. The fund had sold credit protection on $3.6 billion of sovereign debt from France, Italy, Germany and Spain as of June 30, the filing shows, along with a combined $4.1 billion of swaps on U.K. gilt and Japanese government bonds.
The face value of swaps the fund sold on indexes for high- yield, emerging-market and investment-grade debt rose to $21.6 billion at midyear from $5.6 billion in June 2010. The fund sold $10.7 billion of credit protection on the Markit North America Investment Grade Index in the second quarter, raising the total to $11.8 billion.
The cost of insuring non-Treasury debt has soared since July, a trend that would require Pimco Total Return to mark down its existing agreements in computing daily net asset value. Credit-default swaps rise in value as investor confidence erodes, causing mark-to-market losses for those that have sold protection on bonds.
The fund’s coverage on the Markit index would have shown a paper loss of $115.7 million as of Sept. 6, according to Bloomberg data, compared with the $47.8 million gain Pimco calculated as of June 30 in its SEC filing.

‘Flight to Safety’

“The recent spread widening of the index is attributable to the flight to safety moves,” Otis Casey III, director of credit research in the New York office of Markit, a London-based financial information-services company, said in an e-mail response to questions. Investors “shunned risky assets due to continued concerns of the Euro-zone sovereign-debt crisis, policy uncertainty in the U.S. and fears of a slowdown in global economic growth,” Casey said.
Insurance on Italian government debt, priced at 172 basis points as of June 30, more than doubled to 451 basis points on Sept. 6, according to data compiled by Bloomberg. The cost of protecting Brazilian bonds rose 45 percent to 160 basis points, in part because default coverage on emerging-market countries had grown too cheap relative to prices on European debt, said Ajay Jani, a managing director at Gramercy, a Greenwich, Connecticut, investment manager. A basis point, or one-hundredth of a percent, equals an annual payment of $1,000 on a contract protecting $10 million of debt.

Germany, Spain

“It got to the point where Brazil was trading inside of France,” said Jani, whose firm oversees $2.1 billion and specializes in emerging-market securities. “People aren’t used to seeing that kind of relationship.”
In the second quarter, Gross also acquired a German government bond with a market value of $527 million as of June 30, Spanish government debt valued at $1.6 billion and about $1.3 billion of Italian Treasury bonds indexed to Euro-area inflation. The fund’s Italian Treasury bonds have all dropped in price since June 30, including a 12 percent decline in those slated to mature in Sept. 2021, according to Bloomberg data.
“Linkers have a higher duration and a higher credit-risk exposure, so in times of stress you would expect to see nominal bonds outperform linkers,” said David Schnautz, a fixed-income strategist at Commerzbank AG in London. The European Central Bank hasn’t included the Italian inflation-linked debt in a purchase program that has given other types of bonds a “massive boost,” according to Schnautz.

Financial Services

Pimco Total Return’s positions in debt issued by financial- services firms, such as Citigroup Inc. and American International Group Inc., rose to 24 percent of net assets as of June 30 from 20 percent a year earlier, according to last month’s SEC filing. These percentages don’t reflect derivatives such as credit-default swaps. The BarCap benchmark had a 7.2 percent weighting for financial-company bonds as of June 30, according to Barclays Capital Inc.
Discussing “negative” or “neutral factors” for its performance in the second quarter, Pimco Total Return’s quarterly report cited “an overweight of bonds of financial companies” along with holdings related to non-agency mortgages. The financial bonds “lagged the broader corporate market” and “risk aversion put downward pressure on prices” of mortgage- backed securities, Pimco said.

Passive Management Wins in Emerging Markets

I was recently asked about the performance of funds run by Mark Mobius, who has been called a global pioneer by BusinessWeek. Mobius made his mark in emerging market funds, so it got me thinking about the performance of active emerging market funds as a whole. As it turns out, the picture isn’t pretty.
First, let’s see how Mobius has performed. Keep in mind that Asiamoney named him as one of the Top 100 Most Powerful and Influential People in 2006, stating that he “boasts one of the highest profiles of any investor in the region and is regarded by many in the financial industry as one of the most successful emerging markets investors over the last 20 years.”
The first thing I did was to go back to an analysis I did on active management in emerging markets covering the 10-year period ending in 2006. For that period, Templeton Developed Markets (TEDMX) returned 8.7 percent per year. This compared with a 10.2 percent return per year for the DFA Emerging Markets Portfolio (DFEMX) and a 9.3 percent per year return for the Vanguard Emerging Markets Fund (VEIEX).
The next step was to update the data. The following are the returns for the 10-year period ending August 30, 2011.

Mobius also runs the Templeton Emerging Markets Small Cap Fund (TEMMX), which has an inception date of Oct. 2, 2006. For the three-year period ending August 30, 2011, the fund returned 9.1 percent. By comparison, the DFA Emerging Markets Small Cap Portfolio (DEMSX) returned 12.7 percent, outperforming TEMMX by 3.6 percent.
A very persistent investing myth is that active management is the winning strategy in so-called inefficient markets (such as small-caps and emerging markets. As my colleague Vladimir Masek put it: “If the ‘active camp’ is right, and bright, experienced, hard-working managers like Mobius can take advantage of market inefficiencies, then we should see them outperform market benchmarks by wide margins in the most inefficient markets, for example in emerging markets.”
The evidence presented can’t tell us how bright or hard-working Mobius is, as we know he’s both. Instead, it can tell us which camp is more likely to be right. More supporting evidence would make the case stronger, so now we’ll broaden our look to include a wide universe of emerging market funds.

To provide further evidence, I went back to a study I did in 2007 on the performance of emerging market funds versus passive alternatives. The table below provides 10-year returns through August 30, 2011. By reviewing the performance of the funds that were on the 2007 list, we can identify if survivorship bias is tainting the data. It turns out there’s plenty of bias. Several funds on the 2007 list no longer exist. For example, the Invesco Van Kampen Emerging Markets Fund was merged out of existence in April 2011. Others that no longer appear to exist are:

• Eaton Vance Emerging Markets Fund
• TCW Emerging Markets Equity Fund
• Seligman Emerging Markets Fund
• Credit Suisse Emerging Markets Fund Common
• AIM Emerging Markets Fund

Funds with good performance aren’t sent to the mutual fund graveyard. So we have six dead funds from the list of 37 active funds that had 10-year track records as of the end of 2006.
Of the remaining 31 funds, both DEMSX and the DFA Emerging Markets Value Portfolio (DFEVX) outperformed every single one. Only nine (29 percent) outperformed DFEMX, and only 10 (32 percent) outperformed VEIEX. The average surviving actively managed fund returned 14.7 percent, underperforming DFEVX by 5.2 percent, DEMSX by 4.8 percent, DFEMX by 0.9 percent and VEIEX by 0.3 percent. Accounting for survivorship bias would only make the evidence more compelling.

William Sharpe demonstrated in his famous paper The Arithmetic of Active Management that passive management being the winner’s game doesn’t depend on market efficiency. Instead, it depends on the simple laws of mathematics, or what John Bogle calls The Cost Matters Hypothesis. Since all emerging markets stocks must be owned by someone, and passive investors earn the market returns less low costs, and in aggregate, active investors must also earn the market return less high costs, in aggregate passive investors must earn higher net returns than active investors.

The Secrets of High Frequency Trading

In recent years, advances in telecommunications, computing capacity and financial software platform capabilities have seen huge growth in the field of High Frequency and Algorithmic Trading (now accounting for over 70% of all equity trades placed on US exchanges and in excess of 77% in the UK).  HFT firms (which can often make more than 80 million trades in a single day) often enter and exit trades in thousandths of a second, and are conservatively estimated to generate at least $21billion in profits every year.

To get under the skin of the world of high frequency trading, AllAboutAlpha.com interviewed Arzhang Kamarei.  Mr. Kamarei is a Partner at Tradeworx, a quantitative investment management firm with expertise in high-frequency and medium-frequency equity market-neutral strategies.  He co-founded Thesys Technologies, a Tradeworx subsidiary, in early 2009 to address the growing technology needs of high frequency traders.

AAA.com: What is the principal investment strategy behind High Frequency Trading?

Arzhang Kamarei: The majority of US Equity HFT is employed in the strategy of liquidity provisioning, also known as electronic market making.   Historically, such a service was provided by NYSE specialists and NASDAQ market makers but, with the advent of decimalization, human specialists and market makers were no longer able to keep up with the liquidity demands of investors and automated technology became necessary for this function.

To implement electronic market making strategies, HFTs use passive orders, which are limit orders that do not cross the spread, but stay on a limit order book until they are filled or cancelled.  This allows HFTs to profit from capturing rebates and the bid-ask spread.   These profits offset losses incurred by providing liquidity to informed traders or large traders who drive stocks directionally (i.e., adverse selection or inventory risk).  Without the rebate and spread capture employed by passive trading, the majority of HFT strategies would be unprofitable.   HFT strategies that are based on actively crossing the spread and consuming liquidity are rare, although active orders are occasionally necessary for inventory or loss management.  HFTs do not typically have enough alpha to make “all-active” strategies profitable.

A key goal in providing liquidity passively is to be on the top of the bid/offer stack, otherwise known as being at the “front of the queue” for the order book.  The rationale for this is very simple:  adverse selection is lower for passive orders at the top of the stack than for passive orders at the bottom of the stack.  For an intuitive understanding of why, consider the following:  if you are bidding at the top of the stack and are hit, the remaining orders on the book support the bid price you have just paid.  However, if you are hit on a bid at the bottom of the stack , it is very likely that the price you just paid is in the process of becoming the new offer.  Buying on the offer and selling on the bid is a characteristic of active strategies that consume liquidity; as mentioned before, these active strategies have a high hurdle rate for profitability and are not feasible for market makers who have very small alphas.  To give a sense of perspective, consider that an HFT making $0.001 per share in SPY (a typical HFT profit margin) has an alpha that is worth $0.001/$120 – or roughly 0.0008%.   A one penny spread is 10 times this amount.   In contrast, long term investors are able to effectively employ active strategies.  Their alphas are orders of magnitude greater than the cost of crossing the spread and afford them the ability to choose when to execute trades as opposed to having to wait for the contra side as market makers do.

Once one understands the disadvantage of being at the bottom of the stack, it becomes much easier to understand the importance of speed in HFT.   As new price levels form, HFTs compete with other HFTs to join the new price as quickly as possible in order to secure advantageous stack position for passive orders.  After all, shaving off microseconds is only a meaningful objective if one is in competition with other market participants who have similar response times.

HFTs are sometimes perplexed by the negative insinuations that are made against their form of market making behavior.  From their perspective, liquidity provisioning in today’s marketplace is a highly competitive enterprise that is governed by market forces.   Compare this to the dynamics of market making twenty years ago when NYSE specialists and Nasdaq market makers dominated liquidity provisioning.  In that era, specialists enjoyed monopolies on market making for a particular stock, had full knowledge of size and direction of client orders (often including the disclosure of the ticket size of the “upstairs trader” – i.e., orders not even yet on the floor), and often had the discretion to fill customer orders against their book at times and prices of their choosing.  In the old days of NYSE trading, if a large mutual fund sent a five hundred thousand share order to buy IBM to the floor of the exchange, the broker in the crowd would tell the specialist he had “size to buy.”  He might, in fact, even disclose to the specialist (and others in the crowd) the total size of his order.   On top of these disadvantages for customers, spreads were mandated to be $0.0625 per share, or what would amount to 62.5x current HFT profit margins.  Although one might argue that HFTs do not have the same stringent market making requirements of the specialist era, the fact remains that academics, research analysts, and even regulatory agencies have recognized that today’s markets are more liquid and less expensive than before the advent of HFT.  This is no doubt due in part to the improvement in liquidity provisioning that has arisen from the better risk management that computers provide over human traders.

AAA.com: What are the key markets high frequency traders look towards and why?

Arzhang Kamarei: HFTs prefer markets which:  (1) allow for short-term strategies that can go home flat with no net exposure;  (2) have trading venues with low latency matching engines;  (3) have securities with lot sizes small enough to allow for precise risk control; and (4) are markets in which automated market making has some advantage over human market making.    For instance, if the swaps market continues to predominantly trade in very large lot sizes, it will not be an attractive asset class for HFTs.   This is because large-sized, low turnover trades have much higher risk and holding period than HFTs typically target.  As holding period and risk increase, the importance of alpha increases – and market makers must then begin to form alphas similar to those of their clients simply in order to manage their inventory.  In addition, this leads to a market dynamic where automated trading loses advantage over employing a human trader who can make long term predictions and evaluate unique, idiosyncratic transactions much better than a computer can.  In such a market, humans have an edge over machines, especially as the complexity of the factors which influence alpha increases significantly.  To take the example to an extreme, consider how many real estate or private equity transactions are currently executed by a computer versus a human being.  Being an “alpha-less market maker” in such a market is not possible.

HFT strategies perform better in volatile markets for simple reasons.  High volatility is correlated with high volume and as volumes increase, HFTs’ absolute profits increase.  To make the example more concrete, if an HFT’s profitability is approximately $0.001/share and that firm typically trades 100 million shares a day, on days when they trade 150 million shares their profitability will be greater.  An additional reason that volatility benefits HFTs comes from the competition of liquidity seekers.  In volatile markets, liquidity seekers become highly competitive in their behavior and aggressively compete for volume at the same prices.   As competition forces liquidity seekers to be more aggressive with their active orders, this can drive spreads wider and increase the margins of passive liquidity providers.  This gain in profit margin, however, is typically secondary to the gains from higher volumes.  Given the highly competitive nature of HFTs, it’s not difficult to understand why – competition drives liquidity provisioning such that wider spreads are quickly competed away.

While HFTs do see their profits increase during periods of increased volatility and volumes (as market makers commonly have throughout history), the liquidity they provide via passive orders serves to dampen this volatility, not to increase it.  Put differently, the activities in which HFTs engage during volatile markets are exactly the behaviours that reduce volatility.  However, because of the simple fact that HFT P&Ls increase during volatile markets, many assume that HFTs have somehow created this volatility to begin with.  To assume so is to confuse correlation with causation.  To make an analogy, this is similar to arguing that air conditioning manufacturers cause hot weather because whenever temperatures inside buildings rise greatly, their sales increase.   Given that HFTs have been this business for several years now, if they were able to spontaneously generate volatility at will and then benefit from it, such a perpetual profit machine would ensure that they would have significantly larger market caps than they currently enjoy.  For anyone who seeks to understand why our markets have had such volatile bouts in the past few years, one only need to look at the news headlines.  The past three years have seen talk of another Great Depression, the imminent demise of the dollar, devastation in the housing market, the potential disintegration of the euro, and a downgrade of US creditworthiness.  Finally, if this is not adequately convincing, one should consider the volatility in asset classes not dominated by HFTs over this same time period (such as credit default swaps) or instances of extreme market volatility that pre-existed current HFTs (for example, April 4, 2000, when the Nasdaq market fell nearly 15% and recovered to nearly flat in the same day).

AAA.com:  What are the key risks in High Frequency Trading and how to traders mitigate those?

Arzhang Kamarei: The key risk in liquidity provisioning is inventory management.  Informed traders who have strong alphas or large traders who have significant size to move help create this risk.   Of course, this risk is no different than the risk faced by specialists years ago when an informed trader could be accused of “running over the specialist” by asking for a market, transacting on it, and then continuing to drive the stock aggressively in the same direction.  The tactics for controlling this risk are to keep net exposures low and diversify across different securities, just as it is in any form of portfolio management.  Although volatile regimes can be dangerous for any trader and increase the risk of adverse selection for HFTs, volatile regimes bring an increase in volume, which benefits HFTs who see a greater demand for liquidity provisioning services (i.e., it’s a “volume business” and volumes are good in volatile markets).   A positive side effect of this is that HFTs are incentivized to provide passive liquidity on volatile days, thereby dampening volatility overall.   Consider that no day in 2008 saw a loss of the same magnitude as Black Monday, despite the fact that many considered the economic risks at the time to rival those of the Great Depression.

Technology failure risk is managed by building redundant systems with human oversight at all times.  HFTs are very focused on real-time risk management and, given the fact that many trade with their principals’ own capital, this is hardly surprising.

In terms of market structure risk, significant strides have been made recently by exchanges and regulators with the advent of single stock circuit breakers.   In the past, NYSE specialists could help institute a halt when trading became anomalous.  Although HFTs replaced many of the key functions of specialists, until recently, the elimination of this feedback loop and the lost ability of market makers to pause trading during turbulent activity was not identified as a key risk factor by regulators.    Single stock circuit breakers should provide a safety cushion that addresses this issue.

AAA.com: What are the key challenges for investors in the HFT arena?

Arzhang Kamarei: On a day to day basis, the main challenge for any HFT comes from competition with other HFTs.  The barriers to entry in the HFT space are relatively low as the cost for acquiring the appropriate technology has decreased significantly and is not greater than the cost of starting a small hedge fund.  This is amply evidenced by the high number of small prop shops in the HFT space.

As an industry, the greatest challenge for HFT comes from the risk of adverse regulation with unintended consequences.  For instance, consider the concept of a transaction-based tax.  The problem with such a tax is that it targets a specific business model as opposed to targeting profitability.  HFTs are in a low margin, high volume business.  Their expected profits per trade are extremely low at approximately $0.001/share.  On the other hand, long term investors have large alphas and expect profits in the tens of cents, if not dollars, per share.  To see how lopsided this tax is, consider that a tax of 1 basis point on SPY, the most liquid equity ticker, is more than the entire profit margin of an HFT.  To make an analogy, it would be akin to the Internal Revenue Service instituting a $1 tax on every item sold in a store.  A jewellery store would easily be able to pay a $1 tax per piece of jewellery sold with no adverse consequences.   On the other hand, a book store would be affected much more harshly by such a tax.  And a low-margin dollar store would likely see its business completely decimated.  Although some pundits do not seem to be concerned about the elimination of HFT, they have yet to give an example of a successful financial market which did not have market makers.  The marketplace is a delicate ecosystem and it seems unlikely that the elimination of 50% of trading volume and the overwhelming majority of passive orders would not have a serious impact on the health of the system.

Finally, an argument that is often repeated by adversaries of HFT is that HFT is not socially useful.  There are serious questions about the philosophical underpinnings of this line of reasoning.  Free market economies are based on equal opportunity, low barriers to entry, and competition.  Free markets are not based on social utility.   Legislators do not seek to tax mutual funds that underperform ETFs for not achieving any social utility.  Similarly, regulators are not seeking to ban hedge fund managers who have a high correlation to beta for being socially useless.   That HFTs are willing to engage the debate on these terms is likely a testament to their confidence that the generally accepted view that HFTs improve trading costs and liquidity provision for all market participants is true.

What does this mean for traders?

Any innovation, regardless of sector is met by those who embrace, those who resist, and those who misunderstand.  HFT has experienced all of these.  The truth is that HFT combines rigorous intellectual disciplines including finance, economics, mathematics, physics and computing – and creates highly profitable opportunities for investors.  Alongside this, high frequency firms provide essential liquidity and counterparty availability in the market.  In some senses, you could see them as the lubricant to the efficient functioning of the markets.

This is a huge growth sector- and with scientists entering the fold from fields as diverse as biology, neuroscience and even astrophysics- the future of HFT is going to be very interesting.