Hedge Funds Stumble and Fed Takes Pre-emptive Action
Four Experts Discuss Why Liquidity, Leverage and Transparency Are Crucial
The hedge fund, glamour child of alternative investments, is having its day of reckoning. August and September of this year bore witness to an unprecedented wave of hedge fund meltdowns across a broad swath of the investment spectrum. Emerging market debt and equity, mortgage-backed securities, distressed securities, convertible arbitrage, merger arbitrage, yield spreads, credit spreads and leveraged long players all took their lumps. At the same time, managed futures, the stepchild of alternative investments, is having its day in the sun as investors focus on issues relating to transparency, liquidity and counter-party risk.
As year-end approaches, many in the alternative investment community are wondering what repercussions might lie ahead as the effects of credit tightening combine with investor redemptions and force possible additional selling into illiquid markets. Will the possibility of additional failures of the magnitude of Long Term Capital Management and D.E. Shaw prompt Congress to pass new legislation that increases the scope of investment regulation?
In order to answer these and other pertinent questions, we've assembled a panel of distinguished experts to share their thoughts on the proper role of managed futures and hedge fund investments within a diversified portfolio. Our panel includes:
Craig L. Caudle, Liberty Funds Group. Mr. Caudle is the President of Liberty Funds Group. His efforts are focused on business development and marketing. He graduated from Texas Tech University in 1983 with a B.S. degree in International Trade. Mr. Caudle currently serves as the Director of Development for the Foundation for Managed Derivatives Research. He is also the Chairman of the Trading and Markets Committee for the Managed Funds Association and serves on the MFA's Conference Committee.
Mark Kassirer, Phoenix Research and Trading Corporation. Mr. Kassirer is a founder and Chairman of Phoenix Research and Trading Corporation located in Toronto, Canada. He was previously CEO of Deutsche Morgan Grenfell (Canada) and executive vice-president of Burns Fry Limited, an integrated Canadian investment bank, responsible for fixed-income, equity trading, and risk management.
Barry S. Seeman, AXA Global Structured Products, Inc. Mr. Seeman is Managing Director and Co-Head of AXA-GSP. His responsibilities include the development of structured financial solutions for the AXA organization and the management of new investment products in alternative asset classes. Prior to joining AXA-GSP, Mr. Seeman has held the following positions: Head of Financial Institutions Derivatives Marketing at General Re Financial Products, Co-Head of Financial Institutions Derivatives Marketing at Citibank and Head of New Product Development at Swiss Bank Corp/O'Connor & Associates.
Michael [Name]. Mr. [Name] is the Director of Research for [Name], a leading hedge fund management and consulting group with over $750 million under management. He joined [Name] in 1998 after most recently serving as head of the family office of a private, European investor, where he supervised the identification, selection and monitoring of hedge funds, managed futures, private equity and venture capital investments. Mr. [Name] has over 16 years of experience in global asset management. He is a member of the Association for Investment Management Research and the New York Society of Securities Analysts.
Q: In spite of the overwhelming evidence in support of the argument that managed futures investments provide an excellent diversification from stock, bond and hedge fund investments, hedge fund investors in general, and funds of funds in particular have shied away from this area. Why haven't managed futures developed a larger following among this group of savvy investors?
Caudle: Hedge funds have been a beneficiary of the explosive growth in mutual funds and managed funds in general during the 80's and 90's. As investors increasingly turned to professional managers, it seemed less of a reach for an investment advisor or consultant to advise a client about participating in an alternative strategy that concentrated on more traditional instruments rather than on futures contracts. Another factor hindering the growth of managed futures is the fact that many traditional money managers and consultants share similar backgrounds and investment experience, which do not include futures trading. This has made them less comfortable with managed futures products. I also believe, at least some reluctance toward managed futures has come about as a result of the industry's inability to explain the source of its returns. Recent studies describing performance persistence and returns generated by trend following should help satisfy some critics, but as long as managed futures is viewed strictly as a skill based investment, general acceptance will suffer.
Kassirer: There are three reasons why we believe that investors have shown a preference for hedge fund investments relative to managed futures investments. First, hedge fund managers have done a better job of explaining their strategies. They are usually supported by a plausible fundamental argument. Managed futures too often look like a "black box". Second, managed futures are perceived to be more volatile and to have longer drawdowns than hedge funds. Third, most hedge funds "feel" more institutional, with key personnel coming out of major investment banks, armed with more sophisticated analytical tools and an institutional approach to risk control, trading mainly in stocks and bonds as opposed to commodities and futures. As we have seen recently, all of these reasons do not always hold up to closer scrutiny.
Seeman: Being a market neutral fund of funds, we have never viewed managed futures as simply a diversification from traditional investment portfolios, rather we view each investment vehicle (hedge fund or managed futures fund) as the opportunity to achieve real returns. We look closely at the trading strategies involved and the manager's ability to implement these strategies on an efficient, robust and fiduciary basis.
From 1994 through the middle of 1998, hedge funds collectively performed better than managed futures on a risk adjusted basis, producing more consistent returns with lower volatility. The historically volatile returns in managed futures have kept many investors away from this class of asset allocation. However, the recent market gyrations and the positive performance by CTAs will obviously help expand the investor universe.
Managed futures possess key attributes over hedge funds which should make it attractive to "savvy" investors:
- significant liquidity,
- excellent price discovery (especially in tracking NAVs and risk control), and
- the potential for high returns in volatile markets.
However, the drawbacks that may have impeded the growth of this market are:
- investors' inability to understand trading models or methodology,
- potentially volatile return profiles for the programs,
- the use of high leverage with still misunderstood derivative products.
In light of the current markets and the debacle of Long Term Capital, the challenge for hedge funds and managed futures alike is the increase in transparency of information. Investors will require better reporting of portfolios and returns than the industry is accustomed to, and investors will want to know exactly how the returns are achieved. Black box approaches will no longer be desirable. And this is the area where managed futures could shine. Given the current reporting standards required by regulatory law, progressive organizations can expand on this to enhance their relationship with their investors.
[Name]: It is interesting to note that many of today's top-tier hedge fund managers began their money management careers as futures traders. In a good number of these well-known firms, their programs have broadened significantly to include a larger number of asset classes.
The early days of managed futures trading were often characterized by extreme volatility, very high levels of trading, due diligence difficulties, and remarkably high transaction costs compared to securities trading. This resulted in many sophisticated investors turning away from managed futures and more toward equity or fixed income based hedge fund strategies.
Q: This past August, the HFR Fund of Funds Index measured a loss of 7.29% while the Barclay CTA Index measured a gain of 5.83%. Do you think that the events during August that attributed to these disparate returns have caused hedge fund investors to re-examine their allocations with a more favorable view towards CTAs, or are managed futures simply a hedge against debacle?
Caudle: August's performance cast a favorable light on managed futures. The events that transpired during August and September leave the hedge fund sector with a bit of explaining to do. In recent years, sometimes at the expense of managed futures, hedge funds have been marketed as alternative investments with low correlation to stocks and bonds. Studies reveal, however, that hedge funds demonstrate a significant degree of correlation with stocks. Managed futures have not produced stellar returns over the last several years while global economic stability created an ideal environment. Managed futures products, however, have been profitable and have become a more stable diversification tool for the portfolio manager wary of economic developments that might dislocate traditional markets.
Kassirer: In August, the diversion between returns in managed futures and hedge funds was striking, as I believe it will also be in September and October. It is clear that many hedge fund strategies that appear uncorrelated with stocks and bonds through periods of economic expansion are tightly linked fundamentally with the business cycle though credit sensitivity when the cycle turns down. One of the primary reasons that investors have sought out alternative investments is because they are expected to be relatively uncorrelated with stocks and bonds. If this is not true for many hedge fund strategies just at the point in the cycle when it is needed most, this will be a concern going forward. Managed futures strategies have won an important battle by surviving the current test. While this will shift interest to managed futures, it will not be sufficient to move the mainstream institutional investor if the strategies still look like a black box. Institutionally, it is difficult to rationalize investing in a strategy that you don't understand.
Seeman: The current markets have forced all investors to look at any manager who can generate positive returns. I do believe that many hedge fund investors will view managed futures in a more positive light. There should be some strong themes emphasizing the need for managed futures in any investor's account.
First is the notion of positive performance by managed futures in significantly down markets. That alone may speak for itself. Second, in these recent sell-offs of most global markets, the least liquid assets were hurt the most. Some of the better known hedge fund debacles were a result of leveraged positions in illiquid securities. Managed futures can boast daily liquidity of the account itself, with asset positions that are marked-to-market daily on a regulated exchange. Hedge funds may offer monthly liquidity, but also require a 30-day redemption notice.
[Name]: Our firm has long been a proponent of the use of managed futures as a vital component of a well-diversified absolute return driven portfolio. We have acted on that view by offering investors managed futures choices for the past 7 years.
The superior performance of many CTAs through this recent market crisis has provided some "real-time" evidence of the value of managed futures as a truly non-correlated asset class. If an investor's overall outlook includes more volatility, including rapid and significant trending in equity, fixed income and currency markets, a meaningful allocation to managed futures should be fully considered.
Q: Although managed futures investments are currently gaining in popularity while hedge funds are gaining in notoriety, successful investing is not judged as a popularity contest. Both of these areas provide unique investment advantages. How would you differentiate the relative advantages of managed futures and hedge funds?
Caudle: For investors concerned with liquidity, flexibility, and accountability, managed futures products are marked to market on real time basis, use predominately exchange traded investment vehicles, tend to have monthly liquidity, and are heavily regulated. Hedge funds tend to be less regulated, more secretive, and to have longer lock up periods. These traits allow hedge funds to implement more exotic and at times more profitable strategies.
Kassirer: It is very difficult to generalize since there are so many types of strategies in both managed futures and hedge fund investing. For example, managed futures strategies showed a lack of correlation with equities during the last few months; most hedge fund strategies did not. On the other hand, Phoenix's Fixed-Income Arbitrage Fund was uncorrelated with equities during this period, and earned about 1% each month because it had eliminated all credit exposure as far back as January of this year. Similarly, many managed futures strategies need trending markets to do well, and there are periods of low volatility and range trading that can be wonderful for carry strategies in many hedge funds but which can frustrate managed futures trend followers.
In general, the greater liquidity, transparency, and less fundamental linkages to the business cycle are pluses for managed futures. These have to be weighed against the more apparent and rational fundamental logic supporting most hedge fund strategies. The ideal strategies are those that take the best of both these attributes into either the managed futures or hedge fund strategy. This is how we try to manage our managed futures business.
Seeman: Both of these investment areas have compelling and unique advantages. In light of current events, there is a renewed emphasis on liquidity, both with regards to the instruments traded within the portfolio, as well as the liquidity associated with redemption policies for the investor. While the majority of hedge funds provide for monthly redemptions with thirty days notice, some still offer only quarterly liquidity, and in some cases, only yearly. For managed futures fund investors, monthly liquidity with ten days notice is usually the rule, and in managed accounts, nearly daily liquidity is available.
Investment transparency is another area in which managed futures investments have the advantage. The ability to provide daily reporting of NAV enables the managed futures investor to implement comprehensive risk monitoring not usually available to the hedge fund investor. On the other hand, hedge fund investments offer investors participation in a broad range of strategies covering many asset classes versus a less well defined set of choices within the managed futures arena. Traditional hedge fund managers focus upon "arbitrage" strategies for extracting value in mis-valued securities.
With respect to the use of leverage, both managed futures and hedge funds can implement a wide range of levels. The significance here is that managed futures managers can typically provide timely information, so investors can judge risk-adjusted returns in their manager analysis.
[Name]: The key difference lies in the type of market environment that each needs to function well, and the core methodology they use to "take money out of the market". These factors are also a key to their non-correlated nature. The vast majority of hedge fund equity strategies tend to have a directional component, and most often that is an innate long bias. This is natural and logical given the long-term upward trend we have seen in stocks. Although hedging can be significant, with the exception of short only strategies, those hedges in many cases serve to protect the portfolio from losses, and preserve gains earned from superior selection of a larger number of long positions. Of course there are exceptions, but for the most part these strategies will generally perform better in an upward trending market.
Relative value, non-directional hedge fund strategies, in both equity and fixed income markets, require certain levels of market liquidity and stability to function well. These strategies are built upon long standing relative relationships between certain assets, and depend on these relationships to move in and out of equilibrium. They also require a healthy, liquid market to execute and finance these trades.
CTAs, on the other hand, do not generally depend on a continued upward trending market to enhance the value of their positions. Although they may employ certain variations of relative value strategies, for the most part, they are seeking to anticipate and profit from sustained price movements. Their goal is to analyze and forecast the direction, speed and magnitude of price movements, and to position themselves accordingly.
Q: Long Term Capital Management's imprudent use of leverage resulted in an inability to meet massive margin calls and evoked fears of system wide failure which prodded the Federal Reserve Bank of New York into action. As a result, voices in government are asking for greater regulation of hedge funds. Given the weaknesses exposed by Long Term Capital's near demise, do you believe that greater regulation of hedge funds is warranted?
Caudle: I have seen few examples where greater government involvement has been the correct answer to any business problem, and I doubt regulators will ever be able to protect investors from the advisor arrogance and misuse of leverage evident in the Long Term Capital case. Having said that, however, I think a level regulatory playing field for alternative investment funds might not be a bad idea.
Kassirer: In every cycle there always are some players that are taking too much risk when the cycle turns. Frequently, it is in real estate or the financial industry because leverage is inherent in those businesses. Sometimes it is the cyclical players that get caught when the music stops. This time it was a small part of the hedge fund industry. The supervision that is required and appropriate for the hedge fund industry is through financial intermediaries, the commercial and investment banks. This is already happening as counterparties tighten up their credit standards. Government regulation is neither required nor practical.
Seeman: I do not think that greater government oversight in hedge funds is warranted. I do believe that the government may force certain reporting requirements (the SEC) and certain reserve requirements (Fed, OCC) at Commercial Banks and Investment Banks which provide leverage and other credit lines to hedge funds and other investment vehicles.
The real issue is not government control, but rather more prudent lending requirements at the banks and investment banks. Given the events over the last six months, hedge funds are going to be forced to provide more information with regard to holdings and portfolio moves. Banks will need to understand the risks involved in loans to illiquid portfolios.
[Name]: A number of significant market events combined to force Long Term Capital Management (LTCM) into an uncontrollable tailspin. Although it is hard to make a complete assessment without all the facts, the impact on the credit markets and many related money management strategies has been crystal clear.
Credit and liquidity are the lubricant that makes the fixed income markets operate smoothly. Without liquidity, the market is like an engine without oil; it will grind and smoke for a period of time, but if not immediately lubricated, it will seize. Although I am a staunch believer in free market dynamics, and less government intervention in capital markets, not more, at the same time I do see the need for regulators to preserve liquidity in times of crises. Going forward, I do not think that we will see increased regulation. Instead, I expect we will see investors and managers act in their own best interest to re-establish equilibrium, and curtail excessive borrowing by turning away from those strategies that require it.
Q: In 1994, large investment portfolio losses at Proctor & Gamble, Gibson Greetings and Orange County, to name but a few, were initially attributed to the use of exotic derivatives. In spite of the subsequent vindication of derivatives usage, many pension funds redeemed their managed futures investments. Once again the easy access to leverage contained within most derivatives has been brought to center stage, this time by Long Term Capital. What changes, if any, do you think will be made by institutional investors, pension funds and endowments vis--vis their portfolios of alternative investments based on this most recent blowup?
Caudle: There will be portfolios that benefited dramatically as a result of allocations made to alternative investments and there will be portfolios whose losses were exacerbated due to alternative investment exposure. History has shown that the people who lost money will blame the products and not their own misuse of the products for the losses incurred. Those managers who conducted proper due diligence, used sound portfolio management techniques, and maintained a solid understanding of the instruments in their portfolio will continue to invest in and be advocates for alternative investments.
Kassirer: Most users of capital markets will respond to the recent revelations by reviewing their investment strategies with respect to asset allocation and risk. These reviews will likely lead to a decreased allocation to hedge fund strategies in the near term. This is analogous to 1994 when CTAs did surprisingly poorly and suffered redemptions. However, as we come out the other side of the cycle there will be great opportunities to profit from many depressed hedge fund strategies. This in turn will draw investors back in again. In the interim, managed futures managers have an opportunity to use this period of comparative advantage to start growing again after several years of relative stagnation. However, institutional accounts will only respond favorably to those CTAs that "feel" more institutional, and can respond intelligently to the "black box" issue. Whether for CTAs or for hedge funds, we will enter a period of increased due diligence requiring transparency and evidence of adequate risk control.
Seeman: Simply put, leverage can enhance overall returns when times are good, or it can destroy any strategy when times are bad. We've seen this in derivatives, real estate, stock investing and now hedge funds.
I believe that all investors who engage in alternative strategies will have to make a strong case to keep the allocation in these funds. The issue may not be the returns; many hedge funds have performed better than traditional markets through these turbulent months. The real issue is not getting caught with a significant, high profile debacle. Therefore most investors will require a thorough understanding of any funds holdings, level of leverage and expectations going forward.
[Name]: The LTCM team was extremely well respected and experienced, and was able to gain the confidence and investment capital of a large number of sophisticated investors and professional asset allocators. The circumstances that led to the firm's severe losses were truly unique and hard to predict, but the extreme leverage levels gave them very little room to safely maneuver.
The implications for sophisticated investors are clear. They must add a page to their due diligence questionnaire that examines liquidity correlations between markets. It is no longer enough to be fully up to speed on a manager's strategy. Allocators must now understand who their counterparties are and how they react under stress, as well as who their fellow investors are and their capability to create a redemption-driven crisis. These factors are certainly not new, but have been viewed as less important given the extreme levels of liquidity we have experienced globally over the past several years.
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