CTAs Reposition Themselves to Compete with Hedge Funds
Four Prominent Trading Advisors Discuss Their Reasons for Crossing Over
Copyright 2000 Barclay Trading Group, LTD.
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Since 1990, assets under management in managed futures investments have more than tripled, from approximately $10.5 billion to approximately $33 billion. During this same time period, hedge fund assets, according to Hedge Fund Research, Inc. (HFR), have grown from approximately $39 billion to approximately $370 billion.
Most commentators on the subject attribute the higher growth rate of hedge fund investing to four primary factors. Hedge funds have had higher rates of return and their overlying reliance on traditional investment instruments translates into greater investor familiarity. Hedge funds have also been able to better articulate the reasons for their profitability, especially when compared to the black-box explanations of many trend-following CTAs. And many equity investors have the perception that hedge funds can provide shelter from a broad-based market downturn.
Certainly, there can be little doubt as to the success of hedge funds in providing their investors with high absolute returns. Since 1990, the HFR Fund Weighted composite index has recorded a compound annual return of 18.80%. This compares very favorably with compound annual returns of 16.63% for the S&P 500 Total Return Index and 8.10% for the Barclay CTA Index during the same time period.
However, it is extremely important to not lose sight of the fact that these hedge funds' returns were achieved during the greatest bull market ever seen. It is said that all ships rise when the tide comes in. Is the reverse also true, that the ships sink when the tide rolls out?
To those hedge fund investors looking for true diversification, it might come as some surprise that the correlation between the HFR Fund Index and the S&P 500 during down periods is 0.69. If you account for the fact that the HFR Fund Index includes fixed income funds as well as equity funds, the correlation of equity hedge funds with down S&P periods is probably significantly higher.
Be that as it may, investor infatuation with hedge funds is stronger than ever. In the past two years, hedge fund assets have doubled. The Managed Futures Association renamed itself the Managed Funds Association. EMFA, its European equivalent, is now called AIMA, Alternative Investment Management Association. Several CTAs have recently developed and are now marketing their own hedge funds. Others are trying to reposition themselves as global macro players. Has the managed futures industry developed an inferiority complex or is this a recognition of broader trends afoot? In order to gain a better understanding of the issues involved, we've invited a panel of distinguished CTAs who have recently entered the hedge fund arena to comment on some of the issues. Our panel includes:
A.R Arulpragasam, ARA Portfolio Management Company, L.L.C. Mr. Arulpragasam is the president of ARA, a CTA/CPO with approximately $185 million under management. He is also the president of Arktos, L.L.C., General Partner of Beta Hedge, L.P., and trading manager for the Beta Hedge strategy, a market-neutral equity hedge fund with approximately $90 million under management. Prior to founding ARA in 1992, Mr. Arulpragasam spent eight years in yield-curve arbitrage and five years in private consulting. He received his B.S. in mathematics from the Massachusetts Institute of Technology in 1977, following which he pursued graduate studies in operations research at Stanford University.
Michael P. Dever, Brandywine Asset Management, Inc. Mr. Dever is the president, principal and sole shareholder of Brandywine Asset Management, Inc. He has been actively researching and trading derivatives since 1979. Brandywine is a fully integrated research, trading and advisory firm using fundamentally driven systematic trading programs in global equity, interest rate, foreign exchange and natural resource markets. Mr. Dever is a business graduate of West Chester University in West Chester, Pennsylvania.
Melissa F. Hill, Sabre Fund Management, Ltd. Ms. Hill joined Sabre in 1996, where she is responsible for client relations and marketing. Ms. Hill has extensive experience of the investment markets, having previously spent eight years in investment banking and two years in the pension fund industry.
Patrick L. Welton, Welton Investment Corporation. Dr. Welton is the CEO and Chairman of WIC. He developed the mathematical analysis techniques and systems software employed by the firm in its trading and portfolio management. Dr. Welton has engaged in futures and equity market research since 1981. He is currently serving on the Board of Directors of the National Futures Association. WIC manages approximately $160 million for a variety of bank, institutional, fund and family office clients around the world.
Q: For years, your firm has been successful in the managed futures industry. Recently, you have thrown your hat into the hedge fund ring. What prompted you to take this action?
Arulpragasam: ARA's charter has always been to deliver portfolio enhancement products which meet the current needs of institutional investors. In 1992, ARA registered as a CTA/CPO, but not because we viewed ourselves as a CTA. Rather, we registered in order to legitimately deliver a managed futures product.
At that time, institutions actively sought "alternative" investments to diversify away traditional portfolio risk. The growing managed futures industry was appealing, but (following large losses in real estate and energies) better risk quantification and control were demanded. ARA's diversified commodity fund, with statistically controlled volatility at client-defined levels of risk, met that institutional need. In the last two years the U.S. equity market has capped a tremendous bull market with a final surge of truly unsustainable proportions. Currently, institutions are seeking products to protect those enormous gains. ARA has now entered the hedge fund arena, but not because we see ourselves as a hedge fund. Once again, it is simply to be able to legitimately deliver our short-biased, market-neutral hedge product to meet the current institutional demand for such products.
Dever: At Brandywine, there was never a conscious effort to "become a hedge fund". What differentiates us from most CTAs is that we have always utilized a quantitative approach that incorporates fundamental data, statistical arbitrage and relative value strategies. So becoming a hedge fund was a fairly organic process. In pushing the efficient frontier, we simply expanded our global trading to include long/short U.S. equity exposure as well. The migration was quite natural and will continue as we feel that our quantitative approach is rational and provides a statistical "edge". For that reason, we see our global trading business expanding to include international equities and convertible securities. If our model can be applied to a market that is liquid and possesses diversifying characteristics, we will trade it.
Hill: SFM is one of Europe's oldest derivative fund managers, having been managing money in the futures area since the early eighties. In 1996 the company adopted a new business plan based on the partners' recognition that the hedge fund industry offers a greater range of instruments, styles and strategies from which to achieve effective diversification as a business and to deliver performance to Sabre's clients. Modern market conditions require robust trading techniques and it is vital to keep up to date if we wish to stay at the "cutting edge" of the alternative investment industry. Entering the hedge fund arena has allowed Sabre to identify and pursue niche trading strategies, such as our unique UK equity pairs programme. These niche strategies, which are not crowded by competition, offer greater opportunities for profit. In addition, hedge funds are a more popular medium for investment. The majority of hedge funds strategies are derived from equity market trading, rather than futures and options trading employed by CTAs. This makes hedge funds more closely aligned with investor interest.
Welton: This was a logical, calculated business decision commensurate with the long term goals of our firm to grow managed assets over time to the $1 to $2 billion range. From the 1970's to the mid-1990's, CTAs focused upon a limited set of FCM sponsored commodity funds and aggressive private investors. In late 1994 the principals of Welton Investment Corporate (WIC) collectively decided to best serve its investors, and therefore the firm, we needed to focus on the so-called alternative investment management world. In its best representation such a manager can devote all efforts toward achieving the highest risk adjusted rates of return through improved portfolio diversification and reduced volatility with few of the strategic, instrument, or regulatory restrictions that diminish the best interests of the investor. Such investors include private banks, institutions, pension funds, and private families as well as others.
Q: At present, relatively few CTAs are attempting to bridge the CTA/hedge fund gap. Do you think that many other CTA firms will soon follow in your footsteps? Is this a short-term phenomenon or is there a broader trend afoot?
Arulpragasam: I don't like to think of it as a gap. CTAs offer active management of futures portfolios, whereas hedge funds offer active management of cash and futures portfolios. We are simply a subset of the hedge fund universe. A more useful perspective might be to think about it as expanding our product universe. The expansion into other hedge fund products is very natural and will definitely continue and broaden. To date, most CTAs have not expanded into hedge funds, because they don't have the skill-set to do so; many CTAs are just "guys with a system". The bad news is that our industry is populated with surprisingly few skilled risk managers and portfolio managers; the good news is that the percentage is rapidly growing as managed futures comes of age. We are witnessing the start of a broad trend that will identify skilled portfolio managers and reward them with broader product acceptance amongst institutional investors.
Dever: I don't feel it is a short term phenomenon or a broad trend. The issue is whether you are a futures trader or an asset management company. I feel that this comes down to how one's strategy, technology, and philosophy are applied to instruments beyond the scope of futures. If your trading methodology is trend-following in nature, the transition will probably not be a natural progression. In addition, the analytic, data and technological resources necessary to make such a transition are capital intensive. In the final analysis, if your firm's trading approach is not applicable to trading cash equities, convertible securities or options then you probably don't possess an edge outside of the futures market.
Hill: A number of CTAs have adopted the hedge fund label, but in some cases this is a marketing exercise. However, natural contenders for the hedge fund label are FX managers and securities managers. FX has always been looked on as being quant driven and even if you trade the hell out of securities, people still think a manager is doing something respectable.
It may be quite difficult for some CTAs to shed their clothes. Hedge funds are typified by results which are believed to be independent of systemic market behavior and CTA strategies, being largely directional, are set up to exploit systemic risk. CTAs are largely systems driven, having constructed trading rules around past pricing patterns. CTAs also cater to the smaller market - - deal sizes are smaller in the futures markets and so CTAs may not be geared up for the size of hedge fund business. The only way a CTA can really make the transition to hedge fund manager is by adopting new strategies and consequently employing new people.
Welton: Depending on the firms' individual business objectives and risk reward profiles, I believe you will see CTAs continue their efforts in this direction. The demand is certainly there. I read recently where endowments, family offices, and institutions have been estimated by some analysts to have alternative investments totaling $1 trillion with a projected growth of 15-20% over the next few years. Specifically with respect to our long term goals, WIC's emphasis will be to continue growth of alternative investment portfolios in individual accounts, international and domestic pools and U.S. public funds. We plan to expand both our capabilities and reach within the institutional investment community through participation in existing products as well as more focused application of managed futures and portable alpha strategies as a key part of overlay products which enhance the return of portfolios for banks, insurance companies, and other financial product providers. An increasing emphasis for our availability in managed accounts will be to accommodate all aspects of advising structured products making best use of the type of portable alpha return WIC can provide.
Welton Global Funds Management Co. plans to sponsor domestic and offshore funds during 1998 with greater strategic flexibility beyond managed futures, including the use of securities and hedged yield curve arbitrage applied to G7 debt markets adding significant strategic diversification to the directional futures strategies, options, and statistical arbitrage trading currently available in its managed futures (portable alpha) product.
Q: Have you found it necessary or beneficial to make any changes in the instruments you had been trading or your trading style in order to present yourself credibly to experienced hedge fund investors?
Arulpragasam: Absolutely not! ARA's focus has always been on risk management and portfolio enhancement. Our new product, Beta Hedge, is an equity-based, cash-only, market-neutral, mixed fundamental and technical product. As such, it indeed represents a completely different trading style and in brand new instruments. But that was a product design decision, not a subsequent marketing decision. As long as products are designed around client needs, there should not be any need to subsequently modify them in order to effectively market them.
Dever: Brandywine's philosophy has always been to integrate new markets and strategies into our portfolio that will enhance our risk adjusted returns. With the addition of securities to our arsenal, a product such as our Spectra Global Program has the same composition as a typical global macro trader's portfolio in terms of market exposure. I don't feel there is any reason to eliminate a market or style that improves your portfolio to "fit in". I believe the fundamental and quantitative aspects of the Brandywine Trading Model, combined with the broad universe of instruments we trade, are appealing to hedge fund investors. This is our strength.
Hill: Sabre has acquired an experienced asset allocation and product structuring team from a major UK broking house and we now manage a stable of hedge funds of funds.
It is our policy to develop and introduce new strategies as part of our emerging manager programme. With regard to trading style, we now employ a more quantitative approach, and our UK equity pairs programme is an automated strategy using statistical arbitrage. Trading is effected by OTC contracts for difference on the FTSE.
Welton: Absolutely. I believe an appreciation of risk-adjusted performance is a key characteristic for the hedge fund investor. Our initial research of the marketplace included discussions with a Swiss private bank which shared results of a questionnaire they had provided their clients.
Those clients indicated a risk reward appetite which included average annualized returns in the 15-20% range with a maximum monthly decline in value of not more than 5% and a cumulative decline of not more than 15%. To reliably achieve that type of return profile over time requires Sharpe ratios greater than 1.0-1.5. It is our opinion that this is not achievable over meaningful periods of time trading a limited group of futures markets with a single directional strategy.
We deliberately undertook an extensive research process emphasizing diversity in opportunities, sources and methods of returns. This has lead to the incorporation of dozens of additional markets, instruments such as options, and strategies such as volatility and statistical arbitrage-based models.
Although past performance is not necessarily indicative of future results, we have steadily maintained our performance goals (approximately 20% annualized) over the past few years while reducing volatility (as measured by standard deviation) by approximately half to about 14% annualized- - our new target is 10%.
Q: Do you find that your CTA background is a help or a hindrance to gaining credibility within the overall hedge fund community?
Arulpragasam: Initially, it is probably a slight hindrance. However, when painted in the light of having successfully managed portfolios and risk in an extremely complex subset of the hedge fund universe, it can also be portrayed as invaluable experience.
Dever: Brandywine registered as an investment advisor back in 1989. As it turned out it was not necessary at the time, but our intention has always been to be an asset management company. We do not want to be pigeon- holed into a category. Over the long term, we want to be a multi-billion dollar asset management firm that offers superior risk-adjusted returns through the use of systematic and quantitative methods. So we do not either promote the fact that we are a CTA or hide it: it is simply a registration that any fund manager who trades futures has to have for that matter. Credibility is earned on the playing field. For instance, our Spectra Global Program has performed well since inception, generating a 42% annualized return with a Sharpe ratio of 2.74.
Hill: Our long term experience in the alternative investment arena has been invaluable in broadening the scope of our business. Our reputation as a CTA has certainly not hindered our asset allocation process in selecting hedge fund managers, and on the marketing side, if we did not speak from a position of authority and experience, it could be a problem.
Essentially managed futures and hedge funds have the same target: absolute performance. Having been in the business of providing absolute returns for 15 years has proved to be a major advantage.
Welton: Initially I would have to say it was a hindrance. There was the potential for instilled biases in the minds of allocators who perceived (and tended to label) CTAs as highly leveraged, volatile, commodities traders. Once those initial obstacles were overcome through detailed discussions, these same people developed a greater appreciation qualitatively for how our portfolios could deliver access to a diverse set of global markets, the employment of multiple trading strategies, and the ability to provide full transparency through daily mark to market pricing. More accurate value at risk modeling and notional funding are definite pluses as well. Quantitatively, the performance data speaks for itself.
I might add, from a product design standpoint, I see a huge potential in the realm of structured products for CTAs in the alternative investment community since such products, to have the most advantaged construction, must have the ability to be notionally funded - - something more available in the CTA community.
Q: The last time that hedge funds were popular was in the late 1960s. By the early 1970s, the entire industry had been decimated by a prolonged stock market correction. If we get another prolonged correction, can we expect more of the same, or will it be different this time?
Arulpragasam: Any long-biased hedge fund which is not completely market-neutral will suffer greatly in a major market correction. Although there are many hedge funds, there are very few truly hedged funds, so history will probably repeat itself to a degree. Beta Hedge is a hedged fund, which dynamically adjusts its hedge in order to remain truly market-neutral. It is both dollar-neutral and beta-neutral. As the equity market continues to rise, sophisticated investors will increasingly diversify their assets into rigorously hedged products such as Beta Hedge. That trend will hopefully mitigate the negative effects of a stock market crash.
Dever: I'm glad you asked that question. What comes to my mind is, "What is a hedge fund?" Is a hedge fund simply a fund that uses leverage? If a leveraged long small-cap fund is a hedge fund, in all likelihood it would be punished in a bear market. In fact, with the amount of leverage available today through broker/ dealer structures and enhanced leverage products, the results could be pretty frightening. To me, a "true" hedge fund consists of absolute return strategies whether it's relative value, neutral strategies or directional market plays. A "true" hedge fund will add value in any market environment where there is the volatility necessary to extract value.
Hill: In the late 60's and early 70's, the hedge fund strategies employed were largely equity based and there was not the volume of OTC markets available, as today. The prolonged stock market correction of the early 70's probably found most funds caught long and we now have a wide range of instruments and strategies to diversify risk and produce absolute returns. Also the growth of market neutral funds has reduced reliance on market direction to make money. (During the period of market volatility between August and December 1997, our market neutral fund did not experience a down month.) However, it is of course possible to throw too much money at an individual style as time develops, but it is difficult to predict when this will happen. In addition, there is a risk that the bigger global macro and theme funds, that can only be long or neutral, are not well equipped to survive if volatility picks up.
Welton: This will depend largely on how effectively each fund manager meets the expectations of his/her clients. This, I believe, is a function of the diversification of a hedge fund manager's market exposure, trading styles and risk management. Given most hedge funds are securities based with style specializations, many of them could languish in prolonged correction. As a firm, I believe Welton Investment Corporation is well positioned strategically as a multi-market, multi-strategy global fund management company with only a modest dependency on traditional equity prices. Such conditions would likely create many opportunities for our other strategies and markets. Personally I am very optimistic about our firm's ability to meet the challenges which lie ahead and to effectively service the needs of our investors.
Copyright 2000 Barclay Trading Group, LTD.