Emerging CTA Firms Must Overcome Unique Challenges
Copyright 2000 Barclay Trading Group, LTD.
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Every year, new CTA firms enter the managed futures arena and, not surprisingly, the mortality rate among these "emerging CTAs" is fairly high. Starting a new business in any industry is always risky and managed futures is no exception. Out of the 180 CTA programs managing less than $5 million on January 1, 1990, 57% were out of business five years later. However, of the 66 CTA programs managing more than $25 million on January 1, 1990, 77% were still in business five years later.
Small CTA firms face many of the same challenges encountered by small firms in other areas of business. However, small CTA firms face an additional challenge that seems to be unique to money management firms. In most cases larger investors, before committing their capital, demand to see multi-year performance histories with significant assets under management. How can a CTA raise significant trading equity when having money under management is one of the prerequisites for raising that money?
Given this daunting problem, it is surprising that any emerging CTAs break through into the mainstream, but many do. Ten years ago, there were approximately 22 CTA programs with assets under management in excess of $50 million. In 1995, there are 85 CTA programs with more than $50 million under management.
In order to get a better idea of the issues and challenges faced by new firms with small equity bases, we've gathered a distinguished panel of CTAs who, until recently, may have been considered emerging CTAs. These firms have clearly emerged, and, in our opinion, will most likely be among the 77% still in business in the year 2000. Our panel includes:
Craig Croman, Zimlev, Inc. Mr. Croman is the president of Zimlev and has traded futures contracts as a full-time professional since 1978. Zimlev currently manages approximately $40 million for clients.
Hugh R. Haller, Webster Management Group. Mr. Haller is the president of Webster Management Group. Webster was incorporated in October of 1991 and currently manages approximately $50 million in domestic and foreign managed futures.
John R. Hummel, AIS Futures Management, Inc. Mr. Hummel is president of AIS Futures Management, Inc. and AIS Capital Management, Inc. He has 28 years of investment experience. AIS currently manages approximately $77 million in the futures market.
Holliston Hurd, Hill Financial Group, Ltd. Ms. Hurd is Director of Marketing for Hill Financial Group, and has been involved in trading futures and in market research since 1983.Hill Financial Group currently manages approximately $23 million in client assets.
Q: Each year, many new traders enter the managed futures arena, but few develop successful businesses. What do you attribute your success to?
Croman: First and foremost, Zimlev attributes its success to the trading model. After each analysis, other firms have concluded that we are non-correlating. Zimlev has become successful due to relationships that were developed over 18 years and due to our willingness to accept "incentive fee only" accounts
Haller: Webster decided early in its development that to compete as a CTA required something very different from what was required, say, three to five years ago. We felt that it was very important to build a business around a trading philosophy as opposed to the other way around. With this in mind, Webster placed a significant emphasis on the planning process, resulting in a five-year business plan which we revisit constantly and update at the end of the year.
In order to execute this plan, Webster utilizes the talents of five equal partners. This structure provides a foundation of resources that no one of us could match. Collectively, we offer more as a group than any one of us could offer singly. In our decision making process, we ensure that everyone is on the same page. We are aware that certain decisions are slowed down, or not made at all, by one of us hedging, but that has been positive. Nine times out of ten that partner was right and we've reached a better answer. The result is a common vision for Webster. We agree on our objective, or we do not go forward.
Hummel: First, trading is a business. A successful business requires a well thought out business plan, good management, a high-quality dependable product, a targeted marketing plan, client servicing, adequate financing, and professional, motivated employees. We have tried to properly develop each of these areas.
Secondly, we work with clients so that they understand the risk they are assuming at different levels of leverage and the reasons for drawdowns. A client who is well informed and has realistic expectations will be more willing to stay with the investment during the inevitable drawdowns which we all experience. Finally, our MAAP investment approach is totally systematic, diversified, and meets our internal risk-adjusted return requirements. These factors, we believe, allow us to deliver a consistent and dependable return to clients. The systematic aspect of our approach allows us to spend valuable time on additional research and on the management of the business.
Hurd: As the industry shifted towards larger institutional players, a conservative product that delivered competitive returns with minimal return volatility was needed. The largest influx of capital was coming from the institutional sector of the market; therefore, Hill Financial Group (HFG) developed the Multiple Strategy Program (MSP) in 1991 specifically for the institutional investor.
The risk and return expectations of the institutional investor are much lower than that of the retail investor. The institutional investor places more emphasis on risk, and as a consequence, we have positioned our product to produce competitive returns with much less risk relative to the average CTA. The risk management technology was developed to target and maintain a specific level of risk. I feel that this unique perspective attracts clients and keeps them with us for longer periods of time.
Non-correlation of returns to the industry has been one of HFG's biggest benefits to the institutional investor. The system technology was designed to be non-correlated with the long-term trend followers. HFG's trading system is unique in that changing levels of volatility dictate different strategies which are optimal for the current volatility environment. When designing a multi-advisor fund the investor can lower return volatility by including HFG in the mix of CTAs. The non-correlation on a daily basis is also an added benefit. Many investors are pleased with the way the program delivers on days when large moves occur. Because of the short-term nature of the program, we have generally reversed before a trend begins.
Q: When you first started out as a CTA, what was the main obstacle that you had to overcome in order to gain investor confidence? How did you overcome that obstacle?
Croman: Zimlev's most difficult obstacle was gaining investors' trust in our performance numbers. We overcame this by believing time and patience were our allies. By encouraging our investors to monitor our performance we gained the trust we needed and allocation of funds began.
Haller: Webster's major hurdle starting out was overcoming our lack of relationships in the industry. We started with a small, proprietary account and struggled to implement our strategies effectively. As a result, we had no basis for a track record, but while this was certainly an obstacle, we believed there was more to building investor confidence than a 13-column performance table. In addition, the principals of Webster came together because of like beliefs and complementary talents--as opposed to proximity or prior association. Consequently, we started out by operating from several different locations. This was generally construed as confusing and lacking commitment.
We overcame both obstacles by working very hard to develop meaningful relationships. This meant demonstrating to people that we were professional and committed to our business long term. We made ourselves as accessible as possible and provided in-depth quantitative and qualitative information. As our performance record grew and the results were consistent with our sales message, potential investors became more comfortable. Our relationships solidified and people let go of the preconceived notions that all emerging CTAs have to overcome when starting out in our industry.
Hummel: Disbelief in back tests was clearly the main obstacle. Initially this was overcome by the confidence shown by a few friends and close business contacts. Fortunately, we had a traditional investment advisory business which provided revenues to support our futures business. Looking back, I have empathy with both new traders lacking real-time results and with potential investors' skepticism. For all practical purposes, real-time results are the dues required for entry into the business.
Hurd: Hill Financial Group began as a retail organization and as a consequence produced returns with extreme volatility. In order to shift the focus from the retail market to the institutional market, we developed and implemented the Multiple Strategy Program in 1991. To ensure that our risk management technology was effective and to control return volatility, we also raised the minimum account size to $250,000. At that level of investment we were able to target a specific risk level for each account. The biggest obstacle that we had to overcome was to convince our potential clients that the program would maintain consistent return volatility.
Consistency over time is the most effective way to gain investor confidence. Also, by telling a client what he could expect, and then meeting or exceeding those expectations, we added to our credibility as a CTA. The track record attracted the institutional player and we then raised our minimum to $l million in 1995, a level that we feel is ideal for managing risk on a daily basis.
Q: Did you develop your trading system from insights gained from your own market observations and experience, or did you also rely on the experience of others?
Croman: Development of our trading system was gained by relying on the insights gained from my own market observation as well as the experiences of others.
Haller: Individually and as a group, Webster has considerable experience trading the futures markets. Our insights have been shaped over many years and numerous situations trading both on and off the exchange floor. Although Webster is 100% systematic in its approach, we have considerable discretionary experience trading both futures and options. This discretionary experience helped us learn the nuances of individual markets, both fundamentally and in terms of execution. We feel that we have done an excellent job incorporating this knowledge into our systematic trading.
From a research standpoint, Webster has a core philosophy that is rooted in diversification. This philosophy is an outgrowth not only of real- time trading and personal beliefs but also stems from years of studying the most successful traders. In conducting our research, we feel we have identified ways to make aspects of our systems slightly different, but we acknowledge that superior trading is a function of discipline and consistency. This type of stability is achieved over a long time frame, a claim only a handful of traders can make.
Hummel: AIS is an acronym for "applied intelligence strategies" which we define as the combination of the best aspects of human investment experience with the strict disciplines of mathematics through the use of computer technology. Personal experience in the capital markets since 1967 and honest analysis of past successes and failures in personal futures trading since 1981 influenced the general design of our system. Brad Stern, the other principal of AIS, and I spent over a year of intense research in 1990-'91 testing various ideas and concepts. Initially we developed TAAP, a tactical asset allocation process for stock and bond portfolios. With that completed we then turned our efforts to the futures markets and built our MAAP, multi-asset allocation portfolio, for futures portfolios.
Hurd: The Multiple Strategy Program was designed by John Hill, Jr. and is proprietary. The program consists of two layers of technology: price analysis and risk management. The majority of the ideas incorporated at the price analysis level are based on years of price analysis conducted by John Hill, Sr. A short-term perspective was found to be more profitable than a long-term trend following approach. The basic premise is that markets progress through different levels of volatility. The most effective way to capture directional price movements is by developing different strategies as a function of volatility. The MSP is a referral system and is in the markets 98% of the time.
Adding risk management was instrumental in lowering the volatility when developing the system for the institutional sector. The risk management level of the program was developed from ideas utilized by the most successful traders and is comparable to JP Morgan's Risk Metrics.
Q: Has the increase in money under management resulting from your successful trading in any way affected your trading system?
Croman: Yes. Initially we thought this trading system could trade $100 million, but through our experience of trading daily we have realized that we can only trade $60 million on this model.
Haller: In increasing assets under management, the key factor for Webster is not whether our trading profits will disappear, but rather whether our transaction costs will rise to the point of becoming prohibitive. To help guard against this, we constantly measure our real-time trading costs against what we assumed when we conducted our research to make sure our actual costs are not too high. As we grow, we will continue to break up the size of our orders at any one price level in order to hold the line on escalating transaction costs.
Additionally, we will expand our commodity base, both foreign and domestic, while striving to maintain our balanced program. We believe that as long as our transaction costs remain stable, and markets continue to move, then our systems will continue to make money.
Hummel: One of the criteria we established for our system was the ability to manage a significant pool of assets. Having managed large institutional stock and bond portfolios, I believed a similar opportunity could develop for futures portfolios. Our system trades only large, liquid markets and is very long term by futures industry standards. AIS could grow to three or four times our present size without any changes to our trading approach. Beyond that, small changes in the number of markets which AIS trades would accommodate further growth. To that end we conduct ongoing research in additional markets.
Hurd: Hill Financial Group has not yet reached a level of equity under management where returns have been affected. Liquidity and execution become important factors as equity grows. Performance will be carefully tracked to examine its effect on performance. Global and domestic markets can be added to the portfolio in each sector as equity grows.
Q: Since the beginning of 1995, the Barclay CTA Index has gained approximately 10% versus a gain of 24% for the S&P500. Has this made it more difficult to attract managed futures investors? Are investors correct to compare these different investments on a year-by-year basis?
Croman: Yes, as an emerging trader it is more difficult to attract managed futures investors. For example, in 1993 when we were an emerging company, we were in the middle of bond bull markets across the globe. Because of above-normal returns we were told our services were not needed. Emerging traders are more affected than non-emerging traders. In 1995 in similar conditions, we received investor confidence. Zimlev was more affected in 1993 than in 1995.
Investors are correct to compare the mentioned investments on a year-to-year basis from a correlation point of view. But from a long-term portfolio mix point of view, these investments should not be compared on a year-to-year basis.
Haller: The performance of the S&P 500 in 1995 as compared to investing in managed futures this year has been a hindrance to attracting some potential investors, but to others not a hindrance at all. Managed futures investors cover a wide spectrum of expectations. Many investors view managed futures as a true diversification tool and they understand that there are periods when the S&P will rise and managed futures will not. Like many CTAs, Webster's correlation to the S&P is very low, typically around -.10. Investors know this going in, and this lack of correlation is one of the main reasons they are investing in the first place. Other investors are not as concerned with correlation as they are with overall return. These investors tend to time CTAs and other investments based on momentum and/or short-term performance. For these people, managed futures has not been an attractive vehicle over the most recent period.
Webster's belief is that investors should not evaluate managed futures on a year-by-year basis. We prefer to look at our performance over a three-year period and we think that investors should do the same. At the same time, we acknowledge that investors cannot achieve the same level of comfort with our program as we can; we understand our research intimately and we know the probabilities of timing our program, both good and bad.
Ultimately, what works for the investor is the most important issue. Investors have different thresholds, different beliefs and ultimately different investment objectives. If a shorter time period makes sense to an investor, then he should follow his instincts. Regardless, we feel strongly that a short-term investment does not coincide with our investment cycle.
Hummel: From the beginning our direct marketing efforts have focused on equity investors who have little or no experience in futures. We believe our marketing efforts should be focused on expanding the size of the invested pool of capital rather than marketing to our competitors' clients. Although we have experienced strong returns this year, there is no doubt that the combination of strong stock market returns and the adverse publicity surrounding derivatives has slowed capital raising efforts.
The attitude today toward futures investing reminds me of investors' attitudes toward equities in the late 1970s. Intellectually, investors could recognize the value in equities in that earlier period, but emotionally they found it difficult to invest their money in the stock market. I believe that similar attractive valuations exist today in many raw materials and food stuffs. Given the global economic growth trends it is only a matter of time until major price up-trends could unfold. Therefore, as difficult as 1994-95 has been for our industry we could be on the verge of secular growth that could surprise even the optimists.
Hurd: An investment in the stock market this year has earned investors above-average returns when compared to previous years. Investor psychology is geared such that when alternative investments deliver better returns, money moves in their direction. This has not affected money flowing into the managed futures industry, because managed futures and stocks are not correlated. Most investors are trying to lower the risk to their entire portfolio while enhancing diversification by adding futures to their stock and bond portfolios. The objective is to garner returns similar to the S&P 500 while reducing overall portfolio variance.
Also, institutions who previously did not include managed futures are adding them. A low inflationary environment is not ideal for an investment geared to futures, but the potential is always there to hedge in an inflationary period.
Copyright 2000 Barclay Trading Group, LTD.