One of the selling points for managed futures has always been their use as a diversification from traditional equity and bond portfolios. Moreover, numerous studies have shown that managed futures not only are non-correlated to equities but also tend to be negatively correlated to equities in bear equity markets (see “Safe haven”).
Since the subprime crisis began in July 2007, the Barclay CTA Index is up 13.45%, the Barclay Hedge Fund Index is down 8.50%, the Dow Jones Industrial Average is down 18.20% and the S&P 500 Total Return Index is down 19.29% through September.
Hennessee Group LLC reported that September was the worst month in a decade for hedge fund managers. The Hennessee Hedge Fund Index declined 6.24% in September and is down 10.28% year to date. “Despite being defensively positioned, September was the worst month for hedge funds in over a decade. The ban on short selling caused significant losses across most strategies and required funds to alter their trading models,” said Hennessee co-founder Charles Gradante in a release. The various Barclay Hedge sub-indexes show all categories of hedge funds down for the period beginning in July 2007 through September, except for short sellers (see “Across the board”).
WINNERS AND LOSERS
Picking winners and losers can be as easy or complicated as you want to make it. Put simply, since the onset of the subprime mortgage crisis and resultant credit crunch, managed futures programs have been winners and hedge funds have been losers. That is true based on performance and can be extrapolated out into the future if you expect, as many do, that the addition of another $1 trillion of government debt will be highly inflationary. Commodities are an inflation hedge and if inflation explodes further as many expect, there will be a demand for futures programs. The S&P GSCI Total Return Index is up 25.59% since July 2007 despite its heavy weighting in crude oil and the massive downward correction in crude oil since July.
“If the U.S. is spending hundreds of billions of dollars on a bailout, isn’t this inflationary? Commodity prices should go up,” says John Di Tomasso.
Di Tomasso operates a value-based commodity strategy in Canada. It goes long and short commodities based on value. If a commodity is well above its median value, it will go short through options. If a commodity is undervalued, it will go long with futures.
One of the factors Di Tomasso uses to adjust his model is inflation. Commodities are an inflation play. As inflation rises, that fair value level rises as well. “It means that the mean gets higher,” Di Tomasso adds. He uses the U.S. Consumer Price Index (CPI) to adjust his models but has altered that as U.S. CPI numbers are highly questionable due to changes that have tended to under report inflation. “Up here we notice a lot of inflation. I feel like it is more than 5%. The government has a vested interest in keeping inflation [measures] low. In 2008, we adjusted prices to an 8% inflation rate. If we would sell wheat at $10, we would now sell it at $10.80. Early next year we will think of an appropriate number [to adjust for inflation].” He adds with $1 trillion added to the debt of the United States, that number could be quite high.
Sol Waksman, president of Barclay Hedge, says that the current crisis should be good for CTAs, though he sees more deflation than inflation on the horizon. “CTAs as a group should benefit. They have a lot of trends going on — short energy, long dollar, short commodities,” Waksman says.
However, the volatility of futures markets has risen to an unbelievable and perhaps untenable level and no strategy is as susceptible to quick reversals as managed futures, particularly long-term trend followers. This can happen due to so-called one time events that are coming at a rapid pace. It also can occur due to government interventions, which are happening more often. Regulators are being proactive and don’t seem concerned about market impact.
Ira Epstein, founder of futures broker Ira Epstein & Company, says that volatility is so high that margin requirements have gone up in many commodities despite downward corrections of 40% or more. Many brokers will only let some customers trade options in the current environment. The absence of small speculators may increase volatility.
STAND UP FOR YOUR MODEL
As we noted above, there are several measures to select winners and losers. Perhaps the most transitory is initial trading results. So what will the credit crisis mean for alternative investments down the road?
Underlying the entire subprime debacle and resultant credit crunch is the creation of relatively new and extremely illiquid over-the-counter asset backed securities. These products were created, mislabeled as investment grade and allowed to remain on investment bank books until their stench was unbearable. While the bursting of the housing bubble was the match that lit the current blaze, the models that created and rated these securities apparently did not consider a housing downturn as even a remote possibility.
That these specious products were created and took hold in such a short period of time says something about the way Wall Street banks operate and how institutional investment decisions are made. Many of those investors would turn their noses up at managed futures or somehow see them as too risky. Even the regulators at the Securities and Exchange Commission (SEC) seem to take a dim view of hedge funds while giving free rein to Wall Street to peddle new fangled securities.
David Matteson, partner at Brinker Biddle and member of its investment management practice group, sees it as a double standard. He points out that a basic futures offering has more than 100 disclosures they have to include on an offering sheet. “You think they do that with Wall Street? There is a double standard out there. It is time to take an even-handed look at Wall Street products and futures products and stop the double standard.”
Matteson, speaking at a panel on alternative investments at DePaul University, placed a lot of the blame for the subprime debacle on the SEC. “It is ironic that the SEC has had hedge funds in their crosshairs for several years — even saying that hedge funds posed significant systemic risks to the marketplace — guess maybe they should have been paying attention to the brokerage firms they were supposed to regulate.”
Matteson stated that the common thread among the failed Wall Street instruments is that they were all over-the-counter products.
“You are relying on their balance sheet to pay you the money,” Matteson says. “Contrast that to counterparty risk with the structure of futures exchanges and clearinghouses. When Refco went under, it was a global mess. There were all sorts of affiliates in the Cayman islands and elsewhere that failed. One entity that sailed through without a single dollar of customer loss or any kind of a failure was Refco LLC, the regulated registered futures commission merchant (FCM). All the customer cash and all of their market positions were bulk transferred to other FCMs. Same thing when Bear Stearns went down, same thing with Lehman. The futures market is set up so that every market participant has to pay for today’s losses — even unrealized losses — within 24 hours. If you can’t pay your losses by the next day your positions are liquidated, you’re out.”
He added that with futures you are not relying on any counterparty to make good on their obligations. “You are relying on an exchange’s clearing organization, which collects good faith performance deposits every day from [every] market participant. And that clearing organization that is holding your funds, they aren’t making their own leveraged bets on the market; it’s their only job to clear trades and move money between market participants through their member firms.”
Matteson points out that it is a safer model and should be seen that way. “If I was investing for a pension plan and had to invest $800 million I wouldn’t have any counterparty exposure to any financial institution.”
Tom Sowanick, chief investment officer for Clearbrook Research, says as a result of the current crisis, overall demand for alternative investments will not go down but those with less transparency and longer work out periods will. He says private equity, distressed debt and fund of funds should not go out of favor. “The demand for fund of funds should increase for a very simple reason — they employ diversification across multiple strategies as opposed to one strategy,” Sowanick says.
“Real assets will also be in demand… commodities may be the best long-term asset class as global growth and leadership takes firm roots in the east,” Sowanick adds.
MAKING THE CASE
Despite the seemingly obvious advantages to managed futures, they consistently get placed at the kids’ table of the alternative investment universe. And despite those advantages, industry veterans aren’t sure the current crisis will create a breakthrough. Frank Pusateri, president of managed futures consultant Adirondack Portfolio Management and an executive with CTA Fall River Capital, says even though the diversified CTA is making a lot of money this month, it may not translate into allocations.
“Economic uncertainty is causing money to disappear from CTAs. What I hear is that nobody is raising any money and money is being redeemed. People are scared,” Pusateri says (See “Will growth end”).
Waksman adds that futures programs could be hurt by losses in other parts of investors’ portfolios. “Are people going to be redeeming from managed futures because it is liquid losing [money] in other investments?” Waksman asks. “Fear is in the driver’s seat today.”
Pusateri, who helped form the Managed Funds Association when it was strictly a lobbying group for managed futures, points out that managed futures are being hurt with their association with hedge funds. “For better or worse, the CTA community wanted to be a subset of the hedge fund community,” he says.
He points out that the strengths of managed futures — their complete noncorrelation with equities, transparency and daily liquidity — often get lost when they are considered just another hedge fund subset. “The public doesn’t understand that. One of the things that has to happen is that CTAs need to be better as an industry [at creating awareness].”
Pusateri says that managed futures are different from hedge funds with different strengths and weaknesses. “The CTA community, by allowing itself to be linked with hedge funds, has obscured it strengths and inherited the weaknesses of hedge funds.”
Every investment strategy goes through positive and negative periods. That is why diversification is always a good thing. We have learned that an allocation to alternatives — and managed futures is the best alternative to a traditional portfolio in terms of non-correlation and transparency — helps improve overall risk-adjusted returns. Unfortunately many investment strategies have been mischaracterized and misunderstood due to the lobbying efforts of the competing industries that offer them and the regulatory community labeling what are and are not appropriate investments for retail without a solid understanding of the fund strategies.
“There is a natural tendency to want to get safe at the worst times,” says Sowanick, adding that to be successful in the future, “We need to get into the weeds.”
Hopefully as a result of the current crisis regulators, analysts and all those entities that help form public perception will look more closely at the various investment products out there and provide better information regarding the benefits and risks of each investment strategy.