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Second Guessing the Wintons of the World

December 4, 2012

 

 

We live in a world where bigger is always better. Our Hummers may not be fuel efficient, but they sure look sharp. McMansions are the only way to keep up with the Joneses, off-brand is off-color, and you best not mess with Texas. But to what end is this obsession with "more" a function of base psychology, and to what extent does it push us to act against our best interests?

Don't worry- we're not about to bombard you with a Zizek-esque critique of consumerism, but we have found ourselves asking this question around the office a lot more these days. The past couple of years have been rough for managed futures- there's no way around it- but many of the smaller managers we work with have done well during this time period, and far better than their titanic counterparts. Of course past performance is not necessarily indicative of future results, but why do the very large programs tend to see performance flatten out over time?

This is not to say that some of the largest CTAs aren't quality programs. They are the best of the best across almost every quantitative and qualitative measure. But, their past performance really hasn’t been indicative of future results. After all, the giants of the managed futures space were once well known for double and triple digit returns. Today? Not so much.

Some of them will rebound from the current slump. Others may not. But why are they in a slump in the first place? Why aren’t they 100 times better than a smaller manager when they are 100 times their size? Are they delivering smaller results on purpose? Are they getting too big to access the necessary markets and trades?

The real lesson to be gleaned from the state of the asset class today, in our minds at least, is that bigger isn't always better when it comes to your investment portfolio.

Diversification- How much are you getting?

The managed futures asset class is made up of professional money managers registered as Commodity Trading Advisors with the Commodity Futures Trading Commission. That’s a lot of ‘commodity’ in their titles – but the reality is the commodity has increasingly been getting removed from the commodity trading advisor space.

Many managed futures mutual funds, fund of funds, and other types of platforms like to tout the big names they have included in their portfolios- programs like Winton, Transtrend, QIM, and Campbell & Co. These programs are the sterling standard of managed futures in many ways, with  big name recognition and big assets to back them up. Just take a look at the following listing of 20 of the top CTAs by assets under management:

 

 

Program

Inception

Assets Under Management as of Oct. 2012

Winton Capital Management, Ltd. Diversified

Oct-97

$26.4 Billion

Aspect Capital Limited Diversified Program - QEP

Dec-98

$6.8 Billion

Quantitative Investment Management Global Program - QEP

Oct-03

$3.5 Billion

Graham Capital Mgmt., L.P. K4D-15V - QEP

Jan-99

$2.9 Billion

Graham Capital Mgmt., L.P. K4D-10V - QEP

Feb-95

$2.7 Billion

Campbell & Co., Inc. Fin., Metals & Energy (Large) - QEP

Apr-83

$1.6 Billion

Altis Global Futures Portfolio - Composite - QEP

Jul-01

$951 Million

Kaiser Trading Group Pty. Ltd.

Mar-98

$950 Million

Harmonic Capital Macro Value

Jan-07

$886 Million

Renaissance Technologies LLC RIFF - QEP

Oct-07

$818 Million

Quality Capital Management, Ltd. Global Diversified

Dec-95

$772 Million

Mesirow Financial Commodities Mgmt, LLC Abs. Return - QEP

Jun-05

$770 Million

Millburn Ridgefield Corporation Diversified Program

Feb-97

$745 Million

Crabel Capital Mgmt. Crabel Div. Futures 4X

Jan-92

$743 Million

Beach Horizon LLP

May-05

$738 Million

Welton Investment Corporation Global Directional

Jun-04

$713 Million

NuWave Investment Mgmt, LLC Combined Futures (2X) - QEP

Jun-01

$616 Million

BEAM Bayesian Efficient Asset Mgmt, LLC Multi-Strat.

Mar-10

$600 Million

Chesapeake Capital Corporation Diversified Program - QEP

Feb-88

$598 Million

Willowbridge Associates, Inc. Argo

Aug-88

$575 Million

 

 
However, solely relying on these so called commodity trading advisors may not be giving you the commodity market exposure and portfolio diversification you look for in the managed futures space. Each CTA has their own criteria for selecting which markets they’re going to trade with which models, but generally speaking, managers pay close attention to things like inter market correlation, volume, and liquidity when selecting a portfolio of markets on which to trade their models.

But for the larger CTAs, volume and the resulting liquidity can often become the only thing that matters. When you’re managing close to a billion in assets, finding a market that can handle the volume one of your orders generates can be difficult.  Indeed, many of the traditional commodity markets like grains, meats, and softs can’t really handle very large orders without causing a market reaction; and a systematic program doesn’t like to cause a market move – they want to follow a market move.

The result? Many of these so called commodities programs have seen their portfolios get heavier and heavier into financial markets like interest rates, stock indices and currencies.

How much exposure are we talking? That’s a hard question to answer. Our experience tells us that it’s substantial, but pooling data on the subject is no simple task, as not every program shares their exposure, either intended or actual. But from the sampling of data we were able to pull from correspondence, disclosure documents and marketing material over the past several years, it’s definitely something to consider.
 

Program

Total Financial Exposure

Harmonic Capital Macro Value

88%

Quantitative Investment Management Global Program - QEP

84%

Winton Capital Management, Ltd. Diversified

76%

Campbell & Co., Inc. Fin., Metals & Energy (Large) - QEP

76%

Chesapeake Capital Corporation Diversified Program - QEP

54%

Quality Capital Management, Ltd. Global Diversified

48%

Altis Global Futures Portfolio - Composite - QEP

39%

Average

66%

Some of the exposure here isn’t all that shocking. Altis and Chesapeake, for instance, have far more traditional exposure than the others in question. Some of the other programs, however, show very heavy exposure to financials, with an average financial exposure among a sampling of the 20 largest CTAs coming in at nearly 70%.

Why does this matter? Well, on the face of it – people want exposure to commodity markets. So much so, that they constantly lose money doing so via long only commodity ETFs. Commodity trading advisors are a natural fit for those looking for smarter commodity exposure, unless they aren’t really giving investors any real commodity exposure.

One of the things that many CTAs like to boast is that they’re giving you access to price movements across a wide array of asset classes. However, if the amount of "size" they can do in a market like wheat is a tenth of what they can do in the financials because of liquidity issues, are you really getting exposure that counts for  diversification? If wheat has a breakout move like it did this summer, is the nominal amount of exposure really going to move the needle? We're not so sure.

Finally – there is the little problem that financials (especially bonds) have generally been a good place to be for trend following type managed futures programs over the past decade. No doubt that is another part of the reason for so much exposure to that sector. But what if the exposure starts to become over-exposure right when financials don’t produce a tailwind for the asset class? Then what? Can these behemoths change their stripes and move nimbly enough not to disturb markets like cotton, platinum, cattle, hogs, corn, and more? We don’t think so.

Direction Matters, Too

But diversification isn’t solely derived from market exposure; it’s also about how these managers trade the markets in question. Managed futures programs can take advantage of trends both up and down, and there are hundreds of ways to alter the way a program attempts to take advantage of such trends, but it’s the bidirectionality of the trading that, at its core, helps managed futures program to avoid correlations with other asset classes.

The ability to go long and short different asset classes is indeed one of the main reasons so much money is with the behemoths in question, and why they all had such good 2008 performance during the meltdown for nearly every other asset class (including hedge funds).

Given this - you can imagine our interest when our friends at Sunrise Capital indicated that some of their ongoing research seemed to indicate that the larger CTAs may have forsaken this long/short advantage for a stronger long bias.

The best way to highlight this trend is by looking at correlation levels. The Newedge CTA Trend Following Sub-Index tracks the largest trend followers in the space, including Winton Capital, Man Investments, Transtrend, Aspect Capital, Brummer and Partners, Graham Capital Management, and Campbell & Co.. If you take a basic long-short trend following model, and a basic long-only trend following model, and look at their correlation to this Sub-Index since 2000, this is what you get:

 

Year

Correlation to Long/Short Model

Correlation to Long Only Model

2007

0.7335

0.7588

2008

0.7350

0.7654

2009

0.7537

0.787

2010

0.7365

0.7845

2011

0.6949

0.8213

 

No, you read that right. Correlation between the Sub-Index and the long-only model has been consistently increasing since 2000- including 2008. That being said, the idea of a long bias is not exactly revolutionary; indeed, some CTAs believe that inflation and increasing world population and so on create an inherent long bias in markets.

But as the saying goes, trees don’t grow to the sky, and it could be argued that many of these upward trajectories have been fueled by falling interest rates, dollar printing, Chinese expansion, etc. When the scenario eventually reverses, will these programs have swung too far to one side to capture those trends? It’s a question without an easy answer, but one worth asking.

Is it worth it?

Ok, you may be saying, so maybe they’re not all that I thought they would be. Maybe they don’t give me the commodity exposure I would ideally want. Maybe they have a built in long bias.  But they have to have some awesome performance, right? Investors chase performance, and these guys are big. There’s got to be a reason for that.

They definitely have some awesome lifetime performance – and for many that is enough to close the deal, mentally extrapolating that performance into infinity. But the real question you should be asking yourself is what they’re doing now that they’re big.

When a manager gets to be a certain size, their ability to be nimble starts to wane, and their drive to take risks may also start to diminish. It’s the football equivalent of playing a "prevent" defense where your team has the lead and plays to "not lose" instead of playing to win. And really- can you blame them? When your 2% management fee on $10 Billion equals $200 million a year, you can see the incentive to protect the principal instead of growing it.

Take Winton Capital, for instance. FINAlternatives reports:

Winton Capital Management's profit jumped by almost a quarter last year, after assets under management grew by more than half.

The London-based quantitative hedge fund said that its 2011 after-tax profit was £162 million, up 23% from 2010. Revenue rose to £282 million, a 24% jump.

Winton's assets rose by almost 65% in 2011 to US$28 billion, making it the fourth-biggest hedge fund in Europe.

Much of the profit went right into the pocket of Winton founder David Harding. Harding reportedly earned £87 million last year.

These guys don’t need double digit returns to keep the lights on, that’s for sure. And we can’t help but wonder if that played a role in how they’ve proceeded with their program. As we wrote earlier this year:

Harding acknowledged the deleveraging that his programs have gone through over time. If you’re not familiar with managed futures, maybe this doesn’t make sense, or maybe you equate the leverage conversation with things like Jon Corzine’s risky bets, but leverage in the managed futures world isn’t about borrowing money to amp up returns. Leverage in managed futures is about risking more on a per trade basis (i.e. – doing more contracts). The issue with this is that an investor can fall in love with a program’s early history returns on a higher risk basis, yet now be in store for lower returns (at lower risk per trade levels) as the manager’s delever (either by design to protect their huge AUM levels or as a result of becoming more sophisticated with their risk models).  Now, for the more conservative investor, this may be a good thing, but for those relying on past performance to guide their investing decisions, this is a good example of why past performance is not necessarily indicative of future results. The chart below shows the 12 month rolling average of the absolute value of Winton’s monthly returns. That downward slope? That’s a pretty good visualization of how deleveraging can change a program, and brings up that old question of whether or not bigger is always better.

 

DISCLAIMER: PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

However, as we surveyed results for more of the titans, we found that this wasn’t an isolated case. We looked at the average positive and average negative monthly returns for twenty of the top managed futures programs by assets under management on an annual basis, and here’s what we found:

 

Over time, as assets have accumulated, the returns have diminished across the board. What’s more, the risk hasn’t decreased proportionately. Consider these titans had average positive monthly returns of 2.8% in 2000, compared with just 1.09% this year; while the average negative return was -1.47% in 2000 and -1.22% in 2012. These results, juxtaposed with a strengthening long bias and increasing financial exposure have us asking… is our attempt to keep up with the Joneses by chasing big name managers hurting us more than we realize?

Now, to be fair – this decreasing return phenomenon is seen on the rest of the BarclayHedge CTA database as well, so there is more going on that just the manager size – but we’ve mentioned that, haven’t we? Still, our research shows the decline being more pronounced on the larger CTAs – and as we pointed out at the top of the piece, they are supposed to be 100 times better, right?

Another point to consider in terms of falling returns and risk is that there is a point of diminishing returns (pun intended) in the quest to improve risk adjusted performance. Managed futures do not exist in a vacuum, and there is a point where even if they exhibit attractive risk adjusted performance by lowering the risk and the return (but increasing the ratio of return to risk) – the investors will find it less attractive because it isn’t providing a minimum acceptable amount of return. Said another way – the assumption that investors want as much risk taken out of their investments as possible is not ringing true with many of the investors we talk to. They want some higher risk in exchange for potentially higher returns.

What’s the alternative?

We understand the appeal of big managers. It’s like the old business saying – no one ever got fired buying IBM. Similarly, the institutional investor mantra seems to be, nobody ever got fired buying Winton. And at its most basic level, it’s about security. You’ve heard the name. You know of the program. Nearly every other institutional investor has given them their money, so they can’t be all bad. That whole safety in numbers thing.

The problem is that these programs are only secure until they aren’t. John Henry was one of the largest and oldest programs in the game, and their doors, as we recently wrote, are now shut. There are no guarantees, but we understand that desire for security. What’s more, for some institutional investors the large managers are the only game in town. They usually only want to invest in increments of $25mm to $50mm, and for a smaller program, that could end up being the bulk of their assets - an arguably undesirable position for the large investor. The problem is, if you’re looking for the managed futures performance of lore from the titans out there (while, of course, acknowledging that past performance is not necessarily indicative of future results), you may be looking in the wrong place.

That doesn’t mean that there aren’t other managers out there with the profile you seek. Like Rosetta Capital, an agriculture market trader with over a ten year track record and a compound ROR of 42.52%, up 21.59% year to date. Or Covenant Capital Aggressive and their 40% financials exposure, with almost nine years of track record and 66.26% months profitable. Or Quantum Leap Capital, with 6 years of performance and a 21% year in 2011 when the rest of managed futures was struggling. They don't have the name recognition of Winton, and they aren’t going to be looked at by the large institutions, yet, because they are too small. But does that mean they’re no good for you? What is good for you and what you want is likely a whole lot different than what the multi-billion pension fund is after.

Now, each of these programs have had their struggles (with maximum drawdowns of -39.67%, -20.41% and -24.44%, respectively), and no, past performance is not necessarily indicative of future results, but the point is that there are plenty of options out there.

Just because the grandfathers of the industry are slowing down doesn’t mean the rest of the world is. You simply have to keep your eyes open.

 

 

IMPORTANT RISK DISCLOSURE


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IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.

Past performance is not necessarily indicative of future results. The performance data for the various Commodity Trading Advisor ("CTA") and Managed Forex programs listed above are compiled from various sources, including Barclay Hedge, Attain Capital Management, LLC's ("Attain") own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

The dollar based performance data for the various trading systems listed above represent the actual profits and losses achieved on a single contract basis in client accounts, and are inclusive of a $50 per round turn commission ($30 per e-mini contracts). Except where noted, the gains/losses are for closed out trades. The actual percentage gains/losses experienced by investors will vary depending on many factors, including, but not limited to: starting account balances, market behavior, the duration and extent of investor's participation (whether or not all signals are taken) in the specified system and money management techniques. Because of this, actual percentage gains/losses experienced by investors may be materially different than the percentage gains/losses as presented on this website.

Please read carefully the CFTC required disclaimer regarding hypothetical results below.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.