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Looking through the "Mirage" to Managed Futures
August 13, 2012
There’s a reason we frequently regard hedge funds as a headache. The media usually lumps in managed futures when talking about some of the perceived bad stuff about hedge funds (survivorship bias, high fees, etc.) while failing to distinguish managed futures from hedge funds when it comes to discussing other items like poor crisis period performance, transparency, and liquidity. Managed futures often gets lumped in with the bad- even when it doesn’t apply.
While we missed it when it came out, a book called The Hedge Fund Mirage:The Illusion of Big Money and Why It’s Too Good to Be True, by Simon Lack, appears to be causing some of those guilty association issues between Hedge Funds and Managed Futures.While flying mostly under the radar for the first half of the year, the book has seen some recent interest as the Alternative Investment Management Association, or AIMA, saw fit to weigh in on the author’s assertions, leading to further blog posts and debates around the internet, in turn leading to a few clients of ours calling in asking for our thoughts.
We don’t like to debate things we haven’t read, so we picked up the book. As it turns out, there were a variety of arguments we agreed with and make ourselves on a regular basis (like hedge funds are just risk adjusted stock exposure dressed up as alternatives). A few more were drawn from questionable perspectives, but our biggest bone with the book was its treatment of managed futures- in that there were never any distinctions between the asset class and the rest of its hedge fund brethren
And of course the big talking point of the book is the line most often quoted from it, Lack’s assertion that, “if all the money that’s ever been invested in hedge funds had been in treasury bills, the results would have been twice as good.”
That sure got us thinking… is the same true of managed futures? We tackled the issues one by one to get to the conclusion.
The Big Black Lockbox of Doom
Some of the arguments raised by Lack deal with how opaque hedge funds can be, making them hard to navigate as an investor. His background in investment banking gave him the ability to recall in detail the innate secrecy of hedge fund managers. Any openness regarding the investments of a firm were large interpersonal. He highlights an interaction with one manager, explaining, “When we asked if we could see the portfolio on a regular basis, Marc [the manager] said we were welcome to stop by any time and he’d talk about any position we liked. This was portfolio transparency at that time- there would be no computer file e-mailed every month with a list of positions, or access granted to the fund’s custodian, but we could visit anytime we were in the neighborhood and chat.”
Lack goes on to lament the liquidity of hedge funds, with the use of lockup periods and withdrawal penalties being the most common. However, a more insidious restriction on liquidity is the institution of so-called “gates,” where redemptions will be blocked at the sole discretion of the manager on the basis of market conditions and “protecting the investor.” Lack cites the Credit Crisis in his isolation of the harms therein, highlighting 2008 as an example of a time where the use of gates was potentially abused.
A quite staggering episode involved Randy Lerner, billionaire owner of the Cleveland Browns NFL franchise and Aston Villa (an English football club) in 2010. A dispute arose with a hedge fund he had seeded when he tried to withdraw his investment. The manager of the fund, Paige Capital, suspended redemptions because Mr. Lerner’s withdrawal represented more than 20 percent of the fund’s assets. Although this is not an uncommon mechanism to protect investors that don’t wish to redeem, in this case Mr. Lerner represented almost all the assets in the fund. It was in virtually all respects his fund. Nonetheless, the case wound up in court, and as (Vardi, “Billionaire Cleveland Browns Owner Claims Hedge Fund Is Hiding His Money,” 2010) memorable quoted from the court documents, “[W]e are fully prepared to litigate this matter to the bitter end because we will continue to manage your money, and collect management and incentive fees, until this matter is resolved many years hence,” Christopher Paige, Paige Capital’s general counsel, defiantly wrote in a March letter, court filings show. “You cannot win because you will spend more litigating than we’re fighting over… we decide the best way to protect the funds, and your opinion is irrelevant.” This was to say the least an unconventional reaction from a fiduciary.
These two hedge fund characteristics combine to facilitate manager fraud, in some cases. Lack dedicates a substantial portion of his text to discussing Madoff, and the perils of the funds being held in the manager’s name- giving them ample opportunity to use the funds for purposes not related to investing, like paying bills.
While these criticisms may be fair when applied to the hedge fund world on a whole, there are some important differences in managed futures. Here, via managed accounts, you have full transparency. On a daily basis, an investor can see whether they’re long corn or short gold, and to what extent. Further, you have daily liquidity. Because the trades are placed in each account, your funds are not held in relation to someone else’s, allowing you to allocate and withdraw as you see fit without impacting the other investments held. By contrast, in a hedge fund, money is pooled for investment, so a withdrawal can have a significant impact on the fund’s ability to continue its own strategy, which is why those lockups and gates exist.
In terms of fraud, for 10 years we’ve held our heads up high and said Madoff type fraud doesn’t exist in the managed futures world because you invest your money into a segregated account, not in the name of the manager. This keeps the managed futures manager from being able to use your money to buy a plane or fund a permanent trip to the Caribbean. That being said, the past two years have shown the world that the clearing firm processing the managed futures manager’s trade can engage in fraud. Both the MFGlobal and PFGBest cases highlight the potential for such behavior, but we would still rather have our money in a segregated account than in the name of a hedge fund- especially a small one.
Where’s the Crisis Period Performance?
The criticisms related to structure have not been the most contentious parts of Lack’s book, however. The parts that have drawn the most ire have been related to performance. This is where we run into some differences with Lack, as well.
First up, crisis period performance. Lack first argues that hedge funds have let down investors when they needed them most, citing 2008 as the perfect example. He uses the Hedge Fund Research Global Index, which represented the hedge fund industry as down 23% that year. He ignores that investors still outperformed the stock market even with this loss, but our beef with the analysis is that it ignores the asset class that often gets shoved in as a hedge fund category: managed futures. As we’ve told anyone who will listen time and again; managed futures left the rest of the world in the dust during the crisis (Disclaimer: Past performance is not necessarily indicative of future results).
But back to Lack and Hedge Funds - he attributes the poor crisis performance to problems with correlation, but as we’ve written in the past, and we’ll state again here, this isn’t news. Hedge funds, because of their hefty involvement in equities, are very rarely as “alternative” as one might think. He also misses the point that hedge funds, by virtue of their reliance on leverage and funding for that leverage are uniquely prone to a liquidity crisis.
Where are the customer’s yachts?
Reading on, we did take issue with Lack’s assessment of the ‘high fees’ in the hedge fund world (and by association in the managed futures world). In a chapter titled after the famous 1995 book Where are the customer’s yachts?, Lack argues that the total fees gained in the hedge fund industry greatly outnumbers the dollar value returned to investors. To arrive at this conclusion, he assumes that both the management and incentive fees are deducted each year from 1998 to 2008, and that the management fee alone is assessed in the aftermath.
Here is where things get sticky. Lack acknowledges that these are rough estimates, derived by holding performance relative to assets under management. His data for assets under management are taken from the Barclay Hedge database. Speaking from experience, we can tell you, without reservation, that the manager by manager assets under management field in that database is frequently inaccurate. It is often the last thing managers update, and there is confusion amongst managers whether they update it per program, or as a firm overall, and more.
The AIMA report does a good job of taking Lack to task here, citing a 2012 research paper:
The 2012 paper by the Centre for Hedge Fund Research at Imperial College, based on returns as recorded by the HFRI index, produced a very different outcome. As Table 5 below shows, the study concluded that, out of an average gross return over 17 years of 12.61%, 9.07% went to the investor and 3.54% to the manager. Put another way, 72% of the profits went to the investor and 28% to the manager.
But really, the bottom line is this - if you don’t like the performance, then don’t pay the fees. Don’t invest with 2/20 managers then. What we’ve found, and Lack acknowledges in his book, is that investors, as long as they’re happy with their investments, are not bothered by the income of their managers.
T-Bills Outperform Hedge Funds
And on to the line which is making Lack semi-famous: his lament that hedge funds have underperformed treasury bills over the long haul. Again, the AIMA report does a great job of calling out the methodology used in this analysis, saying:
What is really “truly amazing” is that nowhere in the subsequent 174 pages is this “statistic” actually supported by clear figures or working.
In fact even the academic paper (by Dichev and Yu2) cited in the book to support this view contradicts it and says the opposite – i.e., that hedge fund returns have been higher than those for T-bills.
What our own calculations, using the same core data and time period, show is that investors allocated $1.24 trillion to hedge funds from 1998-2010 and had $1.78 trillion to show for it, a 44% return, while the same amount invested in T-bills over the same period would have produced $1.52 trillion, a 23% return.
So to paraphrase the book’s opening line, if all the money that had been invested in hedge funds had been put in T-bills, the results would only have been half as good.
Now, that is all well and good and we’re happy to sit back and watch the two sides debate this for sport. But we also wanted to know - what of managed futures? What if we put the same analysis to managed futures?
Well, using Lack’s same (per the AIMA) flawed model – managed futures did not fare any better than hedge funds in their battle against T-Bills. The main reason, that pesky -3% annual drag Lack applies to the indices to account for survivorship bias as well as the removal of the T-Bill rate from the returns. As Lack found, if you subtract up to 8% in some years, the returns don’t look very good.
But applying the fixes used by the AIMA, mainly the removal of that 3% bias drag, not removing the T-Bill returns from the index performance, and calculating net gains on the net investor contributions – we found managed futures (using the worst performing index, the BarclayHedge managed futures index) to outpace T-Bills by a count of 37% to 15% since 1998 (The percentage gain is different than that arrived at by the AIMA because the gains are taken off of the cumulative net investor contribution, not a straight multiplication by the total % return of T-Bills since that time. We know it’s a little technical, but this is the way Lack approached it and the AIMA defended it).
Now, the two big questions are whether the AIMA, or our analysis – is justified in taking away the 3% survivorship bias and T-Bill return.
We’ve long had on our list to analyze the survivorship bias issue as it relates to managed futures indices, but before we get to that lengthy project – we’re reminded that investor’s don’t invest in indices. They invest in actual programs with actual track records. For us, the disproval of survivorship bias has always been the reliance by investors on the track records of the program they are investing in over the history of an index.
Having said that, we’ll share the AIMA’s thoughts on it as well:
A study by Edelman, Fung and Hsieh (2011) found that many successful funds stopped reporting, as well as those performing badly, and the overall impact was neutral. A study by Agarwal, Fos, and Jiang in 2011 went further and suggested that self-reporting funds actually underperformed non-reporting funds – albeit by a statistically insignificant magnitude of 2-8 basis points monthly. The study also indicated that while a small fraction of reporting funds may be performing poorly, the most successful funds are no more prone to self-reporting.
These broad findings were supported by an AIMA and KPMG-commissioned paper by The Centre for Hedge Fund Research at Imperial College in London, which studied both active and inactive hedge funds and concluded that survivorship bias and self-selection bias effectively cancelled one another out.
What about removing the T-Bill rate from the returns of the index? This is a tougher one to dismiss than you might think at first, especially in managed futures given their ability to fund and margin accounts with T-Bills, effectively having two investments with the same money. Now, most individually managed accounts don’t have any T-Bill interest which would become part of a CTA’s performance track record, but the same can’t be said for commodity pools which often hold T-Bills in the name of the fund and have the T-Bill returns as part of their track record. Now, we haven’t yet done the study on how pervasive T-Bill returns are in managed futures returns (mainly because it is a moot point over the last several years with T-Bills returning basically 0%), but we can say to you that in 10 years of poring through D-Docs and analyzing managed futures returns, we have seen more track records which exclude T-Bill returns than include them.
But even if managed futures returns were inclusive of the return earned on T-Bills, it would be false to say that the entire index return should be reduced by the entire T-Bill return. For one, a fund can’t hold its entire account in a T-Bill, there must be some excess cash to cushion against trading losses. Call it 80% held in a T-Bill. But more importantly, if that return is part of the manager’s return (which is in doubt itself, but assume for the moment it is), why would it be removed when comparing the performance to T-Bills themselves. Imagine a hedge fund manager who invested only in T-Bills (maybe we’ll see that strategy following the conclusions of the book). His return isn’t 0. He has earned the T-Bill rate for his clients (less fees), and that return – not the return minus the return of the investment he’s invested in- is what needs to be analyzed.
This got us to thinking – with managed futures able to invest in T-Bills AND a managed futures program simultaneously via the investment structure, what if there is no T-Bill interest within the managed futures returns, but there could be? What if we went the other way with the analysis and added in the T-Bill interest rate- say 80% of it to reflect that the whole account can’t be in a T-Bill? As you can see below, when flipping the argument on Lack, T-Bills don’t stand a chance against managed futures.
Sources: Managed futures = BarclayHedge CTA Index, T-Bills = The Hedge Fund Mirage. The above figures were calculated by multiplying the reported monthly performance by the prevous year's total assets, then summing the annual 'earnings'
If you’re a hedge fund investor, we recommend Lack’s book (find it on Amazon here). He has some cutting insight into the industry, and his personal experience in vetting and selecting hedge funds makes for an interesting and instructive read. His conclusions however, especially when it comes to his now famous line about hedge funds earning less than T-Bill rely heavily on some questionable assumptions.
Tilt this assumption one way or the other, and you have drastically different conclusions. Use a better index and you have drastically different conclusions. Consider time weighted performance versus dollar weighted and you have drastically different conclusions. You get the point.
For us, it was an exercise worth doing – and a reminder to get two projects on our list: 1. Analyze the effect of T-Bills returns in managed futures program’s success, and 2. A look into survivorship bias in managed futures indices. Which do you want to see first?
IMPORTANT RISK DISCLOSURE
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In indices, the Dow gained 0.90%, the S&P 500 rose 0.96%, the Nasdaq gained 1.87%, the S&P Mid-Cap 400 E-mini gained 1.85%, and the Russel 2000 E-mini was up 1.56%. In bonds, US 10-year notes lost -0.13%, and US 30-year bonds lost -0.46%. In currencies, the US Dollar gained 0.22%, the Japanese Yen gained 0.45%, the British Pound was up 0.18%, the Euro lost -0.69%, and the Swiss Franc fell -0.62%.
In metals, Gold gained 0.84%, Silver was up 0.94%, Copper was up 0.74%, Platinum was down -1.03%, and Palladium gained 0.69%. In energies, Crude rose 1.61%, Heating Oil was up 3.23%, RBOB Gasoline rose 2.49%, and Natural Gas fell -3.72%.
In grains, Corn fell -1.23%, Wheat fell -0.67%, and Soy rose 0.92%. In meats, Live Cattle rose 0.92%, and Live Hogs lost -0.43%. In Softs, Cocoa was up 2.25%, Orange Juice rose 0.71%, Cotton lost -1.24%, Coffee fell -4.27%, and Sugar fell -5.73%.
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.