“Only invest with managers with 5 year track Record”
“Don’t invest in a program with less than $50 million under management”
“Make sure your investing with someone who’s ‘been there’ before”
A lot of investors out there (including us at times: here and here) have some hard and fast rules when it comes to selecting managers for their alternatives portfolio. Indeed, this is why the large keep getting larger (see Winton recently surpassing $30 Billion, Bridgewater over $100 Billion, and Nassim Taleb’s rant on the futility of trying to play at this game where winners take all). Last time we checked, the breakdown of large versus small managers looked something like this:
Data Courtesy: Attain Post “So You Want To Be A CTA“
At a certain point in an investors filtering and due diligence, only one or two names remain. If you want a program with a 10+ year track record, performance profile of x, staff of at least y, in house compliance, legal, etc. etc. – your list starts to dwindle in a big hurry, leaving just the largest players who have been around for a long time. Turns out asset raising is as much of a winner take all game as ride share apps and search engines.
But are these investors missing the forest for the trees (albeit redwoods), so to speak? Are they doing themselves a disservice by only going with the old hands? Is there a case to be made for the new guys on the block? Turns out there most certainly is – from a pure performance standpoint.
We took a look at our culled database of 600+ managed futures programs going back into the 1980s to find out just how ‘new programs’ perform compared with older programs, plotting the average performance by year of track record across hundreds of programs. This shows the average performance of each program in its first 12 months, its next 12 months, the 12 after that, and so on and so forth until looking at the 10th year (12 month period) of track record for those programs which go out 10 years plus.
(Disclaimer: Past performance is not necessarily indicative of future results)
You can see a definite downward sloping curve, showing that programs do very well in their first year, great but somewhat less well in year two, and worst and worse until year 8, when there is a bit of a move back to normal levels.
What is going on here? First and foremost is a bit of backfill bias. What is that? Well, when managers submit their programs to the database in hopes of raising money, they rarely do it after posting three years of negative returns. The more usual pattern is for a manager to start out, have success, and then submit their program’s performance to the databases, “backfilling” the data to their first month of trading. This creates very good looking first years of returns, as the poor first years were never submitted in the first place. They never became official ‘managers’ and never got into the database for us to analyze at a later date (what’s called survivorship bias).
But there’s more than just the bias issues happening here, because even if we ignore the first three years of track record – the same pattern exists:
So there must be something more than just backfill bias – which, by the way, is not more than 18 months in our experience, on average. That something else could be what the MJ Blog, (unfortunately, it’s not Michael Jordan’s blog) calls Structural Alpha. That’s what we’ve referred to as smaller managers being able to access markets like Corn and Cocoa and the rest which the Billion Dollar plus managers can’t because of position limits and market impact (i.e. when they want to exit, their size moves the market so much as to hurt their position). Speaking of market impact, or slippage as it is known in the systematic trading world, here’s our old visual from this post on the extra large managers trying to exit a trade.
Protecting vs. Performing. Which leads us to the final answer here, which is established managers making a natural transition to asset protectors versus asset performers. This is a bit of a cliché and there’s more than a few high profile big firms which still swing for the fences. But more often than not, the normal performance profile for managers is higher returns and higher volatility in the early parts of their track record. There’s a few reasons for this, including manager naivete at their outset, where they simply didn’t know as much as they do now in terms of risk control, the known unknowns of risk, and operational efficiencies. You know the old saying… if I’d known then what I know now.
There’s also the simple math of risk reward. When young and starting out, just like in many endeavors, it is well worth the risk to be a little more aggressive in order to make a name for yourself, in a sort of ‘better to have loved and lost then never have loved at all’ type game. But as you get more successful, as you become ‘married’ to a track record and large number of assets – the risk/reward shifts. Sure, at a base level you have to keep performing. Nobody’s going to stick with you forever if you’re not. But the risk shifts from a risk of not ‘making it’ to a risk of losing what you have. As an example, if you lose -20% in a month, you might lose 50% of your assets. If you lose -20% over three years, you might lose 5% of your assets.
The big institutional investors may argue it isn’t worth the risk for them to take a chance on a new manager. Now, they are often talking career risk there, why take a flier on a new manager when you can get most of the return with an established manager and not risk operational issues, big reversions to the mean, and so forth which might cost them a job. And for 5% to 10% of their portfolio – they are probably right.
But for the smaller, more nimble investor who is after better risk adjusted performance – and doesn’t have a job to worry about losing, and is doing more than 5% in alternatives; is avoiding the perceived risk of less sophisticated operations, a smaller staff, and more worth the trade off in performance? Can you actually get the better performance outlined above by trying out “new talent.” We sure think there is a case to be made for the new manager. And an even stronger case for the new manager who makes it through a due diligence process where many of the operational issues that are a perceived risk can be removed as an issue. And an even stronger case for the new manager who isn’t really new – who instead is a disciple of an established manager, of a trading desk at a bank, and so on. We know a few names, if interested.
There are risks to new managers – but most of them are identifiable, and thus able to be addressed. And the risk is mirrored by defined advantages to new managers. So if you’re in need of a little something extra. If in need of a diversifier to your diversifier, a satellite strategy to your core managed futures holdings, there are worse things you could do than looking at a new manager. Sign up here to be notified of new managers and funds which become available through our industry relationships.