Episode #02 Insights into Managed Futures featuring Amy Elefante Bedi, Ernest Jaffarian, Phil Hatzopoulos
Introduction Welcome to CME Group's podcast series on managed futures. My name is Niels Kaastrup- Larsen, and I'm the host of the podcast Top Traders Unplugged. Today I'm delighted to welcome you to a series of short conversations with industry leaders in managed futures. I'm joined by Amy Elefante Bedi, director of hedge strategies at Washington University Investment Management Company, in Saint Louis; Ernest Jaffarian who's the CEO of Efficient Capital Management, as well as Phil Hatzopoulos, who's the Global Head of Buy Side Sales at the CME Group. 1
Niels: Amy, as an investor, it's not good news when we think of low performance. How do you frame this development in your decision making about investing in hedge funds and in managed futures in general? Amy: It's certainly something that's come up, repeatedly, over the past few years with the disappointing performance across hedge funds in general. For us, probably more so there than with a specific focus on managed futures, but we could touch on both. On hedge funds, broadly, we think that the purpose in our portfolio is independent returns. So, we have to look at beta exposure, which isn't very significant in our portfolio. We still do have alpha generation taking place - maybe not at the levels we'd like to see, but I'm hoping that returns to more of a normal situation as a little bit of assets flow out of the industry and markets return to more of a normal state. In terms of managed futures, in particular, the bulk of our portfolio is exposed to equity-like risk. As Ernest was saying, we look to them to protect performance in periods that are challenging for equities, and that's not just where we've been. So, over time we still expect non-correlated equity-like returns for CTAs over a full market cycle. We're OK with that being a bumpy path. Niels: Sure, absolutely. Now, before we leave this topic of performance I want to, again, turn to you, Phil, and just see if you've noticed any shift in terms of the landscape of managers - in, let's say, the emerging managers or managers that have simply had to close shop because they can't attract investors in the first place in this subdued performance environment? This clearly impacts, of course, the liquidity in the business if we have a decreased number of managers in this space. 2
means. Phil: Interestingly enough, I mentioned at a previous point that we've seen twenty-seven straight months of inflow. But at the same time, the statistics that the NFA, National Futures Association, puts out, here we've got the fewest number of registered CTAs today since 1988 - when you think about what that Is it because managers can't attract investors? Is it because there's a bias towards 'only the largest shall survive' and there's been a consolidation? I think it's probably healthy for the industry to have a shakeout. I expect as markets normalize we come back to the period that Ernest referenced earlier where, in the future, we'll see the returns mean-reverting, then you'd probably see that number expand. When we talk to some of the institutional investors, although we are hearing that they're looking for smaller niche managers to fill particular gaps in the portfolio, and they're out looking to allocate to some of the smaller hedge funds and CTA managers. At the CME we're agnostic. We will provide support to the smallest or the largest CTA equally to help them succeed in their business. Niels: Sure, great. I also heard some talk recently about liquidity and concentration of positions among managers. In the CTA space clearly, some managers have now started to go outside the exchange traded futures which, so far, has been one of the trademarks of the industry. This might, of course, add some concern on the investor side should we have another financial crisis at some point, which I'm sure we will. Are these concerns that you think about, Amy? Do you find that CTAs are becoming more similar in the way that they invest? How do you look at this, if at all? 3
Amy: In terms of exposure to less liquid types of contracts, that's something that I think can be quite diversifying and we are interested in doing, but, maybe in a limited size. Which I expect would be the perspective that many investors would share. I think in terms of the overall liquidity in the market and managers behaving too similarly; I'm not horribly concerned with that just because the overall size of the industry is still significantly smaller than its historical peak. I find that to be somewhat comforting. I think, for me, it's more a matter of capacity concerns with individual shops and the fact that if everybody is trading fifty-billion dollars, the diversification benefits of investing, in commodities, and foreign exchange tend to be significantly diminished. Niels: Sure. Ernest, in a firm like yours, you spend a lot of time actually looking at the individual positions of the managers, I assume. When we look at performance (at least in my mind) the return disbursement between managers is actually higher than I remembered it to be for quite awhile. This, in some ways, suggests that there isn't really a concern about concentration positions and themes, certainly not, if you take into account the actual strategy that they employ. What's been your experience in that area? Ernest: Well first, you're absolutely right about many CTAs expanding, shall we say, their trading programs. A trader that we've had a relationship with for many years now has 30% exposure to equities. That's not why we invested. That's not what institutional investors are looking for. Since we've had a managed account forever, we still have the pure futures program. We do not participate in that expansion, to keep the pure access to the CTAs. Another CTA has added a 30% component to value trades. They're a good diversifier for the CTA. Again, when an institution comes to us they already have their value exposure in other places. That's not what they're looking for out of the CTA space. One of the things that you do have to do is you have to ask yourself the question, "Am I really getting the program that I think I'm getting because programs do evolve." 4
The other big thing that you made reference to, which is really true, is that as a manager's size grows (and we see every position) what happens is that they have to concentrate their position on the deepest, most liquid markets which means that they start to lose their diversification. The dispersion among core macro momentum managers is usually easily traced to where they have their exposure. Do they have a heavier exposure in equities, or in FX, or some other sector, and that sector gave opportunities while another sector didn't give opportunity? We find, in our portfolio, we tend to give about 30% of our exposure to the core, traditional momentum and try to keep it pure, not let the other elements slip in. Then, we use 70% of the exposure for unique and diversifying managers within the CTA space. Most people don't realize how broad this space is. That allows for a balanced exposure across multiple sectors because a smaller manager can still play really effectively in the less liquid markets, but it takes a combination of managers to get that access. One can't just go to one large CTA and get that balance. Niels: Sure, sure. Very true. If I can bring up one other topic in this question, it would be smart beta versus traditional managed futures, because if we're concerned about products that are becoming too similar, I think we should be concerned about the smart betas. There are fewer ways, in my opinion, of being different when it comes to creating a simple replication strategy. Thus, strategies could end up being very similar in their approach and also in their positioning. Ernest, what's your view on that? Is it a smart decision for investors to use a cheap alternative, or is it true that you get what you pay for? 5
Ernest: Yeah, there's two different sides to that question. Let me just say, that because, from my perspective, there is an overemphasis on the fee question, many times we'll see people invest because they "got the best deal." That's not the best idea. In our core product we can invest in any CTA program of any type. If we see a program at 50 basis points and zero, and net of fees and we feel it's significantly superior to other investments we have, we are not constrained at all. We certainly can invest. Have we yet made that kind of investment? No, and the reason is because of all of our mathematical analysis we still think that getting the best thinking of a manager provides the best value. The only question then is, what's the appropriate compensation? So, I understand the movement towards smart beta. I understand the focus on fees. But, I say getting the best thinking of a manager in the CTA space is the best value proposition - let's talk about what the right level of compensation is. Niels: Now, another theme that I have met a lot in my traveling is this whole fixed income ghost that a lot of investors are worried about when they see that managers are still long bonds, or still long short-term interest rates at the moment. I just wanted to ask whether this is a valid concern? Should investors be worried about individual positions when, clearly in the CTA space, they are buying a systematic process that is not predicated on forecasting anything? That's part of the diversification they're getting from these managers, unlike the discretionary managers. I don't know who wants to go first on this one, but, should investors be that detailed in their concerns? 6
Amy: To me, if you have looked at drivers of returns, over time, and gotten comfortable with the fact that they come from diverse places it doesn't make sense to be overly concerned about this in the long term. In the short term, it seems as if choppy rates are causing problems for some strategies. But, I think all the studies have shown that longer-term trend following can do very well across all types of bond markets, but this question certainly continues to come up. Ernest: I've been in this business long enough to remember when rates went up, and the CTAs did very well in that environment. Just an interesting data point: our core portfolio has exposure to well over twenty managers. It reversed its rate position this last week. It's a very small position, and it could flip back again, but I think that people don't appreciate the fact that positions among disciplined, systematic traders (and well thought methodologies), they're responsive. Actually, I personally believe that if rates were to reverse and go up, it's the opposite of stocks. You don't worry about stocks crashing up, but you do worry about them crashing down. Rates, if the economy starts to heat up, can crash up. The same way that people look to CTAs and say, "I need some protection in a serious negative event in the stock market." I think they need to say, "I need some serious protection in a serious, very fast rise in interest rates. Now, I'm not predicting that. I don't believe, personally, that that's going to happen in any reasonable short timeframe, but I do not concern myself that CTAs would capture that. They would capture that move. Niels: Absolutely. 7
I want to bring our conversation to a close with a few short questions if you don't mind. I would love to hear your different opinions as you represent three different parts of the managed futures industry. What's the biggest threat, and what's the biggest opportunity for the managed futures industry as we head into 2017? If I could start with you, Phil, on this one. Phil: It's always hard to know what the biggest threat is. You won't know until after you've seen where it's behind you. But, markets that don't behave as you expect, government intervention - we've seen with the bond buying, what that's done to correlations and make trend following very difficult. So, I think that remains a risk going into 2017. Then there's the volatility, and Brexit, and what are the markets going to look like going forward? Also, a different risk is that we've read about this shift into passing and passive investing. We're coming up on seven and a half years of a Bull Market in equity and memories are short. So people are thinking, "Oh, look at the returns on the S&P Index." Even though they're completely incomparable, in my opinion, the risk there is as momentum gains speed into 2017, if the Bull Market continues, where people take money out of active into passive. Niels: Sure, sure. Absolutely. Ernest, what do you think of this? Ernest: Yeah, I'm not worried about the markets. That's not the biggest threat. People should remember that the futures markets were the only markets to stay open all the way through Black Monday (I was a floor trader back then). I think the single, biggest threat to the CTA world is a regulatory threat. Regulations could destroy the industry. 8
For example, if all transactions started to get taxed it can become cost-ineffective to trade the financial markets because of the fee load that's being placed on them. Or (and we've seen this already happen) where regulators in their infinite wisdom say, "You know what? We can't allow any short trades right now because we don't want to take any chance of someone trying to push the market down." Now, you don't have a true free trading market. It destroys the ability to trade the market appropriately. If the regulatory reporting requirements rise to an unreasonable level and the pure costs that just your infrastructure needs to support your business (to meet all the regulatory reporting requirements) can really sabotage smaller, competitive businesses. So, the good news is we've got a pretty effective market system. We can handle financial crisis'. Let's just all work together to make sure that the regulatory side of the business stays at an appropriate level. Niels: Sure, sure. Amy, any thoughts on this? Amy: I suppose, coming at it from a more performance perspective, I think the biggest threat is that the crisis alpha properties that we're all looking for are somehow diminished by a factor that we're not anticipating. I'm not predicting that that will happen, but it's been a frustrating patch, of late, for the medium term guys, with markets being choppy and range bound. I tend to think of managed futures strategies as agnostic to the macro environments. It's been a prolonged period that's been frustrating, for sure. Niels: Sure. I want to stay with you for little while longer and just ask you: When it comes to investing in managed futures, what's been the biggest challenge for you as an organization, not necessarily for you as an individual, to overcome in order to embrace this space? 9
Amy: So, we're committed to the concept that these are strategies that offer protection to an equity portfolio that we really need, and that they're unique in that they offer positive expected returns while doing that. The problem is twofold, and maybe these issues are interlinked. I mentioned the bias among institutional investors that these strategies are 'black boxes.' That tends to be somewhat paired with reluctance, historically in the industry, to give significant transparency to investors where they can get comfortable. I have joked in prior conversations about having a meeting where you felt like you were talking more about having a meeting rather than having an actual meeting where you learn something about what the manager did. I think it's, at a minimum, reasonable for investors to have a sense of how trading systems are developed, what they're designed to do, what situations would work well or not work well for those strategies. It can be a very long education process, in some cases, for us to get managers to see that we need that information. Then, having the well-informed investor can mean having a longer tendered investor that can serve everybody well. In some cases, we've just never gotten there and have had to pass on allocating to certain firms. So, that's the start of the conversation. Once we've gotten comfortable being able to communicate internally that these are a different flavor of an important partnership that performs a role that's fundamentally comprehensible - that's another element that's also challenging. Niels: Sure. OK. Now, it's said that if somebody wants what you're selling, the only thing that stands in the way of them getting it is fear. So, Ernest, how does the managed futures industry remove that fear that some investors clearly have for this strategy? 10
Ernest: I don't know that the managed futures industry can. We've developed some financial engineering techniques that can move risk more from the investor to the manager, and that can certainly help. I do agree, and I value the role that the CME plays - education is so important. Ultimately the investor has to do the hard work of understanding the characteristics of the space. If they don't, I can assure you that they will divest at absolutely the wrong time and they will invest, again, at absolutely the wrong time. So, education - and that's not something a manager can sell in a presentation, sitting across the table, talking about how good their returns are. That's something that we have to all, collectively in the industry, do is commit to helping people really understand the character of the space so that people will invest for the right reasons and with the right time horizon. Niels: Sure. So, we've talked about a few of the key topics in this conversation today. Is there any question that you feel is really important that I didn't ask you, that you want to share as we come to the end of our conversation? 11
Phil: I feel like you've asked several very good questions. I think, from an institutional investors perspective, as they go through the process of making the decision to allocate, again, going back to your previous question about fear. The best way to overcome fear is knowledge. So, you fear the unknown. The more they learn, and reach out, and take advantage of resources available (certainly by the CME group) to help educate them on managed futures, it would certainly help in ultimately reaching the decision of allocating. Ernest: I would just make a concluding comment that the managed futures space, from an investor's perspective, is a complex arena. We have over 8,000 CTA programs in our database. I think engaging the help of people that have dedicated themselves to the managed futures space is important. I don't mean that in a self-serving way. Tapping into the resources at the CME is a good example of that. There's a lot of good literature. So, I would just say that it's really important not to come in just saying, "I'll buy this manager," or, "I'll buy that manager." It's really important to actually do the heavy lifting of research, and rely on people that have focused their careers in this way. Amy: I suppose my only remaining comment is just that there is, I think, a lot of tension between optimal portfolio construction and optics that we could all live with. That's something that I think all investors need to grapple with in their own way. 12
Niels: Amy, Phil, Ernest, thank you very much for sharing your thoughts and opinions on managed futures. I really appreciate your openness during our conversation today. To our listeners around the world, let me finish by saying that I hope that you were able to take something with you on your journey in the investment world. If you did, please share these episodes with your friends and colleagues and send us a comment and let us know what topics you want us to bring up in the upcoming conversations with industry leaders in the managed futures space. From me, Niels Kaastrup-Larsen, thanks for listening. I look forward to being back with you on the next episode. 13
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