Managed Futures Selection Factors

Managed futures are marketed as having low correlation to stock and bond markets.  However, within the strategy, returns between managers (known as commodity trading advisors or CTAs) have varied.  According to David Kavanagh, CEO of Grant Park Managed Futures Mutual Fund, and Greg Anderson, Chief Investment Officer of Princeton Fund Advisors, returns are affected by four factors:  type of market securities, trading strategy, timeframe and research methodology.  They may trade in different futures covering currencies, energy, equity, fixed income, food or metals.  Obviously, the trading strategy - whether it is trend following or contrarian - affects returns.  Timeframes are how long a security is held.  They may be held for days or months.  Research methodology determines the trading signals for the manager.  They can be quantitative, top down or technical (charts).

According to Anderson, the four risks in the managed futures space are selecting the wrong manager, poor design of the investment portfolio, trading strategies becoming obsolete due to changing markets and tail risk.  Kavanagh adds understanding the edge of any CTA over its competitors.  The manager selection process considers several factors:  track record, trading strategy, fund's operations and back office, experience of the principals and fit within a portfolio.  On a more detailed level, Anderson would consider the interest income, cost structure (including trading commissions), trading results and an audited performance history.

This article can be accessed here at www.finalternatives.com.

Notes from a Hedge Fund Survey - Part II

SEI and Greenwich Associates conducted a survey of institutional investors and hedge funds.  Part I was summarized earlier.  Part II was released later and dealt with issues on investing, institutional standards for fund evaluation, selection and monitoring.  105 investors participated in the survey.  They could be classified as endowments, foundations, family offices, corporate funds, public pension funds, consultants, union plans and non-profit organizations.  85% of the institutions are located in the US with some in UK, Canada and Scandinavia.  Their assets under management (AUM) fit into four bands:

• 42.2% had less than $500 million
• 15.5% had $500 million to $1 billion
• 25.4% had $1 billion to $5 billion
• 16.9% had more than $5 billion

The new top three challenge for investors is manager selection.  This is due to the increasing number of hedge funds being launched due to the recovery in the markets and Graham-Dodd legislation.  Many have indistinguishable strategies.  If a manager can define his unique strategy to investors in understandable terms, he is ahead of other funds.  In terms of the criteria for selecting managers, investors emphasize investment philosophy, the quality of the personnel on the investment team, risk management and having an identifiable, repeatable source of alpha.  AUM of a fund is low in importance for investors when choosing a fund.  20% have no AUM minimum and 15% have a $50 million to $100 million minimum.  The age of the fund does not seem to affect investors.  According to the survey, 14% would invest in a fund with no record and 24% in a fund with one to three year record.  Large institutions are more willing to hire emerging managers.  Smaller investors favor larger, more established funds.  Smaller investors also are more likely to hire investment consultants for their advice.  Larger investors are more likely to invest directly in hedge funds.

The other worries have remained the same since the credit crisis in 2008 - portfolio transparency, poor performance, leverage, risk management and liquidity.

2011 Investment Outsourcing Round Table

Pensions & Investments published the transcript for the 2011 Investment Outsourcing Round Table that was held on June 1st.  There were six participants from different roles in the investment community.  They were:

• Christopher Delany - associate treasurer in finance and administration at Gettysburg College
• Jay Gepfert - senior consultant at New England Retirement Consultants LLC which evaluates investment outsourcers for institutional investors
• Jonathan Hirtle - CEO of Hirtle, Callaghan & Co. which manages $20 billion in portfolio outsourcing strategies
• George Mateyo II - senior director of investments at the Cleveland Clinic Foundation
• R. Bruce Myers - managing director of consultant Cambridge Associates LLC which manages $105 billion in outsourced strategies
• Kevin Quirk - founding partner and principal of Casey, Quirk & Associates LLC, a money manager consultant

Some interesting ideas discussed were:

There is a movement towards outsourcing as an investment solution because of poor performance in the equity and bond markets, increased demand for alternative investments and institutional investors spending less money and time on managing their money.  Outsourcing has traditionally been confined to the worlds of pensions, endowments and foundations.  Corporations with defined contribution plans (i.e. 401K's) are starting to look at outsourcing to protect themselves against fiduciary risks.

Delaney at Gettysburg College decided to partially outsource the university's endowment.  The college defined the responsibilities of the board, employees and the consultant based on where everyone would add the most value.  The consultant would have access to the best fund managers.  An analysis was done by Delaney to determine where each person would be comfortable and keep those responsibilities.  Any weaknesses would be outsourced.

The current investing environment needs to have disciplined portfolio management across all asset classes.  Currently, the fund industry is based on where the manager invests and the benchmark for that universe (the performance of large cap managers are compared against the Standard & Poor's 500).  This started in the easy investing decades of the 1980's and 1990's.

Outsourcing also has conflicts of interests that need to be avoided.  Consultants that are paid fees by fund managers, paid soft dollars because they are broker/dealers and paid by manager search.

The source for this article can be found here.

New Bottoms Up Approach to Hedge Fund Investing

Investcorp, an investor in hedge funds with $5 billion in assets under management, has created a proprietary, bottoms-up method for choosing the best managers.  Deepak Gurnani, the Chief Investment Officer, started the Alpha Project in 2003.  The research approach consists of reviewing the performance of trades for each hedge fund strategy.  For example, for merger arbitrage, Investcorp examined every merger since the 1990's and analyzed the performance of that classic trade.  These individual trades are compiled into fund returns.  The results are used for tactical asset allocation among different funds, manager selection and investing Investcorp's assets.  Its portfolio has a better risk adjusted return (as measured by the Sharpe Ratio) even after subtracting fund costs (i.e. prime brokerage and stock loan).  This is in stark contrast with traditional research that looks at the performance of equity markets, volatility, credit spreads and currencies to explain hedge fund returns. There are four issues with this approach:

• Fund strategy contributes to returns
• Investors only receive 25%-50% of alpha returns because of the 2 and 20 incentive fee structure
• Risk and transparency issues such as style drift, side pockets and insider trading
• Liquidity

Manager Selection Process for Private Equity

For investors, the manager selection process begins with their investment strategy.  Using this as the baseline, they identify which fund managers match their strategy.  The managers may be ranked in various categories based on their performance and experience.  Any team not falling in one of the following would not be invested in:

• Star - top quartile returns for at least 3 funds for at least 2 business cycles
• Established - top quartile returns for most of its funds (at least 3 funds) for at least 2 business cycle
• Emerging - new fund manager team with limited history in working together
• Re-emerging - turnaround situation;  previously star or established team that is being re-structured, had bad returns or had operational issues

The investors should use their network to find good investments and quality managers.  Star teams are referred to new investors by their current universe of investors.  New investors should establish a relationship with star managers before they start raising funds for their next follow-on funds.

In the prior post, we read a study on how private equity fund manager performance persists from one fund to another.  Therefore, successful managers are oversubscribed when opening a new fund.  They will first allow the investors of the original fund first crack at investing in the follow-on fund.  Because of this, the fund will generally be closed before new investors are invited.  Fund managers tend to retain known investors as fund raising can be time consuming and expensive.  New investors that could be invited to the fund would be those with industry experience or can help in exiting positions.

Once a manager is found and is receptive to having the new investor in a fund, the next step for the investor is to conduct due diligence on the manager.  The first step is screening.  This means eliminating funds that do not have the right investment strategy or performance/quality requirements.  About 1/3 to 1/2 of funds are pass this stage.  Then the investor interviews the manager to get a detailed understanding of the organizational structure, people, office dynamics, experience and track record.  Based on the information gathered, fund managers are evaluated to choose the best investment.  Funds are graded based on a relative ranking and much of the decision making is subjective.  More detailed due diligence is done for funds that get through the evaluation process.  The investors look at any legal issues, any issues from the initial due diligence phase and check references from co-investors, competitors, officers from past investments and past investors.

The investors decide whether or not to invest in a particular fund.  It does not mean that the investors will not look at the team again for another fund.  On the other hand, the manager has to accept the new investor into the fund.  The manager may reject the new investor if there is too much money invested already or if the investor has a history of defaulting on investments or causing problems for the manager.

Recent Articles on Manager Selection

I was alerted to two articles at http://www.finalternatives.com regarding manager selection.  The first article contained the results from SEI, "a leading global provider of asset management, investment processing and investment operations solutions for institutional and personal wealth management",  (Source:  http://www.seic.com/enUS/about.htm) and Greenwich Associates.  Of 111 investors asked, 54% planned to increase their asset allocation into hedge funds.  The top two criteria were investment process transparency and risk management abilities of the firm.  The article can be accessed here.

The second article is an interview with Hal Daughdrill, Chairman of Diversified Trust Company.  This is repetitive  but the most important factors for selecting a manager are people, process (for stock selection and portfolio management) and structure (how much the manager has invested in the fund, liquidity, fund lockup provisions, etc.).  He also mentions that not being located in New York can be an advantage.  The article can be found here.

Creating a Hedge Fund Portfolio

Earlier, I had written some articles regarding how investment advisors and consultants pick the best mutual fund managers for their portfolio.  Let us return to hedge funds and discuss how fund of hedge funds do the same.  Again, I will rely on presentations from NYSSA's Fourth and Fifth Annual Manager Search and Selection Conferences.  I have combined details from three experts over the two conferences.  They are:

• Ben Appen, CFA - founding partner at Magnitude Capital (Fourth)
• Jeff Moses, CFA - Lyrical Partners (Fifth)
• Robert Teeter - Ten-Sixty Asset Management (Fifth)

Magnitude Capital uses experienced hedge fund professionals to source investments.  The team includes senior employees from UBS, Deutsche Bank and D.E. Shaw who have extensive contact lists.  They use a six step process to make investment decisions:

1. Risk Management:  In addition to accounting for the common risks (i.e. credit, liquidity, etc.), Ben considers crisis risk management.  The credit crisis of 2008 saw a rapid decrease of available borrowing, illiquidity in certain products and cross asset selling.  Rob also asks if liquidity is needed for the whole or just part of the portfolio.
2. Strategy Analysis:  Ben and Rob invest in different strategies based on market conditions.  Jeff focuses on buying long/short managers at a discount to the Net Asset Value of the fund.
3. Sourcing:  Networking, hedge fund service providers, databases and conferences are used to find managers.  Rob noted that there was greater institutional demand for the largest hedge funds.
4. Evaluation and Due Diligence:  Both quantitative and qualitative methods are used.  In the former case, past returns, correlation of these returns with other investments and how they affect the current portfolio are analyzed.  The latter method includes meeting with managers, reference and background checks, reviewing the fund's operations, auditing financial statements and general administrative review.
5. Portfolio Construction:  Ben's firm has a proprietary "optimizer" to help make investment decisions.  It ranks the incremental value of each manager.  This rank plus the investment team's judgment creates the portfolio.
6. Monitoring:  Ben tracks market conditions, portfolios (using monthly risk reports) and managers (weekly estimates, monthly risk reports, quarterly meetings and quantitative analysis).  Jeff wants to have broad conversational openness with managers in addition to receiving detailed portfolio holdings.  Rob said that transparency was increasing but wondered if people were taking advantage of the situation.  He noted that knowing the holdings in a portfolio does not make people aware of all the risks.

If you would like to read more advanced articles that are thoughtful and insightful, please go to Hedge Fund Portfolio blog.

Choosing the Best Fund Managers - Part III

Continuing on the manager selection topic, there was another presentation by Richard Schaffer, CFA, of Chartwell Consulting LLC and Nathan Sonnenberg, CFA, CAIA, of Fortigent.  Both firms provide investment advice to family offices, endowments and foundations and high net worth investors.  A slice of the buy-side commonly referred to as private wealth / mini-institutional investors.  The process is similar to the institutional side discussed earlier.  Both firms are looking to construct a portfolio of managers that will provide the best returns with low volatility.  I will highlight the differences:

• Additional attributes of managers
• Success in a variety of market cycles
• Reasonable fees
• Tax efficient
• Manager introduction for private wealth is done through networking and industry conferences
• Close monitoring of trades for separate managed accounts

Schaffer is the Director of Research / Senior Partner at Chartwell where one of his duties is investment manager search and selection.  Sonnenberg is a Managing Director in charge of asset allocation and risk management.  He oversees equity manager search and selection.  

Choosing the Best Fund Managers - Part II

Let's continue David Judice's concepts on selecting funds for investors from the Fourth Annual Manager Search and Selection Conference hosted by NYSSA.  In the first article, we concentrated on picking the best investments and listed the factors analyzed.  Now, let's review the reasons for removing an investment from a mutual fund.  They may originate from the investor or manager side.

From the investor:

• Re-balancing portfolio
• Change in market conditions cause a change in tactical asset allocation
• Change in investment policy statement (i.e. investor's goals or risk tolerance)
• Opportunity cost (Is there a better investment to fit investor's goals?)

From the manager:

• Unexplainable and poor returns.  Every manager will have three year periods of underperformance.
• Returns,  high or low, that do not fit expectations.  This may mean the manager, investment process or risk profile of the fund has changed.
• Key investment personnel leaving
• Firm is giving less transparency, access or client service
• An unprecedented, large loss
• Having liquidity or capacity (i.e. fund has too much assets under management) issues
• Trading execution issues
• Taking on too many investment styles

The manager selection process usually results in buying market indices plus 1-2 active managers to outperform the benchmarks.

Many thanks to David, Citi and NYSSA.  This was a fantastic presentation.

Choosing the Best Fund Managers - Part I

At the Fourth Annual Manager Search and Selection Conference in May 2009 hosted by the New York Society of Security Analysts (NYSSA), the most impressive presentation of the event was given by David Judice, a Managing Director who is the Director of Traditional Strategies Research at Citi.  His team researches over 1,000 products (mutual funds, ETFs and separately managed accounts) for Global Wealth Management to help investors make proper investment decisions.

According to a chart from Dalbar: Quantitative Analysis of Investment Behavior (www.qaib.com), the average equity investor's annual return lags the S&P 500 Index by 7.5% annually from 1988-2007.  During the same period, the average fixed income investor's annual return is 6% less than the Lehman Aggregate Bond Index.  There are many factors that cause investors to underperform the indices:

• Too many mutual fund choices
• Chasing "hot" managers that have strong returns over the past 3 years
• Limited time for detailed analysis
• Current market conditions are not included when researching funds
• Changing fund managers at the wrong time
• Equating strong returns with good investing skills
• Mixing emotions into investment decisions

To create a portfolio of the best fund managers, Judice's team uses a 5 step process.  The investor sets objectives for desired returns, risk tolerance and time horizon.  Once that is known, the team reviews the market conditions for the best tactical and strategic asset allocations for the investor.  Manager research is done using qualitative and quantitative analysis to identify the "best of breed".  Then the team helps allocate capital to the different managers that fit the investor's needs.  The portfolio is monitored on an ongoing basis to maintain its suitability for the client.  The process is refreshed as an investor's objectives may change.

Strategic asset allocation considers long term goals and risk aversion.  Tactical asset allocation maximizes returns based on current market conditions.  Proprietary research is used to find investments that will have extra returns over the intermediate term (1-3 years) by identifying the best managers and investing styles.  For example, the relative value strategy outperforms prior to or during recessions.

When researching a manager, his team looks at the following factors:

• Personnel and Firm - Credentials and expertise of key professionals, ownership structure of the fund, how key professionals are compensated, any turnover, experience and success of the firm
• Investment Process - Investment idea generation, portfolio construction methodology, sector/industry concentration, any volatility guidelines, investment style consistency, performance
• Research - Depth of research analysts; industry expertise; databases, technology and analytical tools; number of companies covered
• Operations - Assets under management, growth or stable personnel, legal or regulatory issues, when the firm closes funds to new investors

Research has proven that there is some persistence in fund managers.  The managers in the top 25% tend to stay there.  Managers in the ninth and tenth deciles are 2.5 times more likely to disappear.

Clarification on Portfolio Strategies

Yesterday in my summation of a presentation at the Manager Search Conference at NYSSA. I wrote that a portfolio should hold two main strategies: style-based and flexible. I should clarify these two terms. Style-based means choosing a manager that is constrained in a specific market cap or region. Some examples would be managers in small cap value stocks, emerging markets debt or Japanese stocks. A flexible strategy would allow the manager to invest in the best opportunities that they can find. The more famous managers would be George Soros, Paul Tudor Jones and Ken Heebner.

Updated Concepts in Choosing Investment Managers

One of the more interesting presentations at the Manager Selection Conference at NYSSA mentioned in the previous post was regarding selecting the right investment managers for your portfolio.  I am only the messenger here.  The following is list of ideas from the brain of Thomas Latta, Managing Director and CFA.

The financial crisis of 2008/2009 brought an end to the concept that "beating the market" was good enough for investors. If the benchmark is down 50%, is it good news that a manager is only down 45%? This provided a wake-up call to traditional money managers. The challenge is to fix this error but not commit the old error of timing the market.

This can be done by having improved risk management processes, qualitative analysis of managers and building a portfolio from a mix of different strategies. Better risk management involves managers having strict selling criteria, diversification, tail risk management and close monitoring of active risks. When managers are rated, there is a premium on experience, diversity amongst the managers (in terms of training and process experience) and knowledge of behavioral finance i.e. the science of crowds. The portfolio should hold two main strategies: style-based and flexible. However, this increases the need to monitor at a total portfolio level.

The trend for the advisor is to choose funds with concentrated portfolios of 20-30 positions in either traditional or alternative asset funds. This allows the advisor to choose managers with more freedom in investment decisions, that can manage their Beta and have lower correlation with the market.