Risk Measurement for Managed Futures Funds

There are five main types of risk management formulas that apply to managed futures funds.  Each has their limitations and caveats.  They also are separate measures.   They are:

• Margin-to-equity ratio:  This is the initial margin (in cash or Treasury bills) needed to establish the portfolio divided by the amount invested.  A low percentage means high leverage.  This may be misleading as the manager may have long and short positions or may be trading across different exchanges.
• Capital at risk:  When managers add a position, they attach a stop-loss rule to limit their losses.  This ratio calculates the total of the portfolio's losses if each position triggers the rules and divides it by the amount invested.  This is not an exact number because of the terms of the stop-loss rule.  The rule begins a transaction when the price is hit.  In a extremely volatile market, the actual trade price may be very different from the stop-loss price.  Capital at risk also does not account for offsetting long and short positions.
• Value at risk:  The potential loss for a given period and confidence level.  For example, a 95% one month figure of $10 implies that the portfolio has a 5% chance of losing more than $10 and 95% of losing less than $10.  Since the credit crisis of 2008, this has been the subject of some papers as measuring tail risk inadequately.  This is because the calculation is based on a normal distribution.
• Maximum drawdown:  This figure calculates the largest percentage loss for an investor for a specific period.
• Stress test:  This calculates a portfolio's losses by running different scenarios on the individual holdings to determine the effects on each scenario.

Funds of Hedge Funds: Making a Comeback

According to the InvestHedge Billion Dollar FOHF Club survey in March 2011, funds of hedge funds with more than $1 billion in assets under management (AUM) gained approximately $29 billion in assets in 2010,  despite outflows in the first half of the year.  They ended the year with total assets $625 billion.  Of this figure, more than a third ($226 billion) is in the hands of the 10 largest funds.  Globally, there are 109 managers with $1 billion or more in AUM.  In the second half of 2010, AUM grew by 4.8% with the ten largest firms adding 9.6%.  Here is the list of the largest funds:

John Paulson Performance: 1st Quarter 2011

There was an article at www.finalternatives.com about the performance of John Paulson's hedge funds in the first quarter of 2011.  Three of the funds (Advantage, Advantage Plus and Gold) were in negative territory after a disappointing March.  On the other hand, the smaller funds (Partners, Enhanced, Recovery and Credit Opportunities) were up for the quarter.

Managed Futures Basics

Managed futures funds invest in futures and forward contracts on currencies, commodities, financial indices and ETFs.  The funds, called commodity pools, are run by a commodity trading advisor (CTA).  The management fees are between 0% to 3% of assets under management (AUM) and the incentive fees are between 10% to 35% of profits.  The fees are also called "2 and 20".

Most CTAs use a black box to establish trading rules.  There are managers that act as mutual fund managers and create their positions.  They are a minority though.  The rules are not static and adjusted constantly due to copycats, poor trade execution, AUM growth and changing market conditions.  The three types of black boxes are trend following, non-trend following and relative value.

Trend following strategies are based on action of the asset prices; much like technical analysis for stocks.  The moving average strategy uses the average price of an asset to buy or sell.  The moving average may be calculated in various ways:  any number of days or different weighting of prices.  If the current price is higher than the moving average, the fund buys.  If the current price is lower, the fund sells.  This strategy works well when the asset moves steadily in one direction.  It does not work well in a volatile market or a market in a narrow trading range.  The break-out strategy uses the same buy and sell signals as the moving average strategy.  Instead of using the average of prices to trigger the trade, the fund uses the price range of the asset.

Non-trend following strategies include countertrend and pattern recognition strategies.  Countertrend strategy uses models to identify trades.  Pattern recognition is similar to technical analysis of stock charts where the CTA will find trading opportunities based on the price action of the asset.

Relative value strategies invest in related futures contracts that have experienced a short term price difference. The manager may perform an arbitrage trade as the prices return to their historical relationship.

Further information on managed futures can be accessed at Attain Capital's managed futures blog.

Commodities: Some Basic Ideas

Commodities can be valuable holdings for an investor because their returns are not or negatively correlated with the stocks and bonds.  Instead of buying physical commodities directly, the investor can purchase futures contracts based on an index composed of different commodities.  This is the same as a stock index where the prices of stocks create the index price.  Some examples of commodities indices are the S&P Goldman Sachs Commodity Index, Dow Jones-AIG Commodity Index and Reuters/Jefferies-CRB Index.  Each index contains different commodities, weights and manners of settling expiring and buying new contacts.

In a period of high inflation, commodity futures provide downside protection because the underlying commodity prices increase and securities decrease. The CAIA study material and Mark Anson's Handbook of Alternative Assets cite a study from 1990-2008 where a 60%/40% investment in the S&P 500 and US Treasury bonds are compared to a 55%/35%/10% investment in the S&P 500, US Treasury bonds and a commodity index.  On the general, the average monthly return remains the same but the summary chart shows the following benefits:

• Steadier monthly returns
• Less months with negative returns
• Average negative return is lower

Insider Trading Trial: Raj Rajaratnam of the Galleon Group

For the past three weeks, Raj Rajaratnam, former head of the Galleon Group, has been on trial for insider trading.  It has been estimated that $45 million in profits or avoided losses were garnered by the hedge fund.  Last week, a portfolio manager, Adam Smith, testified about how the hedge fund tried to avoid detection.  The traders would make misleading transactions such as selling a portion of their position when they were tipped off on negative news.  They would create emails designed to operate in the opposite direction of the inside information. The true intent of their trading would be conducted through faxes.

Two trades were mentioned specifically:  ATI Technologies and Goldman Sachs.  The ATI trade was made based on information from a Morgan Stanley investment banker.  The Goldman Sachs trade was made based on information from a Goldman Sachs director, Rajat Gupta.

The news sources for the article are at:
Bloomberg article on ATI
Bloomberg article on GS
Reuters article on GS

Introduction to Commodities

One of the hedge fund strategies that have not been detailed before is managed futures.  This strategy actively invests in futures and forward contracts on currencies, securities (such as stocks, bonds, ETFs and indices) and commodities.  This article will touch on the latter.  Commodities are used in the economy to produce finished products.  Some examples of raw commodities are gold, silver and oil.  Some finished products are cars, computers and cell phones.  An investor may buy/sell commodities through six vehicles.

An investor can purchase the commodity.  For most of them, it is not realistic as the investor would have to transport and store the commodity somewhere.  When it is sold, then it would have to be delivered.  It is easy to do when an ounce of gold is involved;  not if it is several hundred barrels of oil.

A more conventional way is to buy securities of companies that buy, produce and sell commodities.  Additional risks are introduced using this method.  Stocks and bonds are influenced by stock and debt market conditions that have little relationship to the commodity markets.  They also are affected by corporate events such as mergers, buyouts, bankruptcies, etc.  Finally, as part of companies' risk management efforts, they hedge their positions against the commodity.

A third way is to buy or sell futures contracts that are sold on public exchanges.  This is an option that allows the investor to buy or sell the commodity at the strike price at the expiration date.  Settlement is done in cash. There is inherent leverage in futures as investors can put up 10% of the price to buy them.  This is called the initial margin.  Depending on the value of the contracts, investors may be subject to margin calls to maintain a minimal investment amount.

The investor can buy or sell private option contracts called swaps or forwards.  These are between two counterparties with no exchange involvement.  These are customized but have much less liquidity than futures. The investor is subject to the risk that the counterparty may default.

The fifth vehicle is a commodity-linked note.  These are intermediate-term debt securities that may or may not have their principal protected.

The last one is an ETF.  It can be bought on an exchange and is just like an equity ETF.  For example, GLD gives the investor a position based on the price of gold.