Hedge funds: haters gonna hate

Much in recent press arguing against hedge funds.  Probably related to news of another large pension fund divesting completely.  Plenty of vitriol around; a good summary of why not to invest in HFs from Barry Ritholtz is here, which further sources material from FT regarding ‘zombie funds’.

Let me highlight a couple reasons I’m still happy to invest in hedge funds:

1. Problem with averages + performance persistence = opportunities.  I recently wrote about how alternative asset managers (including HFs) show much more persistence in returns, unlike conventional asset managers.  Thus, as often thrown in as a throwaway comment in the articles above, there are managers out there which consistently beat the averages to provide attractive returns.  Unlike picking the best-performing long-only equity manager, hedge fund managers tend to show more consistent outperformance.
2. Risk premium diversification, at needed risk level.  Though most articles focus on how not diversifying hedge funds are as a group (probably because HF indices tend to have a massive overweight towards Long/Short equity and credit, which have high correlations to long-only equity), there remain several investment strategies which provide true diversification (e.g. managed futures/CTA).  Though some of these diversifying strategies are available in more conventional form – e.g. through an ETF or mutual fund – I appreciate the additional capital efficiency provided by higher-risk versions in ‘proper’ hedge funds.  More of a barbell approach to alternative investments (an aside – here is a new paper by Nassim Taleb et al. regarding mathematical justification for a barbell approach).

In sum: hedge funds can be massive wastes of fees, particularly if their performance starts to look very much like long-only equity.  However, even a small bit of due diligence can yield solid managers with solid track records in solid diversifying strategies.

Hail to the quants…

I’ve written before about the merits of systematic trading…indeed I do a bit myself, in addition to investing with some quant shops.  Anyway, looks like they had a better year in 2014 than most stock pickers.  Congrats to those who have been long-term patient with the momentum traders – as expected/hoped/implicit in momentum strategies, years of lacklustre performance (e.g. 2009-2013) were more than compensated by 2014’s returns for a great many funds.

This leads to both Q & A:

• A: I distinct recall speaking with many existing/potential investors in managed futures/systematic trading, in which the question was asked: is momentum dead?  Are the systems broken?  Hopefully 2014 helps answer that.
• Q: is the performance of 2014 sustainable?  For example, 2008 was a great year for the strategy, with a bad year in 2009.  So will 2015 be like 2009?  I wish I knew, but for the moment I’m staying invested.

Round 3: winning the mental battle against volatility using managed futures

In the previous posts (here and here) I have illustrated a couple approaches to one of the most dangerous parts of personal investing: the mental anguish caused by volatile (equity) markets.  It’s one of the main reasons we as retail investors tend to buy high and sell low: it’s tough to watch the big oscillations that an equity portfolio experiences.

So far I’ve shown a very easy-to-implement solution (the ostrich method) and a somewhat easy approach (a leveraged investment in bonds).  Today I’ll talk about another method, which is adding an uncorrelated strategy to the equity portfolio: managed futures.

I’ve written about managed futures before.  In a nutshell, the strategies employed by these funds tend to be momentum-related, and therefore exhibit near-zero correlation with equities.  That’s about as good as diversification gets.  Let’s take a look at the managed futures index (the Barclay BTOP50) versus the S&P500 since 1997:

Better diversification = better portfolio. Source: Quandl and BarclayHedge.

A few observations:

• The performance of managed futures does indeed occur at different times than stocks.  There seems to be a toss-up whether managed futures will make money when stocks are gaining value
• A 60/40 mix of stocks and managed futures looks like better value portfolio diversification than 60/40 stocks and (unlevered) bonds.  This is due to managed futures having 3 beneficial characteristics versus bonds in the period:
  • Better returns (5% p.a. versus 1% p.a.)
  • Correlation to stocks closer to zero (-0.17 versus -0.27)
  • Volatility – and thus ‘diversification bang for the buck’ – higher (8% p.a. versus 5% p.a.)
• The 60/40 mix of stocks and managed futures seems a lot less ‘equity-like’ than the 60/40 stocks and bonds mix.  That’s the impact of the strategy diversification

So we can see that, when a material part of the portfolio is moved from equities to managed futures, the result is a better risk and return tradeoff.

Extension: let’s consider the same approach as last post, which used futures or similar to create a Triple 5-Year Note.  It turns out that a common practice among managed futures providers is targeted volatility, so we can in effect choose the amount of volatility we would like our investment in managed futures to have.  Some managers keep low volatility (e.g. 5-10% p.a.), whereas others have quite high volatility (e.g. 25-30% p.a.).  Let’s look at the effect of this on the equity/managed futures portfolio:

Higher volatility of diversifier = better diversification. Source: Quandl and BarclayHedge

We can see:

• The blue line remains the S&P500
• The purple line is the 60/40 mix of stocks and managed futures
• The green and red lines are different mixes of stocks and a theoretical managed futures manager achieving 3x the risk and return of the index (I am aware of managers who have achieved this, but I don’t think their track records are public)
• In order to make the 60/40 mix of equity and 3x managed futures seem sensible, I’ve switched to a log scale on the chart
• Two conclusions to note:
  • With the higher volatility, the 60/40 mix has pretty amazing performance, which doesn’t resemble equity very much.  So stocks have essentially become the diversifier, even though they’re a larger proportion of capital.
  • A higher volatility managed futures program means you need less capital invested to get the same diversification benefits.  In this case, switching from 60/40 to, say, 85/15 gives about the same diversification as the old managed futures case with better performance.

In sum: adding a diversifying strategy to the equity portfolio improves risk-adjusted performance quite a bit.  If you’re looking for ‘bang for the buck’, a high-volatility managed futures program should allow for a smaller capital allocation while maintaining diversification benefits.  And that should allow for less portfolio volatility overall, which helps win the mental battle.

Anyone for oil?? Anyone?? Bueller?

So the stock and bond markets are yawn-worthy these days.  What’s a trader to do?  Clearly, it’s time to sell oil:

Excuse me, your oil is leaking. Source: thinkorswim by TDAmeritrade.

WTI crude is down about 25% from mid-year highs.  Since end-Sep, there has been a pretty much straight-line fall of around $20.

A lot of headlines can, have, and will be written about this fact.  Among the themes I’ve already seen:

• Russia is doomed, as are a lot of EM countries which rely on high oil prices to sustain government spending.
• US shale oil is doomed, as break-evens for these wells is around $75.  That’s the end of a great run in job creation, US oil self-sufficiency, etc. etc.
• Global industrial production will get a nice lift from cheaper energy prices.
• Global inflation will have a big drag.  Probably not exactly what the world needs, with inflation at or near zero in much of the developed world.

And some more of my thoughts, which I haven’t read other places (yet).

• Alternative energy, particularly electric cars, will face a big headwind as Americans see sustained gas prices < $3.
• Remember Scotland’s referendum, which relied on oil revenues to handle the gap in government spending?  They assumed $110/barrel.  So they would already be about 30% in the hole.  Ouch.
• Systematic trading is a great way to take advantage of these types of moves.  I’m pretty sure there aren’t many fundamentals guys staying short oil at this level (or likely remained short at the $80 or $75 level).  Momentum strategies would still be short.
• Tying together my previous posts on the subject:
  • No, I don’t like long-only commodities for the portfolio.
  • I prefer the momentum strategies of managed futures to get commodities exposure.
  • Extension: we could use some serious investment in better battery technology.

In sum, thanks to the oil price for keeping markets lively the past week or so.

No one likes commodities anymore

A prime example of why I don’t favour long-commodities in the portfolio: I don’t understand how/why they can fall, seemingly forever, on well-known economic themes.

Grains had it bad for most the year, but oil caught up.  Here are 2 long-only ETF/ETNs showing the issue: USO follows the oil price, and CORN follows the corn price.

One characteristic that has been nice is sustained trends.  That means medium-term momentum funds have made a killing on these products this year.  A small pat on the back for inclusion of the managed futures mutual fund.

In other news, the equity markets seem to be rattled again – just a couple days after the JCB adding a ton of stimulus, and GPIF buying a new $180bn in equities.  Maybe back to proper two-sided markets??

Latest addition to the portfolio: managed futures mutual fund

An earlier post outlined my thoughts on the stock market at these levels… given the volatility of the past few days, I’m even less certain of near-term performance.

Anyway, I continually seek out diversification in my portfolio: strategies or asset classes which perform at different times than my core long-equity allocation.  These days I’m less certain about asset-class diversification; with ultra-low interest rates, long fixed income seems a bad bet.  Commodity prices have been crashing, so maybe long commodities is an option.  Real estate prices have had a good run, but I’m unconvinced they can hold their own when rates rise.  Option volatility has ticked up lately, but still at very low levels.

So what next?  Strategy diversification.  For example, if I’m reasonably sure that long fixed income is a bad idea, how about going short fixed income?  If I’m unsure about when commodity prices will turn around, how about using a momentum strategy?  These type of strategies are employed by managed futures funds.  The upshot is the funds’ ability to diversify my long-equity portfolio: due to the strategies employed, momentum-focused managed futures funds have around zero correlation to equities.  That’s about as good as diversification gets.  In addition, the momentum strategies used means an opportunity to short stocks when they’re falling (e.g. in 2008, when the funds made good money while other strategies were killed) – so a bit of an offset for my long equities during a selloff.

One of the main reasons to hate managed futures funds of late was fee loads: most of these strategies charged hedge fund fees (2 and 20, or more).  With the new crop of mutual funds, however, the strategies have much more palatable fee loads (more like 1% p.a.).  Much easier fee hurdle to beat.  So just be careful when choosing a fund – the performance of momentum managed futures funds should be highly correlated with each other, so stick with lower cost options.  This often means looking in the prospectus (!) or even SAI (!!) to find out what ‘hidden fees’ are paid to the hedge fund manager.  Hint: if you see a clause like the following, below the breakdown of expenses, think ‘hidden fees’:

The cost of swap(s) and structured note(s) include only the costs embedded in the swap(s) and note(s) that reduce returns of the associated reference assets (i.e., Underlying Pools), but do not include the operating expenses of those reference assets. Returns of swap(s) and note(s) will be reduced, and their losses increased, by the operating expenses of the Underlying Pools used as reference assets, and such operating expenses may include management and performance fees of a Commodity Trading Advisor (“CTA”) engaged by Underlying Pools, as well as Underlying Pool operation, administration and audit expenses One or more of the Underlying Pools used as a reference asset for a swap(s) or note(s) may pay a performance fee to a CTA, even if the return of other reference assets associated with the swap(s)/note(s) is negative. The operating expenses of reference assets, which are not reflected in the Annual Fund Operating Expenses table above, are embedded in the returns of the associated swap(s)/note(s) and represent an indirect cost of investing in the Fund. Generally, the management fees and performance fees of a CTA employed by the Underlying Pools that may be used as reference assets range from 0% to 2% of assigned trading level and 15% to 25% of the returns, respectively. 

I stay away from these funds.  There are managers/funds out there worth the fee loads, but I’m too small an investor to access them!