Aside from the stigma hedge funds have received after recent industry debacles, the investment vehicles are thought of as a place to go when the stock market is misbehaving. But is this always a good idea?
In the last several years, the $400 billion hedge fund industry has become an increasingly prominent component of the investing arena, and it remains one despite its recent hurdles. Consistent returns and low equity drawdowns have attracted both institutional and high net-worth investors into the fray. But diversification is the main selling point - if hedge funds are not correlated to movements in the stock and bond markets, they should be an attractive source of returns for even the most conservative investors.
But the degree of diversification attained from hedge fund investments may be overstated. A recent study in the Journal of Alternative Investments found the movement of the S&P 500 index accounted for 79% of the return derived from U.S. equity hedge funds and 63% of the return generated from international hedge funds. These findings do not imply that hedge fund managers lack a skill component in their trading, but rather that their dependence on the larger stock indexes to generate positive performance may prevent them from realizing attractive returns during bear markets.
These results don't seem confined to equity-oriented hedge funds. based on an analysis of the major hedge fund indexes for the last five years, many hedge fund styles that use investments other than stocks are surprisingly correlated to movements in the S&P 500 stock index (See "No place to hide" right). Most likely this is due to a similar sensitivity to changes in volatility and interest rates shared by stocks, bonds, and mortgage-backed securities, which commonly are used in market neutral, arbitrage and relative value hedge strategies. Thus, it appears the use of a single-strategy hedge fund to protect against downside risk in the stock market is of questionable value.
Probably the best investment during difficult market conditions is a well-balanced hedge "fund-of-funds." Such a structure would include a plethora of strategies chosen because of its ability to profit during periods of extreme volatility in the interest rate markets and during unpredictable world events, such as political instability or war. There are a considerable number of these funds currently available. However, a study performed by James Park, chairman of the New York-based investment firm Paradigm Capital Management, showed that the average fund of funds allocates to only five managers. Although there are funds of funds that allocate across a broad array of methodologies, the fund of funds sector as a whole has apparently not embraced diversification as a risk-reducing strategy.
One way to increase the diversification in a fund of funds is by the introduction of managed futures. As shown in "No place to hide," the returns of commodity trading advisors (CTA) are not correlated to either the S&P 500 index or the returns of the major hedge fund indexes. But even though managed futures and hedge funds are both considered alternative investments, there are substantial differences between the two investments. The biggest differences are in the areas of account structuring and trading styles; other distinguishing characteristics include transparency, pricing of instruments and market liquidity.
Hedge funds are almost exclusively "fully funded"; to allocate $1 million to a hedge fund manager, that much cash must be deposited in the manager's investment vehicle. But for managed futures, there are important differences. Because CTAs only use a portion of the money allocated to them for margin, it is an increasingly common industry practice to fund a given CTA allocation only partially. For instance, a trend-following CTA might be instructed to trade a $1 million account, but only be allocated $250,000. The balance, known in the industry as notional funds, can be used to fund other trading advisors or be placed in other investments. CTA accounts that are fully-funded can be regarded as a simple sector weighting; in this instance, managed futures would be considered an available methodology within the hedge fund universe, just like event-driven, global macro and arbitrage. But if a CTA allocation is notionally funded, investment capital would not have to be reduced in any of the other strategies to fund the managed futures component. Hence, in this instance the return generated by the CTA can be considered portable alpha (or the return in excess of investment performance if you only use fully-funded strategies).
It is important to factor the importance of Treasury bill interest into the evaluation of CTA returns if notional funding is being considered. [TABULAR DATA OMITTED] Typically, CTAs include the interest income earned by their accounts' cash balances in their monthly rates of return. If a CTA is only notionally funded, no interest income is earned; thus, for evaluation purposes, it is important to subtract the risk-free rate from their performance. The balance is the profit or loss generated solely from trading activity, without regard for interest earned by T-bills or by active cash management.
There are ripple effects to removing interest from CTA returns. It is important to not subtract T-bill interest a second time when using a performance measure such as the Sharpe Ratio to compare manager performance. The key here is an apples-to-apples comparison - if CTA returns without interest income are compared to hedge fund returns with interest, the futures sector will appear inferior.
The argument is similar when calculating the correlation between investment programs. In fact, notionalized CTA returns (where the interest earned is not included) are usually found to be less correlated to hedge fund returns than CTA returns with interest income.
Differing trading styles
Another major difference between hedge funds and managed futures is that the trading styles used in each investment can vary significantly. Many hedge funds, especially those strategies, attempt to profit by buying and selling like securities simultaneously, thus "locking in" the difference. Many of these funds use leverage to enhance their returns. In some cases, leverage is used at high levels, as in Long-Term Capital Management's instance. The returns for a fund that is leveraged often are "bimodal," with a profile that does not conform to a normal distribution. Although such returns may seem stable, it is quite difficult to evaluate performance using commonly accepted reward/risk measures. "Normal takes on bimodal" (page 80) shows a typical bimodal return distribution. A fund-of-funds manager easily could calculate the average monthly return for the hedge fund, but the term average has no meaning in this particular example - the "average" monthly return lies between the two distributions and has never been achieved by the hedge fund.
The same is true for other performance measures, such as downside volatility and the Sortino ratio. The biggest contributing factor to a bimodal distribution is imbedded options. Although the hedge fund manager might not use options in his investment strategies, a portfolio can exhibit behavior associated with options - a steady return over time but with an occasional losing month of such magnitude that it could not have been predicted using any of the volatility-based performance measures described earlier. In the case of hedge funds of this type, qualitative analysis - interviewing the trader, evaluating his methodology and performing due diligence on the track record - is a vital tool in determining if past performance is indicative of future returns.
Because CTAs are typically either long or short, do not incur borrowing costs, or rarely sell puts or calls, managed futures returns are almost exclusively normally distributed. As a consequence, quantitative tools such as the Sharpe ratio are quite useful in assessing trading skill. Additionally, normally distributed returns also are easier to predict and, if included in a portfolio of bimodally distributed investments (such as hedge funds), should protect the entire portfolio from losses resulting from large changes in interest fates.
Managed futures offer characteristics unique in the realm of alternative investments. The first is transparency. For hedge funds, complete transparency is unheard of. And even quarterly reports often are not released to investors as was rumored to be the case with Long-Term Capital Management. But because CTAs typically do not trade in swaps, repurchase agreements or synthetic contracts, CTAs usually are more willing to open a transparent separately-managed account with a client than are their hedge fund counterparts.
There are several advantages to investing in a separate account as opposed to a fund. Copies of all transactions and brokerage statements are sent directly to the client, which makes the task of monitoring risk levels and determining exposures to various markets easier. Investor liquidity also is enhanced - because most limited partnerships only allow redemptions at the end of each month (or have lock-up provisions of six to 12 months). An individual account can be liquidated in a matter of hours.
Asset pricing is another characteristic to an investment in managed futures. Because virtually all of the transactions of a CTA are priced either by an exchange or in the bank foreign exchange market, it is quite simple to mark-to-market any given account at the end of each trading day. Hedge funds do not offer this convenience. In fact, some of the more exotic hedge funds trade securities that are quite difficult to price; in the most extreme circumstances, hedge funds actually have priced their own portfolios, which inevitably has led to problems for investors. This combination of limited transparency and a lack of clear asset pricing can have disastrous results.
Finally, the bulk of large CTAs tend to operate in the most liquid futures and currency markets. Some of these markets are more developed and larger than the New York Stock Exchange; their depth allows these traders to manage substantial assets with little appreciable reduction in their risk-adjusted performance. According to the National Futures Association, there currently are 2,733 registered CTAs. Although the capital committed to managed futures (about $35 billion) pales in comparison to the amount in hedge funds, the combination of liquid markets and the growth in the number of talented managers could result in a substantial size increase in the managed futures industry.
There are three benefits from adding a managed futures component to a hedge fund-of-funds. First, because managed futures are not correlated to the movements of the S&P 500 or interest rates, CTA returns can add considerable diversification to a portfolio of market neutral and global macro fund managers. Second, because CTA commitments can be notionally funded, the return obtained from a managed futures allocation can be realized for a fraction of the capital used for fully-funded investments. Finally, the normally-distributed return stream of CTAs and the increased transparency of most trading advisors offer investors a more dependable return stream and give them a mechanism for liquidation if conditions warrant.
Richard Bornhoft and Ben Warwick are principals of The Bornhoft Group Corp., a registered investment advisor in Denver specializing in alternative investments. E-mail them at firstname.lastname@example.org.…