Wednesday, July 19, 2017

It's a electronic futures world - Now what do we do? The changing role of brokerage

Automated execution is taking over futures markets. Actually, the battle is over. Voice (non-electronic) and manual execution are reserved for illiquid products, old school firms, smaller traders, those who may be undertaking spreads, complex legged or option strategies, roll strategies, and some block trade. However, the use of electronic trading can vary by market and sector. Technically, we are referring to manual (MAN) versus automated (ATS) trade execution where automated is generated and/or routed without human intervention. Non-electronic would be a separate category. By far, automated to automated trades dominate most markets even in many commodities.  The high frequency automated traders are the new market scalpers. Financials have a higher percentage of automated trading over commodity markets.

From the latest CFTC research, (see Automated Trading in Futures Markets by Haynes and Roberts), we have a graphical analysis of the ascent of automated trading across many markets. Some markets have seen slower growth but the direction is all the same.

What does this mean for the brokerage world? The overall theme is that relationship brokerage has come to an end. We define the old world of relationship brokerage as an environment where brokers provided access to execution services, generated trade ideas and execution strategies for working an order, and market color from what they were seeing in the market. The new world provides easy market execution services and connectivity at low prices, but there is limited interaction between users and brokers concerning trade ideas and market color. The fee and service of a broker relationship with a client is broken. For many who did not need the relationship services, this is a good thing. You get anonymous wholesale execution and low prices, but for those that need support for market analysis, the service is not present. 

I make no value judgment when I say the world has changed. Pricing for brokerage is sharper, but information flows may be worse. Information flow and color has always been a two-edged sword. The color you receive on the behavior of others comes at the price that your information may be seeping to competitors. Nevertheless, market anonymity causes fragmentation, uncertainty, and potential volatility at extremes. There is more unknown about competitor actions. In the new world, there is still a need for information flow, color, research, and execution services. It will just have to come through some other conduit.

Monday, July 17, 2017

When markets disrupt so does performance - June managed futures and outliers

What kind of month was June for CTA's? Well, you can look at the distribution plot of returns for the month to get an idea of the extremes. We created the QQ plot for the 377 firms that reported to the IASG database for June as of last week. This can be done for smaller more specialized samples, but we took the maximum set of data reported to IASG. 

A QQ plot is a comparison of the quantiles of a set of data to test the distributional properties, specifically its uniformity. A uniformed distribution, like a normal, will find data on the straight line. 

It was a bad month for many CTA's with much larger than expected loses and with a negative skew or tilt, yet there were some clear winners for the month. The power of diversification and the wide choice among managers shows that not all CTA's are alike even within some standard classifications. Some of the big winners were associated with commodities which did not suffer from the whipsawing seen near the end of the month in equities nor the change in bond direction. Bigger losers were those firms focused on trends in financials. Interestingly, many of the poor performers were also hitting max drawdowns. While more formal distribution tests reject normality, the performance numbers were often consistent with 10% annualized volatility, but a locational mean that was much lower than expected from historical averages. The spread was expected, the average was not, and a few headline at the negative extreme. 

Sunday, July 16, 2017

Suffering from regret in the hedge fund world - A problem for all investors

We have learned from behavior finance that one of the key thing that investors do not want to suffer from is regret. From prospect theory, there is a desire to sell winners and hang onto losers in order to avoid regret not suffer from loss aversion. Loss aversion tied everywhere to the decisions we make. Picking the wrong manager. Picking the wrong strategy. Picking the wrong time to enter or exit a trade.  Investors do want to make a decision only to find out that ex post it was a poor one.

So when will regret be greatest for hedge fund strategy decisions? It should be tied to the dispersion in returns. If there is a wide spread between the best and worst strategy, there will be greater regret that the action taken could have been wrong. Similarly, there will be more loss aversion or regret for strategies that bounce around from the best returns to the worst. A hedge fund strategy that has more change in their strategy rankings may need higher returns to entice investors to hold given there may be regret. 

We have looked at the dispersion of returns in the Eurekahedge data base of hedge fund strategies from 2000 through the first half of 2017 to get some idea of the dispersion in performance and the potential for regret.

The maximum and minimum of hedge fund strategy returns have declined since the financial crisis. The minimum returns for strategies have hovered around zero and the maximum has fallen closer to ten percent. The dispersions of hedge fund returns across strategies have fallen over the last few years, but the important number is the wider dispersion if there is market turbulence or a crisis. Picking the right hedge fund strategy becomes all the more important when equity markets sell-off and there is a increase in correlation across asset classes. 

However, the data get very interesting once you move to strategy specific analysis. We conducted a simple analysis by asking the question, "How many times is a strategy the best performer or the worst performer in a given year?" We are looking at nine strategies over 17 years, so there are a total 34 best and worst events. All things equal, there is a 1/9 chance that a strategy will be worst in any given year. Clearly, more volatile strategies are more likely to be the best or worst, but we want to focus on the potential for regret. 

If you pick the best what is the likelihood of that strategy being the worst, or what is the chance of being the worst for any hedge fund choice. This can be explored more deeply, but I present just the counts for best and worst. The winner for most times being at the extreme is managed futures followed by distress. Four strategies have three times been the worst. Only managed futures had been five of seven times the worst performance strategy. Distressed followed by managed futures had the most frequent number of best strategy performance. 

Given the extreme good and bad performance for managed futures (CTA's), there may be a wariness by investors relative to multi-strat or macro which are more likely to always be in the middle of the pack with performance. A focus on regret is real given the chance to end up "wrong" with a strategy choice.

Using hedge pricing as a weapon - the firms with scale will squeeze smaller firms

The idea that hedge funds are getting 2/20 for management fees is becoming a myth. Dynamic pricing is being used more aggressively by hedge funds with a wide range of management and incentive fee options. For example, in the managed futures space, there seems to be a willingness to offer beta products as low-cost alternatives as well as traditional alpha plus beta products. The low cost products are being marketed as trend-following beta at low cost while higher priced products are being offered as alpha generators relative to trend-following beta. Of course, there is not a clear definition for what is trend-following beta so there is something more going on with this pricing. (The beta may be associated with a peer index, so the beta firms offer a low cost product to match a bundle of competitors.) This approach is being used by a number of larger firms.  

Since smaller firms have been shown to perform better than larger firms, lower fees by large firms help to cut the return edge associated with smaller firm. Secondly, lower fees after fixed costs are covered will create a barrier to entry for new firms who have to grow to break-even. Lower fees will mean a higher breakeven AUM is necessary to turn a profit. As the break-even level of AUM is raised, marginal firms are forced out of business unless they can consistently generate incentive fees to cover fixed costs. Additionally, it will harder for smaller firms to charge premium prices if the market fees are moving lower. This approach is extremely disruptive to the market structure as we believe that this pricing is being used more and more as a weapon to stop entrants and create barriers to entry. Now some of this pricing is not conscious action since for large allocations the investor sets the price, but changing the product mix, a willingness to negotiate prices, and lower posted prices all have impact on competitors. 

While any marginal dollar is valuable for smaller firms, the profit for firms will fall if the costs of marketing does not decline but the market price for management services is lowered. None of this should be news or surprising, but the economics of scale and pricing is becoming more relevant as returns from hedge funds move lower and the dispersion of returns compress. As the hedge fund industry moves from high new growth to taking market share from other firms, pricing as a tool for firm growth will become more sensitive to the impact of others. This is good news for investors, but bad news for the upstart firm who may thing that a good investment idea and hard work by itself will lead to success.