Managed futures moving into positive territory - some have been finding trends

The SocGen CTA index gained 2.7% for the month of November placing the returns for the managed futures index in positive territory for the first time since May. The CTA index is now above the Barclays Aggregate bond index and only slightly below the returns for the S&P 500 stock index. 

The good returns were caused by getting the direction of the main market exposure correct because the size of the market moves were quite modest. Stocks around the global ended the months in a tight range. Bonds gained for the second half of the bond but generally yield curves flattened on rising short rates under the expectation that the Fed will raise rates in December. Metals, energies and agricultures were all generally down for the month with declines of over 4 percent in the energy complex. Currencies continued to follow trends based on the expectation that the dollar will still strengthen in response to Fed action.

It was noticeable that the most liquid markets had some of the largest moves so those funds that focused their trades in energy, currencies and bonds were able to generate good returns. A decline in volatility also helped managers with signal generation and position sizing. Generally, we find managers do well in lower volatility shallow trend environments where price signal to noise ratios are more well-pronounced. 

There has been some grumbling by investors about managed futures performance this year, but the index suggest that returns, albeit modest, may prove to be acceptable relative to traditional assets.

Hedge fund diversification benefit - styles matter

This table is from the latest research piece by Andy Lo and shows in a heat map the benefit of different hedge fund styles. The dedicated short bias has the lowest correlation relative to all of the other styles for the simple reason that most hedge fund states have a long bias. An investor is buying a different view. The next two styles that have the most diversification benefit are global macro and managed futures. These two should be the diversifiers of choice for any investor once the decision to hold alternative investments is made. 

A two step process may be an effective approach. First, determine whether you want diversifiers or substitutes and then second, choose the best managers within the style space. No different than the work on strategic asset allocation, the allocation decision may matter more than the manager selection. 

Futures ecosystem - the extinction of the FCM species?

The consolidation of FCM's in the futures industry will continue and some may ask the question why FCM are needed at all given a greater portion of the fees from trading goes to the exchange. One third of all FCM's holding customer funds have disappeared in the last decade. It is unlikely that we will see another 30 disappear, but it is not clear how profitable this business can be for firms. The top ten FCM's are all associated with banks and not stand alone entities.

The chart from the FIA tell the story. If you are a small fund or small hedger or if you do not have the right credit, you will not have a place to trade. The system will not work for you, and CME's ads about the marketplace for hedging risk will be just a dream. Of course, costs will go up and there will be point where brokerage and clearing will be profitable, but it will be at the expense of the small trader. Perhaps I am exaggerating, but which one of the top ten clearing firms will want to service smaller firms?

We have written about the decline in FCMs and how the futures industry is in upheaval in our past posts, The futures industry ecosystem is broken, Basel II and futures clearing, and Futures industry changing structure. This problem will not go away and may in fact get worse at the point where more will need financial hedging services, and industry leaders do not seem to really care.

Hedge funds - substitutes or diversifiers? - that is the question

The CAIA and AIMA groups developed a hedge fund framework for trustee which provides a good introduction on how to classify hedge funds for a portfolio. Cutting through all of the issues of alpha and beta focuses on two large groupings, substitutes and diversifiers. Now all hedge funds will provide some diversification versus a traditional equity and bond investment, but the degree of differences matters. 

The substitutes are those hedge fund strategies that can fill-in as an alternative to a equity or bond investment with less risk. If an investor does not want as much directional risk, he can sell bonds and buy a fixed income arbitrage fund. If an investor wants less directional equity risk, he can buy a long/short equity fund. There will be exposure to stocks or bonds but at a lower beta and a higher likelihood of alpha.

The diversifiers are hedge fund styles that will provide a greater degree of diversification because the correlation will be low and potentially negative during "bad times", those periods when equities do poorly. The diversifiers include managed futures, which have low correlation during crises, global macro which will take large beta bets from both the long and short side of the market, and equity market neutral which reduces most of the market beta.

Substitutes look to lower volatility and add alpha. Diversifiers look to dampen volatility through dynamic beta. This simple framework makes the question of choosing hedge fund styles very simple. Do you want a substitute for market exposure, or do you want diversification protection? Answer the macro question and then focus on the right managers within these two major classification.