Hedge Funds And Alternatives – When There’s Blood In The Streets… by The Attain Alternatives Blog
We always thought it was Jesse Livermore (if you’ve never read Reminiscences of a Stock Operator, pick up a copy) who said this infamous market mantra. But a quick Google search shows it was actually Baron Rothschild, who made a fortune buying into the panic which followed Napolean’s Battle at Waterloo. (As an aside, this was the first instance of high frequency trading, as Rothschild had a carrier pigeon deliver news that Napoleon had been defeated before the rest of London knew; so the quote perhaps should be ‘buy when there’s blood in the streets, and you have an information edge’)
But back to the proverbial blood in the streets… While this is usually a market maxim reserved for traditional investments and related to investments beaten down in price; the contrarian in us can’t help but think there’s some well publicized blood in the streets as it relates to hedge funds and other alternative investments. We’re talking pieces in the Financial Times, Morningstar, Investment News, Wealth Management, and the New York Times. To be fair, as more investors consider these as an alternative to the traditional asset classes, it’s only fair to expect journalists to try and identify and uncover any potholes to avoid.
But while some of these potholes are ones you should avoid, others aren’t really potholes at all. Their choices along your investment journey. Decisions on whether to take this route or that route. To help you make sure you don’t get off on the wrong exit – we’ve highlighted some of these ‘avoid hedge fund’ pieces to help highlight the inaccuracies, potential lapse in detail, or if it is in fact a deserved critique. Enjoy:
Critique: Speculators/Hedge Funds Manipulate the Markets
This one never gets old. Markets move, people freak out, and that’s followed by a bevy of blame computerized Managed Futures and Risk Parity programs unduly influencing the markets. First rule of financial journalism = when in doubt, blame the computers. First up the Financial Times.
Yet some analysts say the severe reaction might have been worsened by forced selling by vehicles such as commodity trading advisers (CTAs), risk parity funds and other computer-driven strategies that respond automatically and dynamically to market turbulence.
“These systematic strategies come in many flavours, and respond to volatility in very different ways and over disparate timeframes, but unease at their size and influence has grown. Some investors and analysts argue they exacerbated the turmoil of last summer, when fears over China triggered a stock market crash.”
This time, Financial Times included to rebuttal to this, making our jobs a little easier.
Managers of CTAs and risk parity funds scoff at this, and argue that blaming them for deepening market turbulence is wildly inaccurate, given that even with their greater heft they are dwarfed in size by traditional mutual funds and other hedge funds, which also tend to sell in herds.
Moreover, very few will respond to a one-day jump in volatility, and try to minimise the turnover of their investments to keep trading costs under control.
The above does a good job of explaining that this is mostly hyperbole used to sell newspapers (or digital ads on what used to be newspapers), but we’ll offer a few thoughts here. One, these programs and computer algorithms don’t exist in a vacuum. They are enlisted by investors to generate returns, so the blame can’t be just on the computer-driven strategies – it would be better placed on the investors who enlist the strategies. Two, there are position limits and risk limits in place here. Managed futures and global macro funds are designed to be the fly on the bull or bear’s back, not the bull or bear itself. In technical terms, they don’t seek or want a lot of market impact when putting on/taking off their positions, and will size positions accordingly (and increasingly so – use execution algorithms) so that their movements in positions don’t cause movements in markets. Finally – even if this is all true – can the press play both sides of the equation here, please. We don’t recall hedge funds, managed futures, and Global Macro funds getting a huge thank you from the world for putting pressure on oil prices throughout 2014 and 2015. If we’re the scapegoat when prices go up, why the crickets when prices go down?
Critique: Managed Futures Mutual Funds have Hidden Costs via Swaps
Warranted: Yes, in some cases
Now this is the sort of critique that has merit. For those that aren’t aware, Managed Futures Mutual Funds have exploded over the past couple of years. These structures allow for a lower minimum investment than what were required in the past, but to get the square hedge fund peg into the round mutual fund hole, many of the early mutual fund companies launching managed futures funds did so via the use of a “swap.” This allowed the mutual funds to still be able to pay the sub-advisor’s their typical 2&20 hedge fund fees, which aren’t allowed in the mutual fund world (or at the least would make for an enormous expense ratio). Here’s Morningstar analyst Jason Kephart’s take, via Investment News.
“A total return swap is an agreement where the fund makes a fixed payment and gets an amount equal to the total return from an index or other investment, such as a hedge fund.”
Funds have to include a subadviser’s fee in its expense ratio. By using the swap, the fund can relegate its cost to a footnote (or simply a holding) and remove it from the expense ratio, Mr. Kephart said. And even then, the fund can simply report a range of potential costs.
The move can drop an expense ratio from 3% to 1.75% or less. “I can see how they would not want to advertise how big the fees actually are,” Mr. Kephart said.
Morningstar complained to the SEC about swap disclosure in an August 2015 letter. “In recent years, funds offering ‘liquid alternative’ strategies have more frequently held swaps linked to the return of a commodity pool, or a private index…if there are costs associated with the management of the CFC or expenses embedded in the return being received (in the case of swaps on the return of commodity pools), these expenses should be footnoted in the financial statements and reported either in calculations of total operating expenses or as acquired fund expenses in other filings.”
Today, these types of swaps are mostly a relic from when these sort of funds originally launched, thanks in no small part to juggernaut AQR – who chose the less traveled path of direct market access. For example, newer funds Auctos and $IMXIX don’t use swaps. As the lawyers urge you – read the prospectus (or call us) to figure out if the Liquid Alts mutual fund you’re using uses swaps.
Critique: Alternative Investments can be highly correlated