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.
Hedge Funds
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
Warranted: No.
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.”
[drizzle]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 with stocks
Warranted: Yes, with one big exception
Here’s a rather big critique which is starting to gain more of a voice – that these alternative investments aren’t all that alternative. WealthManagement.com highlighted this in their ‘10 myths of Hedge Funds’ piece, pointing out how some hedge fund products are diversifiers in name only.
“Absolute return” implies that you make money in good markets and bad. The 2008 drawdowns (about half those of the equity markets) blew up this fantasy. Hedge funds had equity beta of around 0.3 going into the crisis, but declined more than expected when illiquid assets were marked down. The only hedge funds that made money in 2008 were CTAs (commodity trading advisors), and they did terribly for the next five years.
We’ll be the first to tell you that not all alternative investments are alternative, going into detail how Hedge Funds, Commodities, and Private Equity don’t provide diversification when it’s needed most in our “Truth & Lies in Alternative Investments” whitepaper. But while this may seem like a complex look into the different return drivers of different asset classes, the reasoning is pretty straight forward – private equity, long/short equity, stat arb, credit arb, distressed debt, and more are using the very stocks and companies that make up a traditional stock portfolio, albeit in more sophisticated and risk controlled ways. They’re also big believers in leverage, borrowing money to structure their investments – tying them to the credit cycle along with the rest of the economy. The one big exception, managed futures – as pointed out in the article because they exposure across stocks, bonds, currencies, and commodities; and aren’t exposed to the credit cycle. About that last line…. terribly for the next five years? That’s a bit of a stretch. Managed Futures indices have gone on to make new equity highs in 2014, 2015, and 2016. {Disclaimer: Past performance is not necessarily indicative of future results}.
And while talking managed futures, here’s how the Financial Times explained them, referring to them by their technical name, CTAs (Commodity Trading Advisors).
CTAs are trend-following, algorithmic hedge funds that tend to buy securities that have already gone up in price, and sell falling ones.
That’s a pretty decent definition, except for the word securities. Managed Futures funds buy and sell exchange traded futures markets, mainly – not ‘securities’ such as outright investments in company stocks and corporate bonds. The simplistic definition ignores the fact that those buys and sells can be on markets as varied as German Bunds, Cotton, Japanese Rubber, or London Aluminum. To learn more about Managed Futures, click here to download are “What Is Managed Futures” whitepaper.
Critique: Nobody wants Alternatives Funds, they’re being pushed on investors.
Warranted: No
The New York Times Deal Book has even taken interest in this space, saying that despite the outflows from other hedge fund like products, retail investors are sticking with Managed Futures Mutual fund products. But their reasoning? Because it’s being pushed to investors.
That interest may largely be because brokers and financial advisers have been selling liquid-alt funds to investors as an alternative to risky and richly priced stocks and bonds, Mr. Black said. “Nobody is calling their broker and saying ‘I would like a multi-alternatives fund or a managed futures fund.’”
This is a bit of a stretch. First, the tremendous growth in the RIA space has shown there’s a big movement away from ‘brokers’ pushing product into fee based ‘advisors’ recommending investments that fit client needs. So while there may not be a huge number of people calling up saying they want a multi-alternatives or managed futures fund, there are surely lots of people saying they want more out of their portfolio. More diversification, more risk protection, more return drivers, and no more 2008 like debacles. Those conversations lead to the advisors seeking out those products which can help meet those needs, mainly managed futures funds due to their unique qualities, so any pushing of these products is because the advisors are being pushed to find them.
Critique: The Hedge Fund Party is over, look at the outflows
Warranted: Maybe
Media wants you to know that there’s a mass exit in the Hedge Fund industry, implying that this could be the beginning of the end for the group (despite Managed Futures seeing massive inflows).
For hedge funds, the news is getting worse. Investors pulled an estimated $25.2 billion from hedge funds last month, the biggest monthly redemption since February 2009, according to an eVestment report. The monthly withdrawals were the second straight for the beleaguered industry, which saw $23.5 billion pulled in June. They bring total outflows this year to $55.9 billion, driven by “mediocre” performance.
Every report of outflows, performance trailing the S&P, or pension ditching their hedge fund allocation is used as proof that something’s wrong in the hedge fund space – with too many funds chasing too few opportunities – leading to an inevitable reckoning where hedge funds assets shrink considerably. Here’s Reformed Broker from a cleverly named post, nothing recedes like success:
There’s surely a lot of hedge funds out there, nobody’s arguing that. And the performance hasn’t been great the past few years. But a few things to remember here.
One, the performance isn’t supposed to beat the S&P. Articles saying the hedge fund indices are trailing the S&P for the year have little to no meaning to those actually invested in the space. They invest for risk adjusted returns. Of course, if the risk adjusted returns aren’t there – that is a problem – and when the stock market is at all-time highs with record low volatility, that’s a tough benchmark to beat both on a straight return basis and a risk adjusted basis. So most of these redemptions could simply be a reflection of stocks back at all-time highs, where the appetite for diversification will recede – leading to redemptions from diversifiers.
Two, not all alternatives are affected equally by too many people trying to do the same thing. 300 different hedge funds trying to scoop up distressed debt will push the price of that debt up, making for lower returns. 300 private equity firms trying to find good companies to invest in will push those prices up, making for lower returns. But 300 managed futures firms trying to get on the same trend may not cause the same problem. We’ve seen AQR answer the question of too much money being in trend following with their research showing trend following is at most 0.2% of the size of the underlying equity markets; 3% of the underlying bond markets; 5% of the underlying commodity markets; and 0.2% of the underlying currency markets. And we don’t have to look too far to know that lackluster performance And we don’t have to look too far to see why macro and managed futures funds struggled in August. The trend in rates reversed with talk of the Fed tightening. Rates didn’t go back up because there was too much money in quant trend following strategies. They went back up because traders, banks, investors, risk managers, and so forth processed the headlines and reacted. This wasn’t a too much money trying to trade problem, it was a you’re in the wrong trade problem.
Finally, there’s still a world of opportunity out there. Just look at moves like Oil falling 50% in 2014/2015. Too much money in hedge funds didn’t evaporate that opportunity? For unique strategies identifying different return drivers, there’s still plenty of opportunity out there and assets will likely continue to rise. But for crowded strategies like long/short equity or Private Equity – the top may be in, with fewer funds and less assets on the horizon.
Peak Hedge Fund Pushback?
Whether we’ve seen peak hedge fund assets or not remains to be seen. But we can’t help but feel we may be at a new high in hedge fund push back/criticism. As noted earlier, that’s to be expected with stocks at all-time highs, but this also feels like a buying opportunity for the contrarian in us. You can just see the graphic at some point in the future, showing asset flows into stocks and out of diversifiers, just as the top was in. There’s hedge fund blood in the streets on the page, are you buying or selling?
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