When science meets art: choosing the right manager.

Managing a multi hedge fund managers portfolio or a fund of funds, generally implies that, as the manager of such portfolio, you need to consider 3 main characteristics during your selection process from an investment point of view, (leaving aside the operational aspects intentionally for now).

Quality
Risk/return profile
Individual correlation

The first one is universal and resides in the intrinsic quality of a hedge fund manager, meaning his ability to generate consistent returns in line with his proposed strategy specifications and within a corresponding time horizon. It also takes into consideration the pedigree of the main decision maker, the experience and competence of the research team.

However, this intrinsic quality leaves quite some room for interpretation as for the investment rational, since this hedge fund will be part of whole group supposedly targeting a certain return objective and potentially a risk constraint. Picking a hedge fund exclusively on these terms may have, however, undesirable impacts.

Therefore 2 other characteristics? come to consideration in that context, so to maintain the integrity of the pool and to contribute to your diversification requirements.

The first one relates to the risk/return profile of the hedge fund you are selecting. This profile provides a strong indicator as per its return capability vs. its risk level, often looked at as its volatility of returns. The more the profile is detached from the other components of the portfolio, the more diversification it is expected to contribute to the portfolio. The Sharpe ratio is an indicator of such profile, but it is not sufficient to identify the hedge fund actual positioning vs. your other investments (Graph 1).

Graph 1: Risk Return Profile. Source: NS Partners

The second characteristic is the individual correlation of the hedge fund you are selecting to each of the other components of the portfolio. The lower the correlation the better additional contribution to diversification this new hedge fund brings to the mix. It is generally accepted that a correlation of 0.5 or lower is preferable, a negative correlation being considered as the best possible situation, all other conditions being validated, i.e profitable with an acceptable level of risk (Table 1).

Table 1 : Correlation analysis. Source: Ns Partners

From there, one need to appreciate that these characteristics bear some subjective factors, not in absolute terms since a ratio is a ratio. But it is only a ratio. Meaning that as a portfolio manager of a fund of funds you still decide what ratio is acceptable and in what range of profile and correlation do you allow your portfolio to be allocated to. I can’t deny that a few years of experience, multiple market cycles proven resilience are co-substantial to rational choices. Nevertheless, it is probably where science meets art.

Past performance is not indicative of future results. The views, strategies and financial instruments described in this document may not be suitable for all investors. Opinions expressed are current opinions as of date(s) appearing in this material only. References to market or composite indices, benchmarks or other measures of relative market performance over a specified period of time are provided for your information only. NS Partners provides no warranty and makes no representation of any kind whatsoever regarding the accuracy and completeness of any data, including financial market data, quotes, research notes or other financial instrument referred to in this document. This document does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorized or to any person to whom it would be unlawful to make such offer or solicitation. Any reference in this document to specific securities and issuers are for illustrative purposes only, and should not be interpreted as recommendations to purchase or sell those securities. References in this document to investment funds that have not been registered with the FINMA cannot be distributed in or from Switzerland except to certain categories of eligible investors. Some of the entities of the NS Partners Group or its clients may hold a position in the financial instruments of any issuer discussed herein, or act as advisor to any such issuer. Additional information is available on request.
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Will 2016 be the year for managed futures?

Source Bloomberg. Linear regression showing quarterly performance over ten years of the Newedge CTA index and the MSCI World. This graph shows how CTAs generate large levels of alpha in both up and down markets but add very little value in a choppy environment where market performance is zero. — Source Bloomberg.
Linear regression showing quarterly performance over ten years of the Newedge CTA index and the MSCI World. This graph shows how CTAs generate large levels of alpha in both up and down markets but add very little value in a choppy environment where market performance is zero.

It will be no surprise to readers of this blog that investors who were able to overweight managed futures (also known as Commodity Trading Advisors or CTAs) in their portfolio outperformed during market shocks, especially in 2008. January of this year is proving no exception with the Newedge CTA USD Index up 4.18% in a market where the MSCI World (also in USD) was down 5.35%. Generally, managed futures use technical/systematic models that utilize futures and forward contracts to trade long or short exposure to international equity indices, interest rates, currencies or commodities. Their sources of return vary but empirical evidence shows that generally managed futures strategies perform well during market downturns (Sep ‘08, Sep 11 ‘01, ‘98). This is the main reason they have been touted as natural hedges to an overall portfolio of risks (especially equity risk), carrying an implicit long volatility component.

Again, not all managed futures funds make their money in the same way, but most seek to benefit from trends which, in their more basic form, are persistent price phenomena that stem from changes in risk premia. When risk premia increase or decrease, underlying assets have to be repriced and as long as there is uncertainty about the future, there will be trends for CTAs to capture. It is therefore also intuitive that there is a long volatility component in there. If you feel 2016 will be a year where global growth will be reassessed to the downside and markets question the ability of central bankers to restore stability, this could be the strategy for you.

“There are many more advantages for investors” claims Manel Sarabia of NS Capitrade who runs a trend following strategy out of CM Capital Markets in Madrid. “As well as offering low levels of correlation to other investments (going from positive to negative depending on the trends essentially), they are highly diversified into anything from 50 to 200 different markets. CTAs are also very liquid (by the mere nature of the futures contracts they trade in) and offer transparency very few other managers can match. Capitrade for instance, offers clients real time access to all its positions through a web based portal” adds Sarabia.

Buyers beware though. It seems intuitive to also assume that a manager following long or medium term trends will not be “automatically” well positioned to benefit from a trend reversal or market crash. This has been the case when trend following managers lost money during several corrections Oct ‘05, May ‘06, Aug ’08 and Aug ’11 (see graph above). On the other hand, when the trend is confirmed, their models should capture the movement very well… often helped at this stage by rising volatility.

“This is why we recommend a blend of strategies and managers” opines Sébastien Poiret who co-advises several fund of funds including a dedicated fund of CTAs at Notz Stucki in Geneva and goes on to add “we recommend placing approximately 2/3rds of our allocation in trend following strategies (mainly long term) and the rest in short term managers that may trade on tick data and usually try to benefit from short term trend reversals and range break outs. This latter category includes managers that have very little correlation between them (unlike most trend following funds which are usually playing the same trends) and also carry a long volatility component.”

“Investors need to accept there will be volatility ‘along the way’ exemplified by the 2009 to 2013 period where a few quick reversals came to abruptly take away months of painstaking performance generation. The best managers carry over time a Sharpe ratio of 0.8 to 1 and if they annualize between 12% and 15% performance, you can assume 15% volatility and therefore peak-to-trough drawdowns of 20%. That’s the nature of the beast” concludes Poiret.