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| Professionally Managed Futures Investments | |
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| 202 South Second, Fairfield, Iowa 52556 641 469-5188 800 844-5188 fax: 641 472-2074 | |
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Hedge Against What?
By Roy G. Niederhoffer Hedge funds perform well only when stock gain, says one pro. Reprinted courtesy of Barron's, February 1, 1999 |
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As many fund investors discovered during the unhappy third quarter of 1998, no
investment is an island. While equity markets plummeted worldwide, credit-quality
spreads widened dramatically, which pummeled virtually every type of fixed-income
security other than U.S. Treasuries as capital flocked to the safest, most liquid
instruments. And then, as suddenly as it began, the crisis faded.
With no inconsiderable help from interest-rate cuts by the Federal Reserve and
other central banks around the globe, equities took off on one of their greatest
rallies in decades, and the boom seemed intact. But then, last week's devaluation
in Brazil sent new shock waves through the global stock markets, and once again,
almost no world market or investment strategy escaped unscathed.
Some investors who doubt that equities are preordained to return 20% every year
have sought alternatives, notably hedge funds. And until recently, many of them
have performed admirably, providing strong returns while avoiding many of the
pullbacks in equities.
But during the market debacles of last August and September, what many investors
thought of as diversified hedge-fund strategies turned out not to be diversified
at all. That included - but wasn't confined to - those used by Long-Term Capital
Management. Almost every type of hedge-fund strategy lost money, from those
based on going long equities to "market-neutral" approaches, from convertible-bond
arbitrage to global macro trades, as the chart here shows. The sole winners in
the carnage: commodity trading advisors, or CTAs, a/k/a managed futures accounts.
The poor performance of so many hedge-fund strategies last fall, no doubt shocked
their managers and investors, and not just because of the extent of the losses.
They were surprised that the various hedge-fund strategies - all designed to
provide some protection during market upheavals - failed to deliver their
promise and instead led to massive hits in tandem with the stock market.
Why? One possible answer: A hidden "long bias" has crept into many types of
hedge-fund strategies, even those that don't involve equities.
Scrutinizing the performance data carefully, we find that these funds perform
well and are very good alternatives to equities - as long as stocks are going
up. That isn't because most hedge-fund managers are closet stock buyers
(excepting, of course, those whose strategy is to be long equities.) Instead,
they have been making money from the same conditions that make share prices
climb: declining or stable interest rates, ample liquidity and an environment
in which the risk premium is overpriced (one in which riskier investments do
better than safer ones).
But during difficult times, like last August and September, a very different
set of circumstances arises. Suddenly, as liquidity dries up and risk is
eschewed instead of embraced, hedge funds start performing very much like
equity index funds.
To explore this phenomenon, a brief foray into statistics is necessary. The
measure known as the correlation coefficient can serve as a fast guide to the
relationship between two sets of data. It ranges from plus 1, which indicates
that two series move in lock step, to minus 1, where they are in opposite sync.
A correlation of zero means there is no discernable relationship. For example,
the U.S. stock market has a plus 0.6 correlation with the German market; they
tend to move together in the same direction. Meanwhile, the correlation
coefficient between long-term bond prices and the consumer price index is minus
0.5, since the two move in opposite directions.
In months when the S&P 500 was rising, investors have benefits from diversifying
into hedge funds, whose performance at such times has very little relationship
to the price of U.S. equities. But as the table here indicates, in months when
the S&P fell, hedge funds' performance tended to be highly correlated with
stocks. And that, of course, is precisely what investors don't want.
But how did commodity trading advisors do so well as the S&P 500 crumbled?
With a reputation for high volatility and high fees that probably was well-earned
in the past, the managed futures industry missed the explosive growth enjoyed by
many other sectors of the hedge-fund world. But in recent years, fees have
dropped, the volatility of many advisers' performance is declined dramatically,
and the strategy as a whole has become much more viable, as well as increasingly
valuable in portfolios.
The most common CTA strategy is long-term trend following, in which advisors
capture extended price movements in fixed-income, currency and commodity
markets. As stock markets headed downward in the third quarter, this strategy
chalked up record profits in long U.S. and European fixed-income positions,
as well as short positions in commodity markets which declined in the
deflationary environment.
Other strategies employed by futures advisors include short-term momentum
trading, which simply means placing one's bets in accordance with the
direction of large or rapid futures price movements that may last just a few
days or hours.
Another strategy is contrarian trading.
Here, trades typically last from one to five days and are made against the
prevailing market trend.
Followers of momentum strategies usually profit from most large price swings
that last a few days, while contrarians tend to perform best in the highly
volatile, emotional atmosphere that often accompanies stock-market declines.
Recent demand for high investment liquidity, low leverage and full transparency
should aid the managed futures industry.
Most CTAs offer managed accounts to their clients, allowing full disclosure
of positions and trades. These accounts usually offer daily redemptions and
additions, though some may permit only monthly entry and exit. And the
leverage employed by managed futures traders usually ranges from zero to
two times their equity, providing some comfort after last year's disasters
involving extreme leverage. (Some reports put Long-Term Capital's leverage
ratio at 50:1.)
Many of the largest managed futures traders have track records that date back
10 or even 25 years, showing positive performance in inflationary periods, in
bear markets for stocks, as well as in the bull market of recent times.
As investors search for alternatives to equities, accounts run by Commodity
Trading Advisors are one possibility that some investors might do well to explore.
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© 2007 Iowa Capital Management, Inc. All rights reserved.