A Whole New World

By Cliff Stanton and Jeremy Frank

November 2016


We are two weeks post-election, and clearly, “the times they are a changin’.” Concerns of deflation have quickly shifted to inflation, causing the bond market to go through convulsions. The yield on the 10-year Treasury has increased roughly 50 basis points since the election, and long term Treasuries (as measured by the Bloomberg Barclays 20+ Year Treasury Index) have fallen over 7%. Interestingly, an article in FundFire on election day noted that the largest bond manager in the world, PIMCO, will, “…make a gradual shift into alternative investments as it steps back from its reliance on bonds, according to the new CEO, Emmanual ‘Manny’ Roman.” PIMCO and other bond managers are undoubtedly worried about the outlook for their flagship strategies at this inflection point.

On a related note, our conversations with advisors of late have been centered on the need for yield when many yield producing assets are overvalued and under pressure in light of rising rates. Further, balancing myriad risks (e.g., equity, default, term, liquidity, inflation, etc.) with monetary and fiscal policy completely up in the air is a challenge on the minds of all investors, to be sure. Our belief about investing is that there are moments to take on healthy helpings of risk, i.e., when a true fat pitch exists, and there are moments to shy away from risk, protect capital, be patient and live to fight another day. We think we are in the latter environment, despite what has happened in equity markets over the last two weeks.

The phrase “the devil is in the details” has never been more true. The outlook for everything from emerging markets, international developed equities, mega cap US exporters, small cap domestic companies, and on and on is as uncertain as uncertain can be at this point. The shifts that could occur may in fact lead to the kind of “fat pitches” we referred to above, but for now, employing the prevent defense would seem appropriate. As we’ve written elsewhere recently, risk continually mutates, and so must our defenses. We’d advise a careful examination of the risks in your portfolios. Know what you are holding and why, in the context of meeting the stated goals of the client, and take the steps necessary to reduce drawdown potential. The most interesting times in this business, and the best times to make money, are when fear overtakes greed. Asset values become dramatically more attractive, but you’ve got to be able to deploy capital when those moments occur, which means you’ve got to preserve it in the meantime.

The Data

October was rough for most alternative and traditional categories, as there were few places to earn profits. Bonds, domestic equities and international equities all posted losses. Managed futures did not provide a hedge during the month, posting losses that exceeded most equity markets. This is to be expected over short-time frames, as the category is not a direct hedge, rather, it’s a diversifier with low to slightly negative correlations to equity markets. In this negative environment, market neutral and long/short credit funds were able to buck the trend and post small gains.

All the major alternative categories continued to experience outflows; even the seemingly immune managed futures category slowed considerably. It is probably fair to speculate that recent performance has finally caught up with the category. Many funds are in double-digit drawdowns that extend back to early 2015. However, as we have pointed out multiple times in the past, investor behavior tends to be a contrarian indicator to future performance; given this slowdown in flows to the managed futures category may be a good sign for those who stick with their allocations.

Alternatives in the News

While the Country is Vehemently Split, Hedge Funds Seem to See Trump as a Positive

Whether they support him or not, many large hedge funds seem to see Trump as a positive for the economy, or at the very least for their investment portfolios. See a few links below:


Sad News for the Hedge Fund Community as a Pioneer Passed Away at Age 64

From the New York Times:

Lee Hennessee, a pioneering woman in the male-dominated hedge fund industry and the creator of one of the first indexes to track its secretive transactions, was found dead on Oct. 29 at her home in West Palm Beach, Fla. She was 64. The cause was apparently a stroke, said Chase Scott, a spokesman for the family. Ms. Hennessee was a frequent presence at industry conferences and was an early supporter of the industry association 100 Women in Hedge Funds. Ms. Hennessee started her hedge fund index, tracking which strategies were making or losing money across the industry, in 1987. That same year, while working for E. F. Hutton, she founded the Hennessee Hedge Fund Advisory Group, a division of Hutton. The firm conducted research and advised clients about investments in hedge funds, an industry that at the time was growing quickly but was even more tight-lipped about strategies or returns than it is today.

Hedge Fund Clients Dump Humans for Computers and Still Lose

As is usually the case, investors may have given up on their existing investments to hire computer-driven counterparts just in time for performance trends to change. Of course, this is a sweeping generalization, but many high performing quantitatively-driven funds are suffering in 2016. From the above linked article:

Losses at Leda Braga’s computer-driven hedge fund (Systematica Investments) this year are running at about twice the level suffered by a macro fund run by billionaire Alan Howard (Brevan Howard Assset Management). Yet, while Braga has raised money, investors have pulled billions of dollars from Howard’s fund.

The divergence is a sign of the sweeping changes underway in the $3 trillion global hedge fund industry, where investors are shunning flesh and blood traders and putting their faith, and hard cash, in algorithms to bet on macro-economic trends.

Speaking of Computer-Driven Performance – A Must Read Article on Renaissance

Gaining insight on the notoriously secretive and extraordinarily successful Renaissance Medallion Fund can be very difficult. Here’s a good read on the firm’s history and a rare glimpse inside the organization.

Education


Rehashing an Old Question – Capacity and Trend-Following Managed Futures

Given our product lineup, it is unlikely anyone would be surprised that we have been researching trend-following approaches rather extensively over the past few years. With that, one of the exercises we go through anytime we are researching new strategies and markets is an analysis of liquidity and capacity. Given the growth that managed futures mutual funds have seen over the last 18 months, coupled with recent poor performance, a natural question is not only what the capacity would be for a fund, but also whether the strategy itself has reached capacity.

Of course, the last time that managed futures funds had great performance (2008), followed by strong asset growth (2009-2012), the strategy went into a relatively long and deep drawdown. At that time, many were concerned the strategy may have experienced excessive asset growth, and that capacity was playing a role in the underperformance. Given everyone will have some extra time this holiday weekend, I’m sure most will be looking for decent whitepapers to read, so I’ll point you to a good paper NewEdge wrote in 2013 that addressed both the drawdown managed futures funds were experiencing and a framework for thinking about capacity. Their conclusions were that, at the time, capacity was not impacting returns and that the drawdown was well within expectations, given the return and volatility profile of the strategy. Subsequently, it’s interesting to note that trend-followers went on to have strong years in both 2013 and 2014.

But what about now? According to BarclayHedge, assets under management for systematic traders within the managed futures category have remained pretty stable, at just under $300 billion. This implies that any growth that has happened has taken place primarily in the mutual fund space. Our own analysis indicates that NewEdge’s conclusions still hold and, all things considered, it is probably safe to say that the managed futures industry has not reached capacity.

And Lastly

From everyone here at 361 Capital, we hope you had a Happy Thanksgiving.

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