What do you really want?

What do you really want?
The last few months have been tough on most investors. Not only have most asset classes — and long-only-related strategies — been in negative territory, but stories abound about the top names in the hedge fund world struggling in this environment, from Ray Dalio of Bridgewater to Bill Ackman of Pershing Square to David Einhorn of Greenlight Capital to John Paulson of Paulson & Co. Investors have reacted; hedge fund assets have been declining, and most liquid alternative categories have likewise experienced net outflows.

Our observation is that these outflows are often times a function of unrealistic expectations. As we point out in the Education section below, investors routinely mistake “low correlation” or “uncorrelated” with “negatively correlated.” Only negatively correlated assets rise in a falling market. Most alternative strategies, regardless of the vehicle type in which they are run (e.g., LP vs. mutual fund), are designed to exhibit low correlations and/or low betas to traditional assets. If negative correlation is the goal, then those investors should allocate to dedicated short sellers, such as bear market funds in the mutual fund world. Those funds have collectively lost 20.2% annually over the past five years ending in September, according to Morningstar.

A portfolio is a collection of assets assembled to achieve a certain goal that is almost certainly not measured over days or weeks. As Yale’s David Swensen has said, “Casual commitments invite casual reversals.” The purpose of a robust due diligence process must be to avoid making such an error. The due diligence process has to ensure that investors know what they are buying, what the return drivers are, and what embedded risk factors exist. Investors must acknowledge that the dips in the growth of a dollar chart may be painful in that moment, but are to be expected. If the initial reaction is to sell when a strategy prints a negative return, we’d suggest re-thinking the diligence process itself, rather than the strategy selected.

Liquid Alts Corner
The Data


Data as of September 30, 2015

Volatility continued in September and equity markets were down globally. The Russell 3000 Index was off 2.9%, the MSCI EAFE Index was down 5.1%, and the MSCI Emerging Market Index was lower by 2.6%, all in dollar terms. This once again created a headwind for long/short equity strategies, which lost 1.8% on average during the month, but were still able to provide some downside protection. Long/short credit funds were down about 1.3%, struggling in an environment that rewarded duration and punished corporate credit, with junkier fare losing almost as much as U.S. equities. Multialternative funds were down about 120 basis points, as all major asset classes posted losses, but managed futures funds were able to generate positive returns (+1.4%), in part due to the continued slide in oil. Lastly, equity market neutral funds earned just over 1%, which was impressive given their net long exposure and the increased correlation across stocks. Equity market neutral is the only category with positive performance in 2015 (+0.5% through September).


Data as of September 30, 2015

Asset flows exhibited the same general pattern we’ve seen all year. Managed futures and multialternative funds had strong inflows, bringing in nearly $800 million and $600 million respectively, while all other categories experienced outflows. Market neutral, long/short credit and long/short equity all shed roughly a quarter of a billion during the month. And while managed futures funds had inflows, those flows were fairly concentrated, with the top four funds accounting for almost all of the positive flows for the month. The long/short equity space was a bit more complicated, as huge performance dispersion within the category has driven large dispersion in fund flows. Several funds saw outflows in excess of $150 million, while many more funds had modest inflows of between $25 and $100 million during the month.

Alternatives in the News
2015 hasn’t been kind to hedge funds thus far, with many high profile funds closing their doors.

Hedge funds and hedge fund firms have been closing at an alarming rate in 2015. Everyday seems to bring new headlines of funds or firms shutting down amidst poor performance and “lack of investor interest.” Below are a sample of some very recent announcements:

  • Fortress will be shutting down its roughly $2 billion Global Macro fund in the face of large losses. The fund is down 17% in 2015 through September, much of which came in the first month of the year due to a Swiss franc trade that caused pain for many macro-focused hedge funds. The fund launched in 2002, and its assets had been hovering between $3 and $4 billion since 2009.
  • Bain Capital is liquidating its Absolute Return Capital hedge fund after suffering losses over the last 3 years. The fund had roughly $2.2 billion in assets as of August 1 but was down 13% in 2015 through July.
  • MeehanCombs, a credit-focused fund, is shutting down after losing 6% last year and 7% through August in 2015. More than half of the firm’s assets were from liquid alternative funds run by Hatteras and BlackRock, both of which asked to redeem in August. Rather than leave the remaining clients with the less liquid assets, MeehanCombs made the decision to liquidate the portfolio and shutter the firm at the end of October.
  • After a difficult year, Armored Wolf, a firm founded by former PIMCO executive John Brynjolfsson, has decided to close, returning outside capital by year-end. Mr. Brynjolfsson will then focus on managing his own cash, which we suspect grew considerably as his investors lost money.
  • Cargill is shuttering $7.4 billion Black River Asset Management, spinning off three of the firm’s funds to employees of the firm. The firm’s remaining two funds will be absorbed into Cargill’s risk management division.
  • Liongate Capital Management, one of London’s best known hedge fund of funds, which ran nearly $3.5 billion at its peak but has recently fallen to less than $500 million, will be shutting down. The decision has come after lackluster performance, investor outflows and the departure of the founders earlier this year.
  • Additionally, it appears Renaissance Technologies will be shuttering its $1 billion Institutional Futures Fund due to lack of investor interest. Thus far in 2015 the fund is down about 1.75% and since its launch in 2007 has annualized at just 2.86%.

Education
August and September left many investors shaken, as volatility spiked and losses mounted across asset classes and strategies. This left many investors conducting post-mortems on their portfolios, which likely led to disappointment to some extent, as many “uncorrelated” strategies seemed to be correlated. When looking at a portfolio on a daily basis during times of stress, investors are almost guaranteed to be disappointed. Any given day, week or month, strategies or assets that are uncorrelated over longer periods can behave similarly to overall market movements, and if risk has increased, the moves will be larger. Ideally, investors will have thought through this possibility ahead of time, which will allow for more level-headed thinking during market turmoil. One’s emotional response to daily moves should be considered when constructing a portfolio. The key is to know that you will have an emotional response in the face of losses, but rather than react, trust that you have constructed a portfolio to be resilient in timeframes longer than a day, week or month. If, as an investor, you find yourself ready to jettison assets after a week, quarter, or even a year of disappointing performance, then you are probably better off holding Treasury bills, as you are almost guaranteed to be selling for the wrong reasons.

One problem that becomes clear every time market volatility rises is that investors expect “uncorrelated” to be negatively correlated. In other words they are really looking for a direct hedge. The problem with direct hedges is that they are rather expensive when you don’t need them, and the pain of holding those positions for months or years before they payoff often leads to abandoning such positions prior to the time when they would in fact become useful. The simplest example would be the iShares VIX Short Term Futures ETN (VXX). Had you held VXX during August and September, you would have made a staggering 60% gain — certainly an effective hedge during a horrible time for the rest of your portfolio! However, there’s much more to this story. This same ETN, if purchased at the end of 2014 and held through the end of September, would have been down nearly 19% during the same timeframe that the S&P 500 Index lost only 5.3%. Maybe not such a good hedge after all… What if an investor was looking for a hedge after the meteoric rise of 2013 and purchased VXX then? They would be down 40%. What if VXX had been bought on the day of its inception, January 29, 2009? That investor would be down 90%. That’s after gaining 60% over the last two months!

So what’s the point of beating up on VXX? It’s that direct hedges are costly and that positive returns to such hedges are usually produced over very short time frames, requiring deft timing skills if they are going to be captured. Alternatively, prudent investors should probably rely on indirect hedges or uncorrelated assets that over longer timeframes produce returns that are independent of the market, knowing that at any given point these investments may behave similarly to the market. You build a portfolio for the long haul; getting too focused on day-to-day movement can only undermine the hard work you have already done.

Technology

At nearly 33 years old, the Bloomberg Terminal still remains one of the most relied-upon technologies for those within the investment management industry. Not only is it still utilized extensively within the industry, but it is also a piece of finance history, as it has gained two museum appearances this year. A current Bloomberg Terminal setup is one of the artifacts in the “Tools of the trade” display at Silicon Valley’s Computer History Museum that traces the history of financial technology back roughly 10,000 years. In addition, the Smithsonian’s National Museum of American History included two very distinguishable custom Bloomberg keyboards, one of which belonged to bond trader, Bill Gross. For a good read about the history one of the financial industry’s most recognizable and crucial technologies click here. In the meantime, I can’t wait for the Oculus Rift-based terminal!

And Lastly…

Our own Josh Vail, Senior Vice President of Sales at 361 Capital, ran an impressive sub-3-hour (2:58:40) marathon earlier this month at the Chicago Marathon. We want to congratulate Josh on his outstanding accomplishment. He placed 129th in his division and 827th overall; there were a total of 37,182 runners that finished the race (10,144 men). We recognize his dedication and hard work to accomplish his goal of finishing the race in under three hours. CONGRATULATIONS JOSH!

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