Futures Investing by Institutions
Tom O'Donnell, partner at the Bornhoft Group Corp., knows pension investing
from the inside. Earlier in his career he was program director at the Virginia
Retirement System, one of the largest public pension funds and among the first
to invest in managed futures. Mr. O'Donnell helped launch the retirement
system’s managed futures program in 1991.
He’s also been on the other side. He left the Virginia Retirement System in 1995
and went to work for Chesapeake Capital Corp., at the time one of the largest
commodity trading advisors. More recently he was a vice president in the
Alternative Investments Group of Newedge USA, focusing on capital introduction
between institutional investors and managed futures providers.
Here he gives a detailed discussion of how big institutions go about investment
decisions and what special issues this process poses for managed futures and
Bornhoft Group specializes in multi-manager commodity trading advisor portfolios
for institutional and other investors. The firm has allocated close to $1.9
billion to CTAs over the years and currently oversees $770 million in assets.
“There are a variety of myths and misconceptions about managed futures,
but proper education can overcome those obstacles.”
Opalesque Futures Intelligence: How did the Virginia Retirement System
come to invest in managed futures?
Tom O'Donnell: Back in 1990, when the suggestion first came up, we were
admittedly taken aback by the thought of it. At the time derivatives weren’t
viewed favorably, and initially we thought that leverage and the idea of
investing in things like pork bellies seemed odd, particularly for a public
pension fund. However, as VRS investment staff we had a fiduciary responsibility
to investigate any investment that could help us achieve better risk-adjusted
returns for the beneficiaries. We were compelled to act in a comprehensive way,
gathering the evidence for and against all of the investments that we became
aware of, including managed futures. After gathering the evidence and doing the
research, we wrote a white paper about managed futures. We got investment
committee and board approval and started the program in May 1991. Incidentally,
that’s when I came to know Richard Bornhoft. His firm was one of the firms we
hired at the inception of the VRS managed futures program to pick CTAs on our
OFI: Just to be clear, is there a difference between commodity investing
TOD: Yes. Commodity futures were the first futures contracts CTAs traded,
hence the name. Over the years, the arrival of financial futures enabled CTAs to
become more broadly diversified. Many CTAs trade over 150 futures markets.
Commodity-only investing represents a subset of the markets that CTAs trade.
However, the name stuck and they are still referred to as CTAs. It is important
to mention that CTAs invest both long and short in an effort to capitalize on
the directional moves in the markets, while much commodity investing that has
occurred is in long-only commodity indexes. The differences are quite meaningful
since CTAs have the ability to make money during rising and falling market
environments while long-only commodity indexes do not. When commodity prices are
declining, long-only commodity investments lose money.
OFI: Are there other differences or similarities?
TOD: When an investor decides to invest in long-only commodities she must
decide what percentage to allocate to commodities, say 5%. CTAs are more
opportunistic and focused on generating an absolute rate of return. They know
that a static 5% fixed weight to long-only is not always optimal. Long-only
commodity indexes have been cited as a good inflation hedge. It is less well
known that managed futures are, too.
OFI: What are the barriers to pensions allocating to CTAs?
TOD: It is actually no different than any other investment; it requires
education and a willingness to dedicate the time. Institutional investors and
their consultants need to get their hands on the data and try to write the
research report that proves why they should not invest in managed futures. We
tried this at the VRS when I was there and ended up reaching the opposite
conclusion. In addition to the need for education, another barrier may be
institutional investors’ strategic asset allocation policy, which is the main
driver of their total return. It involves defining asset class boxes and
assigning percentages to each box. Generally speaking, each box represents a
specific asset class like equities, fixed income, real estate, and more recently
commodities. It is also common for there to be many sub-boxes within these asset
classes, like US large-cap value and growth, international equity, emerging
markets, international fixed income, etc. For any investment to make it into the
investor’s portfolio it must fit into one of the strategic investment policy
boxes. CTAs invest both long and short in the world’s portfolio of
exchange-traded, liquid, global markets, comprising equities, interest rates,
currencies and commodities. I imagine that many investors aren’t quite sure how
to get their arms around something this diverse.
OFI: What’s the solution?
TOD: To the question, “Where do we put this in our strategic asset
allocation policy?” the simple answer is: the alternative investments box.
During my twenty-year career, we have witnessed incredible asset growth in the
alternative investment industry. The number one reason for getting into
alternative investments is diversification. What amazes me is that approximately
85% of the money invested in alternative investments has been allocated to
equity-based and fixed income-based hedge fund strategies, which means it is in
equities and fixed income. One of the lessons from 2008 is that it is difficult
to achieve true diversification when you don’t change the asset class.
OFI: Are you saying hedge funds are a problem?
TOD: Please don’t misunderstand me, I am a big fan of hedge funds, but I
believe it is a mistake to put all hedge funds and CTAs together in the
alternative investments box. Investors would be better off putting their
equity-based and fixed income-based hedge funds in their equity and fixed income
asset class boxes respectively. Long/short equity hedge funds should be seen as
an alternative to long-only equity and viewed as a way to improve one’s source
of active equity management. The global market diversification that can be
achieved via a properly constructed portfolio of managed future and global macro
strategies makes it difficult for it to fit neatly into a single asset class
box. These belong in the alternative investment box. The statistical and
empirical evidence supports this claim.
OFI: Is diversification managed futures’ main selling point?
TOD: My belief is that the primary reason to get into managed futures is
diversification. However, it is equally important to achieve attractive,
absolute, risk-adjusted returns. The variability among CTA returns in any 12
month period is quite large and there are well over 1,000 CTA and global macro
programs available to choose from. Manager selection and portfolio construction
are among the keys to achieving success in managed futures and should not be
overlooked. When I was at the VRS, we knew we didn’t have the time or the
experience to pick the managers ourselves. That is why we hired firms that are
specialists in this area.
OFI: How does futures investing work for retirement systems?
TOD: Another selling point for managed futures and global macro relates
to the ultimate objective of a pension fund, which is to pay benefits. We all
know that markets move in two directions, up and down. Shouldn’t investors seek
to take advantage of both types of moves across all exchange-traded markets in
equities, interest rates, currencies and commodities? Long-only, also known as
buy-and-hold, or as I like to say buy-and-hope, is guaranteed to fail at some
point, and for some time. Pension funds don’t have the luxury of skipping
monthly benefit payments during bear markets. They need to consider carefully
what percentage of the portfolio is invested in relative return strategies
versus absolute return strategies. Relative returns that are negative do not pay
benefits no matter how good they look against the benchmark. The pension fund’s
ultimate objective is an absolute rate of return called the actuarial rate. No
combination of relative returns strategies can achieve an absolute rate of
return consistently. Institutions need to include absolute return oriented
investments like managed futures in their portfolios.
OFI: What happened in 2008?
TOD: It was not only a very difficult year for long-only equities, it
also turned out to be an ugly year for long-only commodities. By contrast,
managed futures returns in 2008 were in the positive double digits on average. I
should point out that managed futures has a long history of performing well in
difficult equity market environments.
OFI: But in 2009, managed futures was the loser. What’s your view on
TOD: In 2009, equity markets did well, by extension leveraged beta
strategies –by which I mean traditional hedge funds – did well, while managed
futures was flat-to- slightly negative. That demonstrates, yet again, that
managed futures is not correlated! You may look at those returns in the rearview
mirror and say, we should have been 100% in managed futures in 2008 and 100% in
equities (or leveraged beta strategies) in 2009. But nobody can run their
portfolio that way. Performance chasing is a very difficult and dangerous game
to play. If you want to smooth out your equity curve, true diversification is
essential. While past performance is not indicative of future performance,
managed futures and global macro strategies have a compelling history of
delivering true diversification and absolute risk-adjusted returns.
OFI: Will the 2009 experience discourage institutional allocations to
TOD: It is frustrating, and dangerously misleading, when the financial
press publishes articles saying things like “Hedge funds got back on track, but
managed futures managers failed to live up to the hype they generated in 2008.”
The question I have for them: is it reasonable to expect an investment that has
zero-to-negative correlation with equities and is invested in over 100 markets
long and short, to perform as well as the market that is experiencing a rally?
OFI: Are there other reasons institutions don’t invest much in managed
TOD: There are a variety of myths and misconceptions about managed futures, but
proper education can overcome those obstacles. To the extent that consultants
aren’t conducting their own due diligence and research on topics like managed
futures, there is a problem. After all, consultants are an extension of their
clients’ staff and should be proactively seeking ways to help their clients
build better portfolios.
OFI: Do you mean that institutional consultants and advisors are an
impediment to futures investing?
TOD: I’m sure it did not help, and probably created additional confusion
in the eyes of institutional investors, when many funds of funds lost money in
2008. I suspect that institutional investors expected funds of funds to allocate
their capital to the best mix of hedge fund strategies. Unfortunately, we found
out in 2008 that many of these funds of funds invest exclusively or primarily in
the traditional hedge fund strategies (or leveraged beta strategies) that I
mentioned earlier. Investors might assume that if their fund of funds doesn’t
allocate to managed futures then managed futures must not be a good investment.
However, they would be wrong because the more likely scenario is that the fund
of funds does not have the necessary expertise with CTAs to pick the managers.
Investors would benefit from reaching out to the firms that do have the
OFI: What about the complaint that CTAs have big drawdowns and high
TOD: As I stated earlier, there can be wide differences between CTA
returns. And yes, some CTAs on an individual basis have exhibited big drawdowns.
However, equity markets have, in many cases, exhibited even bigger drawdowns.
The lack of correlation that exists between different styles of CTAs makes it
possible to significantly reduce the downside volatility. Manager selection and
portfolio construction are very important. It is also important to remember that
standard deviation measures total volatility. Standard deviation does not
differentiate between good risk (upside volatility) and bad risk (down side
volatility). Just because a CTA has a higher standard deviation than the equity
market doesn’t mean the CTA can’t help smooth out the investor’s equity curve.
OFI: Have institutional priorities changed in recent years?
TOD: Following 2008, the themes that resonated among institutional
investors were liquidity, transparency, regulation and diversification. Managed
futures has long offered these attributes and should be a standard by which
other investment strategies are judged. Learning about and investing in managed
futures will strengthen institutions’ hand in bargaining with other managers
that don’t embrace these practices—for instance, if the investor is going to
agree to a three-year lock-up, they should expect a premium return relative to a
managed futures program that can offer daily liquidity and complete
OFI: Have there been changes since you worked on the managed futures
program for the Virginia Retirement System?
TOD: Yes. The evidence that investors can build better portfolios by
including managed futures is even more compelling today. The global market
diversification that can be achieved through managed futures is more
significant. The universe of CTAs has grown significantly, CTAs’ track records
are longer and the assets under management in the managed futures industry is
much greater. There is also more research to rely on for educational purposes
and the strategies being employed by CTAs are more sophisticated. These are just
a few things that come to mind.
OFI: What do you see happening this year?
TOD: With the equity market rally in 2009, I hope institutions are
rebalancing their portfolios and turning those unrealized gains into realized
gains. I hope investors won’t forget about 2008 and will re-visit the “don’t put
all your eggs in one basket” advice of modern portfolio theory and seek true
diversification. I think investors, and their consultants, will come back to the
role absolute return strategies have in achieving institutions’ ultimate
objective of paying benefits. If they do these things, managed futures and
global macro will get well deserved attention. I’m optimistic this will happen.
It just takes time, and a willingness on the part of investors to think outside