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Opalesque Futures Intelligence

Futures Lab: Innovative mainstream products: ETFs and mutual funds may open market to futures

Tuesday, June 16, 2009

Global Mainstreaming of Liquid Alternatives

A new market may be opening for the services of commodity trading advisors, global macro managers and quantitative traders. This year a number of alternative investment products have been launched in mass markets worldwide. More are in the pipeline. Many of these use, at least in part, futures-and-options trading strategies.

This development is potentially so important that we decided to devote Futures Lab to it. Below you will find descriptions of intriguing new products and commentaries from industry watchers as to what’s happening.

Both the European and US public markets have attracted novel products, although in different formats reflecting regulatory variations. The investment programs are shaped not only by managers’ strategies and market demand but by the regulatory framework, in particular the UCITS system in Europe and mutual fund requirements in the United States.

Here we review both markets. This issue’s Practitioner Viewpoint contains an article on what UCITS means for alternative investments.

Investors emphatically do not want to repeat the experience they had in the 2008-2009 crisis. This is the case for both large and small investors, both institutions and individuals.

Those who had hedge fund investments and suffered from the liquidity squeeze want more stringent rules about redemption. People who were surprised about losses want to have more information about the funds.

At the same time, retail investors whose conventional stock and down portfolios went down steeply in the crisis now seek new options. Alternative investment products introduced under US mutual fund or European UCITS regulations meet these various demands from different parts of the market.

Investors want liquidity and transparency, says Maarten Nederlof, founder of Safari Advisors LLC and former co-head of Deutsche Bank’s hedge fund capital group.

After the redemption freezes many hedge funds instituted in the crisis, being able to redeem has become a priority for alternatives investors. Exchange-traded funds, US mutual funds and UCITS vehicles meet investors’ desire for greater liquidity. But not all strategies are suitable for these formats.

Managed accounts and managed futures are very liquid, while hedge funds are not, Mr. Nederlof said, speaking at a press briefing. “Expect a surge of interest in exchange-traded funds and managed accounts.” He expects a regime change in investment management that will favor liquid strategies and greater oversight and risk management.

The packaging or format of an investment program – such as private limited partnership versus regulated public fund – is becoming more important. “There are strategies that can be packaged in a 1940 Act structure,” Mr. Nederlof said, referring to the US law governing mutual funds. Managed futures is prominent among those strategies.

It is notable that the new products do not necessarily or primarily target retail investors. Institutions are often a big part of the market. For that reason, we prefer to use the term mainstream alternatives rather than retail products. For instance, one offering – an exchange-traded hedge fund index from Deutsche Bank – explicitly warns that it is not for everybody but only for sophisticated investors.

Still, these products are available in the mass market, whether in the form of an open-ended US mutual fund, an exchange-traded fund or a UCITS III vehicle, and are open to a much broader customer base than has been the norm for alternative investments.

Institutional/Retail Convergence

While some products invest in outside hedge funds and commodity trading advisors, others use models to replicate the returns of hedge fund or CTA indices. One pioneering product, the Rydex/SGI Managed Futures Strategy Fund launched in March 2007, uses a quantitative methodology to track Standard & Poor’s Diversified Trends Indicator.

Richard Goldman, chief executive of Security Global Investors (SGI), says there is tremendous demand today for alternatives as investors seek to diversify their portfolios after traditional stock and bond portfolios performed spectacularly badly. “We believe investors are looking for new solutions, new products,” he said, at a press briefing.

The Rydex/SGI alternative funds – which cover other strategies in addition to managed futures – are distributed through financial advisers. Preliminary results from a survey of financial advisers in the US shows that close to one-third want to increase their clients’ allocation to alternatives. “Intermediaries have lots of questions about asset allocation, how products like alternatives fit into their business,” Mr. Goldman said.

Rydex/SGI executives have been crisscrossing the United States talking with financial advisers. Sanjay Yodh of SGI says family offices and high-net-worth investors are now moving to mutual funds for added transparency and liquidity.

Daily liquidity, required for open-end US mutual funds, does come at a cost—the returns will likely be lower than can be achieved in a limited partnership hedge fund with the same strategy. Nevertheless, many institutions do not want to be trapped in illiquid investments.

Mr. Yodh and others see a convergence between the retail and institutional realms. Rydex/SGI is planning new products for the convergent market.

Standard & Poor’s Diversified Trends Indicator Returns, Best Five Months

MonthDTIS&P 500
Oct. 200810.4%- 16.8%
Sep. 19908%- 4.9%
Sep. 20045.6%1.1%
Feb. 20085.3%- 3.2%
Aug. 19905.2%- 9%

Rydex/SGI Managed Futures Strategy Fund offers investors a feature that proved to be very elusive in the crisis—real diversity. This shows clearly when you look at the best months of the DTI index the fund replicates (table1). DTI had its top performance mostly during months when the S&P500 had a steep decline, like October 2008.

This pattern has generated interest among registered investment advisers who are the gatekeepers of the mass affluent market. The fund had close to $1.7 billion in assets as of April. Across all strategies Rydex manages about $20 billion; separately SGI has $17 billion.

Manages futures and global macro strategies have an inherent advantage in extremely turbulent markets, points out Dr. Gabriel Burstein, global head of mutual and hedge fund research at Lipper and an ex-global macro trading and investment strategist at Goldman Sachs and HSBC.

“In periods of market turmoil and difficult markets in general, bottom company fundamentals become invisible, unpredictable and unreliable,” he says. “The only visible predictable elements are at the top: the macro view. When fundamentals disappear, technical patterns dominate and systematic investment averages through the excessive noise.”

Macro and managed futures out-performed other strategies in 1994, 1998, 2001 and 2008 by exploiting technical patterns, according to Dr. Burstein. Managed futures are not only for alternatives investors any more, he says, pointing out that UCITS mutual funds in Europe and Asia have started to offer these strategies.

The ETF Option

This March Deutsche Bank launched an exchange traded fund that invests in hedge funds and CTAs. Part of the db x-trackers platform, the db Hedge Fund ETF is linked to a Deutsche Bank index of systematic macro, equity hedge, market neutral, credit and convertible and event-driven strategies.

Well-established managers of large funds are among the constituents of the index. Table 2 shows the constituents of the systematic macro portion.

The ETF is listed on Frankfurt Stock Exchange. Pending approval, Deutsche Bank expects to list on the London Stock Exchange, Euronext Paris, Borsa Italiana and SIX Swiss Exchange. Since it is exchange traded, the fund has intra-day liquidity. Deutsche Bank is the market maker and offers two-way prices on and off the stock exchange.

The ETF’s underlying funds are Jersey unit trusts listed on the Irish Stock Exchange and managed by Deutsche Bank affiliates. Outside managers are sub-contracted as trading advisors to manage the portfolios. Deutsche Bank has sole control of the assets.

Constituents of dbX Systematic Macro Index
Systematic macro is part of Deutsche Bank’s Hedge Fund Index, the basis of an exchange-traded fund launched this year.

Commodity Fund: Millburn Commodity
CTA: Aspect Diversified
CTA: BlueTrend
CTA: IKOS Financial
CTA: Millburn
Multi-Markets
CTA: NuWave
CTA: Winton
Currency Fund: FX Concepts GCP
Global Macro Fund: Polar

The Deutsche Bank hedge fund ETF is compliant with UCITS III regulation for European mutual funds. However, it does not target the retail market. The prospectus states that “the db x-trackers db Hedge Fund Index ETF is intended for non-retail investors and, therefore, is appropriate only for sophisticated investors who understand its strategy, characteristics and risks.”

In the US, this month WisdomTree Investments filed with the Securities and Exchange Commission for three ETFs with alternative strategies—one is managed futures. WisdomTree is an index and ETF specialist. The to-be-launched managed futures ETF will use a quantitative, rules-based model to trade futures and other instruments with the goal of achieving positive returns in both rising and falling markets.

Again this month, Index IQ announced the launch of an ETF designed to replicate the risk/return characteristics of global macro and emerging markets hedge funds. The IQ Hedge Macro Tracker ETF trades on New York Stock Exchange Arca.

Index IQ previously sponsored two other hedge-fund replicating mass market vehicles, one an ETF and the other a mutual fund. The firm says the products “bring hedge fund style investing to a broad range of investors, from sophisticated family offices to retail investors.”

Manager Interest

Managers worldwide appear to be very interested in going the regulated mutual fund route. Every European hedge fund that can do its business without leverage is interested in launching a UCITS III vehicle, says a manager. Because of regulatory rules, that mostly means those trading futures or forwards and other derivatives—CTAs and global macro managers in particular.

Notable recent offerings include BlueTrend, a UCITS fund with a systematic, diversified trend-following strategy that targets 15% to 20% returns annually. It was launched in December 2008 and is sponsored by Merrill Lynch International and managed by BlueCrest Capital. This is the first CTA on the Merrill Lynch UCITS platform. BlueCrest manages $7 billion in the same strategy.

Interestingly, Bluetrend and several funds in the DB index (Aspect Diversified, Winton) are among the best funds in terms of long-term performance according to a large allocator—see our Top Ten for this issue.

Early in 2009, Hamburg-based Aquila Capital started offering a CTA fund in UCITS III format. AC Pharos Evolution has daily liquidity and a strategy focused on short-term, systematic trading.

Like the other offerings, the Aquila fund is for larger investors as well as the mass market. The firm says it received attention from pensions, insurance companies and funds of funds. The same strategy has been available in the hedge fund format. Some of the hedge fund clients reportedly switched to the UCITS version.

The trend toward mainstreaming alternative investments is not new, but has become stronger and more widespread. There’s been a dramatic shift, says Mr. Goldman of SGI; hedge funds that used to offer only private partnerships are now interested in working within the 1940 Act.

An example of the hedge fund-mutual fund convergence is US-based AQR Capital, started some 10 years ago by a group of managers from Goldman Sachs led by Cliff Asness. The firm is known for quantitative high-frequency trading hedge funds. Mr. Asness was director of quantitative research at Goldman Sachs Asset Management. This year AQR started to launch a series of mutual funds.

JP Morgan Highbridge Statistical Market Neutral Fund is an early instance of the convergence. The long/short equity strategy is managed by Highbridge Capital, a hedge fund business that is part of JP Morgan Chase. The fund has been in operation since 2005 and has $3.14 billion in assets under management.

That AUM could be seen as an indicator of the growth potential of mainstream alternative products, but JP Morgan’s distribution network doubtless gave this fund a big advantage. The real potential of mainstream alternatives is yet to be seen. The funds mentioned in this article (table3) are likely only a beginning.

Funds Mentioned in This Article

NameFormatStrategy
Rydex/SGI Managed Futures Strategy FundUS mutual fundReplicates an index
Deutsche Bank Hedge FundETF, UCITSMulti-strategy, including macro
WisdomTree Managed FuturesUS ETFQuantitative
IQ Hedge Macro TrackerUS ETF Combines global macro and emerging markets
BlueTrend FundUCITS Trend-following
AC Pharos EvolutionUCITSAquila Capital’s CTA program
AQR FundsUS mutual fundVarious quantitative trading strategies
JP Morgan Highbridge Statistical Market NeutralUS mutual fund Long/short equity



 
This article was published in Opalesque Futures Intelligence.
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