Brian Walls and Galen Burghardt are considered among an elite group of managed futures researchers. The pair authored the book: Managed Futures for Institutional Investors: Analysis and Portfolio Construction.
This is the second part of a two part interview. For the previous interview, click here.
Opalesque Futures Intelligence (Mark Melin): Managed futures' might be at its moment in history. There appears to be a debt crisis looming that is now being openly discussed, VP candidate Paul Ryan is making note of it, the problem is mathematical. There is a point in time where the government just cannot continue spending nearly double revenue. The Fed cannot be continued buy 60% + of the bond float as it is said to have done in 2011. At some point, this is going to have to come to end and when that is unwound it is potentially going to create volatility for a decade.
Galen Burghardt: This is a really key time. The move to managed futures is right for a number of reasons. The markets are sending unusual messages and the managed futures industry has finally matured.
Brian and I have been pounding pavement the past couple of years in an effort to reach institutional investors. Part of the reason for writing the book was a desire to translate the managed futures industry for people who wrestle with real assets. And then, taking a page out of Willie Sutton's book of wisdom, we focused on pension funds and endowments because that's where the money is. And they have some of the hardest problems to solve.
OFI: What do you find the main challenges you have when educating pension funds, family offices, and professional investors?
Brian Walls: Return expectations. For some reason the managed futures strategy gets carved out as a pure alpha strategy that should be four seasons in terms of performance. Investors, in my opinion, still look at it with a very much like a get-rich-quick kind of mindset. Other strategies get additional leeway; investors are much more understanding that they are connected to the beta of the stock market or the bond market. Investments in stocks are really investments in a business and professional investors might provide this approach more latitude, and a lot more forgiveness. Investors are coming around. The idea of being gated or being side pocketed is just completely unacceptable to some.
OFI: Four season positive performance is unrealistic expectation. When they don't understand the fundamentals of how performance is generated, generally, it seems they are pretty unforgiving about going through difficult market environments.
Brian Walls: It is accurate to observe that some don't understand. It is like when you are looking at long/short equity you seem to look at it through the lens of how the S&P 500 index does and there is a degree of understanding, certainty. By contrast, when investors do not understand how managed futures generates returns, how the strategy works, you just want it to make money every quarter.
OFI: This is ridiculous because, as we know, managed futures is primarily based on trend following and most of the major indicies reflect the performance of this strategy. I would imagine the Newedge CTA Index, so that means that we are waiting for a market environment of price persistence. There has to be price momentum. If there is not price persistence in a given timeframe / market, an investor should not necessarily expect positive performance for a trend following system; that is just all there is to it. But 2008 was interesting example; your volatility led the price persistence.
Brian Walls: Central banks and governments only like price persistence in one direction.
OFI: The other direction we always get blamed, it is the evil speculators.
Brian Walls: Stock markets go up and bond markets go down price persistence is -- as bond yields go down then price persistent is okay.
OFI: That is interesting. When you speak with hedge funds, pension funds, professional investors, and you talk about managed futures' performance in the aggregate what indices do you tend to quote?
Brian Walls: Honestly, we tend to quote our own just because we know the construction methodology is the best. So, we know how the Newedge CTA Index is constructed. We know that there was never any back sell from the day it was started on January 1, 1990.
Because we were very skeptical of back sell in general when it comes to portfolio construction and Index construction, which is effectively the same thing.
We are very suspect, because you have experienced this world and you know who won and you know who did not win, and it is easy to come up -- and when you are trying to come up with very simple robust rules you have to be careful.
In the Newedge CTA Index the question was: what is the available performance from the big managers? So, the only rules of the Index are that we have a basic selection methodology and actually Galen or Ryan can send it over, which is we look to -- it is based on assets under management.
What is the mean of assets under management in the industry and who is greater than one standard deviation? Above that, the only exception is we will not take less than 20. So, it is very much, who are the biggest managers? We do not look for strategies, we do not look for diversifications, just who are the biggest manages, number one.
Number two is: who is willing to give us daily returns? Because CTAs must be willing to provide daily returns - it is a daily return index (one point which makes the Newedge index unique among other indices).
Number three is: that they have to be open for investment. It is not fair to compare a portfolio of closed managers to what is available. So, they have to be big, they have to be willing to provide daily returns, and have to be open. That is it.
We re-adjust the index once a year and they are equally weighted. So, it has never been back filled and we have never -- and if a manager goes out of business, we eat the return as long as they are report it and if they stop reporting, we just eat zero for that weight or the risk free rate, which is now zero, but when the index you get 400 or 500 basis points, right. But now the risk free rate is effectively zero, so we just eat the risk free rate on whatever was remaining on that weight until the next rebalancing.
OFI: Does survivorship bias and dropout rates impact the Newedge index?
Galen Burghardt: Not at all. As things have proved out, only one CTA has ever dropped out of the index in mid-year, and that was Bridgewater, and that was certainly not because they were not successful.
When you think about it, the index is about as free of the long list of biases that plague most indexes of self-reported returns as it could possibly have been. The index has been reconstituted live every December using CTAs who were large, open for investment, and willing to report daily returns. The only reason a CTA drops out of the index is that some other CTA has become larger. Or, in the case of Bridgewater, because they don't want to report daily returns any longer.
If there is a bias in the index, it is more likely to reflect any bias there might be in tracking the returns of large, mature CTAs – a kind of superstar bias.
OFI: It would be fascinating to get a direct account into Bridgewater. I would speculate that he is primarily trend following, but he also probably throws in some spread arb and some different strategies. He appears to analyze market environments, kind of like Winton, who has algorithms that determines likelihood of market environment and then the appropriate trend model. Kind of like PE investments, except Bridgewater seems to me to be a little more diversified in his strategies.
Brian Walls: They do appear to be much more multi strategy and seeking out various types of risk premiums, but they I have never heard them disclose exactly what they do, like you said to be. But even so sometimes you can have their positions and you still do not know what the strategy is. We have managers like that now. One manager was was asked why he had such a big bet on German yield going down? Because you are long bonds he says, there might be long bonds that might be a synthetic position to express something else.
OFI: Yes that is true, you could hedging synthetically an interest rate play and we wouldn't entirely understand the hedge unless the manager explained it. They are running a tightrope: some might want to provide investors a basic understanding of risk and performance expectations, but don't want to give always the algorithmic secrets.
Brian Walls: Doing something synthetic and is more liquid and it gives me a 95% correlation I am going to express it this way. Might have some options on against the position.
OFI: Regarding validity of the performance reported to the Newedge CTA index, just to confirm the NFA audits all the top 20 CTAs. I cannot imagine there being a member of the index that is not an NFA member, am I correct in that assumption?
Brian Walls: Right.
OFI: And we both know that the NFA audits not only the performance, but then they view the reporting of performance to databases to be promotional and they review that as well. So I think it would be fair to say then that that this Newedge CTA Index, the performance has been audited by the NFA, everyone is an NFA member, and that reporting of that performances has been audited to the NewedgeCTA Index, as it likely has been done to the BarclayHedge BTOP50, the Altegris 40.
Brian Walls: What we do is we use BarclayHedge as a calculation agent, so every manager sends their returns independently to Barclays and independently to us. We both calculate an index value and then compare it. If we come up with a difference, we find it that day and then in addition, we both reconcile the daily return to the manager's reported monthly returns every month, ensure that our dailies add up to the reported monthly, because it is the monthlies that are audited.
So we do it at Newedge as well as BarclayHedge does it at Barclays so that we have two independent verifications, that we both came up with an index value. It is important to note that since daily returns are just estimates, they are not audited, you do have to be careful when you are taking daily returns from people. Daily returns cannot be subscribed to or redeemed, there is accrual that may not be have been done perfectly and you cleaned up at the end of the month. So you have to know that a daily reporting is not done with as much care as a monthly audited number.
OFI: I personally find the daily reporting fascinating, particularly if a market event hits and you want to know how CTAs in general have been reacting over market events, I am constantly going to the Newedge CTA Index.
Brian Walls: Friday was a good example. We were watching the markets rally knowing that managers probably had other positions, but really I could not wait till Monday morning to see how did it affect the industry, I think it was down 1.37% on the day, which is a big day. But not as big a day as you kind of got from the emotions of talking to people.
OFI: People were looking at trends in one direction and then all of a sudden it might look like it is going back to a choppy environment. So I tend to hope that trends start to pick up, that is what everyone appears to be looking for.
Brian Walls: That is good about the indices, they are daily and we are careful about them, very proud that many people will use them as the benchmark and that some people do not want to use them as the benchmark because they are a little too tough to beat.
OFI: I liken the Newedge CTA index, the Barclay BTOP50, the Altegris 40, those are all pretty much the equivalent of the Dow Jones Industrial Average in that it is the largest managers, there is seldom dropout or survivorship bias issues in the reporting, everyone is an NFA member with audited returns. Performance might be a little more conservative than the general Barclay CTA Index.
Brian Walls: The managers in the index are going to represent the large portion of the assets under management in the industry, because they are the biggest managers, they naturally have -- for the ones who are willing report and are open it is going to be 50%, 60% of the assets in the industry.
OFI: It seems that the assets gravitate towards those top CTAs, whether it is the top 20 or the top 40, how do you see the industry shaping out over say the next three to five years?
Brian Walls: We have looked at this a few years ago and have found that the deal of being in this industry for 20 years, I find it to be a very persistent comment that the bulk of the assets are with the largest managers and even though the largest managers have changed over the last 10 or 15 years, that fact has always been the case, more than 50% of the assets have always been with the ten largest managers, it is just those managers change every three to five years.
So, I do not find it that different, have been around a long time number one, and number two, I do not see it changing, because as the institutional investors get involved, being with big name firms with big compliance departments and big research departments and big footprints gives them a certain amount of comfort. They are not going to leave a lot of carry forward from a survivor issues on the table. It gives them a lot of comfort that they cannot go too wrong picking one of the top five or ten managers. I do not see that changing much as more investors get involved. I see the fund of funds not chasing those managers as much because they are trying to deliver more diversified and more value, so just putting together portfolios of the big names does not seem to be as interesting as it once was.
OFI: Brian and Galen, thank you for your time. Significant insight as always.
Yearly Returns for Newedge CTA Index
The Newedge CTA Index is equal-weighted and reconstituted annually, and has become recognised as the key managed futures performance benchmark. The index calculates the daily rate of return for a pool of CTAs selected from the largest managers open to new investment. The index is designed to accurately reflect the performance on the managed futures space. Estimated monthly performance numbers may included Managers Estimates, that have not been independently verified.
Past performance is not indicative of future results. There is risk of loss when investing in futures and options.
Opalesque Futures Intelligence
Monday, September 03, 2012
Newedge's Brian Walls and Galen Burghardt Managed Futures Index Performance
Investment indexes generally have degrees of study bias issues. Top industry researchers Brian Walls and Galen Burghardt discuss this and more.