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Opalesque Futures Intelligence

Interview with Thomas Schneeweis, CAIA Founder and Leading Academic

Thursday, December 13, 2012

Renowned alternative investment academic Thomas Schneeweis, who founded the CAIA and teaches at the University of Massachusetts-Amherst and is Director of the Center for International Securities and Derivatives Markets, discusses his new book Postmodern Investment (Wiley 2012) and other industry issues.

Editors Note: It might be difficult to pinpoint exactly who is the top academic in the alternative investing arena, but Thomas Schneeweis consistently ranks at the top of the conversation.  Mr. Schneeweis is co-founder of the Chartered Alternative Investment Analyst Association (CAIA) and founder of the Journal of Alternative Investments, and is currently a professor at University of Massachusetts / Amherst where he works as founding director of the Center for International Securities and Derivatives Markets.  (See full biography at the end of the section)

In this issue of Opalesque Futures Intelligence we publish an interview with the pair and part one of a response to the book Hedge Fund Mirage (Wiley 2012).  In the January issue we publish a review of their new book, Postmodern Investment (Wiley 2012) and the second part of the response.

Mark Melin (MM): You talk about the world changing and what having occurred in the past not being entirely relevant towards the future.  Your book Post Modern Investment: Facts and Fallacies of Growing Wealth in a Multi-Asset World identifies interesting issues for alternative investing practitioners and academics, but for different reasons.  Why don't you start by addressing risk in today's alternative investing environment as it relates your central thesis?

Thomas Schneeweis (TS): George Santayana is noted for his famous statement "Those who cannot remember the past are condemned to repeat it." What he failed to point out is that in a world of change those who only remember the past are also condemned to repeat it."  It is a central focus of this book, as has been shown in recent years, that sole reliance on the  simple benefits of stock and bond diversification or a less than critical acceptance of  'financial institutions' product presentations comes at a cost.  To reduce that cost, investors need to reset their investment decision process  to one not solely based on traditional presentations of modern finance to one based on the current world of multi asset allocation and an understanding of the players in that world. In so doing investors must refocus on the fundamental risks of investing in any investment idea and the necessity of 'personal due' diligence.

Too often investment practitioners attempt to sell products based on expected return rather than risk. This is understandable.  When selling a product, one often focuses on 'investor greed rather than Investor fear".  This is true for alternative investments as well as traditional assets. For example, hedge funds (simply non benchmark driven strategies) were once sold (and often still are) as absolute return investments; that is, something that could make money in all market environments. Managed futures are still sold as "offsets to "equity investment. Real estate and private equity as long term long risk investments in which value is not based on traditional market fundamentals. Lastly, commodities can be viewed as an inflation hedge.  We know that much of this is simply not true. However, there is just enough truth in each statement to make a good story however unpleasant the end of the story is for many investors. 

MM: You are both an academic and practitioner.  Describe your practitioner business endeavors and how this impacts your academic thought?  You address issues with bringing together academic thought with practitioner knowledge.  What are the nature of the issues and why does it matter?  As the co-founder of CAIA, how has your professional career addressed this problem?  What are hurdles you have overcome towards educating those on alternatives?

TS: Let us start by saying that there should be little conflict between academic and practitioner thought. Truth is Truth and Fact is Fact; however, as discussed above the ideas and ways ideas are presented are often impacted by the 'world' of the presenter. Academics live in a world in which 'high level journal publications' are the prime basis for advancement. Practitioners live in world in which 'product revenue' often dominates the presentation. I have lived in both worlds for over thirty years. As creator of a major university research center, a major 'academic/practitioner' journal, a major professional association and well over 100 articles between us - i know what it takes to win in the academic world.  As part of successful investment firm (a 3+ billion managed account hedge fund platform), a ELS hedge fund, a Managed futures fund, and a commodity index product I have seen both the benefits of academic ideas in how products can be created (e.g., tracking products, non-traditional commodity products), however, we have also seen how often academics fail to relate to real world facts and how often practitioners fail to admit to the academic failings in their 'product presentations'. Often I read a manager maintain that his best returns follow his worst drawdowns.  No kidding or else you would not be here. Often I hear of hedge funds being presented as a single strategy when in fact they are primarily a legal construction with many alternative approaches to investment management.

It was, in fact, this conflict between the two worlds (academic and practitioner) that led to the creation of CAIA as a central local to bring together the best of academic and practitioner knowledge. We do not always get it right; however, the very fact that we can bring into question both sides means we must be doing something right. However, here is the problem. Change is hard and admitting to it is even harder. This is true in both the academics and practitioner worlds. If an article is at variance with the previous perceived truth or process, one will have an almost impossible task of having it published. Similarly, in the practitioner world, new products that are at variance with many 'investors' historical products often have a difficult time reaching an investor audience. In short, as you often read on the back of the car in front of you - if you thing education is costly try ignorance. The question remains how to get people to pay for it especially if it is a public good.

MM: You have sections in your book: The Myth of the Average: CTA Index Return In Extreme Markets and Commodity Trading Advisor Annual Performance.  What do you find as the most compelling message in this work?  On page 115 you address what surprises you about CTA risk.  Can you elaborate?

TS: The risks and sources of returns to CTAs remains one of the most misunderstood topics in investments. CTAs are often presented as providing positive returns in just those markets in which traditional investments (stocks and bonds) perform poorly.  OK I can always find periods in which an asset strategy which is not fundamentally related to the returns of another strategy may provide positive returns when other assets perform poorly. The real question is what is the source of returns to both assets and how one can expect these assets to perform well in the future. However, simple reliance on 'past performance' does not do it. Here are a few facts: 1) not all CTAs are trendfollowers, 2) those that are may use a variety of rules based strategies, 3) to the degree that one is a trendfollower, CTAs should not make money in high volatility markets (those are the least trending) and 4) since CTAs make money in part in the cost of carry, it is harder for them to make money in low interest rate markets.

One can go on and on and on….. I am not against CTA investment. I ran a CTA for years. I also knew when it would more likely make money and when it would not, however, I rarely see an academic or practitioner who knows the difference or how to model it. In regard to the Myth of the Average, one must not refer to average returns over some past time period as a sole or even meaningful forecast of what will happen in future time periods. What  one can do is to find unique financial markets and conditions which are similar to expected conditions in the future (e.g., the worst and best equity markets or  periods of high or low interest rates) and determine the degree that a particular strategy approach may be expected to profit in such a market environment.

As a sidebar 1, often CTA risk is less than many traditional assets (stocks), in part since CTAs can easily risk adjust and as sidebar 2, no academic should publish in CTA area without talking to a practitioner and practitioner should publish in the area without considering academic research on the potential sources of return to futures based trading.

MM: You have interesting thoughts regarding correlation and MPT.  Please elaborate and speak to the central issues and consequences of improper correlation analysis.

TS: The MPT is a nice simple and worthwhile construct. Two assets which are expected to be affected differently by the same information may have return characteristics such that they can be grouped together to create an investment which has a lower anticipated volatility than either of the assets individually. Correlation between two assets is one way that one measures the differential impact of information on the standardized relative return co-movement of two assets.  Unfortunately historical estimates of correlation are often a very poor way of measuring how two assets move together across a wide variety of markets - it is very unstable and is conditional on changes in market conditions, outliers ….. See article on Schneeweis, "What a Difference a Day Makes" AIAR Forthcoming.

Unfortunately correlation is easy to measure and has become a central part of the investment lexicon, just as auto-correlation etc.  However, do not, I repeat do not base investment decisions on this simple number (e.g., correlation). It is merely a statistical measure of past events - Get a good reason why two or more assets may provide 'real' diversification benefits regardless of what the data says.

MM: Chapter four addresses the Zero Sum Game concept in managed futures.  Why not touch on your thoughts and how this impacts the managed futures investment category?

Again depending on how the strategy is implemented and in what market environment - CTAs may provide the potential for taking advantage of certain market environments - e.g., breakouts in which one player (e.g. government) is willing to take continued losses for a wide number of reasons.  In short, even in a zero sum game - a player on one side can make money as long as the play on the other side is willing to lose (often because they are looking at their entire portfolio and other non-direct financial costs).

MM: You end Chapter 4 by addressing the common myths and misconceptions of Managed Futures.  What do you find is the most problematic misconception relative to managed futures?

TS: The number one misconception is that CTAs are designed to make money in volatile and poorly performing equity markets. Note - many CTAs do not trade equity futures (equities often follow a random walk) but may make money in negative (often volatile) equity markets if currency or interest rate markets are driven in a directional form due to crisis in equity. In short, a statistical anomaly and not a causal one.  The number 2 misconception is that CTAswho make money often do after big drawdowns. Yes high historical volatility CTAs who happen to make it through a large drawdown (who lives another day) would have a historical return pattern that in which high positive  returns follow negative returns  that but it could simply be survivor bias. The number 3 misconception is that CTAs have no economic basis. They may provide liquidity support as well as informational trading benefits. The number 4 misconception is the belief that certain statistical performance measures such as Sortino ratios have any real value. They have little if any basis in statistical analysis.

MM: You address governmental organizations such as the Fed attempting to isolate people from risk.  Is such a concept possible?  How does your thesis compare and contrast with Talib's new book?

TS: One truth that has withstood the test of time, is that expected return is a function of expected risk. Investors must focus on the underlying risk of any strategy and how it drives expected return.  Now I am not against all approaches to managed the negative impacts of some investor behavior but get real - with no risk comes  no return or you have to have someone else bear the risk and pay a nonmarket price for it. I know Nasem well and for many years. We have had many good arguments and I do not want to put words in this mouth. I do believe that the only way to understand the risk of a strategy is to trade it and to see risk up front. That is what you are employing an investment manager for - their ability to adjust your portfolio to changing risk  but this is not strictly rule based). But ability does not mean will.  I sometimes confuse individuals when I point out that I am often happy when I lose money, since that means that I can also make it. For me the risk of trading in many markets is reduced simply because of I have lived through them.  I am the anti-fragility of Nasem. I am stronger because I have been stressed and lived. Individual need stress or conflict to learn how to adjust to changing risk environments.

This is another book in itself - what is risk, how to confine it, how to measure it (VaR is problematic at best). Is it fair to lull individuals into believing there is no risk or little risk? People should learn to live with risk (our forefathers did) and to find ways of coping with the stress that comes with a risky world in which not all of that risk can be hedge or diversified away. We have to come to live with the Frank Knight presented dichotomy of risk and uncertainty in which risk is a world in which the probability of an event can be estimated but uncertainty is a world in which we have no real way to measure the probabilities of an event outside of very general statements of may or may not, should or should not.

MM: You have pointed opinions regarding the book Hedge Fund Mirage and in fact wrote a white paper on the topic.  What is your key thesis and the points of academic disagreement with Mr. Lack?

TS: See my paper on it (Schneeweis et. al., An Academic Response.....)  Simply put, the hedge fund industry is a $2 Trillion industry and growing. In a world of informational transparency it must be offering something that some individuals want. But more seriously, Lack's measure of return (IIR) is limited, and his data (HFRX index) is problematic and his results would be different if he used any of the other more traditional hedge fund indices (equal and asset weighted and none of which has survivor or backfill bias). Moreover, he uses a simplistic at best measure of relative performance. if one wants a simple approach to test the historical benefits of overall hedge fund return, simply look at year to year analysis which adjusts for differential asset weightings and yet uses traditional measurement theory. If one does this one would see a different picture of the potential benefits. But give us all a break, the benefits of hedge funds or the potential benefits are not illustrated by an aggregate average of a simple set of self reported hedge fund managers with a wide variety of strategies over some historical periods. That is baby hedge fund analysis 101 at best. N no serious investor would invest in hedge funds or not invest in hedge funds based on a simple historical analysis of an aggregate hedge fund index. It is our duty to instruct investors on the true benefits and risks not to distort those risks pro or con with dated historical numbers which do not reflect current strategies or approaches to return and risk management.

One can go on and on - Now there are some benefits in his book. Some hedge fund managers or firms are less than forthright. That is one of the stories of our book, Postmodern Investment (John Wiley, 2012). The real benefits of a particular strategy or investment cannot be told without a more detailed understanding of the individual strategy, the individual investor and what the relative expected risks and expected returns are from investing in that strategy. People forget, that just because a strategy does not perform well in a particular period that it was a "bad' ex ante investment. One would expect any risky investment not to perform well in all markets. The proof of a strategy is less in its historical performance than a well understood story on how it should perform in a future economic event.

MM: What are the most significant challenges academics and practitioners face going into the future?

TS: Things change and we have to constantly adjust our ideas on the benefits on any one investment idea. MPT is now over 60 Years old it is APT (Ancient portfolio theory). We no longer need to diversify among just stocks and bonds as we have futures, options, collars spreads, multi- assets.

I do not want to hear what happened twenty years ago. Ten years of out-dated data from periods which have to relationship to today's markets has little if any relevance. Today's S&P 500 is not the S&P of 20 years ago, Today's HFR or CTA indices have little in common with the strategies in those indices ten years ago. The real estate and PV markets have little in common with their parent products of the 1980s and 1990s. Today, corn is more of an energy commodity than an agricultural commodity yet there it is in the agricultural section.

I do not know how to address the Washington Lie of Investments. When discussing a product or a traditional academic model, I often know I am lying (or at least not fully informative) and I suspect my audience knows that I am not being completely forthcoming. Moreover, I know that they know that I know that they know that I am lying (or at least not fully informative). Unfortunately not everyone gets the joke. We have to learn to be a little more honest with ourselves and others that every financial product comes with a fatal flaw (or risk) in a certain economic or market environment (without some risk all one can expect is a risk free return). At the very least one must instruct investors to do due diligence  on both the product and source of the product while knowing full well that the individual on the other side may have a different set of priorities? Remember, as I tell my students - If it were simple they could hire a monkey and feed it bananas.

Selected References
Crowder, G., T. Schneeweis, and H. Kazemi, Postmodern Investment: Facts and Fallacies of Growing Wealth in a Multi-Asset World. John Wiley, 2012.

Schneeweis, T. and G. Crowder, "The Myths and Misconceptions of Growing Wealth in a Complex World", INGARM, September, 2012.

Schneeweis, T. and H. Kazemi, "An Academic Response to the "Hedge Fund Mirage", INGARM,   September, 2012.

Schneeweis, T., H. Kazemi, and E. Szado, "What A Difference a Day Makes",  INGARM, January, 2011.

Schneeweis, T., H. Kazemi, and E. Szado, "The Use of IRR in Hedge Fund Analysis: Buyer Beware", INGARM, May, 2012.

Schneeweis, T.  "Where Academics/Practitioners Get It Wrong: An Open Letter", AIAR Fall, 2012.

This article was published in Opalesque Futures Intelligence.
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