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Opalesque Futures Intelligence

Ben Warwick Talks Strategy Replication in Private Equity, Convertible Arbitrage and Managed Futures

Thursday, January 10, 2013

Ben Warwick

Ben Warwick is a well known author and alternative investing practitoner. In this interview we address issues of uncorrelated investing, uncovering key strategies and tactics.

Mark Melin (MM): Ben, your book Searching for Alpha was influential in my personal career. Why don't you talk a little about the book, and in particular you have some pointed opinions about Modern Portfolio Theory, Professor Markowitz, and the Sharpe Ratio.

Ben Warwick (BW): Well, thanks Mark! The book came out a long time ago, back in 2000. It seems like a different world. We have had three market upheavals since then.

The book was an attempt to take the concept of efficient market hypotheses and apply it to the way people were building portfolios. The book talks about methods to add alpha through alternative investments as well as doing simple things such as reducing fees or being more tax efficient. When the book was written hedge funds weren't nearly as accepted as they are today, especially with the larger institutions. So a lot of what was said in the book was pretty unique at the time.

In terms Modern Portfolio Theory, there is benefit in doing that math. I have a mathematics background and look at investing from this standpoint. I was an engineer by training, but I think at the same time those results have to be taken with a big grain of salt. If you had done some sort of portfolio efficiency run in say June of 2008 and you compared it to what you got had you started in December of 2008, you would get very, very different results.

The same thing is true today. If you ran a portfolio optimization, obviously it would load very heavily on fixed income, because that asset class has gone through a 20-year bull market.

MM: Isn't that crazy? And fixed income quite frankly is considered a risk asset now by certain fundamental managers.

BW: Absolutely! If you look at it from valuation standpoint, one of the things we look at is the price risk. If you are going to buy a 10-year treasury note, let's say 1.60% yield, which is about where it is today, you better have all your assumptions exactly right. There is no room for errors. If you are off by say 100 basis points on your inflation estimate, that could be a losing position for you from a real return standpoint. Looking at the equity markets, I think the valuations are much more earthbound. You don't have to have those assumptions as tied down. I think there is a lot more room for error when you have more reasonable fundamentals that you are working with.

MM: In your wide ranging experience as a leading practitioner, have you ever seen a situation where the Fed is essentially keeping interest rates at absurd levels? The integrity of the market as a price discovery mechanism is really being called into question here? Do you have thoughts in that regard?

BW: Yes, it almost reminds me of the opposite thing that was happening in 1987, because in '87 we were seeing the economy was slowing down and the Fed just continued to raise rates until October the 19th, where they completely changed their interest rate policy. I see some similarities of course in the other direction. The Fed is just absolutely dead set against raising rates. They keep extending out the time when they are going to allow rising rates to reappear. But there is only so much the Fed can do. If market participants decide they don't want to hold long-term paper, they are going to sell that paper and you are going to see a rise in rates. This represents a very big risk, especially for more conservative investors that are more exposed to fixed income.

I see investors going out (to obtain yield), not only from a credit standpoint, but also from a duration standpoint, much further than they probably should be going. I think that could be very, very dangerous.

MM: It's interesting. I have seen professional investors move from U.S. Treasuries and now start to get into the muni market a little more, which has its own unique set of challenges. I don't know that there is necessarily a risk free method of generating returns anymore, which to me when you look at Modern Portfolio Theory, what Markowitz did is he took a bond allocation and a stock allocation. I have said this to him through a third party I would love for him to take a managed futures allocation and reduce that bond allocation and that equity allocation, that's where Modern Portfolio Theory really shines.

BW: Yes, it's true. Let me just talk a little bit about the sort of the two asset class portfolio. I think that it makes a lot of sense to add equity and fixed income in a portfolio, because they sit across from each other on the balance sheet. They counter each other. If you look at it from a company standpoint, generally speaking if you are going to do something that's going to help a stockholder, that generally is going to hurt a bondholder, and vice versa, so it makes a lot of sense to combine those two asset classes in a portfolio.

"When you start adding something like managed futures, which actually benefits from rising volatility, that adds a whole new dimension to the portfolio diversification."

Now, when you start adding something like managed futures, which actually benefits from rising volatility, that adds a whole new dimension to the portfolio diversification. If you look at a year like this year when you have managed futures products generally down a few percent or so, you could look at that two ways. You could say, because I have managed futures in my portfolio, I am lagging by, say, 100 basis points. Another way to look at it is, I may be lagging by100 basis points, but from a risk standpoint my exposure is so much lower, because I have this non-correlating asset in my market portfolio. I might be lagging by a 100 basis points, but you know what, if something happens in the world, I am going to be so much further ahead than anyone else because of this allocation.

"I might be lagging by a 100 basis points, but you know what, if something happens in the world, I am going to be so much further ahead than anyone else because of this allocation."

It really does make a lot of sense from a risk return standpoint to think about managed futures, and there area lot of other ways to measure risk than just the standard way, which is volatility. There are just a lot of different boxes that you are checking when you add a managed futures component to a portfolio.

MM: Exactly! Markets are cyclical. I was involved in a study about the cyclicality of managed futures market cycles. Most people are familiar with the periodic table of asset classes and they notice that no one asset class ever appears at the top on a consistent basis. The same is true in managed futures relative to market environments. It always goes in cycles. Managed futures has just gone through one of the worst market cycles arguably in its history from a statistical standpoint. The question is at what point do trends come back in the market? At what point do we start to see some volatility which tends to help the trend followers? What investing trends are you looking at?

BW: Well, I try to look at it from the value standpoint as well, and one of the trends that we are looking at, just as an example, is the differential between U.S. and foreign stocks. It has bowed out significantly, where the performance of foreign stocks is lagging U.S. stocks in a very dramatic fashion.

It's similar to another kind of graph that we look at of just money flows. There is over a trillion dollar differential between the money that's flowed into bond funds versus the money that has flowed into equity funds. So the bond asset class itself has almost doubled just in the last three years because the new issuance is being snapped up so readily by mutual funds that are growing very quickly in that space, which is largely the result of the retail investor and in some cases the institutional investor going in.

So the one mantra that I always try to think about in those scenarios is buying low and selling high. And what you are seeing is you are seeing people doing really kind of the exact opposite of that, they are favoring the asset class that has a much higher valuation, for one that has much more reasonable valuation.

MM: In trader lingo we would term that "chasing returns" -- which typically never works out.

BW: That's exactly right. You can't really assign valuation to managed futures, but I would argue that we are probably closer to a bottom in that asset class than we are in something like fixed income. So you just really have to use a little bit of logic when you are allocating capital, when you are allocating other people's capital.

MM: Exactly. Sometimes it can be counterintuitive, particularly in managed futures. Investing in certain programs or managers after a drawdown is an interesting technique. Speaking of interesting allocation techniques, your firm, QES, has programs under development. Word I'm hearing is you have a private equity strategy replication fund in the works. Tell me about the underpinnings of that, that's interesting because I don't immediately understand how a replication strategy can deliver the beta in private equity.

"We were interested in creating a way for people to get returns very similar to traditional private equity but in a more liquid manner."

BW: Yes, we have been very, very interested in private equity, really in the last few years. We have placed private equity here for clients in-house, and people have been attracted to private equity historically because of the performance. Generally, private equity returns are about 500 basis points above the benchmark returns in CD and S&P 500. It's a very attractive asset class. Unfortunately, it's not very liquid. It's not liquid because when you get into a private equity fund, it's generally a 10 or 12 year lock up. Essentially investors start putting money in and then you end up taking it out when the underlying companies are sold. From the very first day the money is called to the last day that you get your last bit of cash flow could be over a decade. We were interested in creating a way for people to get returns very similar to traditional private equity but in a more liquid manner.

(To build the liquid private equity product) we teamed up with Preqin, the leading database provider in the private equity space. We are able to look at a lot of different information. We combine the purchases the private equity managers make and the exits that they have. We consider the leverage that's used. We consider the amount of dry powder that's in the industry, which is the amount of cash on the sidelines. Then of course the timing element from private equity purchases and sales, which is very, very valuable information to have. What we do is we port this information to what we call a PME, a Public Market Equivalent. We see where private equity managers are investing from a sector standpoint and we build a sector portfolio out of that.

"The reason I think that we are getting some traction here is because there is academic evidence to support the notion that when private equity funds crowd into certain sectors of the equity universe, it creates momentum."

The reason I think that we are getting some traction here is because there is academic evidence to support the notion that when private equity funds crowd into certain sectors of the equity universe, it creates momentum. Basically their buys are more or less the momentum signaling device for us. When we recreate the portfolio that private equity, your buyout firms are doing just on a holistic basis, we end up getting return that's very similar I would say, maybe a correlation of .8 or so to the private equity indices, and still maintains that return dynamic that people like, but the big difference with us is daily liquidity, transparency, much lower fees.

MM: Let me go back to something you just said, because one of the issues in private equity has always been individual investment selection. What I just heard you say is your investment selection methodology is by analyzing essentially where the industry as a whole is placing assets and then replicating that asset flow. That's a fascinating selection methodology. Is that an accurate statement?

BW: Yes, it is accurate, and what's interesting is when we did the research - and there is over two years of research that went on this product - it became obvious to us that private equity returns aren't as dependent on the idiosyncratic elements of a purchase. In other words, it's not that they bought a specific company is going to drive the return. What's going to drive the return is that they are in that sector of the universe.

For example, what are we seeing private equity guys doing today? They are doing consumer staples; they are doing healthcare deals because they are trying to figure out Obamacare; they are doing materials deals.

Those are the parts of the equity universe that we want to emphasize in our portfolio, because we are following what these guys are doing. We can't get a 100% replication of the return, because obviously there are elements of manager alpha that we can't get, but we can get a good chunk of that return, 70% or 80% of it, let's say. We can do it in such a way that an investor can get in and out on a daily basis. So you are giving up a little bit on the upside, but you are getting something in terms of liquidity. We feel that for some investors that could be very, very attractive.

MM: Well, liquidity and private equity, those are not synonymous terms. Let's get to the Convertible Arb strategy that you are rolling out too, because that also sounds interesting. What are the strategic underpinnings of that offering?

BW: Well, Convert Arb is a strategy that I sort of grew up on. Started allocating the Convert Arb back in the 1990s and was fortunate enough to have a guy come here and join as a partner. A guy named Mike Revy, who has an extensive background in converts; has not only traded converts for Lehman, but his family convertible shop called Froley, Revy was one of the largest convertible bond managers in the U.S., before they sold it.

I had an interest in capturing the dynamic of the convertible bond universe, but there are obvious problems with the strategy, mostly liquidity. As the issuance has gone down over the years in convertible land, it's a little tougher to get that paper, but at the same time, it's always hard to short a stock.

MM: Talk about the underlying structure of the strategy, the different approaches.

BW: There are two types of Convert Arb trading; there is the volatility trade, where you basically hedge out the equity risk and then you are left with this piece of volatility that you are long, and that one has gotten tougher just because volatility has contracted.

"What's interesting about our convert arb strategy, which is a replication strategy, is that it's futures only, so it's extremely liquid."

The other type of convert trading is gamma trading, where you long the gamma. So what you are doing is constantly adjusting that hedge ratio between the long convertible bond and the short equity, and that actually has been a pretty good strategy to be in, in the last few years. It did okay in '08 and it has done fairly well since '08, and so that was our approach.

What's interesting about our Convert Arb strategy, which is a replication strategy, is that it's futures only, so it's extremely liquid. We actually can create a return that's very, very similar to the convert arb return, but we don't use any convertible bond, so that's very unique obviously.

MM: Well, that is unique, because if you are using only futures, part of that strategy is collecting the interest rate residual, and in a future contract the interest dividend isn't distributed it is included in the pricing mechanism.

BW: Yes. The biggest part of the trade really is correctly recognizing where the convertible bond universe is in terms of richness and cheapness in equity investment. There are times when convertible bonds are going to act more like an equity, sometimes they are going to act more like pure debt, so that's what we are adjusting constantly.

We get information on the convertible bond universe as a whole. So we look at it as a whole as opposed to looking at each individual bond that's in that index, and that's how we adjust our equity and fixed income hedges.

MM: Let's go to my favorite topic, managed futures. Why don't you talk to me a little about your background and then talk about the index you created. I am going to make the assumption that the index is based on a trend following strategy. Talk about if there are any overlays. Do you have a mean reversion overlay? What are your timeframes? And then let's talk about leverage relative to risk management?

"We have seen evidence of crowding in trades, these guys moving in the same trades."

BW: Sure! Well, I think that managed futures represents one of the better strategies to try to replicate, and the reason why is because if you look at the universe of CTAs the larger managers basically do the same thing, which is trend following. And they are in the same markets, so if there is a trend in, say, global fixed income, they are going to be in that trade. We have seen evidence of crowding in trades, these guys moving in the same trades. Also, there is definitely, like an 80-20 rule.

MM: The Pareto principle.

BW: The largest five CTAs are basically 20% of the industry.

MM: Right. That's ridiculous!

BW: Yes. There is a lot of that type of behavior as well. It gives us a chance to be able to replicate CTA returns. And I have had a lot of experience in this area. I wrote a book called 'The Futures Game', which talks a lot about the futures markets and I actually created, I think, what was the very first sort of index fund for managed futures. It was called the Managed Futures Index Fund. We had an agreement with Managed Account Reports, which back in those days in the 90s was sort of preeminent. We were recreating their index, which was called the MARTAI, Managed Accounts Report Trading Advisor Index, and it was a dollar-weighted or cap-weighted index, which was somewhat unusual for that space. When that firm was bought by Euromoney Magazine, we lost the ability to track the index, but we did that throughout the 90s and had good results, and then I brought that experience to the managed futures space.

"It's a trend-based strategy, but it has a countertrend piece as well."

But you were right about trend and countertrend. It's a trend-based strategy, but it has a countertrend piece as well. You need the countertrend in there because countertrend trading is a decent part you can't ignore in overall CTA returns. And there are some indices that are trend following only, but we are both trend-based and countertrend-based. We trade in 23 markets, and as you can imagine those would be the more popular markets for CTAs.

MM: What's your AUM?

BW: The mutual fund tracking our index has about $115 million under management in the Aspen Managed Futures Strategy Fund. There are a few separate direct accounts in addition to that. The fund launched last August and so they have gotten some good traction in the marketplace. Our partner in this project is Aspen Partners and they have been very active in the managed futures part of the investment industry for a long time, so they were a good partner in our opinion to create a fund with.

MM: Are you targeting the RIA marketplace? What is your distribution strategy?

BW: It's mostly independent RIAs at this point.

MM: Right. Those are the guys that seem to actually get it.

BW: Oh yeah, and I was one of those guys. We ran a multifamily office for years here until we sold it a few years ago.

MM: You see a lot of managed futures guys coming from family offices. If I had to like put a pin on where most of the guys that I am aware of come from, I would say family office would be the top background.

BW: Exactly! Because we are the guys that designed the products, our whole approach was we come about it as somebody who ran family money, from multifamily office background. So when we create a strategy it's all about solving a problem. And so the big differentiators on any managed futures product is to design something that has the highest possible negative correlation to equities during tough times for equities.

Managed futures can be the product if you want to hedge your portfolio against a disruption in the equity market, this is the one that I think would be a very logical one to consider.

MM: Fascinating conversation, Ben.

About Ben Warwick:
Ben Warwick is the author of several books, including "Searching for Alpha: The Quest for Exceptional Investment Performance," (Wiley, 2000), The Futures Game: Who Wins, Who Loses and Why (McGraw Hill, 1998) and "The Handbook of Managed Futures," with Carl Peters, (McGraw-Hill, 1996).

Mr. Warwick founded Quantitative Equity Strategies (QES) in 2002 as a platform for implementing his quantitative investment strategies. The firm manages assets with traditional long-only equity and fixed income, private equity, managed futures and alternative investment mandates. QES has developed an industry leading expertise in building investment programs that can replicate alternative returns, while offering daily liquidity and transparency. These products include the HFRq, a hedge fund replication strategy developed in concert with Hedge Fund Research in Chicago; the Managed Futures Beta Index, with Aspen Partners; and the Nomura QES Modeled Private Equity Returns Index (PERI), which was developed with Nomura Bank and Preqin, the leading source of information in the private equity industry.

This article was published in Opalesque Futures Intelligence.
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