A CTA High on My Watchlist: Protec

Protec Energy is a fundamental relative value CTA who has generated consistent performance through a variety of difficult market environments for managed futures trend followers – 47% in 2010; 63% in 2011; 11% in 2012 and 17% year to date.  (Returns reported are from a direct managed account falling under NFA reporting guidelines which means performance is reported net of all fees and expenses.)

Protec is a niche CTA trading long volatility option spreads in energy markets – crude, gas and diesel.  The CTA’s public track record as an NFA registered CTA only dates back to 2010, but the CTA has a much longer track record trading as a hedger in the physical distribution markets.  Thus, when this CTA ranking is considered in the algorithmic P (A|B) Analysis, they receive a penalty for a short track record, highlighting the need for qualitative due diligence to accent the algorithmic CTA rankings.

Co-Founder Todd Garner has over 25 years experience in physical energy markets, 14 of which have been operating Protec Fuel Management, an energy procurement distribution firm.  Prior to Portec Mr. Garner held senior positions at the Williams Companies in Tulsa, Oklahoma, including Vice President of Risk Management.  Mr. Garner’s trading partner, Andrew Greenberg, was a floor trader at the NYMEX where he was manager of ConAgra’s crude oil and refined products operations.

This fundamental experience plays significantly into Protec’s trading strategy.  “When people see things that don’t make sense in the energy markets, that presents opportunity,” noted Mr. Garner.

Trading Strategy

Protec utilizes a “reversion to the mean” options trading strategy.  Using fundamental analysis, Garner and Greenberg determine a fair value pricing model for physical crude oil, gasoline and diesel fuel.  When markets dislocate from Protec’s definition of fair market value, they place a trade in anticipation of the market reverting to the mean, returning to their fair value analysis.

Protect executes their directional trades using options spreads so as to limit risk on each trade.  Typically a trade is long volatility, buying the closer to the money option and selling the further from the option.  While this strategy can limit upside, risk is limited to.  “We generally like to risk no more than 5% of our total equity at any one time,” Garner said.  In fact the CTA’s worst monthly drawdown was 5.02% in September of 2012.  The CTA is considered a low delta strategy due to the options spread execution.  Had the CTA employed the same directional technique with futures contracts the rate of change – and related volatility and drawdown statistics – might be expected higher.

Many of Protec trades are seasonal.  The CTA has generally been long the energy complex from July to September due to winter seasonality, hurricane season, refining turnarounds and the farm harvesting season, which utilizes a fair amount of fuel.

The CTA’s time horizon is typically 30 to 90 days with some trades lasting six months.  With just over $80 million under management, the firm typically executes their trades on the energy trading desks of major firms such as Shell.  “We don’t like to show our cards to the trading floor,” Garner said.

Market environments in which the CTA is expected to find difficulty would be flat, sideways markets.  Conversely, markets where volatility exists, and dislocations occur, this can present opportunity but can be a slippery slope, Garner notes.

AlphaMetrix Releases Statement Denying CFTC Allegations

In response to a CFTC civil suit against AlphaMetrix alleging fraud, the firm issued a statement denying the charges alleged in the suit and re-iterated it is fully cooperating to properly liquidate funds on the its managed accounts platform.

The statement reads:

On November 5, 2013, the Federal Court in Chicago entered a Consent Statutory Restraining Order sought by the CFTC.  AlphaMetrix agreed to the entry of the Order because it is consistent with its efforts to liquidate and return the funds. AlphaMetrix denies the allegations that it violated the Commodity Exchange Act as alleged in the complaint filed by the CFTC.

The Order appointed a Corporate Monitor for all commodity pools operated by AlphaMetrix. The Corporate Monitor is directed and authorized to ensure that at least 95% of pool participant funds are retuned to participants by no later than fifteen (15) days from the entry of the Order.  AlphaMetrix will cooperate with the Corporate Monitor.

It is anticipated that additional pool participant funds will be released once tax, audit and other such service fees are estimated and accrued for as directed by the funds offering memorandum. AlphaMetrix is currently communicating with Deloitte to engage them to complete final audits. Deloitte has audited funds for AlphaMetrix since 2008.

The CFTC filed a lawsuit against AlphaMetrix, the embattled alternative investment account platform services provider, on .  The suit claims that AlphaMetrix misappropriated $2.8 million claimed for its own use funds from CTA fees it had promised investors to be re-invested.   Perhaps most ominous, the CFTC accused AlphaMetrix of distributing false and misleading account statements to conceal fraud and said they took the actions to prevent further violations of the Commodity Exchange Act.   After the firm stated they would engage in an “orderly distribution” of investor assets, the firm had plans to continue certain business operations including the popular conference series and the fund administration business, according to a firm source.    The case is U.S. Commodity Futures Trading Commission v. AlphaMetrix LLC, U.S. District Court, Northern District of Illinois, No. 13-07896.

AlphaMetrix to Engage in Orderly Fund Redemption, Conference Plans Still In Tact

AlphaMetrix released a statement saying the firm would begin orderly redemptions of client assets held on its managed account platform and a spokesperson said the firm will remain a viable entity.

The statement reads:

“In light of recent redemption requests, AlphaMetrix has determined that its sponsored funds will no longer be able to effectively trade the investment strategy employed by each trading advisor. As a result, AlphaMetrix has decided that it is in the best interest of all investors for the funds to cease trading as of October 31, 2013, and enter into an orderly liquidation. For all investors who have not already redeemed, it is anticipated that AlphaMetrix will distribute 90% of the proceeds to investors on or about November 21, 2013. The balance will be distributed upon the completion of a final audit.”

As reported yesterday, plans for the firm’s Miami Beach conference are in place and the firm will likely attempt to engage in some sort of workout with CTAs with whom it owes fees.  “The January 2014 conference remains on track and AlphaMetrix will continue to operate its risk, research and events business,” said Conor Shea, a press spokesman for AlphaMetrix.  The viability of the AlphaMetrix managed account platform remains in question.

On October 18 it was reported the firm was in negotiations for a sale or acquisition of a capital source.  Then on October 21, the National Futures Association (NFA) handed AlphaMetrix an enforcement action that essentially said the firm must pay fees owed to managed futures commodity trading advisors (CTAs) or it would essentially be required to cease trading operations.  The firm had engaged in a series of hectic negotiations with a variety of capital sources and potential suitors in recent weeks, but investor redemptions appear to have been too significant to keep the managed account platform alive.

It is unclear how the bankruptcy will be structured and how much of the debt burden will be assigned to the account platform, which could engage in a bankruptcy.

Exclusive: AlphaMetrix Source Expresses Optimism Firm Will Meet NFA Deadline, Pay CTA Fees; January Conference Still On Track

As a public deadline with the National Futures Association (NFA) approaches that could essentially end the firm’s business, a source inside AlphaMetrix expressed optimism the January, 2014 conference in Miami Beach will take place.  Further, this source considered it likely the firm will pay all outstanding fees owed to managed futures CTAs before the November 1 deadline imposed by an NFA enforcement action.  A formal announcement is expected within days.

If AlphaMetrix does not pay fees to managed futures commodity trading advisors (CTAs) the NFA would prohibit the firm from placing trades for pools it operates, except for liquidating trades, and further would ban it from disbursing or transferring any funds from any customer or pool account without NFA prior approval.  With this crippling event as a backdrop, sources indicate that firm CEO and founder Aleks Kins has been engaged in a juggling act of negotiations with multiple parties, having the goal to emerge from the troubles a different but nonetheless viable entity.  Sources say the structure of the debt load and negotiations to keep creditors comfortable with collateral are key issues.

At the upcoming 2014 Miami Beach conference attendees might expect some of the lavish entertainment to be toned down; as well, speculation is the list of complementary accommodations for many institutional allocators to attend the event might not be as extensive, but the key concept for speed dating between allocators and managed futures CTAs and hedge funds is expected to remain.

Speculation is the firm would likely reduce head count and could spin off some of its divisions, including the fund administration business, which currently has several buyers interested but many of whom are waiting for an opportunity to obtain the most advantageous pricing.  As AlphaMetrix top executives continue to engage in a juggling act, potential buyers and financing sources appear to be using the November 1 deadline to their negotiating advantage. Results of the negotiations are in no way certain.  The worst case is no financing and then bankruptcy, leaving CTAs to fight for their fees among the scraps left from a time consuming and financially draining bankruptcy process that was the case with MF Global and PFG bankruptcies.  Sources, however, now indicate this is a lower probability than it once was.

Regulators continue to be vigilant in regards to customer funds, wary of the potential damage another MF Global or PFG scandal could cause.  If AlphaMetrix customer funds did end up missing, the criminal and legal outcome would likely be significantly harsher for Mr. Kins and his executive staff than was the case with MF Global, a separate source indicates.

Enforcement Action Could Hasten the End for AlphaMetrix

A recent Enforcement Action against AlphaMetrix by the National Futures Association (NFA) could hasten the firm’s path to bankruptcy.

On October 21, the NFA issued a “Notice of Member  Responsibility Action” to AlphaMetrix which instructed the firm to pay $600,000 in fees owed to managed futures Commodity Trading Advisors (CTAs) by November 1 or to cease trading, which for all practical purposes brings the firm to an end point.  Sources have indicated the firm will have difficulty raising the capital and is resting its hopes on an additional capital infusion, which has yet to materialize.   “The enforcement action forces Aleks Kins (firm founder and CEO) to make difficult decisions he had been resisting,” said one source familiar with the matter.

Source: AlphaMetrix in Negotiation for Sale of Firm, But Bankruptcy More Likely Outcome

 By Mark Melin

 

AlphaMetrix, the investment platform connecting primarily institutional investors with hedge funds and managed futures programs, has suspended paying performance and incentive fees to the funds on its platform and fired its Chief Financial Officer, according to a letter  dated October 10 and sent by the firm’s CEO Aleks Kins to hedge fund managers.  Several managed futures commodity trading advisors report being owed in the neighborhood of $100,000 in fees while one CTA pegged their number at $2.5 million.

As of this writing there is no indication customer funds have been illegally transferred and no enforcement actions have been taken, but speculation is an investigation file is not yet closed. Regulators are said to have been in AlphaMetrix’s office monitoring the situation.

The letter was the first public manifestation of a firm having difficulty, but previous clues to the problems existed.  Sources indicated staff layoffs and a drop in assets under management had provided indications as to the troubles preceding the public letter, as well over $1 million in invoices are said to remain unpaid after their recent Monaco Conference.  It is unclear if cancelation of a technology contract for AlphaMetrix to provide transparency into bank balances of various futures brokerage firms to CMEGroup and National Futures Association (NFA) occurred or if the contract terms had concluded but this, too, played into various reports surrounding the firm’s demise.  Certain institutional asset managers, including one well known pension fund from Ontario, Canada, pulled assets the weeks before the letter was sent, according to one managed futures fund manager involved in this withdrawal process.

Speculation is AlphaMetrix is currently in negotiations with an investor group who may take controlling interest in the firm, with likely candidates including a large bank who has a significant clearing relationships with AlphaMetrix.  Due to the heavy debt load it may be most economically beneficial to a buyer for AlphaMetrix to declare bankruptcy and then sell off the technical platform and rights to its various properties, which is the most probable outcome.  But it remains unclear how such a buyout may be structured at this time.

AlphaMetrix entertained several potential buyers during the fall of 2012, according to multiple sources, but failure to come together on valuation of the firm relative to its debt load and lack of a revenue generation model to cover the debt were then cited as reasons for the lack of a sale.

Assets under management at the firm, documented to have been north of $1 billion at their highs, were said to be near $800 million over the summer.  However, based on an SEC filing Bloomberg reported  assets under management to be closer to $146 million.  It is unclear if the SEC filing includes all assets utilizing the platform or just those being managed under the discretion of AlphaMetrix.  The firm’s discretionary management arm was a much smaller part of the business, as the primary business was providing a neutral third party technical platform to provide transparency into the investment, provide un-bias investment due diligence and operate what had become successful industry conferences.

Background and Significant Successes

AlphaMetrix was founded in 2005 as a platform that was said to combine the benefits of a direct managed futures account (transparency into trade positions and all fees, commissions and expenses) while offering the legal protection of a limited liability partnership.  It was registered with the NFA as a Commodity Trading Advisor (CTA) and Commodity Pool Operator (CPO) which meant performance was mandated to be compiled inclusive of all fees and expenses.  Offering the benefits of transparency in a direct account and the legal protections of a limited liability partnership structure through a deep technical platform were just the start of significant innovations the firm pioneered, but some clients grew impatient waiting for promised platform technical enhancements.  Kins nonetheless had built what was considered among the industry’s most significant independent investment platforms.  The research team was led by Ranjan Bhaduri, perhaps among a handful of the most respected researchers in managed futures today.  The due diligence platform also included David Fisher, a former top official in the Chicago office of the US Secret Service, who conducted extensive background checks of managers, while the technical platform provided day by day, and even minute by minute transparency into the activities of the funds in which institutions had invested.  The firm purchased Spectrum Fund Management in December of 2010 in a complement to their existing hedge fund offerings.

The firm also built what had become known as a must-attend conferences for the managed futures industry and hedge fund community.  The events, which started modestly at the Beverly Country Club on the south side of Chicago, would later migrate to more fashionable destinations such as the South Beach district in Miami and the exclusive kingdom of Monaco.  Events would come to include speakers such as former UK Prime Minister Tony Blair and high profile entertainers at night.

Although the firm has been publically criticized for its spending on building the technical platform as well as attracting speakers and entertainers to its events, industry observers note that creating an event that dominates an industry in a few short years and building a robust technical platform and due diligence infrastructure required such spending.

No firm with the breadth of AlphaMetrix services exists in the alternative investment industry, which lends credence to the belief the firm will declare bankruptcy then sell off pieces to the highest bidder.

Beat the Managed Futures Benchmarks? Not so fast…

The following article is excerpted from the upcoming Opalesque Futures Intelligence

LorentMeksi

By Lorent Meksi

When investing in managed futures, how easy is it to beat the benchmark?  Every investment is judged on how well it does not only on an absolute basis, but also relative to a benchmark. In addition to generating profits, the goal of any investment is to beat the benchmark. If you beat the benchmark, whether by luck or skill, you will be viewed as a genius and will be compensated accordingly. If you deviate from a benchmark and fail to add value, you will look foolish and be exposed to significant career risk. As investment professionals, we live with this reality on a daily basis. It is the nature of the game and we accept it. We would all like to think that we can beat our benchmarks. We work hard to create investment processes, follow rules and take calculated risks – all with the purpose of achieving that goal. When the work is done and we see favorable results, we start to believe that outperformance of the benchmark is indeed easy.

Managed futures, aka CTAs, have a long history, but the wider investment community became more interested in the asset class after 2008 when it provided dramatic downside equity protection. The typical path for an investor begins with a decision to allocate to the asset class. Once that decision is made, the next logical step is to determine the best way to access the industry’s returns. There are many ways to access the industry’s returns, including: single managers, multi managers, and platforms.   As evidenced by the high concentration of asset under management (“AUM”) in the largest CTAs, many investors choose to go with the more established managers.

“Many investors evaluate returns and conduct portfolio benefit analysis on managed futures benchmarks that are not investable and then construct their own CTA portfolios with inherent tracking error.” 

Many investors evaluate returns and conduct portfolio benefit analysis on managed futures benchmarks that are not investable and then construct their own CTA portfolios with inherent tracking error.  As the research partner with STOXX® in creating the iSTOXX® Efficient Capital® Managed Futures 20 Index, Efficient Capital Management has made a CTA benchmark investable to those seeking to access industry returns while limiting tracking error and benchmark risk.

Should investors use an index to access managed futures returns, or should they build their own concentrated portfolio by investing in a few hand-selected managers?  With the iSTOXX Efficient Capital Managed Futures 20 Index serving as the benchmark return, how easy is it for investors to create their own portfolio that outperforms that benchmark?  It is certainly quite easy to select a group of managers today, run a proforma, and show that the portfolio with full hindsight bias has outperformed the index. However, if you were to step back in time, would you have chosen those same managers using only the information that was available at that time?Figure_1_AUM_LTD_Vol_Adj_Vami

This article attempts to address these questions and present evidence that suggests that outperformance of the index can be challenging. When investors select CTAs, we believe they value two main factors: size and recent performance. The average institutional investor invests in the large managers (“Biggest”) and managers that have performed well recently (“Best”). To model this behavior, we have gone back in time and created hypothetical portfolios based on these two factors. By simulating manager selection decisions based only on information that would have been available at the time of selection, we essentially create the “Biggest” and “Best” portfolios without the benefit of hindsight.  These portfolios were then compared to the historical performance of the iSTOXX Efficient Capital Managed Futures 20 Index.  The analysis shows that the “Biggest” and “Best” portfolios generally underperform the index. In the remainder of the article we explain our assumptions, show the results and offer some reflections.

ASSUMPTIONS & METHODOLOGY

The iSTOXX® Efficient Capital® Managed Futures 20 Index (“index”) – The Index is developed by STOXX in collaboration with Efficient Capital Management, a leading investor in the managed futures space.  The index has 20 constituents, is completely rules-driven and is representative of the Managed Futures industry’s leading managers by assets under management. Twenty constituents is a sufficient number to ensure a representative return of the Managed Futures industry at large due to the heavy concentration of assets with the largest managers. STOXX independently constructs, calculates and publishes the index value on a daily basis, while Efficient Capital serves as the research partner.

Index Methodology:

Annual Reconstitution – In order to best represent the industry, managed futures traders are ranked by AUM and the top 20 that meet the following criteria constitute the index:

• Minimum of USD 100 million AUM

• Open to new investments

• Offer a managed account

• Offer fees lower than or equal to the corresponding publicly traded fund

• Have at least 3-year track record

Monthly Rebalance – The 20 managed futures traders will be equally weighted after adjusting for volatility. This ensures that every manager has an equal risk adjusted impact on the index return. The rolling 36-month volatility is used.

“Size” factor – The size factor refers to the AUM for a given manager. Much research has been done on the relationship between size and future performance. Academics aside, most investors tend to avoid small managers. As a matter of fact, many investors have rules to purposefully prevent them from investing in small managers. Asset concentration among the top managers is evidence of this fact. Investing with large managers can mitigate headline risk among other things. And although current size may or may not have correlation to future performance, current size most likely is a reflection of recent performance.

Figure_2_AbsoluteRet_LTD_Vol_Adj_Vami

 “Performance” factor – This factor simply refers to the recent performance of a manager. No matter how you look at things, performance is the most important factor in determining whether to invest. We suspect that few presentations of poor-performing managers (either on a relative or absolute basis) are brought before investment committees.

Manager universe – For the purposes of this study we kept the investment universe limited to the constituents of the iSTOXX Efficient Capital Managed Futures 20 Index. Since we make the assumption that investors value size when investing in managers, we believe it is fair to limit the universe to 20 of the biggest managers in the industry. There are benefits to making this choice. The performance data is clean and of high quality given the small and focused data sample. In addition, the performance data is less prone to some of the biases that are typical of hedge fund databases. The universe is comprised of exactly 20 managers every year changing annually to reflect the index constituents.

“Biggest” portfolios – We use the size factor to create the “Biggest” portfolios. Every December we rank the 20 managers by AUM and then select the top one, three and five. We hold these equally weighted portfolios for the following year until we rebalance again the following December.

“Best” portfolios – We use the performance factor to create the “Best” portfolios. Similar to the “Biggest” portfolios, we create and rebalance one, three and five-manager portfolios every December. We use two measures of performance to determine manager selection: absolute returns and risk-adjusted returns. For absolute returns, we use the average annual return for the past three years and for risk adjusted returns, the trailing three year return-to-risk-ratio.

Data – We use monthly net returns throughout our analysis. Data sources include a combination of BarclayHedge, Efficient Capital and Bloomberg. Since we are comparing all the portfolios to the iSTOXX Efficient Capital Managed Futures 20 Index and the look back period for the performance selection criteria is three years, all the comparisons start in January 2003 and end in December 2012.

 

Figure_3_R2R_LTD_Vol_Adj_Vami

BIGGEST AND BEST vs. THE INDEX

The following charts represent the risk-adjusted performance (i.e., normalized to 12% volatility) of the “Biggest” and “Best” portfolios relative to the index. The first chart represents the performance of the “Biggest” portfolios.  All three portfolios compete well. The one and five manager portfolios slightly outperform the index and the index outperforms the three manager portfolio.

 

The second chart represents the “Best” portfolios, using the absolute return selection criteria.  This investment strategy has clearly been inferior to investing in the index. The one manager portfolio was a good competitor for a time, but in recent years the index has prevailed over all three portfolios.

 

The third chart represents the “Best” portfolios as defined by the return-to-risk selection criteria. These portfolios compete better but, in the end, the index prevails.

 

So far we have seen that ”Biggest” and ”Best” portfolios (chosen based on return-to-risk ratio) compare well with the index. Let’s now take a closer look at ”Biggest” portfolio variance to the index over time.  Although most investors aim to be “long term”, the path of each investment (i.e., variance to benchmark and drawdown) tends to matter a lot.

THE PATH OVER TIME

The following chart shows the rolling annual return variance for each of the “Biggest” portfolios from the index (+10% means the portfolio outperformed the index by 10% over the last rolling year, while -10% means that the portfolio underperformed the index by 10% over the last rolling year). As the following chart of risk-adjusted returns illustrates, there have been periods where the portfolios have outperformed the index, but in all three cases, the underperformance has been larger. This is an important data point since we all know that we tend to feel losses more than gains.

FIgure_4_AUM_volAdj_trackingError

 

The next chart offers another insight into the path of these investments as we compare the volatility-adjusted drawdowns between the “Biggest” portfolios and the index. The shaded portion of the chart indicates the drawdown of a given portfolio while the line marks the drawdown of the index. As you browse through the charts, you will see that, with a few exceptions, the index tends to have a more robust profile.

 

REFLECTIONS:

  1. Outperformance of the diversified portfolio (index) over a multi-year horizon by constructing a concentrated portfolio of managers based on the “Biggest” and “Best” criteria has been challenging.
  2. It appears that selecting big managers particularly based on recent performance has made it difficult to create concentrated portfolios that outperform the benchmark.
  3. The concentrated portfolios can be very painful during periods of underperformance and can give false hope during periods of outperformance while failing to beat the benchmark index over the long run.  The “path of returns” relative to the index introduces significant benchmark risk over shorter periods of time.
  4. Since the majority of assets are concentrated in the biggest CTAs, variance to the benchmark (tracking error to the index) is reflective of the average investor’s experience.

Figure_5_AUM_volAdj_drawdown

This analysis makes some intuitive assumptions about how the average institutional investor may approach their managed futures investment decision. The comparative analysis was completed on portfolios that were created without the benefit of hindsight, using only information that was available at the time of the investment decision.  By conducting “honest” backtests, we have demonstrated that the index compares favorably to concentrated portfolios of the “Biggest” and “Best” managers.  Although the analysis might indicate otherwise, we are not suggesting that the index is the best way to gain exposure to managed futures. We are simply suggesting that investors should be careful before concluding that it is easy to outperform their managed futures benchmark.

 

Meksi Biography: Lorent Meksi is a Director and a member of the Investment Team at Efficient Capital Management, LLC. Prior to joining Efficient, he was an options trader for Efficient Capital Overlay, LLC where he started his career and remained until 2006. Mr. Meksi graduated from North Central College in 2003 with a BS in Computer Science and a BA in International Business. He received his MBA degree from the University of Chicago Booth School of Business in 2012. Mr. Meksi holds a Series 3 license, and has been in the industry since 2003.

 

COMPLIANCE NOTES

 

STOXX

STOXX Limited, its owners, data sources, business partners and agents (the “STOXX Parties”) have no relationship to the Efficient Capital Management, LLC, other than the licensing of the iSTOXX® Efficient Capital® Managed Futures 20 Index and the related trademarks for use in connection with the iSTOXX® Efficient Capital® Managed Futures 20 Index.

 

The STOXX Parties will not have any liability in connection with the iSTOXX® Efficient Capital® Managed Futures 20 Index. Specifically, the STOXX Parties do not make any warranty, express or implied, and disclaim any and all warranty about: the results to be obtained by the iSTOXX® Efficient Capital® Managed Futures 20 Index, and the data included in the iSTOXX® Efficient Capital® Managed Futures 20 Index; the accuracy or completeness of the iSTOXX® Efficient Capital® Managed Futures 20 Index and its data; the merchantability and the fitness for a particular purpose or use of the iSTOXX® Efficient Capital® Managed Futures 20 Index and its data; the STOXX Parties will have no liability for any errors, omissions or interruptions in the iSTOXX® Efficient Capital® Managed Futures 20 Index or its data; under no circumstances will the STOXX Parties be liable for any lost profits or indirect, punitive, special or consequential damages or losses, even if the STOXX Parties know that they might occur.

Benchmark Data
Benchmark data was obtained from various internal and external sources, such as CTA databases, Bloomberg, International Traders Research Inc., Hedge Fund Research, and Newedge. Efficient believes the benchmark data to be reliable, but can make no warranty as to its accuracy.  Efficient has not and cannot verify the accuracy of all such information and the recipient should be aware that the information is presented on an informational “as-is” basis and is subject to change without notice.

KPMG’s Chief Economist / Alternative Investments Addresses Fed Exit Strategy, Coming Bond Market Volatility and Challenges to the US as World Reserve Currency

Constance Hunter

Constance Hunter, KPMG’s Chief Economist / Alternative Investments, is known in economic circles for her insight into transitional trends and fundamental market shifts.  We caught up with her to discuss her outlook in regards to some of the significant economic issues that could impact trading markets worldwide.

 

Mark Melin: With Janet Yellen as US President Barack Obama’s choice for Chairwoman for the Federal Reserve, she inherits a $5 trillion long bond position, the largest in Fed history, at a time when interest rates appeared to have touched bottom. What tools does the Fed have left to work with? What are the risks?

Constance Hunter:  Anyone who thinks that the Fed doesn’t have any more bullets left, look what they did just with moral suasion. With moral suasion they were able to end this idea of Q ever, quantitative easing forever; we saw the long end move back over a 125 basis points and we saw people expecting a tapering.

Now, as the data started to come in, it wasn’t as strong as anticipated, so the Fed decided not to taper. They also told market participants multiple times that the activity was going to be data-dependent. The market chose not to listen to them, so that’s the market’s fault.

When you look at the risk of what the Fed is doing, you need to counterbalance that and look at the risk of what if the Fed were not doing this. Although there are a lot of issues, such as price distortions in primary bond markets; the converse issue, the issue of disinflation, of having companies’ inventories being worth less than what they were purchased for is a way more pernicious, way more problematic issue, and so this is something that the Fed is making sure does not happen.

The Fed knows very well that there are limitations to what they are doing. They know that there are what we call structural breaks in the labor market. So there are some shifts going on in the labor market that indicate structural problems rather than just cyclical problems. And they know that this means the natural rate of unemployment is higher than before the crisis.

If you read Janet L. Yellen’s speeches, which I advise everybody to do, because she is probably going to be our next Fed Chair, and she is also very smart, you will notice that she is very aware of the limitations of Fed policy. So with that backdrop, which is critical to have a complete understanding, we look at the risks of what they are doing.

Now, of course the first risk is that we have never done this before, and we don’t really know how exit is going to go. There are plenty of smart people who have looked at it theoretically and said it shouldn’t be a problem, but the reality is we it do not know.  Markets don’t like uncertainty, they don’t like things that are unknown, and it certainly could create a lot more volatility than we traditionally see in the bond market.

I think the biggest risk to what the Fed is doing is we have an entire asset allocation system based on this notion that bonds dampen the risk in a portfolio and provide a stable yield. Assuming we solve the debt ceiling and continuing resolution problem, bonds will still provide a stable yield and will pay principal upon maturity.

In terms of total return, bonds have returned 21.4% or 3.95% per year for the past five years, and 53.1% or 4.35% over the past ten years. If you take the period from November 2007 until the end of October 2012, total return was 32.48% or 5.8% a year, this compares with a total return of 3.77% or 0.755 for equities.   Over the past year the total return for bonds has been -2.55%.  This is certainly not terrible, but if we look at the direction of yields over the next 2-3 years, rates are likely to move higher and total returns for the index will be negative.   Although coupons will move higher, it will take some time before they are high enough to provide positive total returns and this will impact retail investors’ psychology and portfolio returns the most.

“Over the next 3-5 years, total (bond) returns may be negative and volatility will be higher.”

The other concern is how this data fits into models about risk and volatility. Over the past ten years, bonds have had a total return of 4.9% per year compared with 7.02% for the S&P500.  The data will show that for a very low volatility asset, bonds, you can obtain a total return of 4.9%. Over the next 3-5 years, total returns may be negative and volatility will be higher. So using the recent past to make allocation models optimize is likely going to cause some surprises.

When you think of the entire asset allocation paradigm that we operate under, I think it’s very possible that we will see some changes.  .

MM: You said we are in a different market environment.  What is your projection for pricing patterns?

CHFrom a retail perspective, I had a friend who works at a hedge fund, who is a sophisticated investor, say to me “My bond fund was down 4% in July, I can’t believe it. My total annual expected return for this fund is only 4%, how am I ever going to make that back? Should I reduce my bond allocation?” This is completely disregarding those bonds that have been showing a total return of nearly 5.8% per year during the crisis.  There was no talk of reducing the portfolio while returns were high, when rebalancing would have suggested this is the best thing to do.

This is a person who knew what her expected return was and that her volatility in one month exceeded her annual expected return, was thinking “I need to think about reallocating a bit here.” People have been told, bonds are safe, bonds aren’t volatile. That reality is going to change and I think the perception will be magnified.

There is a feedback loop that will begin to take effect as well. As volatility increases, people will become concerned, they will start to sell, that will increase volatility and reduce prices, reducing total returns. This could well set in motion some unusual patterns that we have not seen for bonds.

When you look at return versus volatility on a bond going forward over the next five to eight years, I think that return and volatility relationship is going to be very, very different than it has been over the past five to eight years.

MM: I have heard professionals trading along the yield curve say fair value yield on a 10-year note right should be around 4.5%. If there wasn’t quantitative easing nor Fed asset purchases, do you have a projection on where would the yield of the 10-year note be right now?

CH: It’s interesting, if you look out at the five and ten year forwards, at the markets think rates will 4.5%, But to say that is where the 10 year should be now seems to overestimate the economic situation.

The economy really hasn’t experienced lift velocity yet, right? We are in 2.5% growth per annum growth mode. It would appear we can sustain this growth rate, but this growth rate is hardly setting the world on fire.  If we were at 4.5% of the 10-year we would have a real yield of 3.0% , that is a bit high for an economy that has the level of economic output, unemployment and inflation the  US is currently experiencing.

The US is only adding an average of 180,000 jobs a month, that is only enough to replace population growth. If we keep adding this much a month in a year, we are going to get back to our peak employment level at 2007. But between 2007 and 2014, a year from now, we will have added population, and we haven’t even accounted for that. We are not growing strongly. There is no reason for yields to be especially high. There is really no reason for us to have a positive 3.0% real yield on the 10-year.

MM: The difference is that investors think that US Treasuries are more of a risk asset now than five years ago.  There is a risk in principle repayment that wasn’t previously in play to the same degree.

CH: Absolutely! And that’s what I was saying to you earlier with regard to volatility. If you look outside of professional bond traders retail brokers that are advising an asset allocation strategy for their baby boomer clients who are about to retire, or who are in retirement, that puts bonds in the portfolio as the safe asset. But total returns are unlikely to be good over the next 3-5 years and volatility is likely to be higher than in the past. So it could be the Chicago traders are on to something.

MM: Let me throw a couple of scenarios at you. Looking at a probability table of events, one negative possibility being discussed is the potential for the U.S. to lose its status as a reserve currency. Not that anyone is rooting for this, but facing the reality of the situation is important.  One scenario is that China has been talking about taking on the U.S. as a reserve currency, and they have talked about backing their currency or some new unified currency in gold. Have you heard any of this talk and do you have any thoughts given your background?

CH: First, I go to China regularly. I am a member of the National Committee for U.S.-China Relations. I participate in the Track II Strategic and Economic Dialogues. We make recommendations to the Chinese and U.S. governments at the highest levels, on trade policy, on economic policy, and China certainly has some very bright minds in its government and amongst its academic community.

But you have to understand the implication of backing a currency with gold. Right now China is pegging its currency against the U.S. dollar, they are still doing that.

China is a command economy, it is not a market economy. It is run in a way where controlling the economy is the most important thing. We can see that controlling the exchange rate is quite important to them. This is a concept that is diametrically at odds with being a reserve currency. A reserve currency needs to be able to absorb shocks and allow its own and other economies to stabilize.

Second, China does not have a bond market to speak of. You think there are price distortions in the U.S. bond market?  Go to China and you trade Chinese government bonds, now we are talking about price distortions and government intervention.

Third, China has not demonstrated itself as a global citizen that cares about anybody other than China. And justifiably so, China is very focused on getting its per capita income from $7,500 per year to a middle income level of $12-15,000 per year – it is very far from being in the business of  providing public goods to the global economy.

Why is this important? Goods that are transported and priced in U.S. dollars are de facto guaranteed safe right of passage, right? Partly that’s our military, partly that’s our geopolitical stance in the world, partly that’s our involvement with organizations like  NATO; that is not the case for China.

So those are three really important things, when you add them up, they make the prospect of a Chinese reserve currency quite distant, if not laughable.

MM: The other international players will say that the US couldn’t engage in quantitative easing, bond asset purchases and other measures of deficit spending if we were not the reserve currency, and that we are improper stewards of taking advantage of that reserve currency status.

CH:  But reserve currency status is not something we plucked from the sky because we thought it would be nice. We earned it over several decades and this was a combination of our legal system, our federal reserve system, our military prowess and our economic strength.  We do not force other countries to peg their currencies to the dollar, nor do we require them to hold US dollars in their central banks. It is a voluntary system. If fiscal fights in Washington fail to make any progress, we could well see a situation where foreigners do not want to hold US dollar assets such as US Treasuries. But we should all be aware that the deficit is much more pro-cyclical than most people – especially those in Washington – like to admit.  During the recession we were in a vicious circle where reduced economic activity resulted in lower taxes being collected and more benefits being paid out.  We then enacted a stimulus package which cost some money but very likely saved the global financial system.  We went from a deficit of 10% of GDP during the crisis down to a 4.2% deficit today.

“Everyone in the US recognized the retirement age needs to be raised and benefits probably need to be reduced, they just want somebody else to bear those costs.”

In terms of our unfunded liabilities, quite honestly, you are right, we might not be able to get away with it as much if we were not the reserve currency.  Everyone in the US recognized the retirement age needs to be raised and benefits probably need to be reduced, they just want somebody else to bear those costs.  Nobody wants to be the one who pays for this. Oh yeah, you can raise the retirement age, but as long as it’s on the people who are younger than me.

MM: You and I look like we are about the same age (near 20 or so years from retirement age).  Are we going to get Social Security benefits and are we going to get Medicare benefits?

CH: We are a rather small voting block by the way; it’s the echo boomers and the baby boomers who make up the large voting blocks. And you would think the echo boomers would be on our side here, and you would think they would want the baby boomers to experience later retirement, and we have gradually raised the retirement age, but not sufficiently enough. So we need to raise the retirement age by another 3 years at least and  we need to do means testing.

MM: These are political issues that politicians haven’t been able to address to date.  Just look at the debt ceiling debate, there is even no compromise on easy issues

CH: Well, nobody has elected them to do that!  Neither Democrats nor Republicans want to mess with Social Security, neither of them do; neither of them want to mess with Medicare and Medicaid, it was under Bush that the prescription drug act came into being which costs a great deal of money each year. The increased costs for Medicare and Medicaid are split evenly between living longer and rising medical costs.

“The biggest policy mistake that Obama made in his presidency was commissioning Bowles-Simpson and then letting it die.”

Now, if you ask me, the biggest policy mistake that Obama made in his presidency was commissioning Bowles-Simpson and then letting it die; the biggest policy mistake. There was momentum, there was awareness, we just had a debt fueled crisis, people were aware that debt was problematic in a very visceral way.

Tax payers and voters were aware that even if they had personally been responsible, had personally paid off their mortgage, had personally not got overleveraged, they were affected, right? So you needed to have this sense that even if you were being good, you were going to be hurt by the system, if the system fostered a whole lot of bad behavior.

We were at a juncture where there was enough political awareness that we could actually do something about this, or there was some chance pigs might fly, but we squandered it, and now that the deficit is 4% of GDP, and economy has started growing again. , We have lost a lot of momentum here, there is almost zero bipartisan agreement and it’s quite unfortunate.

One possibility though is that medical costs might not continue to rise as fast as they have over the past decade. The CBO have forecast cost increases based the current increases in health care cost which have been growing much faster than general inflation for a long time. That is not going to continue. It cannot continue. It can’t continue because of the laws of physics and the laws of mathematics.

MM: You think it’s going lower?

CH: Well, it is already going lower, it’s not an opinion. The reality is if you look at medical costs, they are falling, and they have been falling for the last year, and the big question is, is this permanent, is this a new trend, or is this just an anomaly?

One thing that is happing is we are starting have a huge intersection of technology and medical care delivery. So what do I mean by this? When you go to a doctor and that doctor assesses your situation, your illness, it’s a bell curve usually that you are plotted against. The average response is this. Well, you know what, most people are not average; in many cases the mode and mean are far apart, and sometimes you may have bimodal distributions. You are still treated though as if it’s a bell curve.

So they will give people a cocktail of drugs with an attitude “let’s see if this works for you.” Six months later they may say, “Oh well, that didn’t really work out so well. We will try this new cocktail.” This is not only expensive, it does not lead to the best patient outcomes.

So the way we have been historically administering medicine and conducting medicine is based on averages. Current data analytic techniques now allow us  to take heterogeneous populations and create customized treatments. We are able to analyze and process data in a dramatically different way, that’s the first thing.

The second thing is that, we are able to monitor patients in a dramatically different way, with devices. It doesn’t even require compliance from the patient. All you have to do is wear the wrist watch or swallow the chip, and we are going to be able to monitor what’s going on with you and adjust your treatment accordingly.

Thank God too, because it’s happening just in the nick of time. Just like peak oil went away, I think dramatically increasing healthcare costs forever is going to be going away.

MM: What are you most passionate about? Address what’s most interesting to you?

CH: Well, there is a lot that is really interesting. This whole concept with technology changing society isn’t over.  By the way, it’s not just impacting healthcare, it’s impacting how we conduct economic research, how companies implement strategy.

The way people would analyze data and situations traditionally is: first is a hypothesis, The data is analyzes that might represent that hypothesis, or might be able to allow one to test that hypothesis. Regressions were run, more analysis was completed and researchers determine if the hypothesis valid or invalid.  If it’s valid, then you might refine your model a bit so that you have the best fit and the best data and the best coefficients, and you proceed from there, and then you make forecasts. That’s all changing.

Now we have access to structured and unstructured data sets.. So big data technically means unstructured datasets, but you can take structured and unstructured datasets and work with them as if they are the same type of data. We have computing power that’s easily accessible, that allows you to then look at patterns in the data. So the way analysis is done now, from a technological perspective, allows researchers to see the patterns and form the thesis in a different way. This is a radically different way of thinking about problems.

Economists on the cutting edge are looking at this new data analyses methodology. At KPMG we are doing a lot of cutting edge economic research and coordinating with risk analysis. It is very exciting. If one w ants to assess complexity, it is now easier due to both computing power and technology such as data analytics. It’s going to change the way actuarial science is done; it’s going to change the way economics is done.  Don’t underestimate technology.

Constance Hunter Background:

Throughout her nearly sixteen‐year career, Ms. Hunter has honed her ability to pick a needle from the economic haystack of data, synthesizing information to identify turning points for economies or markets. Ms. Hunter was most recently the Deputy Chief Investment Officer for Fixed Income at Axa Investment Managers. Prior to Axa, Ms. Hunter was a Managing Director and the Chief Economist at Aladdin Capital. Prior to joining Aladdin, she was with Galtere Ltd., a global macro hedge fund, where she served as a Chief Economist. Prior to and concurrently with, Galtere Ltd., she was the Managing Member and Chief Investment Officer of Coronat Asset Management. In that role, Ms. Hunter identified macro themes and invested in global equity, credit and FX markets to capitalize on these themes. Prior to founding Coronat, Ms. Hunter was a Partner and Portfolio Manager at Quantrarian Capital Management, a hedge fund that invests in Asian markets. In addition, she has worked as a Portfolio Manager at Salomon Smith Barney, Inc., and Firebird Management, LLC after starting her career as an economist at Chase Manhattan Bank in Foreign Exchange. Ms. Hunter received a Bachelor of Arts from New York University, as well as a Masters of International Affairs from Columbia University. Ms. Hunter is a regular guest on CNBC and Bloomberg TV, as well as being quoted in the Financial Times, Wall Street Journal, Barrons and New York Times to name a few. Ms. Hunter is on the board of the National Association for Business Economics (NABE), a member of New York Association of Business Economics, a member of Money Marketeers, Network 20/20 and 100 Women in Hedge Funds. She is a patron of the World Policy Institute.


 

AlphaMetrix Issues Statement to Quell Rumors

As rumors swirl regarding the potential downfall of a significant player in the alternative investment arena, with concerns regarding customer segregated funds paramount in light of the MF Global and PFG scandals, AlphaMetrix releases a statement  that aims to re-assure that all segregated funds are held at a Futures Commission Merchant (FCM) and not at AlphaMetrix.

The statement reads:

The AlphaMetrix companies were started on core principles of transparency.  We have invested years of hard work and dedication in building a world class marketplace for alternative investments, which has resulted in years of rapid growth.  We are issuing this statement to address inaccurate rumors that have begun to circulate in the marketplace as a result of a recent letter we sent to our fund participants.

AlphaMetrix Group LLC is the parent company of AlphaMetrix LLC and a series of other subsidiaries.  AlphaMetrix LLC is the operator for a series of private investment funds and managed accounts.  At the parent level, AlphaMetrix Group LLC is working  within the capital markets to improve its short-term cash flow. Investor assets remain under the operations of AlphaMetrix LLC, which are on deposit with futures commission merchants and cash custodians and traded by independent investment advisers and commodity trading advisors in accordance with the programs and strategies chosen by each investor. 

 

 

 

 

AlphaMetrix Encountering “Significant Cash Flow Issues” According to Firm

Alphametrix, one of the largest independent alternative investment platforms for hedge funds and managed futures, said it has “encountered significant cash flow issues,” according to a letter obtained by Opalesque and confirmed by multiple commodity trading advisors.

The letter also announced the firing of its Chief Financial Officer and said the firm retained the services of accountant Arthur Bell to “review and assist us in improving our internal controls and recordkeeping procedures.”

“In operation of our business, we regularly run intercompany balances between and amongst our affiliates,” the letter said.  “Our regulated commodity pool operator, AlphaMetrix, LLC (the CPO) is one such affiliate with whom there are intercompany balances.  The CPO’s assets consist largely of a receivable owed to it by (the) Parent. Parent has recently encountered significant cash flow issues and is working to strengthen its current financial position and its continued operation.”

The letter announced it will no longer pay hedge fund and Commodity Trading Advisor (CTA) management and incentive fees.  Alphametrixis a technology platform that enables institutional investors and qualified eligible participants to invest in hedge funds and managed futures programs.