LGT CP is perhaps better known for its $13.5 billion in private equity fund of funds but its fund of hedge funds business has grown to assets of $4.5 billion. US national George Coplit, who formerly ran tactical trading at New York-based fund of funds, Ivy Asset Management, heads up LGT CP’s managed futures team based in New York and Pfäffikon, Switzerland, where Man Group also has offices. This team forms part of an eight strong CTA/macro team lead by Thomas Weber. The firm has other offices in London, New York, Hong Kong, Tokyo and Dublin and is a cosmopolitan firm employing 30 different nationalities.
Absolute return focus
Crown Managed Futures (CMF) has a straightforward objective: it seeks to maximise returns, subject to a 12% volatility target. Coplit agrees with many other fund of fund portfolio managers that “a Sharpe ratio of one would be great for either a single or a multi-manager managed futures fund.”
However, LGT CP does not explicitly target any Sharpe ratio because Coplit is not worried about upside volatility – and many managers in the sector have a positively skewed return profile, which makes the strategy a popular diversifier. CMF also has some positive bias to its return distribution, with a gain to loss ratio of 1.12. LGT CP likes to remind investors that managed futures as an asset class has historically been uncorrelated to equities, bonds, commodities and hedge funds in general: rolling 24 month correlation coefficients fluctuate between small positives and small negatives, neither of which is large enough to be statistically significant.
While the term managed futures for many investors is synonymous with technical and systematic strategies, for LGT CP it defines the asset classes that the managers trade: commodity futures, stock index futures and bond plus interest rate futures on exchanges, with foreign exchange virtually the only over-the-counter (OTC) exposure beside a limited number of swaps. (Foreign exchange remains the odd one out with most trading still carried out OTC.) LGT CP will therefore group many entirely discretionary macro managers under the managed futures umbrella, and is also open minded about funds that blend discretionary and systematic investment processes. The growing number of CTAs employing both fundamental and technical inputs falls into LGT CP’s eclectic category. The weights allocated to the different styles and sub-strategies are regularly rebalanced for top-down reasons like a shift in macro view and bottom up reasons such as a change in manager style. While many investors associate managed futures with traditional trend following, LGT CP is exposed to a diverse range of styles. In March, the portfolio contained only four pure trend followers accounting for 29% of the book and five managers whose style involves no elements of trend following making up 47.2%. The other six managers, who are 23.8% of the portfolio, straddle one or more of trend following, and one or more of the three non-trend following groups: short term, fundamental, and eclectic.
The team’s bonuses are influenced by beating two types of benchmarks. The first is simply a blend of the leading managed futures and CTA indices. The second drills down to the approved manager list and incentivises them to profitably rebalance allocations within their existing portfolio, and rewards them for over-weighting above average performers and under-weighting below average performers. The counterfactual here is simply how an equal weighted portfolio would have performed. The way in which the team are remunerated would seem to focus them on delivering superior absolute returns and the long run track record has met these targets as well as producing positive returns in almost all 24 month periods. Only two out of 90 such periods saw negative returns, which at -1.1% and -0.5% were close to sideways results. The long term consistency here is impressive, even if the product has sometimes lagged its indices over some periods.
There are over 3,000 registered CTAs, but only 600 have the institutional infrastructure that LGT CP’s various due diligence teams insist upon. This does not mean that managers have to be running billions and employing hundreds. The managed futures product does allocate to funds with under $200 million of assets and teams of less than ten people – as well as to funds with over $10 billion of assets. Over the years LGT CP executives have met with 570 of their universe of 600 CTAs. In addition to allocating to smaller funds, they will go off the beaten track geographically. Asia and Australasia are not known for large CTA communities in the way that London or Chicago are, yet two of LGT CP’s allocations are based in the region.
Opacity rules out some managers, including those who do not disclose their own sub-allocations to external managers. LGT CP needs to know what is driving returns and exposures, without needing proprietary details such as exact parameters or timeframes for moving average crossovers. “We know the right questions to ask,” says Coplit, “because the team contains people who have worked inside managed futures funds”. These include analysts Roger Hilty and Nick Mitsiou, who has been a portfolio manager at US managed futures funds Millburn Corp and Graham Capital Management. The managed account structures give LGT CP real time transparency for each and every position, but they do not need to see the source code for the algorithms that are generating the trade signals.
CMF currently holds investments in 15 CTA managers that have been approved by the research committee. Approvals represent just one in forty of the investable universe. Sub-strategy exposures, as aforementioned, and asset class exposures, are detailed. Over the previous four years, on average, commodities were 35% of Value at Risk (VaR), with fixed income 27%, currency markets 21% and equity markets 17%. The latter three were mainly in the biggest markets, with the Brazilian Real and Mexican Peso the only overt emerging market exposures. Conservatively, no diversification benefit between these asset classes was assumed in the exposure snapshot. The names of managers are disclosed to investors but not published – partly because the turnover of managers has been so low that their identities are an important part of LGT CP’s intellectual property.
Risk controls and replacing managers
There have been years when no managers were added or deleted, although on average two changes per year are made. Half of redemptions have been for thepositive reason that LGT CP finds a better manager or is re-allocating to a different sub-strategy. The other half have been for negative reasons, which could include concerns about business, operational or investment risk. Asset outflows can contribute to a redemption decision because LGT CP generally does not want to be more than 25% of a manager’s aggregate assets. The operational, legal and quantitative risk management team of nine specialists, led by former investment banker Werner von Baum, have powers of veto before and after investments are made, and may cite reasons such as inadequate emergency backup systems. Last year, one redemption occurred after key people departed from a firm.
The approach to volatility is flexible at the fund level. Realised volatility does fluctuate around the 12% target although the average since inception, at 12.6%, is very close to the target, suggesting that LGT CP has been adept at forecasting volatility, and calibrating and adjusting allocations to stay close to the target. Margin to equity has varied far more than volatility, ranging from low single digits to the mid twenties, according to underlying managers’ views on the opportunity sets (and changes in exchange margin requirements, cross margining and netting rules). In common with the majority of managed futures funds, generally there is no hard stop loss policy applied to underlying funds or the fund of managed accounts itself. The worst ever drawdown was of the order of 19.3% and investors should be prepared for volatility going forward.
Unexpected investment risks at the managed account level, however, are identified rapidly, because LGT CP draws up contracts with each manager specifying parameters including what they can trade, target margin usage, types and numbers of contracts. These parameters are monitored on a daily basis so LGT CP would be quickly alerted to any deviations. Managers have limited power of attorney, so LGT CP can always step in and take control if needed: investments are only made through managed accounts in this way, and managers cannot instruct cash disbursements. LGT CP also defines a maximum expected loss ahead of investing, tailored to each manager based on quantitative and qualitative criteria determined by the manager’s own history and what is normal for the strategy, referencing the peer group. Managers approaching these maximum expected losses go onto a watch list, which always leads to some earnest discussions and sometimes ends with redemption. Each managed account is a separate, limited liability, legal entity to rule out cross-contamination risk.
Counterparty risks are not a reason to replace a manager, but rather to move assets away from a particular broker or other counterparty. For instance, in 2008 LGT CP was able to migrate assets away from Bear Stearns to other brokers in less than 24 hours. Detailed prime brokerage terms and other agreements are set up between each counterparty and LGT CP. The operational due diligence team are responsible for monitoring counterparty quality and are empowered to exercise a veto over this.
Day to day risk management uses a mix of proprietary systems and third party software. RiskMetrics is used because it complements the in-house systems and is useful for running stress and scenario tests. Such tests help to illuminate what may happen in the fat tails that fall outside the scope of parametric VaR measures. Position sizing is partly informed by individual managers’ contributions to the overall portfolio VaR. Portfolio Science provides real time, position level, risk management reports. Position mapping and administration services are done by NAV Consulting, which is SAS 70 certified and has been pricing hedge funds for 20 years. The managers themselves can be targeting one or more of volatility, margin usage or VaR, and employ a range of risk approaches.
Structuring UCITS and managed accounts
The UCITS product carries an extra 0.7% structuring fee on top of the management fees of 1.5%and performance fees of 7.5% charged by CMF. This extra fee can be subtracted from a CMF track record to show a hypothetical UCITS track record. The absence of a published and itemised total expense ratio seems unusual for UCITS, but it reflects the sensitivity of negotiating fee discounts, that are themselves subject to confidentiality agreements. In any case, the track record shows that CMF has, since inception, more than covered the extra costs which the UCITS product will incur, relative to the relevant hedge fund strategy indices.
The implicit assumption is that the index that Credit Suisse has helped to create to replicate CMF’s performance will show almost no tracking error versus the non-UCITS version. The index meets the UCITS criteria on diversification, rebalancing, and regular publication of returns. The performance of the index is accessed via a total return swap. The cash collateralising of the swap strictly follows UCITS guidelines. The total return swap seems an industry standard structuring model for replicating hedge fund returns within a UCITS fund.
Ireland, as opposed to Luxembourg or Malta, has been chosen as the domicile because LGT CP already has an infrastructure hub in Dublin servicing its other funds of hedge funds and its funds of private equity funds. The fund has been fully approved by Irish regulators, The Irish Financial Services Regulatory Authority, and went live on 4th May. It should be ready for UK investors by 1st June with initial passports planned into the UK and German markets. Euro, dollar and sterling share classes are offered.
Weekly liquidity is judged to be adequate given a short notice period and expected turnaround time of only 10 days, comprised of four days’ notice and six days’ settlement. Coplit has a lot of respect for other funds of CTAs, but it is company policy not to comment on competitors. The UCITS feeder lets LGT CP reach out to more retail investors to complement its predominantly institutional investor base where pension funds are the chief client type. The London Stock Exchange listed Castle funds of funds are already accessible to investors of any size or type, and the UCITS fund further widens the net to include investors who want to deal direct with the manager rather than buying shares via a broker.
Prognosis for the strategy
Coplit is not generally concerned about managed futures funds growing too big, given the depth of derivatives markets. He also points out that most managers will size positions according to liquidity. LGT CP has no view on the possibility that mooted regulations may affect higher frequency trading strategies. Coplit admits that 2008 and 2009 were respectively the best and worst years of his 17 year career following CTAs – and the same applies for the CMF product, which made 21.35% in 2008 (its best year) and lost 9.49% in 2009 (its worst year). But he is adamant that the strategy will, in future, surpass 2008 returns but may also produce a greater drawdown than recorded in 2009. Like most funds in the sector, CMF is still recovering from its 2009 drawdown that so far has met its valley in January 2010.
“Medallion [the CTA run by Nobel Prize winning mathematician Jim Simons] is the Holy Grail of systematic trading” is his response to anyone who sees ‘08 as the end of a golden age. This does not automatically mean that LGT CP insists on a high PhD headcount – not all of their managers have doctorates. Managers can always strive to improve, and those seeking new sources of alpha will drive the strategy forward. Technology matters most where the data is most granular, such as tick data or minute data. Coplit is aware of managers executing trades in 10 milliseconds and does allocate to some with co-located servers (execution engines adjacent to exchanges to reduce latency, or the time lag between signal generation and trade execution). But these new alphas need not necessarily be in the ultra high frequency space, which Coplit views as more relevant for single stockstrategies, such as statistical arbitrage, where other parts of the LGT CP business allocates. The shortest holding period for positions in CMF is on average around 2.5 days, but LGT CP invests with managers who trade across a range of time horizons. The search for new talent saw LGT CP conduct 85 meetings last year with managed futures managers.
Volatility is one factor governing the opportunity set for CTAs and one thing that made 2008 such a great year. The ‘V’ shaped nature of the recovery in 2009 was, Coplit says, largely “orchestrated by policy makers” who are now beginning to unwind policies such as quantitative easing, and also starting to raise interest rates in several countries. Coplit argues that volatility has not disappeared – so there should be opportunities for others to generate impressive levels of returns.