Winton's Futures Fund is primus inter pares

David Harding

There has been a lot of comment in the hedge fund industry on the asset gathering of Winton Capital this year. David Harding's firm has attracted inflows of over $7bn in 2011, which equates to over 10% of the whole industry's capital inflows. This is a remarkable market share of the growth for an industry of over 9,000 funds for investors to choose from.

There has been some commentary that the success of such brand-name big managers is down to the dominance of American institutional flows to the industry, and the limited vision of the investment advisors to those funds. There has been less consideration of the investment performance of the winners.

The tables below come from CM Capital Markets, a Madrid based CTA. Their fund is called CapiTrade Systematic Global Futures, and since they put together and distributed this analysis their three year old managed-account-turned-fund must stack up well on CTA performance criteria. And it does.

But so does David Harding's Winton Capital over the period covered (May 2008 to October 2011). It has been well observed that Winton scaled back risk assumption on their funds during the Credit Crunch, and that since then the funds (Futures Fund and Evolution) have been run with lower risk levels (leverage). It is therefore logical in down-years for the strategy that the Winton funds have smaller losing months and more shallow draw-downs than peer funds. But the success in producing returns this year go way beyond the conservation of capital.

Winton Futures Fund has done better than the peer group in several ways this year: 7 out of 10 positive months (versus 3 for the Newedge CTA index),  a worst-monthly-loss in that time of half of the typical loss of competitors, and a positive year to date return when most CTAs have struggled to make money.

Extending the data window back to May 2008 brings BlueCrest's BlueTrend Fund into the frame as a serious competitor on the basis of performance.  Leda Braga. who runs BlueTrend, is proud to state that she has never reduced the risk appetite of the fund. This has enabled BlueTrend to produce higher absolute returns than Winton over the last 40 months, though with a higher level of volatility. If an investor is willing to take the higher volatility of return and risk assumption, then BlueTrend is a viable alternative to Winton Capital 's Futures Fund. But for the more conservative (by risk appetite) investor Winton Futures Fund is primus inter pares.

Post Script of 2nd December:

Thanks to the two managers mentioned in the above article that came forward with amendments to the data given above by CapiTrend. I should reinforce the point that the returns for 2008 in the above table were supposed to be those from May to December of that year. The returns for some leading managers for the whole of 2008 were:

AHL up 29%

BlueTrend up 43%
Millburn Diversified up 22.36%
Winton up 22%


In addition, other data quoted for Millburn in the above tables are not recognised by the Millburn Ridgefield Corporation themselves. BarclayHedge gives the annual return series for the Diversified Fund as 2008 22.36%, 2009 -7.38%, 2010 12.58% and 2011 (to Oct) as -6.75%. 

Apologies to the relevant managers from me for distributing erroneous data. I hope the thrust of the article still applies, and there is a lesson in this about the source of data and the (mis)use of it!

A Shift in Risk Appetite?

I believe in Marshallian K – so excess money creation goes into financial assets if the real economy doesn't need it. This is what is going on now in American financial markets. We are seeing narrow money creation but not broad money growth. The St. Louis Federal Reserve is showing that the current money multiplier is less than 0.9, that is, printed money is not being multiplied by the banks to the typical extent (2.0-3.0).

What is interesting so far in 2011 is the change in where that money is going. In my last article I made a logical case for flows into stocks rather than bonds based on valuation. I doubted that the flows of mutual funds would reflect that logic, but I have been proved wrong by the data releases* of the Investment Company Institute since. Here is a table showing mutual fund flows on two time frames – the top part of the table is monthly data and the bottom part is weekly data for mutual fund flows this year.

U.S. Mutual Fund Flows

Source: Investment Company Institute

The Table shows some interesting shifts. The pattern last year was for positive bond flows and negative equity flows. Whenever equity flows went net positive last year it tended to be because positive flows to emerging market mutual funds outweighed outflows from domestic equity mutual funds. So for three quarters of the year in 2010 there was a large negative bias towards mutual funds investing in American stocks.

Towards the end of the year holders of mutual funds caught on to the increasing fragility of the finances of municipalities in the States and there were net redemptions from muni bond funds. The outflows from muni bond funds have continued this year. There has been a minor pick up in flows into taxable bond funds this year, and it looks like straight switching within bond mutual funds to safer havens. Net flows across total bond funds are a small positive – and really quite small compared to last year's positive net flows. So the key word in the bond mutual fund story in 2011 is small.

The key words in equity mutual funds investing in 2011 to date are growing and domestic. After some minor end year tidying up, the U.S. mutual fund investor has continued to buy overseas equity focused equity mutual funds as before, but the new new thing is the emergence of significant buying of domestic equity mutual funds. The market for mutual funds in the United States is not like in some European territories where the largest investor in a UCITS funds can be the sponsoring insurer or bank. In the United States, apart from money market funds where institutions own around a third of the assets, mutual funds are held by individual investors. Individuals own 89% of bond funds and 91% of equity funds. And the man in the street in the US has been buying domestic equity mutual funds to an extent not seen in at least four years.

Whilst individual investors are recent converts to the attractiveness of equities, institutional investors crossed that line some time ago and at this point are expressing fervour for the concept.  The Merrill Lynch Fund Manager Survey for February (survey period 4th-10th February) contains extreme conviction on the part of institutions. The Survey overview states "The February FMS is one of the most bullish in years. Institutions have record equity and commodity overweights, very low cash levels and the strongest risk appetite since Jan‘06." It also says that "Hedge fund net exposure rose to 39%, highest since July’07. Cash balances fell from 3.7% to 3.5%, triggering our FMS cash trading rule equity sell signal." 

A mirror of the rated attractiveness of equities is an aversion to bonds in the Survey - nominal bond allocations were very low; the lowest since April of 2006 and near record lows. This is the corollary of the view on inflation (and implicitly commodities) that expectations for global inflation were the highest since June of 2004.  There is a consistency of world view too in the consensus for economic growth. Just 13% of respondents expect the global economy to weaken in the next 12 months. 


Parenthetically it is interesting that professional money managers express the same sentiment now that mutual fund flows have expressed this year  - a strong bias towards the equity markets of the developed world rather than emerging market equities. The expressed appetite for U.S. equities is the second highest ever in the Fund Manager Survey. 

The mental positioning, and Dollar positioning, of investors in equity markets combined with expressed survey views on growth and inflation give a clear road map for contrarian investors. For example I would suggest that the views of Hugh Hendry put across here (Hugh Hendry's views) were for something other than where the consensus has got to. Equity markets are overbought, and extended to the upside. However, overbought conditions can persist and there is little internal inconsistency in the market action for a tape reader to find. One of the market observers I respect puts it that the broad market "continues to demonstrate bullish resiliency".

*Flow estimates are derived from data collected covering more than 95 percent of industry assets and are adjusted to represent industry totals in the weekly data. Data for previous weeks reflect revisions due to data adjustments, reclassifications, and changes in the number of funds reporting.

Consulting One - Team Working in Hedge Funds

There is no such thing as a perfect hedge fund – we are all trying. So in my role as a consultant to hedge fund portfolio managers (PMs), I am usually carrying out remedial work in some dimension. Sometimes it can be about the positioning of hedge funds commercially, but usually it is about what the portfolio managers are doing. I'm going to write a series of articles about my consulting work – this is the first.

One of the key elements I have to investigate in my consulting work is the relationship between team members. I'm going to discuss one project I did with two joint-portfolio managers of an equity long/short hedge fund. This discussion is to raise issues and to describe ways of working. The team in this case comprised two members, PM "A" and PM "B", and they ran reasonably successful long-only products. There are three topics in this snapshot – the ground rules were not well established in this example, there were some important differences in style (personal and investment style) that got in the way of successful team working, and one of the portfolio managers had an unusual trait which had a bearing on his money management style. Finally I have included some of the solutions I gave to the portfolio managers and their boss.



Ground Rules

It is not unusual for a team to move from running long-only money together to managing a hedge fund. In doing so there will, of necessity, have to be new rules of engagement. Clarity of the decision making process is very important, for internal purposes (for accountability and reward), and for external parties like potential investors. It is important that there is agreement about the specific roles to be taken, and that there is a buy-in from the off of the structure adopted. A successful agreement or understanding will have a level of detail in it that may surprise some.

One of the most basic areas not made explicit in this case was the fund's objectives and the consequences that follow from that. The two portfolio managers did not have a common, agreed understanding of what returns would make the fund they both ran commercially attractive. Therefore they did not feel the need to measure their portfolio level risk and monitor it - where they taking too much or too little risk? They just didn't know.

Another consequence of this lack of commerciality in terms of return profile is that they had no notion of what was a the worst monthly loss they could sustain without putting themselves out of active consideration by investors. The worst monthly loss is a key metric both internally and externally. Internally the metric gives an implication of where portfolio level stops should kick in. Externally it is one of a number of measures that give investors an idea of what the whole risk profile should be like – number of winning-to-losing months, drawdown, recovery period, and what is a good and bad month for the style of investment.

One of the issues which provoked some tension in the relationship between the managers was how they split between them the sectors of the equity market they worked on. It was fine, and indeed seen commonly elsewhere, that the market was split into two – one half invested in by one portfolio manager. The tension, such as it was, arose because PM B did not want to be excluded from investing in some of the sectors covered by PM A. It was never satisfactorily covered in discussion at inception in the mind of manager B, and that oversight hung over discussions in the ensuing two or three years.

It is quite usual for a PM in a team of portfolio managers to be able to initiate positions without reference to their partners. But how the team will react to change for the positions (in size or price) does need to be covered in the ground rules. Is there any right of veto, is there a different scale of decision made when the partners don't agree? Once a position is owned is it subject to hard or soft stops – do both partners have to adhere to review and exit levels? For the fund and team under discussion one of the partners was much more engaged in challenging the positions initiated by the other partner. Whilst the partners whose positions were under discussion saw this as a personal style point (one partner was just more vocal/forthright than the other), the other partner saw such challenging discussions as part of the investment process. This difference in perception and therefore activity could easily undermine a relationship under pressure because of returns.



Differences Between the Portfolio Managers

Having had some preliminary discussions for an overview, and discussed at some length how the two portfolio managers spent their time and what structure they had in place in their investment process, some clear points of difference came through. To explore these further I conducted separate structured interviews – asking the same questions to each portfolio manager gave a chance to compare attitudes, preferences, and perceptions of the two team members. To put the following list of differences into context I quote from my written report on the managers: "The managers have fantastically complementary philosophies on the market. They get on very well on a personal basis. In fact they have worked incredibly well together with some quite significant differences in tactical approaches (strategy being broadly agreed)."



Differences in Time-Frame

PM B is more comfortable with the shorter term time-frame that running a L/S hedge fund usually requires. Specifically B is much more willing to incorporate the current implications of market action into his market view by stock than PM A.



Differences in seeing Companies and Stocks

They have a similar level of respect for each other's views on companies (specifically differentiating between stocks and companies). However, when looking at equities of companies (shares) portfolio manager B can be as dispassionate about shares as he can about companies. This is in contrast to PM A – who is still prepared to argue with markets when he likes the company, even when the share price action is saying that the market does not agree with the positive (or negative) view of the company in the short term. So the feedback loop from owning the shares – the P&L – is negative for the position and getting worse (e.g. if it is a short the shares are going up) and that message from the markets, even if it is just about short term timing of the position, is being ignored.



The Fall-back Input - is it Technical or Fundamental?

(or to put it another way "short-term or long-term" or even "stock market or real world")?

Through the structured interviews of the portfolio managers it is possible to tease out where there are differences between the team members on research time. For example, in this case PM A suggested that they needed to have 300 company meetings a year, PM B thought that 100 meetings a year with company management was enough. The different perceptions of what was needed fed through to the weighting given to the fundamentals. Or, as likely, reflected the biases the managers brought into the discussion. Under pressure PM A will rely on the fundamentals to win out, whilst PM B will listen to the message of the markets and will be prepared to cut losing positions.



Conviction or Confidence?

Operators in markets, particularly traders, but to a significant degree portfolio managers as well, bring with them the baggage from their previous life experience to their decision making. So sometimes in analysing a team it is not that there are subtle style differences so much as one of the team is coming from somewhere else attitudinally (or characteristically). There can be a one-sided difference, if you like. Portfolio manager X brings with them epsilon, whilst portfolio manager Y has acquired a trait of zeta.

Through the structured interview it came through very strongly that PM A (or the Alpha member!) had a strong conviction that the most important characteristic of a successful portfolio manager was confidence. It is true that someone operating in markets has to have the belief in themselves sufficient to take on the markets, but the very strong emphasis on confidence manifested itself in the investment process in this case. This happened in two ways.

The first expression of individual confidence, if you like an assertion of confidence of an investment view, was in position sizing. Having done the analytical work PM A would take what I would consider a large position for his initial holding in a stock. Almost by definition the stock was bound to be perceived as under-valued by the market at the point of taking the initial position. If the market further under-valued that (long) position by marking the shares down (causing a loss) this would create a "better" (cheaper) buying opportunity, so PM A would have some bias to expressing confidence in his initial view of the shares by buying more. But the more important point is the size of the initial holding – he may or may not add to the position. Portfolio manager B would take an initial position of less than half the size of that taken by PM A, and look to add to it.

The second expression of confidence was the maintenance of positions of large size. PM A would always look for a further up leg in longs he owned for fundamental medium-term reasons. PM B would have a bias to trim successful positions as the positive momentum waned (to top and tail the positions). There was clear anchoring by PM A in sticking to previously successful positions, and to cut them would, in his mind, be an expression of a lessening confidence in the initial research.





Recommendations and Suggestions to Address the Issues Raised

In this particular case I wrote a 30-odd page report to the CIO of the firm as well as presented my conclusions to the portfolio managers that ran the equity long/short hedge. In the report I made a series of tiered written proposals – key recommendations, other recommendations, and finally at a more elective level, some suggestions. In response to the issues raised above here are some of the Recommendations and Suggestions forwarded:

• You should select what you consider to be "high potential" company meetings for both PMs to attend. This will enable higher conviction positions to be established at an earlier stage with a common background on the company.
  
• Be very clear and explicit (shared between you) on the reasons for having a position in a stock. Indeed there may be five potential drivers for a stock to go up (or down), but you must be clear why you own it (are short of it). The stock position should be in a portfolio for reason of how it will contribute to the portfolio characteristics (factor bets) as much as any stock specific reason (factor). This allows you to control portfolio shape in an informed way. Drift in any one position may not matter, but when aggregated across a portfolio, factors like capitalisation effects will turn you into heroes or zeroes promptly in the hedge fund format. Own positions for a reason and stick to it.
  
• You both have to have the capacity to invest in all sectors of the market.
  
• You need a few mechanistic rules that you can apply to take even more of the emotion out of decision making:
  

1. Automatic locking in profit/reducing exposure after a stated return. So a trading position that gives a 15% plus return in two weeks is completely sold, an investment position that gives 25%-plus return in a couple of months is halved automatically. The trading position can be bought again if it is equally attractive at some point. If the fundamentals still justify a larger position (they have improved since original position taken) then the investment position can be made larger.
   
2. You need a review level and hard-stop level per position. I suggest a 10% loss on book should be a review level, and 15% is a hard stop level (sell whole position, no exceptions). As a reminder the ABC Large Cap Fund has a hard stop at 8% for non-core positions and a hard stop of 10% for core positions, and the ABC Europe Fund has 5 and 10% respectively.
   

• Either can initiate a position, as at present. However there must be a vote before ADDING to a position – both PMs must agree.
  
• Just as you need to know yourself to be an investor, you need to know your partner if you have joint and several decision-making, rather than having a presiding genius. Because you demonstrate some differences in personal style, there are times when you don't understand where your partner is coming from. I suggest that you complete a Myers-Briggs Model™ (Extravert, Introvert, Intuitive, Sensor, Thinker, Feeler, Judger, Perciever) questionnaire. This is particularly relevant for times of stress – we each revert to a fall-back way of operating and this is the kernel of what you need to know of each other for managing money as a team. If you understand more about where each other is coming from (not intellectually but in personal style) then you will be able to tolerate the differences more easily.
  

Brevan Howard Adds Strategies to Increase Capacity

When you are Europe's largest hedge fund manager and run one of the world's largest hedge funds you are bound to run into constraints on the amount of capital you can run successfully. Brevan Howard Capital Management Limited has around $32 billion under management, and three-quarters of that is in the Brevan Howard Master Fund Ltd., a global macro and relative value fund focused on fixed-income and currency markets. 

The only respect in which the BH Master Fund is concentrated is in the number of  major decision makers running it. Alan Howard has the largest risk budget at the firm, and there are a small number of other senior risk takers - the trusted lieutenants of  Howard who have worked with him and for him since the launch of the firm. This small cadre take most of the risk in the Fund. There have been few changes in the risk-taking leadership of the firm in either personnel or number. Alan Howard has to trust this macro and fixed income elite squad, and this trust is not earned quickly. 

A consequence is that unless the style of investment changes, and/or the level of risk assumption across the team changes it is difficult for the Master Fund to take in new capital. Alan Howard has been explicit about this - he has had no intention of changing the scope or style of the Master Fund - so when he opened the Fund to new subscriptions last year it was for a short period and was soon over-subscribed. 

For the firm to grow, Brevan Howard has to add new strategies either in the existing fund(s) or add new funds dedicated to new strategies. The Baker Street based macro mavens have decided to follow the latter route it was announced this week with this press release:

  

"David Gorton and Brevan Howard are pleased to announce the formation of a new joint venture, DG    Systematic Trading LLP, to pursue systematic trading strategies.  David Gorton is the Chief Investment Officer of the new venture with responsibility for the management and development of trading strategies based upon a suite of systematic models which have been running capital since May 2006 including capital allocated from Brevan Howard Master Fund since 1 March 2010.   

 DG Systematic Trading LLP will be FSA authorised and will act as investment manager of Brevan Howard Systematic Trading Fund, a systematic trading fund which utilises Brevan Howard's risk management and execution platform. Brevan Howard Systematic Trading Fund has been seeded with $300 million from Brevan Howard Master Fund and has been successfully traded by David Gorton and his team since 1 March 2010.  For the period from 1 March to 30 September this strategy has delivered returns on allocated capital of 9.3% net of fees." 

For those who can't quite place the name, Gorton is the former JP Morgan trader who was co-founder and is still co-Chief Executive of London Diversified Fund Management. London Diversified Fund Management ran the London Diversified Fund and the London Select Fund, using a style similar to that of former hedge fund giant Vega Asset Management in fixed income/macro. The eventual commercial outcomes of the LDFM funds were also similar to those of Vega.  At the start of 2008 LDFM managed $5bn and today is thought to run somewhere North of $500m. It may be indicative that around $200m of those funds are in a managed account.

The Brevan Howard press release emphasises that the investment strategy to be utilised in the new fund are based on a "strictly quantitative approach". It is also important from the BH perspective that the new Fund utilises the Brevan Howard risk management and execution platform. Each trade and the overall risk profile of the portfolios can be monitored real-time by the BH risk professionals and compliance with the mandate can be verified readily. It is an interesting commercial arrangement in that a joint venture has been formed, and that David Gorton remains running an independent asset management entity, even if he has had to be additionally registered for FSA purposes at Brevan Howard.





Additional: This week Brevan Howard announced that they are set to float a new investment company – BH Credit Catalysts limited - on the London Stock Exchange in December. As the name suggests the Fund trades in the credit markets, and in this particular case with a bottom-up catalyst-driven credit trading style. The underlying Fund is advised by DW Investment Management, headed by David Warren, and has been running for over two years. The DWIM Team consists of 22 professionals based in New York.

David Warren joined Brevan Howard in January 2008 with a mandate to build a credit team. The team spun out from Brevan Howard in June 2009 and continues to use Brevan Howard’s infrastructure and risk management. DWIM’s credit team has a strong track record producing total return performance of +44% in the period from May 2008 to August 2010, a period characterised by some of the most volatile markets in recent history (2008-2010). Over this period the existing credit fund has been the best performing fund at Brevan Howard.

The Listing of the investment company does not necessarily increase capacity for new capital at Brevan Howard, but does allow for the creation of permanent capital for the money management firm, as this is a closed ended vehicle. What Alan Howard did not do is allow more capital into the BH Master Fund and then allocate from that to the Credit Catalyst Fund. This is an externally visible signal that confirms the confidence that Howard has in DWIM.
 

Borrowing, Shorting and a New Wave of Talent for Hedge Funds

The International Securities Lending Association held a briefing last week which disclosed some good industry level data on stock/security borrowing: the arrangements that facilitate shorting.

One of the effects of the Credit Crunch of 2008/9 was that counterparty risk became a major concern. Who you lend to, the quality of collateral, and documentation related to these factors became major operational issues. In a climate in which it became difficult to know for sure who would be around to deliver either collateral or borrowed securities back again the next week, it was inevitable that the willingness to lend declined. Graphic One illustrates that the assets available to borrow fell by 30% in the 4Q of 2008.  

Graphic One

 

The low point for lendable assets coincided with the low for equity markets in March 2009. As a result of implicit government guarantees and the move to bank holding company status for some banks, clients regained comfort with the securities lending market, and lendable assets have been increasing to pre-Crunch levels.

Whilst the willingness to lend has returned to levels seen previously, the desire to borrow securities has not returned to anything like the same degree. On-loan balances, that is the amount of securities actually borrowed, remains at around half the level seen in the first half of 2008 (see Graphic Two).

Graphic Two 

There are a number of reasons why the volume of securities borrowed has declined and stayed at a new lower level. The borrowers of securities would be hedge funds and proprietary trading teams. Capital in the hedge fund industry dropped by 40% from mid-2008 to mid-2009. In the period of the Credit Crunch proper the capital used by prop desks was needed elsewhere in the businesses. In the period after there were regulatory inhibitions on capital devoted to prop trading.  For both types of borrowers of securities many of the those that engaged in running funds or prop capital had reduced risk appetites or measured such high correlation and volatility in the markets in which they traded that they need less capital to put the same amount of risk on. 

Graphic Three

Of course another, if not the, major factor was that financing new borrowings of any sort became extremely difficult - so leverage fell across all activities funded by short term borrowing, including prop trading and hedge fund position financing. The massive de-leveraging is illustrated in Graphic Three, which shows a 62% fall in leverage from 2008 to 2010.

Capital allocated to prop desks today is down by an estimated 90% from the 2008 levels, and will go lower as banks such as Goldman Sachs and JP Morgan have announced they will withdraw from the activity. 

Securities are borrowed in order to carry out a number of shorting strategies: hedging activity to offset long exposures, arbitrage trading to capture mispricing opportunities, and strategies to benefit from corporate changes such as mergers and acquisitions. Whilst there may still be a need for large scale hedging, and there have been gross arbitrage opportunities in the last 18 months, the volumes of M&A deal flow have been down significantly (see Graphic 4).

Graphic Four

The data generated and shared by the International Securities Lending Association also prompted a constructive thought for the hedge fund industry and those who invest their capital in it. A lot of great investment talent is coming out of the investment banks. Not all of them will thrive within independent businesses, but the precedent is strong. A lot of the best talent running big hedge funds now have come out of Goldman Sachs and JP Morgan, and they won't be the only banks to run down their proprietary trading desks further. Let's hope the new wave can reinvigorate hedge fund returns in 2011.

Woke up in Early 2007?

Today’s Bloomberg headlines includes a classic time-warp headline: “AIG’s ILFC Unit Sells 53 Planes to Macquarie for $2 Billion”

So it is game on – if everyone is not quite back to where they where in risk assumption, then at least it is possible to discern a resumption of normal investment bank activities with the usual suspects doing what we know them for.

Should equity markets advance much further or stay at these levels much longer then the next phase should be more secondaries for takeovers and increasing IPOs. ..which is good for investment banks…