01 Top Traders Round Table with Amy Elefante Bedi, Ernest Jaffarian, and Phil Hatzopoulos - 1of2

Niels

Welcome to the CME Group’s podcast series on managed futures. My name is Niels Kaastrup-Larsen, and I’m the host of the podcast Top Traders Unplugged. Today I’m delighted to welcome you to a series of short conversations with industry leaders in managed futures.

I’m joined by Amy Elefante Bedi, director of hedge strategies at Washington University Investment Management Company, in Saint Louis; Ernest Jaffarian who’s the CEO of Efficient Capital Management, as well as Phil Hatsopoulos, who’s the Global Head of Buy Side Sales at the CME Group.

First of all welcome, and thank you for taking the time out to join me for this conversation about managed futures. Before we jump into today’s topics, share with me a short version of your own investment journey and how you got to where you are today. And Ernest, why don’t we start with you. Tell us about your path in the managed futures industry.

Ernest

Well, I worked for a terrific trading firm called CRT, which in the 70s and 80s was the world’s largest market maker in listed options. As I got to know their proprietary trading group, in New York in the treasury division, I became enthralled with the idea of creating a virtual proprietary trading desk. So, I pitched that idea to senior management, and they gave me a green light to research that prospect.

I discovered this whole world I didn’t know existed called CTAs. I did a research project in 1990/1991, reading everything I could read, and doing a mathematical analysis of the space. I wanted to see if we could build portfolios just using mathematical models as opposed to the traditional qualitative due diligence approach.

I became convinced, first, that this was a resilient asset class and that mathematical principals worked well in this space. But, the second thing is, I fell in love with the space. I became convinced that the CTA profile was needed by institutional investors, and was not yet well understood. Professor John Lintner set the case forward really well, that someday everybody would have exposure to CTAs. So, I just made a career change and from that point forward dedicated my career to managed futures.

Niels

Ok.

Amy, I know that you started out in this space by investing with CTAs on behalf of wealthy families back in the 90s. I would love for you to share how endowments approach this space differently, and why that is.

Amy

So, I first came into contact with CTA strategies while working at the old Graystone Partners in the mid-1990s. It just seemed natural to us to use them as a part of an optimal portfolio. The issue is that we created custom portfolios for all of our clients. Even running at moderate volatility, our funds occasionally had single month returns that looked alarming on a stand-alone basis, and our clients were all too aware of that. So, I became experienced, early on, in how challenging it can be to stick with a strategy for long enough for it to work.

In my next stop, at a multi-family office, we had pools of hedge fund investments for our clients. So, our clients were somewhat protected from individual manager performance variability. We had CTA exposure alongside other strategies like long/short equity, and I felt as if that worked a bit better.

When I joined the Washington University Endowment in 2008, I was somewhat surprised to find that our portfolio had no exposure at all to macro. When we began to atone the water, two things became apparent: one was that systematic macro firms still did not meet our definition of institutional quality, and the other was that there is a level of discomfort with black boxes that was difficult to overcome.

For me, the positive effect of that has been that it’s inspired me to educate myself more on the theory surrounding trend following and why it works. I think it’s made me be more of an effective investor in this space, but the negative is that it’s limited our ability to allocate in significant enough size to give us meaningful diversification benefit over time. I think that problem is not unique to us.

Niels

Sure, sure. Absolutely.

Now Phil, just share with us a little bit of your background and how you engage with the managed futures industry today.

Phil

Sure. So, as the Global Head of the buy-side sales team at CME Group, my team is responsible for covering CTA clients, and we interact with managers every day from a products and services standpoint. We’ve committed significant resources to our managed futures initiative, which focuses on bringing awareness, education, and networking opportunities to institutional investors, to help create assets for CTAs.

I really stress the education part with institutional investors because I think, from our perspective, that’s where we can make the biggest impact in the industry. It’s helping them understand why they should allocate to the managed futures space in understanding the value proposition in uncorrelated returns. To help that process we started (probably about four years ago) our annual Managed Futures Pinnacle Awards. That’s a great example of how we recognize managers and showcase the benefits of allocating to a managed futures strategy for institutional investors.

Niels

Sure, absolutely.

Now, today’s conversation will be part of a series where we’ll discuss a few of the big topics that seem always to be on many investor’s minds, when it comes to hedge funds and managed futures; as well as providing favorite topics in the financial press. But, before we get to them, I wanted to start out with a slightly different question, although it’s somewhat related, and that is the role of the traditional fund the fund business. This is especially in the light of the aftermath of the financial crisis where many of such firms had to close shop as their value proposition, at least in the minds of investors, has diminished.

Since you, Ernest, are a veteran in this area, why don’t we start with you? What is the state of the fund the fund model today and where do we go from here?

Ernest

Well, almost anybody I talk to on the institutional side still is thoroughly convinced of the importance diversifying across a number of manager styles. I find overseas, acquiring access via a traditional fund the funds is still a very acceptable approach. But, particularly in the States and sometimes outside of the States, management boards have just taken the position, “We’re not going to pay a ‘second layer’ of fees.” So, the fund the fund model’s out.

So, here’s what I’ve found. It’s put portfolio managers, investment managers, in a very difficult kind of “catch 22” position. On the one hand, they want to have CTA exposure. On the other hand, they don’t like the risk of buying one, or two, or maybe three programs. But then, they don’t have the infrastructure to do a full search and build out a well-balanced program. Even if they could, they don’t have the infrastructure to actively manage that.

We actually have some clients, now, who had exited the CTA space, not because they wanted to. They just didn’t know how to put those pieces together. It’s a creative industry, and there’s a lot of creative thinking that is addressing these issues.

For our part, for example, we’ve created a CTA multi-strat product which is getting very successful trading managers to partner together and create a single program, even though, when you lift the lid, is a combination of multiple programs. So, we found a great receptivity because it solved the problem. I’m getting the CTA exposure. I’m getting the diversification I need. I get the active management I need, and I can go to the investment board with a single institutionally appropriate product.

I think what you’re going to see, going forward, is a continual movement towards creative solutions that allow institutions to get access to this space in a way that’s appropriate from their investment mandate perspective.

Niels

Sure, sure.

Now let me turn to you, Amy, as institutional investors, how do you prefer to find and to access the talent in the managed futures space?

Amy

So, our entire portfolio is direct, and that’s true of these strategies as well. We rely on our network and various industry databases to find our investment ideas, and we do our own due diligence on them. We want to be able to target strategies that are most meaningfully diversifying to our portfolio, and think that a custom approach makes sense in that regard. We also believe, philosophically (as Ernest alluded to), that an important part of how we add value as investors for our institution is to develop relationships with our partners, and we haven’t been comfortable outsourcing that.

Niels

Sure, sure.

Now, some of our listeners today will certainly have the DIY mindset, and maybe want to do it themselves, and pick a few managers instead of buying a fund the funds. So, if I could just stay with you, Amy, for just a little while longer. If you were going to help them with a few questions that they should be asking when selecting these managers, what would they be?

Amy

Some of the questions that I ask of systemic managers are the same as I would ask of other strategies, but with a little bit of a tilt. So, how does a manager develop and test trading systems? How does a manager think about building a portfolio across asset classes? What is the risk management system if something goes the wrong way – are they doing more of it or less of it?

To what extent is a manager focused on building out diversifying exposure to other types of strategies, potentially including fundamental drivers? There can be a conflict between optimizing the fund sharp ratio and optimizing my portfolio sharp ratio. Strategies diversified to trend following may sacrifice the risk taking properties that we’re looking for.

Are there historical examples of manual interventions to cut risk? In trend following, I’d really want those to be minimal. Does a manager have an appropriate level of focus and resources devoted to trading costs? Do they have reasonable plans for capacity? There can be a tension between achieving institutional levels of resources and maintaining sufficient liquidity to trade markets that we expect to be the most diversifying.

Sure, sure.

Now, Ernest, you have interviewed hundreds of managers in your career, so I wanted to ask you whether there was one single key question that you have found to be the most important question to ask a manager when you need to decide on your allocation?

Ernest

Yeah, I ask them if they’ll guarantee never to have a losing month. (laughter)

Niels

And besides that?

Ernest

I don’t know that I can be responsive to a single question, but I would add one piece to what Amy is saying, and that’s that the CTA space is unique in the broad alternative space in that you get quantifiable daily numbers. It’s a liquid space, and that gives you a lot of data points. So, even before talking to a manager, and I respect these questions as really good questions, but even before talking to a manager a person can do really extensive quantitative work and reach a decision, “Is this a manager that I would choose to invest in purely mathematically.” At that point, then do the deep dive on the qualitative due diligence questions.

Niels

Sure, sure. Makes sense.

On this topic, Phil, as an exchange, have you seen a change in the investor base in managed futures when you look at your conversations that you have on both sides of the fence?

Phil

At the CME Group we have no direct insights into manager allocations, so it’s very difficult for us to assess the changing investor base outside of what we see that’s publicly reported and from what we get from various databases that we subscribe to. However, given that we’ve seen twenty-seven straight months of in-fills into managed futures, and this is according to Morningstar Data, there’s no doubt investors are paying attention and allocating to the space.

So, our goal at the CME Group with our initiative is to gain better analysis and granularity of the specific types of investors that are most interested in the space so we can target our efforts accordingly. Currently, we’re focused on the institutional business, but also understand that there’s growing opportunities on the retail side and ultimately our plan is to encompass all investor types to grow the industry.

Niels

Sure. Makes sense.

Now, I recently saw a very large consultant who I think was consulting clients with about 400 billion dollars in assets under management discuss the issue of fees and how they are looking for ways to address the “angry dollar fees,” which is I think the term he used, for fees that are not aligned with the investors interest i.e. management fees. I guess investors will always want to pay less fees, and managers will want to protect these fees. So, how do we find common ground when it comes to this debate, where the parties are happy to work together to not always having to discuss this issue?

Let me start with you, Amy, as an investor. What are the right kinds of fees, and what are the right levels of fees that investors should be paying in your opinion?

Amy

So, in terms of the level, I think two and twenty will become increasingly rare, but there isn’t one-size-fits-all for management fees, in my opinion. The right level depends on the manager’s infrastructure and the level of assets under management. Ideally, we’d have enough of a partnership with our managers to understand what the manager needs to operate the business. Above a breakeven level of assets under management, we’ve been pushing our managers to offer discounted fees to all limited partners, not just ourselves. We also like to see hurdles in place, although there hasn’t been that much receptivity on that as of yet.

Then, you really have to look at the whole package. If you offer a reduced management fee and then pass through unreasonable levels of expenses, that doesn’t help anyone. So, I think it’s important to be clear about each part of the equation.

Then finally, on incentive fees, I think those aren’t “angry dollar fees” for most people, but I think there’s been a little bit of supply/demand imbalance in the industry at times. Some of those shorter term crystallizations that we’ve seen strike me as not very fair to the investor and a lot of them have been going away. We’d love to see that continue to happen.

Niels

Sure, sure.

Now, Ernest, as you mentioned yourself, you represent, in many people’s eyes, an additional layer of fees. So, how have you innovated more specifically, more than maybe you alluded to earlier, when it comes to this area of your business where you face both managers on one side and investors on the other side – how have you solved that, specifically?

Ernest

Yeah, well there’s two things. First, let’s start on the manager side. I can present research that supports this case, but I find that the happy relationship between institutional investors and managers is generally found on the incentive fee side. So, what we’ve seen is a significant decrease on the management fee side, but an appropriate incentive fee that an institution can look at and say, “You know, we don’t care if they do well. If they do well, we’ll do well. We can go to our board and be good about saying that we captured X% of the profits.”

This has become a very strong momentum. To give a sense of the scale, we’ve been running our fund since the early 2000s. When we first launched the fund, our average management fee was about 1.5%. Today the average management fee, in our fund, is a little over 20 basis points, and the managers and the investors are happy.

On our side, what we found is that we need to align ourselves with the managers to take more responsibility for the performance and shift risk from the investor to the manager. The way we’ve done that is, I’ve made reference to creating multi-start product. In the multi-strat product, we actually are the CTA, and the traders become investment advisors to the trading portfolio. So, from an investor standpoint, they’re paying a single fee. They’re not paying a second layer of fees, but they’re paying a single fee, and that has proven to be very important to the investors, and something that investment boards have found acceptable as well.

Niels

How do you manage that with the managers, then?

Ernest

Well, multiple ways, every program isn’t the same. Generally speaking, you’re getting a management fee on the net result of the returns. Some managers may have made money; some managers may have lost money, so you’re only paying on the net result. What we do is we have two standard approaches, depending on the product.

One is the managers share-and-share-alike, regardless of the performance, and they actually see that as a diversifying source of income. There are going to be periods where I’m not good, and somebody else is, and so on, and it will reverse, and it creates a more steady income stream.

On some more specialized products, the managers are compensated based on the amount of contribution that they’ve made to the ultimate return. There are some reasons to do that, and, in some cases, the managers prefer that as well. The interesting point is that, from an investor standpoint, what is done with the managers really doesn’t matter. It’s just a single fee, and of course, they’re concerned that the managers feel that they’re in a fair product, right? Whether it’s paid equally, or paid in proportion to the contribution, from an investor perspective, it doesn’t matter.

Niels

I want to just stay with this – one more follow-up question and that is: doing it this way, where you, in a sense, have to get managers to do something where they haven’t done it usually in the past, does it limit your universe? Have you found that? Or, do you actually find that managers are quite open to thinking outside the box?

Ernest

Yeah, that’s a really good question. I’ve got a deep relationship with a manager who manages over 30 billion and we invested before they had 150 million. But, we have a self-selecting process. We have money with a lot of managers, and we really don’t even talk to managers for whom that would not even be a consideration.

What I find is this, smaller managers in the world of the mega manager that exists today – smaller managers realize that to be successful, and to attract institutional interest, they’ve got to partner. They can’t go in and be a 300 million dollar manager and compete, head to head, with a six billion dollar manager.

So, what we find is a higher degree of cooperation among very talented managers, but not at the very top end of assets. They’re in the growth area where they still have a lot of room for growth and recognize the need to partner.

Sure, sure.

What about you, Phil? The fee discussion when you’re out speaking with the community, does that come up as an issue on either side?

Phil

It doesn’t really come up, from our perspective, with investors. So for investors, again, our focus there is you want to develop relationships as Amy and Ernest mentioned earlier. You want to develop relationships and let them know they can be comfortable viewing the exchange as a neutral resource on the education process where we’re not promoting one manager over the other based on fees. It’s just really getting comfortable with the asset class itself.

Now, on the manager side, that’s a little bit different – what we do for the managers to help them maximize their returns. For us, it’s focusing on providing deep, liquid markets where there’s less slippage in trading. It’s creating trading incentives for various volumes which we have in some products – notably FX, which can help lower manager’s overall costs to help them compete with fee pressure on the investor side.

Niels

Now, let’s jump to another topic that I’ve heard mentioned quite a bit in the last year or two. Here I’m referring to performance, or should I say lack of performance by hedge funds in general. But, since we are focusing on managed futures, let’s talk about the fact that CTAs, at least based on the CTA indices, have generated about half the return in the last four years compared with what they did over the last ten years. To make things worse, the performance over the last ten years is already much lower than what it was over the last twenty or thirty years.

Ernest, let me turn to you first, on this one. Tell me why you think the cause for this development of returns is, in the industry in general, because clearly there are exceptions.

Ernest

Well actually, if you factor in a couple of things, the returns are not that inconsistent over the last twenty or thirty years. There are two big factors if you go back quite a ways. The first is that the volatility of the industry at large was much higher. A lot of CTAs said, “You know what? To be institutional, we can’t trade at a 30 volatility.”

The average volatility of the managers has come down to a more institutional level. Hence the returns have come down. The second factor, of course, is that there used to be a meaningful contribution from interest rates. That contribution is gone.

So, when we do our analysis, we always factor for volatility, and we always eliminate any interest rate exposure. But, I’m a strong believer that the case hasn’t changed, and we analyze managers all the time, and we see that their performance opportunity has remained fairly static. One thing that’s really interesting is, I always say, CTAs have a very hard life to live. True, core CTA investment is like synthetic long gamma in an options trade. If you’re always long options, you’re fighting, fighting, fighting for that time that comes along that is in your favor. It’s great from a portfolio standpoint, but very frustrating from a trader’s perspective.

It may sound strange to say, but since the ’08 financial crisis, we really have not experienced another major financial earthquake. If you study financial earthquakes, over time, what you see is that they come with regularity. We could talk about all the reasons why that’s true, but I would just simply say, “I don’t think the future of financial earthquakes is over.”

We might see the start of a financial earthquake in a few days in the US elections. We don’t know. The thing that’s interesting about earthquakes in the financial markets is that they take you by surprise. They’re not what you’re looking for.

I’m really making just two simple points. One is, I don’t think the returns have changed that much once you factor in important variables. Secondly, the sort of outsized opportunities that CTAs have captured historically, have not been so prevalent in recent years, but there’s no reason to believe that they won’t be prevalent in years to come.

Ending

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