Following the trend players

Managed futures, or trend-following, has been regarded in the past as an arcane and potentially risky hedge fund strategy run by mathematicians and physicists largely for the benefit of high net worth individuals.

Institutions have tended to stay clear of managed futures, not least because the managers, or commodity trading advisors (CTAs), have been small players with few resources. This means they are usually unable to provide the level of comfort that large institutions demand in terms of capacity, transparency and governance.

Yet in the past 10 years this situation has changed. Newer, larger players with substantial resources have emerged who are offering what they believe are sufficient levels of comfort to attract institutional investors such as pension funds. In the UK, for example, there are AHL, Winton Capital and Aspect Capital.

AHL, a systematic asset manager, was set up by Michael Adam, David Harding and Martin Lueck in 1987. Hedge fund manager and futures broker Man Group bought a majority stake in AHL in 1989.

In 1997 David Harding left AHL to set up Winton Capital Management while Adam and Lueck, who left AHL in 1994 and 1995 respectively, together with Eugene Lambert and Anthony Todd, formed Aspect Capital in 1997.

Though each may have a different investment philosophy, all have the same aim: to scale up the operation of managed futures to appeal to the institutional investor. Today AHL, Winton Capital and Aspect Capital have assets of, respectively, $18.5bn (€13.7bn), $6bn and $5bn.

More than half (53%) of Aspect Capital's total assets are managed on behalf of institutional investors worldwide, including a number of pension funds. Anthony Todd, co-founder and chef executive officer of Aspect Capital, says there has been a significant growth in institutional interest over the last few years. "A number of managed futures managers, including Aspect, have identified a build up of institutional interest in managed futures."

This interest goes beyond performance, he says. "Obviously institutional investors are looking for performance, but they also want to see a high degree of corporate governance and they want to see a good degree of transparency and infrastructure.

"In the mid 1990s we could see there were very few managed futures managers who could actually meet that institutional demand. So when we set up Aspect Capital we were determined to build a business that could absolutely meet the requirements of institutional investors.

"We invested heavily in research and development to generate performance. We also put in place a rock solid infrastructure with a significant investment in risk management and technology, in trading and corporate governance, so that we would be perceived as a substantial business with real longevity, rather than a small boutique."

As a result the market for managed futures management has become polarised between a large number of small players and a handful of large players. In November 2006, for example, only 10 CTAs worldwide that reported their numbers had individual CTA programs of over $1bn. These were Aspect Capital ($3.2bn), Campbell & Company ($10.6bn), Capital Fund Management ($1.7bn), Chesapeake Capital ($1.5bn), FX Concepts Trading Advisor ($5.3bn and $2.9bn), John W Henry & Company ($1.1bn), Transtrend ($16.8bn), Winton Capital Management ($5bn) and Yutaka Futures ($1.5bn).

What separates the serious players from the rest is the amount of money they can afford to invest in research and development, says Todd. "There are only a very small number of managed futures managers who have taken that business and actually built a serious organisation round it to be able to meet the requirements of institutional investors, and institutional assets are very much going to those players.

"The smaller boutiques which were in existence in the late 1980s and early 1990s, with less investment in research and development and selling to high net worth customers, are the dinosaurs and are going to find it very hard to survive."

Managed futures have a number of attractions for pension funds today. One is their lack of correlation with mainstream asset classes. In the turbulent years between 1999 and 2003 managed futures generated a return of 39% while global equity markets suffered a drop of 40%.

They also have form. There is a managed futures index dating from the 1960s and some of the leading names in managed futures such as John Henry, Bill Dunn and Keith Campbell have track records going back to the 1970s. "Managed futures have a track record going back 30 years which has demonstrated zero correlation with stocks and bonds," says Todd. "Very few hedge fund styles can do that. Most have a degree of closet beta in there. With managed futures, it's pure alpha. There is also the ability to generate absolute returns over the long term."

Another attraction is liquidity. Pension funds may be nervous of investing in instruments that are not marked to market and where there may be significant lock-ups. Aspect's systems operate 24 hour global trading and real-time risk monitoring. "In terms of price discovery, we're dealing in very tradeable markets, so we mark our portfolio to market literally on a second by second basis. At any time we can look at our screens and see the performance of our program in real time," says Todd.

Capacity is also a consideration. A decade ago, even minimal investment in managed futures by the pension industry - say, 1% of assets - would have been the beyond the capacity of any CTA. Today, the leading players can summon sufficient billions.

Institutional investors also demand a level of transparency from hedge fund strategies than is expected by high net worth clients. Here, Todd feels that managed futures have an advantage: "In some respects managed futures are the simplest hedge fund strategies to understand. When the trend is there, our aim is to capture it. When the trends aren't there, the opportunities for us are very
limited."

In the earlier part of this year, for example, low volatility and an absence of trends hit the performance of some leading managed futures managers.

The perception that managed futures managers rely on a ‘black box' that is comprehensible only to the quant specialists who designed it is also changing.

The systematic trading of managed futures provides the level of comfort that institutional investors are looking for, Todd suggests. "What most institutional investors say they want from a manager is a clearly articulated strategy implemented in a disciplined form. Our strategy is to capitalise on the aggregate behaviour of market participants, and the way that aggregate behaviour manifests itself is through trends in the markets. We can do that in a disciplined way by the application of technology.

"A decade ago institutions were worried about investing in a machine rather than a human being. Now they are recognising that technology provides exactly the discipline they demand. Additionally, technology enables us to trade and monitor over 80 markets, 24 hours a day in the same consistent and disciplined way."

This discipline is evident when markets fall. "One of the benefits of a trend-following approach is that it's inherently stop-loss. If we are following a trend and it suddenly bends or changes direction, we won't fight it. If the market is going down we will go short of it. If it starts to rally we'll gradually close that position and then go long of it."

Although systematic trading requires a robust model, managed futures managers should not be afraid to make changes, Todd says.

"During periods of underperformance we don't just sit back and say let the computers run. We have to be very self-critical. Is our performance consistent with our historic performance and our simulations? Is it consistent with our competitors? What can we learn from what is happening?

"It's always a balancing act. On the one hand if we don't make any changes whatsoever then our competitive position may be compromised. On the other hand, if we're constantly making changes then we lose the discipline.

"The way we approach this is to have a consistent over-riding philosophy which will not change. So we would not, for example, add a discretionary overlay to what we do. But within that philosophy we have the ability to make refinements."

Perhaps the most important change in the past 10 years is that what matters to institutional investors now is not what managed futures managers call themselves but how they will fit into an investment strategy. "To some investors we are selling a hedge fund. To others we're selling alternative alpha. The labels ‘managed futures', ‘CTA' or ‘hedge fund' are becoming increasingly irrelevant," says Todd. "That's a dramatic shift."