World Beta Blog

When the best hedge fund on the planet decides to launch a new fund, it bears watching. Even more interesting is the area Rentech has decided to pursue. The full press release is at the end of the post, and below are my comments as there seems to be a great deal of misunderstanding in the commodities and managed futures space.

On one side there are the almost religious-like proponents of managed futures – dominated by long term trendfollowers who exclaim mantras such as, “The trend is your friend until it bends in the end”. On the other side there exist skeptics that believe the returns are simply survivor bias in a random process. I fall somewhere in the middle, and in my opinion, this is a great example of trying to understand the drivers of a relatively simple strategy.

I have touched on commodities on the blog before:
Q&A with Harvard’s El Erian
Q&A with Bob Greer from PIMCO

. . .and managed futures on the blog before:
Managed Futures…Finally (a review of RYMFX and good background info)
Out of Sample Results and Price Shocks
Hulbert Trendfollowing Article

Some more background reading from the academic literature:

“Commodities and Real-Return Strategies in the Investment Mix”, David Burkhart,(CFA Quarterly conference proceedings)
“Facts and Fantasies about Commodity Futures“, Gorton and Rouwenhorst
“The Strategic and Tactical Value of Commodity Futures“, Erb and Harvey
“Evaluating a Trend-Following Commodity Index for Multi-Period Asset Allocation”, Mulvey, Kaul, and Simsek

I don’t want to repeat what these authors can convey much better than I can (especially the Erb Harvey paper), but below is a quick discussion of the return drivers for commodities and managed futures.

(Again, for a full treatment read the academic papers above.)

Commodity Long Only Returns

Readers of the blog are aware that I am a huge fan of commodities (and that is not just because half my family comes from farming and we are happily growing wheat currently). In my recent paper, “A Quant Approach to TAA“, I had a full 20% allocation to commodities. Since commodities are real assets (i.e. wheat, gold, oil), they have different sources of return than stocks and bonds. (And I love the fact that none of the gurus have ANY allocation to commodities.) In addition, commodities have a low correlation with these asset classes and are a good hedge against unexpected inflation. Historical returns to commodities have been in-line with stocks, with similar volatility. (Although it is important to note that all of the commodity indices have some backfill bias.) Chart below from the Erb paper.

But will those returns continue in the future?

The return to commodities can be explained as the following:

Commodity Portfolio Total Return = Cash Return + Excess Return + Diversification Return

Cash return comes from only having to place 10% margin down on futures contracts, and the rest (or all) sits in T-Bills.

Excess return is the change in the price of the futures contract. This will be due mainly to roll yield. When a commodity is backwardated (i.e. current futures price is higher than further futures price), there exists a roll yield from holding the out futures contract. Historically roll yield has been ~ 2.5% for the GSCI, but has been declining. Energy markets are typically in backwardation, although the GSCI has been backwardated as often as it has been in contango. The bottom line is that roll returns are the expected price of insurance. From the Erb paper:

De Roon, Nijman and Veld (2000) analyze twenty futures markets over the period 1986 to 1994 and find that hedging pressure plays an important role in explaining futures returns. Anson (2002) distinguishes between markets that provide a hedge for producers (backwardated markets), and markets that provide a hedge for consumers (contango markets). He points out that a commodity producer such as Exxon, whose business requires it to be long oil, can reduce exposure to oil price fluctuations by being short crude oil futures. Hedging by risk averse producers causes futures prices to be below the expected spot rate in the future. Alternatively, a manufacturer such as Boeing is a consumer of aluminum, it is short aluminum, and it can reduce the impact of aluminum price fluctuations by purchasing aluminum futures. Hedging by risk averse consumers causes futures prices to be higher than the expected spot rate in the future. For example, Exxon is willing to sell oil futures at an expected loss and Boeing is willing to purchase aluminum futures at an expected loss. The losses incurred by the hedgers provide the economic incentive for the capital markets to provide price insurance to hedgers. Both of these examples highlight a view that commodity futures are a means of risk transfer and that the providers of risk capital charge an insurance premium.

Diversification and Rebalancing return (historically about 2-3%) is simply due to the reduction in variance from diversified portfolios (known as variance drain or volatility gremlins). The three main commodity indices have varying returns, and that is due the differing weightings. GSCI invests in 24 contracts (production weighted so it is heavy in energy), DJ AIG invests in 20 (based on production and liquidity), and the CRB invests in 17 (equal weighted).

Managed Futures Returns

Managed futures typically take advantage of two strategies. The vast majority employ a momentum, or trendfollowing approach. As I detailed in my paper, “A Quant Approach to TAA“, applying a momentum based approach results in similar returns with a decrease in volatility. A trendfollowing approach in managed futures likely gets an additional performance boost from this characteristic, in addition to the extra diversification return of non-correlated long and short positions. Here are two charts from the Erb paper for simple mo approaches :

The minority apply a term structure approach. Below is a simple strategy of going long the GSCI when backwardated and short when contangoed (again, from Erb):

With many of the trendfollowers getting crushed lately, maybe Rentech is picking a great entry point into the field? I like to have a tactical approach to the asset class as a whole, and then supplement that with an exposure to managed futures.

Some symbols:

iShares GSCI Commodity-Indexed Trust ETF (GSG)
iPath Dow Jones-AIG Commodity Index Total Return ETN (DJP)
iPath S&P GSCI Total Return Index ETN (GSP)
PowerShares DB Commodity Index Tracking Fund ETF (DBC)
PowerShares DB Agriculture Fund ETF (DBA)

Rydex Managed Futures (RYMFX)

By the way, this quote from the press release is completely incorrect:

“Managed futures, a type of hedge fund strategy that was originally commodity trading, traditionally works best at times of high market volatility because it arbitrages tiny price differences. “

—————————————————————————

Renaissance to launch new fund
By Deborah Brewster in New York
Financial Times

Renaissance Technologies, one of the world’s biggest and best performing hedge fund groups, plans to launch a managed futures fund with a capacity of $25bn, an unusual foray into an investment strategy that has been underperforming.

Renaissance was founded by former maths professor James Simons, last year the world’s most highly paid hedge fund manager, earning $1.7bn.

The group’s flagship $6bn Medallion fund, which trades in a lot of futures, has been quickly overtaken in growth by its newer Renaissance Institutional Equities Fund, which was launched two years ago and trades only in stocks. The Institutional fund, which was designed to hold $100bn, already manages $26bn. It charges much lower fees than Medallion’s notoriously high 44 per cent performance fee, and was designed to provide lower volatility and a lower trading turnover, appealing to pension funds.

Investors in Medallion last year received returns of more than 40 per cent, and investors in the institutional fund received more than 20 per cent, after fees. The Medallion fund now contains mostly Mr Simons’ own money and that of Renaissance employees.

Managed futures, a type of hedge fund strategy that was originally commodity trading, traditionally works best at times of high market volatility because it arbitrages tiny price differences. Managed futures funds have not performed as well as other strategies in the past few years because markets have had low volatility.

In the year to date, managed futures funds returned an average of 4.2 per cent, compared with 8.9 per cent for hedge funds in total, according to the Credit Suisse/Tremont hedge fund index. There have been few such new funds launched recently.

Like most of the largest hedge fund firms, Renaissance is a quantitative investor, developing complex mathematical models for its trading strategies. Mr Simons has said that his group hires no-one from Wall Street, but instead seeks out astronomers, mathematicians and physicists.
Copyright The Financial Times Ltd. All rights reserved.

The market portfolio is a portfolio consisting of a weighted sum of every asset in the market, with weights in the proportions that they exist in the market.

The concept of a market portfolio plays an important role in many financial theories and models, including the Capital Asset Pricing Model where it is the only fund in which investors need to invest, to be supplemented only by a risk-free asset (depending upon each investor’s attitude towards risk).

Q: What is a good approximation of world assets as defined by market capitalization? Please leave a comment, as I would like to hear your thoughts on estimates. Obviously some assets cannot be estimated/invested in (such as human capital). I have my own estimates, but wanted to gather other opinions first.

US Bonds $?T
Int. Bonds $?T
Commodities $?T
Int. Stocks $?T
US Stocks $?T
US Real Estate $?T
Foreign Real Estate $?T

If you had to name the top 5 best hedge fund managers ever, Julian Robertson would certainly be on the list. (He’s also from Salisbury, NC which is pretty close to where I grew up in Winston-Salem, and there is a book written about him titled, Julian Robertson: A Tiger in the Land of Bulls and Bears.) From the Wiki entry:

The Tiger funds reached a peak of $22 billion in assets in 1998. However, because of poor stock picking and failure to exploit the technology stock craze, Robertson suffered large losses at the end of the decade. When the Standard and Poor’s 500-stock index climbed 21 percent in 1999, the Tiger funds declined 19 percent.

Tiger’s largest equity holding at that time was U.S. Airways, whose troubles dragged down the value of his holdings. Such missteps ultimately led him to close his investment company in March 2000 and liquidate its remaining $6 billion in investments. Tiger earlier faced huge losses due to their trades against the yen in 1998.

After shutting down portfolio management, Tiger is still in operations, albeit resembling an incubator structure for young managers. Having worked at Tiger is like getting the hedge fund gold seal of approval, and below is a short list of managers that have since started their own funds.

Lawrence Bowman – Bowman
Steven Mandel – Lone Pine
Lee Ainslie – Maverick
John Griffin – Blue Ridge
Andreas Halvorsen – Viking
Tom Brown – Second Curve
Quinn Riordan – Elmwood
Paul Spieldenner – Bamboo

In between science and engineering courses at school, I was able to take a few finance courses. One course that you had to apply to get in was Advanced Seminar in Security Analysis taught by Professor (and Virginia alum) John Griffin. I enrolled in the class the Spring of my Senior year (2000), and was the token science student. More about Griffin from the Stockpickr website:

Blue ridge Capital is managed by John Griffin, former right hand man of Julian Robertson as President of Tiger Management. From 1993 to 1996, he was President of Tiger Management, which he joined in 1987 after two years as a Financial Analyst in the Merchant Banking Group of Morgan Stanley. As an Adjunct Professor of Finance at the Columbia Business School, he teaches “Seminar in Advanced Investment Research.”

Blue Ridge Capital is an investment partnership started by Mr. Griffin in June of 1996. The firm seeks high absolute returns by owning shares in businesses with outstanding investment characteristics and selling short the stock of companies with fundamental problems. Investment decisions are based on detailed, company-specific research with a long-term time horizon.

The focus was teaching the students how to conduct value added fundamental research, and every week a different hedge fund manager or analyst would participate in the classes (I remember Herb Greenberg and Lee Ainslie were there). There was a dedication of the trading floor at the business school to Robertson when I was in the class. The final was to pick a stock, long or short, and present it to a panel of hedge fund managers. My stock (being the biotech guy), was Human Genome Sciences, which went from 30 at the beginning of 2000 to 120ish, back down to about 10 or so now.

The class was outstanding, and was one of the reasons I eventually moved away from the lab bench.

{An interesting aside, Tulane has a program where the business school students form portfolios from small caps in six southern states. It is called Burkenroad Reports, and they have beaten the S&P500 and Russell 2000 eight straight years! If you are ever looking for a fun speaker, Professor Peter Ricchiuti is fantastic}

What is Griffen holding now? You can view his picks below and track them at Stockpickr here:

CVA
DISCA
H
AXP
DADE
AMX
TV
LVLT
TMO
MA
BRK
RIG
MSFT
SSCC
COH
SLE
DVA
CROX
JMBA
URBN

I started out my undergraduate at the University of Virginia in Aerospace Engineering. After a year or so in that track (and a summer internship at Lockheed where all I did was play on the corporate softball team), I decided that aerospace was definitely not for me. (My childhood astronaut fantasies certainly were not the same as studying statics and dynamics.) In one of those small insignificant instances that changes your life forever, I was browsing an isle at a bookstore in Boulder, and come across James Watson’s “Recombinant DNA” textbook.

I was floored, and spent the rest of my Summer taking courses in genetics at Colorado (and flying lessons while working as a carpenter – could life get any better? Not to mention living with three girls). When I returned to UVa, I ended up majoring in Biology and Engineering, and focusing all my studies in gene therapy and genetics. Wiki gene therapy primer here.

I dove head first into every genetics course the school offered, and worked in a lab that was attempting to develop a virus to protect the heart against heart attacks. The biggest problem in gene therapy then (and now) was delivering the gene to the right place, and getting it to express (produce) the protein. We were never successful – and after spilling our prized virus all over the lab and the resulting two hour cleanup that entailed, I realized bench work was not for me.

I took some grad courses at Hopkins, but after many warnings from my brother who did the 8-year PhD plan, I compromised and became a biotech equity analyst. The best strategy for investing in gene therapy stocks since that time has been to short everything you can (and then borrow money and short some more). The gene therapy field has been a black hole for investor $.

However, there are beginning to be signs of light at the end of the tunnel. Recent new of a Parkinson’s disease trial has been quite encouraging. (Article in the Lancet here.) The company mentioned in the article, Neurologix, is a tiny $30M publicly traded biotech that popped 50% on the news (NRGX).

Biotech, more so than probably any industry, is driven by potential and hope. At the end of the day, and investor still must be able to develop a discounted cash flow type of model to justify valuations. One of the biggest problems in biotech, however, are the binary outcomes of many of the drug trials. To deal with this characteristic, I use risk adjusted net present value models – rNPV for short. It helps to account for the cost, risk, and time inherent in product development. Instead of going into a long discussion of the method, here are a few links of interest:

Biotech Valuations for the 21st Century
Putting a price on biotechnology
Milken Institute rNPV Excel spreadsheet
BioGenetic Ventures rNPV Excel spreadsheet
What’s a Drug Worth – Motley Fool article

If there is sufficient interest from readers, I can do an example rNPV for one of the early stage biotech companies like GNVC or NRGX.

PS It must be nice to be married to a billionaire to fund your new genetic information company. One of the needs in the marketplace, in my opinion, is an information service that delivers the Amplichip to the consumer (it measures variations of two genes that determine how fast you metabolize certain drugs). Seriously, if I was on any sort of antidepressant or anti psychotic (or knew someone that was), I would make it mandatory to take the test before deciding on a dosage.

I am excited to announce a new feature to World Beta readers – a weekly review of some of the top academic working papers in quant research.

I mentioned AlphaLetters a few weeks ago when discussing a paper that CXO had reviewed. AlphaLetters is a bi-weekly subscription newsletter focused on summarizing the deluge of quant-based working papers in investment research.

They screen over 10,000 finance papers yearly from the major finance research resources (including finance research portals, leading finance journals, university working paper websites and conference/association websites) and identify papers based on which investment professionals can build profitable strategies and improve their portfolio management. They publish summaries on what they consider to be the top 5 papers, and the topics range from new investment strategies (e.g. accrual strategy) to portfolio construction (e.g. refining portfolio optimization). For each paper they usually include the source (web address), a short summary and comments.

You can download a sample issue here, and request a free trial on their website or at Trial@AlphaLetters.com . An example from the sample issue is below.

They have graciously agreed to let us post a small sample of their research on a weekly basis. Look for the first post soon!

Category: Strategy, Consumer-supplier correlation
Title: Economic Links and Predictable Returns
Author: Lauren Cohen, Andrea Frazzini
Source: Yale University working paper
Link: http://www.econ.yale.edu/~af227/pdf/cofraz.pdf

Strategy summary:
Long stocks with high recent customer stocks’ return (customer defined as those to which this company is supplying goods/services), short otherwise.

AlphaLetters comments:

1. Why important
This paper is based on a simple, convincing idea that good/bad news on a customer company should be reflected in the stock price of its supplier company. If the stock prices of customer companies suffer, so should those of supplier companies since their businesses are fundamentally interconnected. The authors found that in reality such news are not impounded into stocks prices timely, and the reasons may be investors’ collectively limited capability to digest new information.

This is another great example that more alpha can come from data items/data sources that’s not yet widely studied.

2. Data source
The supplier-customer relationship information is from the Compustat segment files, and one needs to program to identify the cusip or ticker of customer companies. Other stock-related information is from standard Compustat/CRSP

3. Next steps
The industry profile of the long-short portfolio is yet to be studied, and it may potentially be a big issue for some investment managers to use this strategy. For example, retail industry companies would not have customer companies, so the long-short portfolio should presumably contain no or few retail stocks.

The authors claim that the abnormal excess return is not from stock momentum and industry momentum. A closer look at the correlation with other existing signals will be interesting.

(Note: Original table is corrected, thanks for the heads up)

CBOE just introduced a new PutWrite index to complement their BXM covered call strategy. I imagine this data would be A LOT different had the start date been one year prior (instead of the Summer 1988 date they use).

I have blogged about options writing before, and here is an update of an artificial options selling FOF. I wouldn’t invest in one of these funds, but if I HAD to, I would examine 2 ways to gain exposure.

1. Create a FOF of option sellers. This should help to minimize impact of any one fund blowing up. However, since most funds only trade one market, large risks remain. The performance of a an equal-weighted basket of these funds is in the below table as “AVERAGE” – and you can see the performance has been deteriorating.

2. Sell options on a broad portfolio of world futures markets. Only one fund to my knowledge (and only recently) has pursued this strategy (ACE). Selling options on a broad basket of uncorrelated futures markets makes more sense to me than one single market. I did a simple backtest of this strategy a few years back, and the results were promising.

Foreign markets, especially London, continue to innovate with listed alternatives far more than the US. The US just recently listed the first quasi-hedge fund (GLRE), although there is news that Man is preparing to list the first true hedge fund in the US.

(Although I must say I am looking forward to returning to the “cheaper” cities of NYC and LA after my London trip – it’s expensive here! If any readers are in NYC – drop me a line – I will be there Mon. and Tues.).

A new fund investing in diamonds is to begin trading in London – the full FT article is here.

“Diapason Commodities Management is aiming to raise $400m for the first listed fund to invest in gemstones, buying only large polished diamonds worth more than $1m…[Stephan Wrobel, partner at Lausanne-based Diapason] said Diamond Circle Capital, an Isle of Man closed-end fund that starts trading on the main London market on July 10, will make it easier to invest in the market and its listed structure will provide investors with liquidity if they wish to sell.

The fund will trade the stones it buys but is planning only 15-20 per cent turnover in its portfolio each year, making it closer to the passive open-ended exchange-traded funds (ETFs) that have proliferated for many commodities.

“The idea is to have a portfolio that is well diversified and representative of the diamond market,” Mr Wrobel said. “Most of the time they will be locked in a safe at UBS.” He said the average value of diamonds bought would be about $3m.”

Thought this picture was interesting. . .full text here.

I don’t know how CXO does it, I really don’t. They consistently churn out great reviews of cutting edge academic papers. In a recent review, CXO takes a look at a Andrew Lo paper titled, Financial Econometrics.

An interesting aside, here is the book(s) that forever altered Lo’s college career choice towards economics. [Lots of former scientists, myself included, have done the "reverse Samuelson"]:

Paul Samuelson’s research also led him to take a dim view of portfolio managers. Samuelson (1974) stated that “a respect for the evidence compels me to incline toward the hypothesis that most portfolio managers should go out of business-take up plumbing, teach Greek, or help produce the annual GDP by serving as corporate executives.”

The series is also featured heavily in the book, The Predictors, about quant hedge fund The Prediction Company.

One institutional service that aggregates quant research in working papers is the apt named Alpha Letters. I took their free trial for a spin, and it is definitely recommended if you can get corporate to pay for it. . .

It has been slightly more than 5 months since I started my blogging experiment, and today is officially my 100th post! (It certainly feels much longer than that.) It is a bit surreal to be in a London cafe right now, having just polished off some of the best dim sum I have ever had after watching my first cricket game this morning. It has certainly been a useful endeavor from my perspective – getting emails and questions from all over the world has spawned quite a few fertile areas of research. Stay tuned for some much needed upgrades to the site in the current months.

The Battle of the Quants turned out to be a stellar conference (get those visions of nerds smashing calculators and stabbing each other with sharp pencils out of your head, this was a civil ‘Battle’). A little groggy from sleeping in the JFK airport, and minus one laptop that fried itself on the flight over, I made it through the day with the help of some strong coffee and English tea. A couple notes below.

The most pleasant surprise was the keynote speech by Nassim Taleb, author of ‘Fooled by Randomness’ and ‘The Black Swan’. I enjoyed Fooled by Randomness, but struggled to get through The Black Swan, and skimmed most of it. (I always struggle with books that could be 20 pages long that slog on for 300.) The talk, however, was highly entertaining, and painted an entirely different picture of Taleb than I gathered from his books (namely, an intellectual oozing with pretense). Taleb has started a new company, Universa, that is the follow on to Empirica. (And I believe it has > $1B in commitments.)

Two interesting notes from the talk. 1 – Taleb stated that 97% of his lifetime P&L occurred on one day (you guessed it, 1987). His product seems much less of a ‘hedge fund’ than a insurance type product. 2 – He mentioned how ironic it was that Gauss’s picture used to be on the Dutsche Mark 10 Bill, replete with the normal distribution in the background. Gauss did not invent the normal distribution (Abraham de Moivre did), and could there be a worse example of a normal distribution than the hyperinflation that plagued the German currency?

The second part I wanted to mention was the obligatory ‘Hedge Fund Replication Technique’ panel. I have blogged numerous times on the topic before, and have even penned an article on the subject. I just don’t get the appeal when you can match the returns with a simple buy and hold of world asset classes.

I am here until the weekend attending the IRC Asset Allocation Summit, and if my laptop is working I will send updates from the conference.

Any Brits have any good advice for the rest of my trip?