The Manager Selection Conundrum Solution

Barry Ritholtz recently posed an interesting question to a group of family offices during a presentation he made:

“Who is good at picking Hedge fund managers? Who amongst you has the ability to consistently evaluate managers who then outperform over time?”

In light of 2011’s subpar performance across the hedge fund universe (and in managed futures, for that matter), the question is at least worthy of consideration. The Barclay Hedge Hedge Fund Index had hedge funds down -5.37% last year, and managed futures down -3.02%. Still, as Ritholtz goes on to say, the problem may not be 2011, but a larger issue altogether. Maybe the treacherous landscape of manager selection is making hedge fund allocations more a game of roulette than a tactical investment decision.

We’ve written in the past about our distaste for hedge funds as an alternative investment. Our problem, they’re marketed as alternative investments, but, more often than not, you’ll find their performance highly correlated with that of stocks. Unfortunately, hedge funds and managed futures often get lumped in together. Similarities in traditional fee structures, their purported “alpha” profile, and appeal to high net worth individuals- not to mention the heated debate over whether or not managed futures is its own asset class or not (and we think it is)- push the two investment opportunities into singular generalizations, even though the liquidity, transparency and performance of managed futures in general give them, in our opinion, a distinct edge.

Still, the hedge fund manager selection conversation, despite the disconnect between hedge funds and managed futures, is an important one that managed futures investors should consider as well. And while we may not be able to answer Ritholtz’s question for all absolute return investments, we may have that answer for those allocating to managed futures.

Before we answer that question, we have to answer another: why is manager selection so difficult?  It boils down to understanding why a manager is able to perform the way they do (both on the good and bad side), and not just seeing the fact that they have performed the way they have.

Enter two seemingly complicated terms: Alpha and Beta.

When we talk about hedge funds, managed futures, and many other investments marketed as “alternative”, we tend to hear the term “Alpha” a lot, and Alpha is a measure of the excess return on an investment. The idea behind ‘alpha’ is to separate the portions of return that are derived from skill from those that are derived from simply being ‘in the market’. If you simply buy all the stocks in the S&P 500 in the same proportions, you will earn the same return as the index and have NO Alpha – the returns were not based on anything more than whether the market went up or down. But consider a second manager who invests money into stocks in the S&P 500 in different proportions (perhaps overweighting energy or the like). If the S&P 500 earns a return of 5% for the year, and this manager eanrs 10% by being more exposed to energy stocks – that manager has earned an extra 5% over the index performance, providing an Alpha of 5%.

Next is Beta. Beta is the concept which tries to address the riskiness component of returns, and generally refers to how correlated with the “market’s risk” an investment is. If an investment has a Beta of 1.00, it is just as volatile as the market you’re comparing it to. If it has a Beta of 3.00, its 3 times as volatile, meaning a market gain of 5% would equate to the investment gaining 15%, and so on. Alpha and Beta are linked in such a way that it becomes possible to calculate a Beta adjusted Alpha for different portfolios. So in our example above, an excepted return for the energy heavy portfolio could be calculated using each stocks Beta, and then the Alpha is really any excess return over that Beta Adjusted return, not just the vanilla S&P 500 return.

The problem inherent in the difficulties of alternative manager selection is that investing in Alpha often means you will lack a reliable Beta.

We wrote about this in a 2007 newsletter, explaining:

While Beta may seem like an advanced statistical concept – most of us feel Beta whenever we look at our overall portfolio’s performance. We may see that our portfolio of mutual funds was down in the third quarter, but not feel so bad because they were down less than the overall market. We may see that our high flying growth stock lost 3 times what the market as a whole did last Friday, but comfort ourselves by recalling that the stock had risen many times more than the overall market thus far this year.

We also feel Alpha – with thoughts such as “I’m dropping this mutual fund because its underperforming the overall market,” or “I’m switching into another money market account because I’m doing no better than if I was holding T-Bills,” and so on. So while not putting fancy calculations on paper with Greek symbols and figuring what your investments’ Alphas and Betas are, most people can intuitively work out what the Alpha and Beta are for their STOCK and BOND portfolios. This is because they can feel the differences in return and volatility between any single investment and the overall stock or bond markets.

This ability to intuitively work out Alpha and Beta starts to fall apart when entering the alternative investment world and the often complex and diverse portfolios and multiple strategies employed by hedge funds or managed futures programs. In short, finding a reliable benchmark (a Beta measure) for these kinds of investments is difficult. You may look at the S&P 500 when evaluating the returns of a mutual fund over time, or a government bond index if you’re investing in a fixed income program, but if you’re investing a managed futures program that can go long or short in dozens of commodity, financial and currency markets, what exactly does that line up with? The answer: it’s complicated.

The problem many of those in charge of doing manager selection run into, therefore; is one of understanding (without the normal Alpha/Beta framework) exactly how a manager has achieved their past performance. This impact is amplified in the black box world of hedge funds, where transparency is often a dirty word.

Does that mean you should avoid these kinds of absolute return investments? No (well, maybe hedge funds in favor of managed futures), but it does mean you need to understand the risks involved, and that you need to make allocation decisions from the right frame of mind. Even Ritholtz admits that there are hundreds of funds out there that are probably very worthy of allocation. The problem, going back to the Alpha/Beta conundrum, becomes the selection process.

Ritholtz likes to talk about the importance of process when it comes to managers- the importance of relying on methodology over luck. In our opinion, that process is just as important, if not more so, when it comes to manager selection.

And that comes back to working with the right people- and our solution. Manager selection isn’t easy. In managed futures in particular, there are dozens of elements that need to be considered and continuously monitored. You’re looking at performance, but you’re also looking at the ins and outs of the strategy, risk profile, manager experience, back office functionality, and much more to arrive at a measure of what the ‘Beta’ should look like for each manager.  Some of this is quantifiable, and some of it isn’t. And it’s not enough for that kind of research to be a one and done type process. If you want to protect yourself from things like strategy drift, getting caught like a turkey in an option selling program, or other unfavorable circumstances, these things need to be checked constantly. Do you have the time for that?

Realistically, the ability of family offices and investment advisers to conduct this ongoing due diligence on their own, especially in a world with thousands upon thousands of investing opportunities in the absolute returns arena, is limited. Each kind of strategy would require specialized knowledge for evaluations. Unless the family office or adviser you work with has a massive staff under them (and sometimes, even if they do), selecting managers is going to be difficult… unless they work with a firm that specializes in that space and has developed that ever important process.

Attain, for instance, has long been dedicated to developing an infrastructure that makes it easier for both advisers and family offices to get their clients informed managed exposure while staying on the right side of all regulatory parties.  We work one-on-one with family offices to aid in manager selection that will best serve their portfolios, providing hundreds of pages of educational material, due diligence reports, and allocation intelligence. For advisers, we take things a step further, assisting in the creation of a framework to help facilitate their fee assessment, and ensuring peace of mind by signing non-competes and providing technology-based solutions where the end clients get the information they need direct from the adviser instead of Attain.  And we do all of it at no additional cost to the adviser or family office.

In other words, manager selection IS difficult, but if you’re working with the right people, it doesn’t have to be.

Food for thought for that next family office conversation…

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One comment

  1. […] We’re not sure what Transtrend’s end game is here, exactly; but this all comes back to why manager selection is so difficult. Something we wrote about way back in 2007 and 2012: […]

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Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.

Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.

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