CalPERS Hedge Fund Exit: Earthquake or Godzilla?

The big news in the alternatives world this week is of course that the largest pension in the world CalPERS is ditching it’s Absolute Return unit and unloading $4 Billion worth of hedge funds. Is this the end of hedge fund investing by institutional investors (an earthquake), typical performance chasing by an investor (albeit a very large one), or a result of their enormous size (Godzilla).

If you believe Barry Ritholtz over at Bloomberg – this is an “earthquake” for hedge funds, with other pensions following suit and advisors and the rest eventually waking up to the realization that hedge funds don’t provide higher returns than equities.

This is a huge change… It has enormous potential for disrupting the consultants and infrastructure of the 2 & 20 firmament.

If you believe some hedge fund managers who were quoted in a Business Insider piece – this isn’t about the hedge fund industry’s ability to meet investor expectations, it’s about CalPERS inability to pick managers who could meet their expectations. We even get a little insight into how their manager selection may have suffered:

They got what they paid for since they only invested in managers who would cut fees. So the best funds wouldn’t do that, so they had a mediocre portfolio.

So is this proof that hedge funds don’t deliver on their promise (note to Mr. Ritholtz, most hedge fund’s “promise” isn’t to get “higher” returns than equities… it’s about non correlated returns and better risk adjusted returns), or is it about CalPERS being a poor investor?

We agree with Ritholtz that there are a lot of under performing hedge funds out there and a lot of them are expensive. But institutional investors don’t seem to be as upset about fees and correlation and all the rest of it. A recent survey showed 95% of institutional investors planned on maintaining or increasing their hedge fund allocations (58% maintaining, 36% increasing).

That’s not to say we don’t agree that the grand majority of hedge funds are way more correlated to equities than people investing in ‘alternatives’ would be led to believe. But we also don’t think a group like CalPERS was duped by this. They knew full well the correlation to equities they were getting involved with. Indeed, they likely viewed the absolute return portfolio as more and more a way to capture equity-like beta with lower risk, like many institutional investors do. The problem CalPERS faced that doesn’t pop up for other pensions and investors, is their gargantuan size.

CalPERS $4 Billion in hedge funds was just 1.3% of their portfolio, meaning they have a staggering $298 Billion in assets their controlling for future California state employee retirees. Trying to invest that much money is like turning the proverbial battleship. They just can’t be all that nimble. And indeed, that was one of the reasons given by CalPERS for their hedge fund exit:  “the lack of ability to scale at CalPERS’ size”

So say CalPERS actually loved the hedge fund model, and saw that they could get equity like returns (after fees!) with less risk over a full market cycle. Now what?  They have $160 Billion of stock market exposure! Porting that over to the hedge fund world simply wouldn’t work. They would immediately become over 10% of the entire hedge fund industry ). They would max out the capacity of nearly every manager they worked with. They would become a huge tail wagging the dog.

More than anything, what we’re may really be seeing here is the upper bound of the hedge fund/institutional investor asset allocation game. It’s the curse of being the Godzilla of institutional money. CalPERS seemed like the best client a hedge fund could have… with nearly $300 billion in assets which could be allocated to hedge funds, but some boring performance on what really amounted to a test run (1.5% of assets), likely made them see that even if they were good at picking the right hedge funds – they couldn’t play in that pool in any real meaningful way.

PS – maybe Calpers should move fully into the discount fee camp and just use a Robo-Advisor (link)

The Climate of Volatility, Investing, and Science

Some people have been saying Barry Rithotz’s writing has been going downhill of late (here), and we did like the old non-Bloomberg Barry a little better ourselves if truth must be told – but one of his most recent pieces is a peach, where he ties in volatility, investing, science, and climate change together. His basic message – don’t think about it as global warming, or even climate change. Think about it as a dramatic increase in the global climate’s volatility, what he calls Global Weather Volatility.  And don’t get caught up in the politics about it, get caught up in how to invest in it. As Ritholtz puts it:

I have but two goals: The ability to bet on global weather volatility, and a way to express the trade I like to call “short unscience.” As soon as I figure out how to do this, I am going to make a killing.

So how do you bet on Global Weather Volatility? How do you get in front of that trade? Buy (soon to be beachfront) land in the middle of Florida? Sell short the hurricane insurers?  Buy futures on agricultural crops like Corn, Wheat, Sugar, Cotton, and the rest?  Buy the CME’s stock in anticipation of more hedging and speculation on weather and the commodities it affects? And how do you go about shorting ‘unscience’?

First, is it Weather Volatility or Just More Weather?

Weather Bell Curve

The first problem with trying to go long ‘global weather volatility’ is what exactly does that mean?   The common perception is this means a greater number of  storms, more droughts, and so on. But technically speaking, that would mean ‘weather’ would have greater variations around its mean – not just greater numbers of events.  So we’re talking hotter hots and colder colds, dryer droughts and wetter floods, tons of hurricanes then no hurricanes,  polar vortexes and years with no snow.  Only time will tell, but we suspect most of the fears out there concerning climate change revolve around an increase in the number of events, not the variance in the number of events. It’s semantics, but hey… we review investment manager’s stats all day long, what do you expect?

So how do you bet on a wide variance of possible weather conditions season to season and year to year?

Do you add Sugar to your portfolio on news of dryness and hedge funds doing it?  No. Ritholtz pointed to a recent Bloomberg piece saying “hedge funds were betting on Sugar due to dryness” as evidence that portfolio changes are already being made in relation to climate change, but this is quite a ways off the mark in our opinion. For the most part, those hedge funds playing in the Sugar markets are managed futures funds (something we know a thing or two about), who are predominantly systematic. These systems don’t have coding built into the system indicating when to increase, or change positions based on a lack of rain. They aren’t adding long exposure because of climate change – they are adding it because prices broke above technical levels signaling an uptrend… Maybe that’s due to climate change – but it’s a stretch in our opinion to use that as evidence. And we wouldn’t recommend anybody try and play climate change by simply adding Sugar, or any other commodity, to a portfolio believing that it will go up because it will keep getting hotter or dryer or whateverer.

If it’s more Global Weather Volatility, that means we could have years with record droughts causing tight supplies and higher prices; and years with picture perfect growing conditions causing ample supply and lower prices. The more volatile the weather season to season, the greater the variance in the crop yields season to season. So just buying a commodity isn’t going to get the job done – as the differences from season to season become more severe – bringing more severe up and down price action with them.

So how do you bet on more volatility between crops and more severe up and down price action?

Barry was on the right track with the mention of Sugar, but we view that as evidence of weather moving commodity prices – and specific strategies setup to capture such moves; not evidence of investors betting on climate change. Whether it be Natural Gas prices responding the Polar Vortex, hundreds of thousands of Cattle dying because of an early winter storm in the plain states, or a plentiful corn crop recovering from a year of drought;  climate affects futures prices. Indeed, that’s the whole reason futures exist, for the farmers and consumers to be able to hedge their risk of such weather events spiking or crashing prices.

The problem is… how in the world can you know when the next weather event will happen, and whether (pun intended) it will affect prices, and which prices it will affect. Trying to predict which markets weather will hit next is a guessing game nobody could successfully navigate, and you won’t know which side of the trade to be on either. The only answer is to be in a broad cross section of these markets, with exposure to grains like Corn and Wheat, softs like Coffee and Cotton, meats, and the rest. And to be ready to trade either long or short in each of them, as the variations in the weather can either aid or hurt supply.  The only answer is a systematic approach which insures it will be in the outlier moves up and down by getting into every move, even the ones which don’t see any follow through.

Now, this strategy isn’t for everybody. For one, it doesn’t derive its return stream from the unemployment report, earnings numbers, or the latest tech IPO – so there’s very little to support your investment when you turn on CNBC every day.  Secondly, it is possibly the most frustrating strategy out there, being the antithesis of the consistent monthly returns investors yearn for. Trading such a systematic commodity strategy will be a string of fits and starts, of years of boredom followed by months of incredible excitement when outlier moves finally happen, and of multi-year losing streaks like is being seing right now in the managed futures space.

You see – it’s no mystery how to bet on Global Weather Volatility. You bet on volatility in commodity markets. You enlist a strategy designed to keep its powder dry and head above water during low volatility times,  while insuring it will be involved when volatility spikes – through accepting many small losers until the winner comes. Yes, we’re talking about managed futures, but trend following in particular, and commodity trend following in particular. It’s also long/short commodity funds, global Macro funds, and Ag traders – all of which have a long volatility profile.

What about the fact that volatility across asset classes is near record lows and these types of strategies have been at the bottom of the performance barrel over the last few years?  All the better.  Now we’re adding in some contrarian investing and breaking the performance chasing mentality as well. Where do I sign up?  (Here)

Rise of the Robo Advisors?

The Economist CoverForgive us for stealing from the cover of the Economist, but given the topic it seems fitting. Ever since the major technological advancements of the 20th century, there’s been a growing fear that soon enough robots will control the world (cue the Terminator franchise). Fast forward to today, and this fear has creeped into the financial advisor space of all places, with articles using  words and phrases like “afraid” & “risk irrelevancy” to display the attitudes and dangers all advisors face if they don’t adapt to the shifting mentality when it comes to investing. What are we talking about? And what is a robo-advisor anyway?  Why are people supposedly fearing it?

Who are the Robo-Advisors?

Just like Amazon ($AMZN) ruined Borders and the local bookstores, Netflix ($NFLX) killed Blockbuster, Facebook ($FB)  killed talking to your friends, and Tesla ($TSLA) is trying to disrupt the big auto-makers; the whole idea behind Robo-Advisors is to disrupt the financial advisor space with new technology and lower costs:  mainly algorithms instead of advisors; websites instead of branch offices, and automated text messages instead of hour long meetings. A few leaders have emerged so far in the space, with names like Betterment, Wealthfront, and FutureAdvisor, and a quick view of their websites will show essentially the same message:  ditch your father’s golfing buddy and invest like it’s the 21st century, with easy, intuitive tools to set things up and automated processes after that so you don’t have to worry about it. 

Why is Everyone Talking about them Now?

It’s the financial equivalent of booking an Uber on your phone versus standing in the cab line at the hotel. And it’s gone beyond the idea stage to real money. Wealthfront launched in December of 2011 and in those 30 months, they have since grown to $1 Billion in AUM, which is roughly an average growth of 33.3m a month. Betterment is doing well too, with $502 mm in assets under management. As for FutureAdvisor, they now have over $118mm AUM, with only 18 employees.  And the Venture Capital folks are falling all over each other to get in on the game wondering if this is the next Twitter or Facebook or whatever, pumping over a quarter of a billion into the space, and $95 million in just a few weeks earlier this year.

Bo Lu, the CEO of Future Advisor had this to say about the size of the opportunity

[Read more...]

Lessons Learned From 37 Years of Futures Trading

Originally From Attain’s 3/’11 Newsletter:

Managed Futures have come a long way in the past 37 years, and so has Barbara Mueller, who will be retiring at the end of March after nearly four decades dealing with futures trading. Barbara has been working in the industry since 1973, and has been an invaluable asset to Attain Capital since 2006.

In honor of her retirement, we’re taking a break from our traditional analysis this week to pay tribute to Ms. Mueller. It has been an honor to work with someone as knowledgeable, talented and motivated as Barbara, and here she provides us with her (often comical) insight from 37 years of experience in the world of futures trading.

Moving Forward, Looking Back

When Attain asked me to come up with a list of the best things I’ve learned after more than 3 ½ decades in the futures industry, it was pretty daunting.  After all, 37+ years ago, we were in the stone age of trading. We did have the wheel (and telephones), but there were no personal computers, no fax machines, no stock index futures, no US options on futures, no 24 hour markets, and gold was trading at $135 an ounce.  There were no Treasury bond futures or other financial instrument futures. The CFTC and NFA (the futures regulatory agencies) did not exist yet.  We were governed by the CEA -the Commodity Exchange Authority.  And the list goes on.

Typical commissions were $75 to $100 round turn. Account forms were only 1 page!  Some of the prices were still written on blackboards at the Chicago Board of Trade and you could inspect physical grain there as well.   The whole managed futures industry was an still an embryo, with Richard Dennis not teaching his Turtles until 1983 and Paul Tudor Jones still a clerk on the trading floor. S&P futures, the most popular trading system vehicle in the world, wasn’t launched until 1982 (the minis didn’t start trading until 1997!) Options on commodities in the United States weren’t authorized until 1984 and System Writer, the precursor to Trade Station, wasn’t launched until 1989.

As one of the first women brokers in the futures industry, it’s been quite a journey-and an accidental one at that.  I was just waiting for a teaching job to open up in the Chicago Public School System and my Dad suggested I go to work for one of his friends at the Chicago Board of Trade in the interim. Thirty seven years later, I guess I can no longer call this an “interim” job!

[Read more...]

Natural Gas ETFs – Heads You Lose, Tails You Lose More:

We did our monthly look at how various commodity ETFs track the futures markets they’re designed to follow recently, and found a rather interesting data point in Natural Gas.

Natural Gas(Disclaimer: Past performance is not necessarily indicative of future results)

Nautural Gas VAMI(Disclaimer: Past performance is not necessarily indicative of future results)
Natural Gas Futures = Selling the December Futures contract the last week of November (including exit costs), then using the following December contract numbers)

We’ve talked before about “3 Big Reasons Commodity ETF’s Aren’t Getting the Job Done,” and the usual picture is of the ETF underperforming the asset they track because of prices being in contango and a little thing called roll yield, which the ETFs have to pay if further out prices are more expensive than nearby prices, and if you look back at UNG since inception, it’s clear that the ETF underperforms a simple strategy of rolling the December futures annually:

Natural Gas Compare(Disclaimer: Past performance is not necessarily indicative of future results)

So why is UNG suddenly outperforming the December futures strategy?  You guessed it… Natural Gas has moved ever so slightly into Backwardation – the condition opposite ‘Contango’, where the near prices are more expensive than the further out prices. In that scenario, the ETF earns the roll yield instead of paying it. Here’s a nice graphic and stats from Hard Assets Investor: showing the 5yr annualized roll cost has been 10.37% (a cost of 10%), while the current roll cost is -2.5% (a benefit of 2.5%).

Natural Gas Backwardation detailsNatural Gas Chart Real Hard Investor
Charts Courtesy: Hard Assets Investor

But whether or not the futures are down -67% since 2009 or the worst ETF ever is down -78%, does it really matter. It’s kind of like being the cleanest dirty shirt or skinniest fat kid. You’ve still lost a boat load of money betting on the “energy of the future”.  And I guess that’s what the folks at Direxion and VelocityShares and ProShares were thinking when they launched Inverse Natural Gas products… and not just inverse, but 2x and 3x inverse. Why just go short, when you can double and triple your leverage? Direxion even got the great ticker – GASX – seemingly unconcerned with the link to the world’s number 1 brand for flatulence and bloating relief.

If you had to guess when these guys launched their inverse Natural Gas ETFs, what would you choose:

A. In mid-2008 when Natural Gas had risen ~100% over the last 12 months

B. In 2011 and 2012 when Natural Gas had fallen between 60% and 80% from its highs

Pat yourself on the back if you chose B. These funds were launched in a hurry to capitalize on the big move down in Natural Gas prices, just in time for prices to rally about 130% from their 2012 lows, just like the long Natural Gas ETF (UNG) launched just in time for Natural Gas to fall 80%.  A look at the all time charts for these ETFs is like watching a race to see who the first one to hit -100%.

Inverse Natural Gas(Disclaimer: Past performance is not necessarily indicative of future results)

We’re not sure if this is a commentary on the volatility of Natural Gas, on the dangers of turning futures markets into ‘safe looking’ ETFs, or on the age old problem of investors getting in exactly at the wrong point… but it sure is a weird set of circumstances when investors buying the long ETF are down about the same amount since inception as those buying the short ETF. They can’t win for losing. Here’s the sad performance since inception of the various Natural Gas ETFs:

ETFs that "Make" Money when Nat. Gas goes UP

Total Return
GAZiPath DJ-UBS Natural Gas TR Sub-Idx ETN-94.21%
UNGU.S. Natural Gas Fund-93.83%
BOILProShares Ultra DJ UBS Natural (2X)-76.01%
UNLU.S. 12 Month Natural Gas Fund-64.60%
UGAZVelocityShares 3X Long Natural Gas-49.17%
NAGSTeucrium Natural Gas Fund (25% weighted)-45.58%
DCNGiPath Seasonal Natural Gas-39.32%
GASLDirexion Daily Nat Gas Rltd Bull 2X Shrs24.61%

ETFs that "Make" Money when Nat. Gas goes Down

Total Return
DGAZVelocityShares 3x Inverse Natural Gas -94.16%
GASXDirexion Daily Nat Gas Rltd Bear 2X Shrs -90.95%
KOLDUltraShort DJ-UBS Natural Gas-26.98%
GASZETRACS Natural Gas Futures Contago 6.38%Jun'11

(Disclaimer: Past performance is not necessarily indicative of future results)
Source: Google & Yahoo Finance


About that Volatility = Complacency Claim…

Here’s how the usual reporting on low volatility goes…

There’s Low Volatility because the VIX is low, and the VIX being low reflects investors paying less for future downside protection, and paying less for downside protection means investors are less concerned (or aware) of the possibility of downside… so low volatility means these investors are becoming more “complacent”.  What exactly does complacent mean, we looked it up, via

“pleased, especially with oneself or one’s merits, advantages, situation, etc., often without
awareness of some potential danger or defect; self-satisfied.”

It’s kind of like a person foregoing hurricane insurance because there hasn’t been one in a while. Their recent good fortune of no hurricanes blowing their house down has made them complacent about the possibility of future hurricanes.

The structure of the VIX leads to this low volatility = complacency argument. The Chicago Board Options Exchange’s Market Volatility Index, or the VIX, measures the implied volatility of S&P 500 index, representing investors’ expectations of volatility in the benchmark equities index over the next 30 days.  Higher VIX values indicate anticipation of higher stock market volatility while lower VIX values indicate the expectation for lower stock market volatility. With stock markets tending to ‘take the stairs up, and the elevator down’ as the old saying goes, higher volatility is associated with lower prices most of the time. So, if investors think equities are going lower, they think it will be accompanied by increased volatility, and therefore will be willing to price the VIX higher.

So….we’ll concede that a Low Vix can represent a certain amount of complacency and lack of awareness of possible downside (or upside spikes for that matter) among investors in equities.

But does it follow that low volatility in say, Bonds, means that bond investors are becoming more complacent. While this is mostly semantics and likely only of interest to the most nerdy among you, does it follow that low volatility in Bonds as measured by tight ranges means there is complacency in that market?  We sort of think no. You see, volatility in nearly everywhere but the VIX is measured not by the prices of options to extrapolate the expected volatility over the next 30 days – but instead by the observed volatility over the most recent period, be it 30 days or 100 or the past year.

And that’s the rub… when we say that there’s low volatility in a market like bonds or the Euro Currency because the ranges have contracted, and that means there’s complacency (like we did in our “Complacency Everywhere” piece last week), we’re missing that the tighter ranges are what happened, versus the VIX reading being a measure of what investors believe will happen.  Now, of course, investors being humans – they often project what just happened onto what they think will happen, so there is a high correlation between the observed volatility and expected volatility.

But you can see intuitively that these aren’t the same thing. The observed volatility being low simply means investors were not faced with any market moving information or outside forces over the observed period. It doesn’t necessarily mean those investors are becoming complacent, i.e. – pricing in low volatility expectations moving forward. Luckily, the CBOE came out with some VIX-index like products a while back which allow us to test out this observed versus implied phenomenon. You can see from the charts that while observed volatility is at multi-year lows, the expected volatility is actually at multi-month highs.


Observed volatility = the tightest 10 Yr Treasury Yield 3 month range in 35 years

Expected Volatity = CBOE/CBOT 10-year U.S. Treasury Note Volatility Index - VXTYN (below)

Bonds Vix(Disclaimer: Past performance is not necessarily indicative of future results)

Euro Currency:

Observed volatility = the tightest consecutive monthly ranges in the Euro since inception

Expected Volatility = CBOE EuroCurrency ETP Volatility Index - EVZ (below)

Eurocurrency Vix(Disclaimer: Past performance is not necessarily indicative of future results)

So next time someone (like us) tells you investors are complacent because there’s low volatility – double check their inputs. Are they saying low volatility using the expected volatility of that market looking forward, or the observed volatility looking backwards?  We couldn’t agree more that tighter ranges and a low VIX portend a more volatile climate coming up (not a lower one), but the slight problem in the low volatility = complacency argument didn’t sit so well with us over the weekend… we feel better now for having gotten it off our chest.

About that 2014 Commodity Breakout…

Amidst all of the talk of the death of volatility, the inexplicable bond rally (rates lower), and broken record of new all time highs in US stock markets – we’ll excuse you if you didn’t notice some rather bizarre behavior in farmed commodity markets in May. The poster child was Wheat, which had a trend reversal on May 6th, and didn’t look back, losing on 14 of the next 16 days to post a negative -13.0% return in May.

New Picture(Disclaimer: Past performance is not necessarily indicative of future results)
Chart Courtesy: Finviz

But it wasn’t just Wheat  – similar patterns were seen in Corn, Soybean Oil, Rice, Coffee, and Cotton:

New Picture (1)(Disclaimer: Past performance is not necessarily indicative of future results)
Chart Courtesy: Finviz

What’s going on? Did these grain markets follow the “Sell in May” saying?  Was it the S&P hitting new all time highs? Was it an easing of tensions in the Ukraine (in Wheat’s case)? Was it the price distortion of many Ag commodities like M6 Capital suggested in their newsletter? Maybe. We’re not exactly sure. But one thing’s for certain, the sharp run higher seen earlier this year has reversed course, with Ag heavy commodity indices such as the CRB Index showing the recent weakness.

CCI Reuters Commodity Index(Disclaimer: Past performance is not necessarily indicative of future results)
Chart Courtesy: Stock Charts

A longer perspective can also be of some help here, where looking back 5 years we can see the 2014 moves higher in Coffee and Wheat were reversals of years long down trends. Perhaps these were just short coverings and dead cat bounces instead of the start of a new uptrend?  Perhaps this is a normal consolidation period before moving higher again.  Only time will tell at this point, but one thing’s for certain – the months long pattern of higher daily and weekly highs and lows, which broke the years long pattern of lower highs and lower lows, is now itself being broken.

Wheat(Disclaimer: Past performance is not necessarily indicative of future results)
Chart Courtesy: Finviz