Will Managed Futures be the Next Asian Sensation?

Managed futures is relatively young in the US – the vast majority of the industry (by AUM, anyway) is less than a decade old. But outside the US, it’s even rarer. A few months back we took notice when Winton led the pack on bringing managed futures to China – they were the first CTA to move into the market, which up until recently was blocked by Chinese laws. Winton may have been first, but it doesn’t look they’re going to be alone for long. Via Futures and Options Network:

Last month, the China Securities Regulatory Commission (CSRC) issued its first batch of asset management licences to 18 domestic futures brokers paving the way for the launch of managed futures in China.

Many of the 18 companies are now on the hunt for international partners in a bid to replicate the Winton Capital Management model that led to the creation of the first managed futures fund in China in September.

Other firms are emulating the Winton model – partnering with a Chinese firm to serve as an “advisor” to the local firm’s trading activities – out of necessity. China’s laws may have relaxed a little bit, but American firms are still forbidden from directly buying and selling futures contracts on Chinese exchanges (though that, too is supposed to change eventually).

The million dollar (or yuan?) question at this point is whether the regulatory framework in China is robust enough to keep investors safe. As much trouble as US regulators have been having recently, we’re not exactly convinced that China’s government will be able to root out fraud, especially considering their track record. The article continues:

Another upcoming launch that signifies the liberalisation of the markets is the reintroduction of trading in Chinese government bonds after a 17 year hiatus following a trading scandal that led to investors losing hundreds of millions of RMB. The launch will be the second contract on the CFFE, which began trading on the CSI 300 in 2009.

Whether the Chinese regulators can offer enough protection to enterprising managed futures programs will likely determine whether this market takes off or sputters. Futures trading is complex and risky as it is – mix in a government and regulatory regime with a less-than-stellar reputation…

At any rate, it’s certainly a development worth keeping an eye on.

Chatting with Gary Fencik- Meeting of the Alternative Minds

While attending the CFA Conference in Chicago, we had the distinct pleasure of meeting with Gary Fencik (yes, good old #45 from the 1985 Chicago Bears Super Bowl-winning team) who is a partner of the firm and Head of Business Development at Adams Street Partners, LLC. This interview is a little removed from the conference, but good things come to those who wait, and in a rare turn of events, we’re writing about an alternative investment that’s NOT managed futures with an expert in his field who also happens to be a former player of our all-time favorite football team. Cut us a little slack, eh?

Welcome to the world of Private Equity (PE). Though traditionally an investment offered to only the incredibly wealthy through a network of finance professionals, PE has been thrust into the spotlight repeatedly during the Republican Presidential primary, with continued reference to Republican candidate Mitt Romney’s work with PE firm Bain Capital, but outside of the knowledge that he invested in companies, most people have no idea what, exactly was being done. Essentially, it involves raising capital privately (read: off-exchange) to invest in a company. PE is typically characterized by a long term investing timeframe, a lack of liquidity, and high risk. These investments can be a 10+ year commitment, which is why those in the know refer to that investment point as the point of “losing control.” As such, with a countless number of direct offerings and 1,000’s of funds pooling investor capital worldwide, the core principles of alternative investment allocation strategies hold true even in the PE world.  With hundreds of billions of dollars being invested in PE worldwide, and often in incredibly diverse investing environments among a wide variety of companies, it is clear why the expertise of Adams Street (a leader in PE for nearly 40 years) makes sense to employ.

As the conversation moved from a high level discussion on Adams Street and their PE work, we quickly found common ground on several topics that tie directly back to the core of why alternatives and the ever changing task of investing in them.

For many investors, understanding the need for the diversification value found in alternatives is easy. The perspective through the rearview mirror reflects what many in our space have come to see as a universal truth- that past performance cannot predict the future, but your best bet is to spread your risk and exposure across non-correlated asset classes. For us, the solution was managed futures, Fencik, however, became a strong believer in PE. After opening an office in London in the late 1990s to go global, Fencik and his team found that the rise of Asia had changed the PE landscape, and introduced a new set of challenges. He told us that he believes in the need to work with locals, to make sure you have the right tools, data and people on the ground doing the due diligence, reaffirming some of the sentiments expressed by Sam Zell.

As it relates to portfolio construction, Fencik recommended diversification across different sub-classes and emphasized manager selection as the most important part of evaluating an investment. Whether it’s a giant fund or a small venture, an investment in the US or abroad, the quality of the manager remains most important. He looks for a repeatable process to separate the lucky from the skilled (is there an echo in here?), and remains wary of style drift by an investment team (again, choose your team wisely). Firms tend to raise capital based on past performance, so if they have underperformed since, you need to identify what changes have been made, how the manager is performing against their peer group (not all strategies are built for all environments), as well as whether the size and style of trading are still compatible with your investment objectives.

As huge Bears fans and past season ticket holders, any conversation with Gary Fencik cannot go without a few questions for one of the former Monsters of Midway. One topic that has always been the topic of debate for outsiders is the notion that professional athletes don’t know how to manage their finances.  Fencik unfortunately agrees with this statement, stating that most players have no concept of how short their career will be. As a Yale grad and financial professional, he fully believes in educating athletes on their finances and goes as far as to commit to the NFL’s yearly week long seminar for current and recently retired players where he speaks about managing finances and looking at the longer term picture.

His advice for pro athletes is to spend time with their accountants to help know their net income now, to set a current budget and one for a post NFL career.  Finally he strongly encourages active athletes to network and take advantage of their celebrity status. If a current player asks for a meeting with the CEO of a company, he’ll get the meeting, but 2-3 years removed from the league, he’ll have to fight the HR fight.  Fencik also named at least 10 players from his teams who are now coaches… even though none of them initially aspired to be coaches.

Finally, we asked him about his best and worst personal investments; generally speaking, this is one of our favorite questions to ask anyone, because everyone usually has a good story. The worst investment decision happened to occur while he was playing football – he put money into a seafood delivery service. His best investment was in his college roommate: the founder of Summit Partners (one of the benefits of going to Yale, right?).

Our chat with Fencik was definitely an interesting one. Forget the fan component for a second- it was just nice to talk to someone in alternatives who gets it. Fencik understands the true diversification value of an alternative investment, and while we don’t see ourselves persuading him to abandon the PE world, we look forward to seeing managed futures become his second favorite asset class.

Gensler’s Swap Comments Hold Further Significance

CFTC chairman Gary Gensler’s testimony in front of the Senate Banking Committee today contained a few nuggets worthy of note. Due to his connections to Corzine, Gensler had recused himself from the MF Global CFTC investigation, falling under heavy criticism in the process. Since then, he has stalwartly refused to comment on the subject, but today, that silence was broken. To be fair, much of the commentary on MF Global was touting the company line that the CFTC did everything they could under the circumstances – actually becoming defensive during lines of questioning related to concerns about Corzine in the investigation, stating that they, “didn’t care beans about Corzine,” instead focusing on the client money at stake.

However, for us, there was one very critical component of his prepared testimony that stood out to us. While the comment was made in the context of the swaps debate, Gensler stated (emphasis ours):

Some commenters have expressed the view that if a transaction is done offshore, it should not come under Dodd-Frank.  Others contend that as long as an offshore dealer is regulated in some capacity elsewhere, many of the Dodd-Frank regulations applicable to swap dealers should not apply.  The law, the nature of modern finance, and the experiences leading up to the 2008 crisis, as well as the reminder of the last two weeks, strongly suggest this would be a retreat from much-needed reform. When Congress and the Administration came together to draft the Dodd-Frank Act, they recognized the lessons of the past when they expressly set up a comprehensive regulatory approach specific to swap dealers.  They were well aware of the nature of modern finance:  financial institutions commonly set up hundreds if not thousands of “legal entities” around the globe with a multitude of affiliate relationships.  When one affiliate of a large, international financial group has problems, it’s accepted in the markets that this will infect the rest of the group. This happened with AIG, Lehman Brothers, Citigroup, Bear Stearns and Long-Term Capital Management.

Gensler’s comments were no doubt focused on the London based losses of JP Morgan that came to light over the past few weeks. For us, viewing these comments through the lens of the MF Global experience, this is a larger truth than just the necessities of strict interpretations on swaps. If you’ll remember, one of the major concerns about how the money from MF Global had happened to go “missing” was the potential use of rehypothecation abroad by JP Morgan, above and beyond the limits of U.S. law. Their ability to do so was based on this loophole Gensler broadly referenced – that U.S. based institutions may skirt U.S. law by conducting transactions via off shore subsidiaries.

For the protection of investors everywhere, we hope that Congress will take this comment to heart. We can’t say we know exactly what happened during the collapse of MF Global, and conspiracy theories certainly abound, but in our minds, we want to know that regardless of the MF Global situation’s ultimate resolution, FCMs cannot abuse investor trust here or abroad.

Guest Post: The Great Fall of China?

Continuing the theme of politics influencing investing we witnessed last week at SALT, here’s another great piece from Jeffrey Dow Jones at Cognitive Concord. If China is really the potential disaster described here, now is the time to ask whether or not your portfolio is buckled in.

The Great Fall of China?

One of my themes to watch in 2012 was China. I thought this was going to be a very important year for China, one that generates a lot of debate and dialog. So far, I’d say that this has been mostly correct. Maybe not in terms of the ubiquity and size of the Chinese discussion, but definitely the different dimension.In case you’re still thinking of China as this rapidly industrializing, cheap-exporting, exponentially growing awesome economy that will soon be kicking the United States to the curb and stealing its lunch money, it’s time to stop living in 2007 and wake up in 2012. The vector has changed.Bloomberg Businessweek did a great article on this last week. Giving it a read should get you quickly up to speed on the broader points, especially about why all the drama around Bo Xilai matters for economics.I can’t tell you how fascinating the evolution of this economic story has been to me. Five years ago, I think the word “insecure” accurately summed up the way the U.S. felt about China. That was the context for the discussion back then. Today, however, we’re a lot less worried about what being the #2 economy means — why does it matter if the largest economy in the world is still a very poor nation? — and instead we are nervous that China slowing down may take us with them. Can’t have that, now.  No, sir.

There’s also a newer, stronger component of moral superiority to the debate. Open up the Wall Street Journal and you are repeatedly exposed to commentary about how a “proper” economy ought to be run. Turn on MSNBC and you get a steady stream of human rights stories with China as the main villain.

If you want to take a deeper look at the economic angle and you can clear your schedule for the afternoon, I’ll recommend Hugh Hendry’s latest epic commentary. Hendry runs the Eclectica fund and I used to follow his stuff religiously until he stopped writing and kinda disappeared. This is his first published research since 2010.

In any case, the essence of his argument is that China is speeding towards disaster. I’ve spent a lot of time in this newsletter about negative real interest rates here in this country and the perverse incentives that disquilibria like that can create. But in China the financial repression is far worse and has persisted for much longer. With inflation that usually runs between 7-9% per year and a government-imposed cap of 0.72% on bank deposits, savers in China (a nation that really likes to save, too) is forced to deal with negative real rates of -7%. With that kind of disincentive to save, nobody should wonder why they have a pretty spectacular real estate bubble over there.

For the most part, businesses and investors remain optimistic on China:

Sentiment is high.  But I can tell you one thing about investment sentiment in general: it’s correct right up until it’s too late to matter. Sentiment changes after pain, not before. It’s a lagging indicator, not a leading one.  If you’re interested in avoiding pain connected to with a flailing (failing?) Chinese economy, tracking measures of sentiment won’t help you.

That’s why the other data from that survey is so interesting. It showed that over 70% of these U.S. companies surveyed reporting that China’s regulatory environment is the same or getting worse and 90% that say China is losing competitiveness because of rising costs. Concern about an economic slowdown also rose significantly between 2011 and 2012. So there’s a bit of a contradiction in this data.

Perhaps it’s just a case of people still being optimistic, only less so. That’s not always indicative of disaster.  Though it can be the first step on a slide towards it.

The stock market, on the other hand, is a lot more clear.

It’s worried:

That’s not a healthy chart. Even if you masked the name of it, I wouldn’t want to buy that asset. It’s a classic chart pattern: bubble, burst, bounce, followed by slow-disintegration.

It has taken a while for this trend to really become clear, so you can see why the pre-bubble China narrative persisted in the mainstream until around the end of last year. Being so fixated on Europe in 2010 and 2011 made it that much more difficult to worry about what was happening in the Far East.  Now that we have a better grip on what life ahead for Europe will look like and what it means for the markets, we can turn our attention elsewhere. Just in time to tune into a slowing Chinese economy.

I saw thousands of those charts in the wake of the tech bubble. Most of those charts have no future. They end in bankruptcy or a take-out. As an investor, you want no part of them. You keep hoping that someday, maaaybe, they’ll get back to those old highs but they never do. The old highs were an illusion, an inflated multiple.

Every once in a while, if the asset in question is a large and important company, they just take time to finally grow into their multiple.

Intel is a textbook example of this:

In this example the asset is finally trending in the right direction, making new highs, and doing it from very sensible valuations. Intel pays a 3% dividend and trades at under 12x earnings. (Full disclosure: I do not own it.)

China won’t go bankrupt or disappear the way that a crappy company can. Its chart will someday turn back around. The question is how long. Will the Chinese economy become an investment with a fair multiple and acceptable growth prospects in a few years? Or will the investment’s struggles drag out for decades like Japan?

Uncertain Outcomes

The truth is I don’t know enough about China. I don’t have the answers. Because of my role in the industry and because I consume a way-above-average quantity of financial news and commentary, I might know a little more about it than Joe Shlabotnik on the street. But I honestly don’t know enough about it to speak with certainty and authority. The reality is that very few actually do.

Hendry’s probably more qualified than most — I was reading his research on China years ago — and he’s done fairly extensive travel through the country. In fact, it was from him and his goofy YouTube videos that I learned of all the Chinese “ghost cities” in the first place. Bloomberg wouldn’t do their groundbreaking story on that until about a year later.

But I do know one thing about economies in general, especially the large ones. I know that they are impossible to control. Managed economies inevitably fail. This was perhaps one of the greatest economic lessons of the 20th century. The ones that appear to be working like Soviet-era Russia or the old East Germany are always revealed to have been an illusion when the curtain comes down.

Part of me wonders if, in five or ten years, we look back at China and crack up with laughter. “Trying to manage their economy! Ha! What were they thinking??”

I know that China’s economy isn’t completely managed, but it is something of hybrid.  It’s sorta free, but not really.

As an investment, my beef with China is the same as my beef with Bank of America, Societe Generale, or pre-2010 Greece: they tell me that their financial condition looks one way, but I simply cannot trust it. Perhaps that’s just my hyper-skeptical Gen-X nature. Perhaps it’s because I’ve been burned one too many times in the past. I know deep in my gut that it is in their every interest to make themselves appear as awesome as possible, even if it means playing fast and loose with FASB guidelines or flat-out lying. Given the complexity of their financial situations and a track record of obfuscation, I cannot bring myself to buy what they are selling.

Others can, and that’s great. You have my blessing. Stephen Roach loves China and loves it as an investment too. Stephen Roach is ten times smarter than I am and I have tremendous respect for everything he has to say. If you feel like you want to be bullish on China and want to invest, don’t listen to guys like me, Hugh Hendry, or Jim Chanos. Pay attention to people like Mr. Roach and fund managers like the folks at Matthews.

It’s not like any of us are any better than the others at predicting the future.

The Drama of our Times

Think about the financial crisis as a play in three acts.

The first act took place in the U.S. and exposed an embarrassingly irresponsible consumer with respect to credit and real estate, and a Wall Street loaded to the brim with messy assets, broken incentive schemes, and generally-naughty behavior.

The second act took place in Europe. It exposed a rotten political state and a gluttonous public sector, as well as an equally irresponsible banking system loaded to the brim with a different kind of messy assets.

The final act — as people like Hugh Hendry and Jim Chanos believe — will take place in Asia. Who knows exactly what details will emerge and which assets will move to what levels.  We just know it won’t be much fun.

In any case, even if you don’t want to call it a “crisis” or think of it as the third phase of a global financial event, I see a resolution of the Chinese disequilibrium that has persisted for so many years as something of an inevitability.

Hendry is bullish on the U.S.. I am too, or at least I’m bullish relative to the rest of the world. More specifically, I’m bullish on North America. I would categorically avoid Europe, China and anything connected to it (ahem, Australia), and I’d be less enthusiastic about specific businesses that are relying too heavily on China for growth.  Valuations can change dramatically or even irrationally when investors start revising downward their previous estimates for growth.

The 21st Century

There still exists this idea that the U.S. is somehow a nation in decline. That, like the Roman Empire, we are on our way out, Nero fiddling while the city is engulfed by flame. This couldn’t be further from the truth. The fundamental data simply doesn’t support this idea.  To arrive at that conclusion you have to make some fairly aggressive forecasts about the future, an act which is very difficult to do.

Yes, the U.S. has gigantic problems, and yes, they’re going to be difficult to work out.  Yes, there exists massive risk of everything from another massive recession to a collapse of our currency. But relative to the rest of the world, the U.S. and its economy enjoy tremendous power. None of that is going to change in our lifetimes. I still believe that the first half of the 21st century will, once again, be all aboutthe United States. Nevermind the details of our budget and debt problems — when you couple the U.S.’s geopolitical advantages with its solid demographic profile, it’s hard to be long-term bearish. It might be impossible, actually.  The decline of the U.S. empire will come eventually — don’t worry about that — I’m just not convinced it’ll be during my lifetime.

Along those lines, I am reminded of one of the most elegant things I’ve ever heard said about the United States, that, as a nation we are in our adolescent years, adolescence being the only time in the continuum of a human life that one feels simultaneously insecure and over-confident. Pretty much sums up our national psychology, no?

Like any other teenager, the U.S. will eventually make it into adulthood. It will be clunky, awkward, and exhausting. It will be painful and expensive at times. But we’ll do it. I don’t think it’s quite time toinvest heavily in the U.S., but as I’ve written before, we’re getting closer to that point. One more big freakout or cyclical bear, and I’m loading my and Mrs. Concord’s IRAs with U.S. equities. That’s going to coincide with the nadir of optimism about the U.S., and probably a second round of faith in a new China or hopeful Europe.  I fully expect the world to think me crazy for getting long the United States at such a juncture.

Oh well.

Market Recap

Volatility has made a bit of a comeback in the last week, an extension of the general weakness we saw in April. Supposedly the market is down because of rising bond spreads in Europe and rumors that Greece will leave the EU. This was true a year ago and this was true the year before that. It’ll still be true a year from now. Bond spreads will still be concerning and there will still be plenty of talk about Greece leaving the EU.

The market is down because it’s taking a break. It rallied far and fast in the first quarter and now investors are taking some money off the table. This is the way that things go. Some days, investors feel like taking risk off. Some days, everybody seems to do it at once. It can create a vicious circle and when it does, it can manifest as panic. When the high frequency guys get involved (or hit their “off” buttons) things can get really weird.  Markets go down quicker than they go up.

I think it’s OK to be a little bullish for the short run. We aren’t on the brink of another financial crisis and with all these new bailout and liquidity mechanisms in Europe, I don’t see a meltdown on the horizon.  The biggest legitimate risk that I can see right now is if investors start getting excessively worried about the “fiscal cliff” scheduled to happen next year.  A whole lot of government spending will come out of the economy next year and the year after, and government spending is what has been keeping it all afloat since 2008.  I’m starting to hear analysts talk about it and what it’ll mean for the markets.  Perhaps next week we’ll go through some of it in more detail.

In the meantime,  I see little reason why the market can’t test those old highs in the course of the next 12-18 months.  Somewhere in that range could be the best opportunity for a long-term short that we’ve seen in a while.  My guess is that it’ll coincide with crazy-high bullish sentiment and economic optimism.  Like all the best shorts, it’ll be a difficult one to put on.

Oh well.