File this one under "silver linings." The end of what has been termed a "25-year bender" for equities could see institutional investors looking for other options, and Justin Dew, senior managing director of strategic development in the New York office of Carmel, California-based Welton Investment Corporation, has the answer, managed futures.
Dew, who has been dealing in this market since 1997, thinks investors looking for greater transparency and regulation, not to mention less risky capital appreciation, should look no further.
FINalternatives senior reporter Mary Campbell recently caught up with Dew and asked him more about the outlook for managed futures.
Welton has suggested that managed futures could make up as much as 63% of a well-balanced investment portfolio. Why do you think investors have been slow to embrace them?
There are a number of answers to that question, I'll start with one. It is quite general, but also very true, and then I'll give you some specifics about why some haven't embraced managed futures.
I used to be a large sized allocator to hedge funds and to this strategy class, and the one thing that I consistently ran into was bad branding on the part of managed futures managers and the CTA industry in general. And what I mean by that is…the tendency for managed futures managers to embrace the image of being black box, being ultra-sophisticated with complex models or strategies that frankly they either refused to describe to the investor or couldn't describe in a way that the investor could understand. So instead they would just say, 'Well, it's very complex, it's mathematically oriented.'…So you had this sense that, well, how can I invest in a bunch of computers that are off doing something I don't understand? How can I possibly explain that to my investment committee? And that’s why, I believe, a lot of very large institutional investors—or for that matter a lot of different kinds of investors—have not historically embraced this strategy class.
The other, more simplistic answer, although I think it's not as prevalent, is that in some cases the investors were simply not allowed to invest in things that invested in futures contracts or forwards primarily because they had these somewhat outdated investment guidelines or mandates.
What do you consider to be the three biggest selling points of managed futures?
True, persistent non-correlation is one. If you look not just at our track record but more broadly across CTA strategies in general (using indices or any other combined performance track records) you will see that over any reasonable amount of time, managed futures are one of only two maybe three strategies in hedge funds that offer true non-correlation. Not only are managed futures uncorrelated to US equities (and you could extrapolate that to foreign equities to some degree), they're also uncorrelated to other hedge fund strategies and that's really where the investment community had a very difficult period, certainly in '08, when everything other than managed futures and macro correlated to US equities and, obviously, that was not a good time to be correlated to US equities.
I'd say second would be combined liquidity and transparency. We talked about how managers simply would hide behind a veil of proprietary models and whatnot, now what we're seeing at a minimum is much more transparency in discussions about how we do what we do, or even going to another level of transparency and offering managed accounts or transparency via a third party… And of course, somewhat related to that is the liquidity of the underlying [investments]. I can't speak for everyone, but in most cases managed futures managers only trade in highly liquid contracts, even in the near months, often the most liquid contracts. Not only are you are you trading in generally liquid contracts like crude oil or interest rates or stock indices but you're even trading, generally, the most liquid contracts of those liquid contracts.
Another tremendously positive component of what, collectively, we do is the fact that other than FX (OTC forwards/currency) transactions, everything we do is exchange rated so there is no credit risk at all…So it's not like we're going out and buying a swap with a counterparty that is relatively unknown to us, or we know who the counterparty is but we haven't done a tremendous level of due diligence relative to the credit quality of that counterparty. Here that's not an issue, because in the vast majority of what we do, your counterparty is the exchange and, of course, the exchange requires margin to be posted which alleviates any concern relative to credit worthiness.
Is a shift from equities to managed futures something you're hoping will happen or something you're already seeing signs of?
No, we're absolutely seeing signs already. Institutions get it. They finally realize that they aren't necessarily diversifying their portfolio by adding emerging markets and small cap equities, that there is a correlation there, and even more profoundly, that simply adding hedge funds doesn't get you the diversification you need. So they're actually having the conversation about managed futures, but even more interesting to me is that they're asking very specific questions now about, 'Well, what makes you different?' Now that tells me that they're taking it to the next step and they're saying, 'Okay, we broadly understand and agree with the premises that you lay out' … so therefore, the kind of logical next step is, which managers do we want to hire to manage our assets on behalf of our pensioners or our retirees or what have you?
In the last 12 months we've added foundation clients and pension clients, but I've been hearing kind of anecdotally that others are starting to see increased business from US and European institutions as well.
What sort of regulations apply to managed futures trading?
We've been regulated by the CFTC [Commodity Futures Trading Commission] for a very, very long time and of course are also held to SEC fraud standards. It's something that we're very comfortable operating under, including audits and occasional visits from the CFTC to make sure that we're indeed doing the things that we state we're doing and we're explaining them properly to the private marketplace that we're soliciting. [However], I ran into one investor recently, it's a large US corporate pension, who said, 'We quite like you, but you need to be SEC registered.' But you can't be SEC registered if the only thing you do is trade futures and forwards contracts… even if you want to be, you can't be.
What is the outlook for managed futures in the near term?
I do expect to see a more broad understanding of and respect for the diversification and correlation benefits that, generally speaking, managed futures strategies provide in the institutional investor space. I do expect to see growth in terms of the portfolio percentage allocation and the dollars allocated to these types of investment strategies going forward, and that’s not just me hoping, that's seeing real dollars being allocated from real, both domestic and foreign institutions (corporate and public pensions, foundations, endowments, etc).
Now even if the equity markets were to absolutely take off and have a tremendous return going forward—which, I guess, could happen—I think we have finally jumped the hurdle that has always existed in managed futures where institutional investors look at the space—almost always following a difficult period in equities—and then don't really do their homework, and then equities come back and then they forget about managed futures. That is not what I'm seeing here. What I'm seeing are real lessons learned regarding true diversification, a commitment to not only understand what these people do in the managed futures area but also a commitment to do due diligence on these firms that actually put money to work in the strategies. I don't think that will change regardless of the direction of the equity market, simply because such powerful lessons were learned in 2008.