Sunday, 28 December 2014
Last updated 3 days ago
Oct 7 2011 | 12:05pm ET
World Finance magazine recently named Los Angeles-based Shinnecock Partners the Best Managed Futures CTA Fund in North America. Alan Snyder, founder and managing partner of Shinnecock Partners, started his Los Angeles-based fund 18 years ago but has only recently decided to market it to outside investors. He spoke with FINalternatives recently about that decision, the “über-principles” that guide Shinnecock’s investment process and the joys of managed futures.
Tell me something about the origins of Shinnecock Partners.
I started the fund 18 years ago after a 14-year stint at Dean Witter, which merged later with Morgan Stanley. While there, I was one of 12 EVPs with responsibility for many of the product areas and all of the marketing. The role was really entrepreneurial, which meant building products, departments and, lastly, the Discover Card.
Wanderlust set in to be more independent, and I left. The driver to start Shinnecock Partners was the belief that most investment managers seemed too casual about risk and were frequently more focused on fees than performance. Therefore, needing a place for my savings and not having enough on my own, I rounded up some friends to join me in a “friends and family” fund.
Futures were compelling. Having been brainwashed at Harvard Business School about their power to lower risk and increase returns when I was a young and malleable student, a fund of funds of futures managers was a natural result, particularly with the tax treatment they offer for taxable investors. No doubt foolishly, we never marketed the fund until this January. We decided that being bigger, but not humongous, would increase the returns further, notwithstanding its attractive history. Hopefully, that sounds like enlightened self-interest since we are joined at the hip with our investors.
You say the fund is differentiated from its competitors by your investment process, what can you tell me about that?
Our investment process is driven by three tasks: We scour the world for the best managers. We construct a portfolio of those managers, carefully interlacing them together using the principles of modern portfolio theory. We manage the resulting portfolio through time.
Steps one and two must be interactive. Interestingly, the absolute return and risk profile of a manager is not the sole factor. The critical ingredient is the pattern of returns and how each manager interacts with the others so that that overall combination delivers the most consistent returns and modest volatility, which is our objective.
Guiding all of our efforts are a series of über-principles, like protecting capital, being flexible and being wary of highly leveraged strategies, to name a few.
You also cite “super diversification” as a Shinnecock principal, what do you mean by that?
Diversification by asset class is one vector. In the futures space, as funds become very, very large they have a tendency to become concentrated in financial futures, undermining, we think, some of the power of the class. Ergo, we work hard to have a balance between tangible commodities, currencies and financial futures.
We also diversify by manager—the human factor is real. I can give you lots of examples but I think of one in particular. A manager’s returns had been very good but had become exceptionally good versus his normative behavior. I asked him what did he attribute this change to, because we were concerned that he was having strategy drift and was taking on new risk. He said that his new blushing bride, 25 years younger than he, was a ballet dancer and that she had given him an entirely new perspective on investing. I congratulated him on his new marriage and said that his ballet dancer and her thoughts were not what had made him so talented and that we were going to withdraw. His performance deteriorated sharply thereafter, but there is a happy ending. After three years, when, I gather, the bloom was off the rose, he reverted to doing quite well.
We believe in the power of diversification among people and their firms. In the futures space, if you look at the dispersion of returns among managers even with ostensibly the same strategy, in any given year, it’s really significant. For example, looking at the data at Barclay Hedge over the past nine years, the difference between the best-performing futures managers in any given year and the worst can be as much as 350%. While our own managers’ performance does not demonstrate this wide of a spread, having a mix can dampen out some of the volatility.
Another key diversification vector is by strategy. We’re chickens at heart. Our goal is to grind out a reasonable rate of return, yet frequently funds of funds in the futures space get very concentrated with trend followers. Trend followers are like the little girl with the curl: When she is good, she is very, very good and when she is bad, she is horrid. Yes, we have a number of trend followers, but we also balance them with fundamental managers, of which there are two types, discretionary and systematic. Fundamental managers use macro and micro economic analyses to establish their trading, whether by human judgment (discretionary) or algorithmic trading (systematic). The third category, which I would describe as “all other,” is a blend of pattern-recognition, counter-trend, momentum, etc., that is to say an eclectic grab bag of different strategies.
Yet, another diversification vector is average trade duration for a manager. We bucket managers by how long they hold an average trade, whether from seconds to years. In other asset classes, this can be extremely tax inefficient, generating short-term capital gains taxed at ordinary income rates for positions held less than a year.
You say the taxation of managed futures allows for further diversification, could you explain this?
Futures have a most unusual tax treatment which I think is extraordinarily favorable for any taxable investor. For a regulated futures contract or for a Forex contract through special election, it’s 60% long-term, 40% short-term capital gains regardless of holding period. Thus, an investor could have a regulated futures contract, hold it for one nanosecond and whatever the gain or loss, the taxation is 60% long, 40% short. We believe it’s important to manage how much cash you have in your jeans after taxation. A lot of hedge funds, of course, fly around in the markets, but if it’s all short-term capital gains, given the current tax structure, their returns have to be off the chart to make up that tax delta.
How do you evaluate the performance of your managers?
Carefully, with hard work. Market mispricings, imperfections, opportunistic anomalies disappear over time and a manager or a strategy (particularly a manager) may garner some unbelievable insight into something and trade that insight or even create a whole program around that insight, but often, when that imperfection gets picked up by the rest of the market or the market simply shifts, the frog is unable to hop to the next lily pad and ends up in the drink. We’ve found over the last 30 years that the average half life of a futures manager is about four to five years. That means that it’s important to create a of tool kit to evaluate whether there’s strategy drift or the manager is not able to make the hop to the next lily pad.
We’ve found that one of the most significant things, if the initial homework is good, is how a particular manager is doing compared to themselves. We use statistics to evaluate whether the manager’s returns are within their normative range and when they are not, whether it’s on the upside or the downside. If the manager performance is abnormal then our monitoring of them becomes more intense.
Another tool we use is tracking, through third-party sources independent of the money manager, their monthly change in assets under management. We break it down two ways: changes due to performance, and changes due to additions/withdrawals. Clearly, if a manager is growing like a weed in the spring and pantloads of money are coming into their clutches, can they really absorb that money? Can a manager absorb the huge increase in capital or is it sitting stagnant, or are they trying to deploy it anyway, thereby increasing risk?
How many managers are you invested with now?
Some people believe that you should have as many as 50 managers in a fund of funds. We strongly disagree. Our preferred range is from 12 to 18 and, maybe it sounds harsh, but if the ones that are on the bottom stay on the bottom, and there’s no discernable explanation, we will part company with them.
How do you ensure against fraud?
All protections against fraud are imperfect, but we work hard to try to dodge those bullets. The best protection is quality people because they’re the most enduring safeguard. However, I would hasten to add that we believe that poor performance is the higher risk. Even in some of the worst frauds there are significant recoveries, but poor performance can be crushing with no chance of recovery. I think of a bullet we dodged with a manager using an options-based strategy which had no real deep understanding of the risks they had in the portfolio. They did great for three years, money poured in, then they lost 84%, and it wasn’t a fraud -- it was just that there were a number of years where the risk was masked.
Why managed futures? What is the benefit of managed futures in your portfolio?
Let me answer it with some statistics about the futures category, from the CISDM managed futures index. Over the last 20 years, managed futures has generated a 44% higher return than the S&P 500. In the past five years, the average futures manager generated roughly an 11% return, while the S&P generated a 0.2% return.
Now, a cynic might say, ‘Well, returns are nice but, what’s the correlation?’ The correlation between managed futures and the S&P over the past 20 years is effectively null, negative 0.03, which a statistician would say is just noise, there’s no correlation. Over the past five years, it’s negative 0.01.
The standard quotation when I was growing up in the business was, ‘95% of the individual investors speculating in futures, lose money.’ I think that’s probably true. It’s frequently because individual investors use way too much leverage. In our case, we have always sought to avoid highly-leveraged managers.
Managed futures have had a tendency to be like a giant shock absorber versus other markets, particularly stocks. Looking back in time at almost every major crunch in the equity market, managed futures usually did quite well as a delightful counterbalance. It’s not just the absolute rate of return that counts, because there are other strategies that have had higher returns than managed futures if your timing is right and you pick the right people, etc. Again, it’s the pattern of returns -- modern portfolio theory is right. I think that’s why the futures category is coming out of the closet and is becoming gradually more accepted.
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