Hedge Fund Fail-Mates | Chief Investment Officer

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Two hedge fund strategies failed to keep up with their booming industry last year: macro and managed futures.

Both suffered weak overall performance in 2013, and not for the first time, according to eVestment data. Over the past five years, macro hedge funds have cumulative returns of roughly half the industry average. After fees, managed futures funds haven’t returned anything since October 2010.

But the experts, and more granular data, give strikingly different prognoses for these hedge fund fail-mates.

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“I think that what it boils down to is that 2013 was a very difficult year for both segments,” says Peter Laurelli, eVestment’s vice president of research. “Elevated redemptions at the end of the year showed a combination of money leaving the strategies and money rotating between different funds. For managed futures, it’s more like money leaving; but the macro side, I think, will probably see some investor capital start to come back.”

The hedge fund industry’s total assets under management (AUM) climbed nearly 10% last year. Macro funds’ AUM dropped by 1%, the net result of $9.8 billion in redemptions and $8 billion in investment gains. For managed futures, however, outflows not only surpassed those from macro strategies but were more than double the outflows of all other asset-losing strategies combined. At $143.8 billion, AUM for the struggling sector is at its lowest since 2007. Even the rare managed futures funds with positive performance in 2013 tended to lose investor capital. While investors dumped their commodity trading advisors (CTAs) across the board, they primarily pulled money from those macro managers who had underperformed—assets that may return to the strategy under new management.

“Macro hedge funds are not a homogenous group,” says Francis Frecentese, Lyxor Asset Management’s global head of hedge fund research. “Those who didn’t do well last year tended to have a fixed-income bias.” According to eVestment data, macro equity funds returned over 12% for the year, whereas bond and currency strategies lost 2%. The majority of losses—some later recouped—occurred in June, July, and August, amid a sharp shift in US real interest rates. Risk parity strategies, which fall under the macro umbrella, suffered an uncharacteristic quarter horribilis during this stretch. Several of the typically passive strategies rebalanced—a wise move, according to Frecentese. “The macro managers who really got hurt were not nimble enough or didn’t think that they needed to reposition themselves. The spike in correlations meant the impact spread beyond just the US: Europe felt it, and there was a fairly extreme move in foreign exchange markets. Managers who were positioned more in equities or who had a constructive view on global growth came out the best.”

The roaring stock market may in fact be sparking investor interest in a strategy it has clobbered over the last few years. “Macro hedge funds are a way to get certain exposures that diversify away from equities,” Frecentese explains. “Markets were up 30% last year. If asset owners want to move away from that, macro is one of the places to go. That’s what we’ve been hearing from our clients lately—interest has been healthy.” And how about interest in that other traditional equities safe-haven: managed futures strategies? “Non-healthy.”

CTAs and macro hedge fund strategies first gained traction during the financial crisis as strong performers in adverse markets. When the hedge fund industry as a whole was down nearly 15% in 2008, managed futures strategies were up 11%. Performance has dried up since then, and so too has the strategy’s primary asset base. Commingled funds-of-hedge-funds, once the largest source of capital for both managed futures and macro, have lost their dominant position in the market to institutional funds themselves. While these asset owners continue funding macro strategies via direct investment, the largely systematic managed futures approaches are not proving popular.

For one, strictly quantitative hedge funds are black boxes amid a gathering trend of transparency. Josh Kaplan, head of hedge strategies for $27 billion health care investor Ascension Investment Management, won’t allocate to managed futures funds for that reason. “Managed futures, CTAs, systematic macros—it’s all quantitative and system-driven. When a manager has a bad month, I want to be able to pick up the phone, get an explanation, and understand why my manager is where he is. With quant funds, it’s just because the formula spat out this and that.”

Systematic funds also tend to perform as a herd, Kaplan says, suggesting that one managed futures strategy isn’t all that different from the next. “Every quant manager thinks that they’ve got an edge on everybody else. But the reality is, if you had the secret sauce, you’d have dispersion away from the group.” The three macro strategies in Kaplan’s book displayed serious dispersion last year: One returned nearly 20%, another 5%, and one gained 1%. He remains keen on the macro category.

As much as Kaplan doubts the wisdom of investing in systematic managed futures, he doesn’t see the recent outflows as a harbinger of death for the strategy. “I’d like to think that this really is the downfall of systematic strategies, but my instinct tells me it’s not. These things have ebbs and flows. Money leaves when the formulas are wrong, and it will come back when they start being right.”

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“It takes many good deeds to build a good reputation, and only one bad one to lose it.”

Since Benjamin Franklin uttered these words, there have been innumerable less-wise men wishing they had paid attention—none more so than those in the transition management and asset servicing business who have had financial regulators come down hard on their activities and made them pay for their mistakes.

In December, the US Securities and Exchange Commission (SEC) slapped a $150 million fine on ConvergEx for overcharging clients. (“The mark-ups and mark-downs caused many customers to unknowingly pay more than double what they understood they were paying to have their orders executed,” the SEC said in its ruling.) In February, the UK’s Financial Conduct Authority (FCA) made State Street cough up £23 million for similar offences. (“State Street UK breached a position of trust… caused a significant risk that financial crime would be facilitated.”)

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Both companies admitted there had been “irregularities” and said that these were “legacy” issues, but the affair is not over yet. Tantalizingly, the SEC mentioned an “unaffiliated company” party to ConvergEx’s activity, but has not yet named it. The agency even worked with the Federal Bureau of Investigation on the case—the regulator means business.

On the other side of the Atlantic, the FCA has undertaken a full-scale review of the transition management industry. Few working within the sector avoided an interrogation, and all had been waiting many months for the final analysis, published early February.

It has been a tough and tawdry couple of years for asset servicing. Aside from reputations getting slammed, the landscape has altered dramatically. JP Morgan decided transitions were just not worth the effort—despite the company managing some of the largest asset moves for the biggest clients—while Credit Suisse also threw in the towel on most markets.

Of the 17 companies that signed up to the T-Charter—the industry’s voluntary code of practice—in 2007, just 10 are still standing as independent entities, and only a handful of these are doing any sort of meaningful business. The T-Charter itself has been largely forgotten, and few seem interested in reviving it.

One head of transitions based in the UK said the document had been useful, but only as an educational tool—for suppliers and customers alike—as, without it, the “irregularities” that had been uncovered over the last few years may have remained hidden.

So as 2014 starts, where does the industry find itself? Investors are still moving money, and as unfathomable as it seems to some, the companies implicated in the (well-documented) scandals are still the ones they choose to have do it for them. Regulators have stepped up to reassure investors, and the world continues to turn.

It is not business as usual, however.

New players have thrown their hats into the ring: In September, Australia’s Macquarie bank appointed Credit Suisse veterans Fred Fogg and Lance Vegna to its portfolio solutions group, while insurer Legal & General’s investment arm has been quietly ramping up transitions work using its passively managed portfolios.

The “original” companies that weathered the storm have found it necessary to adapt, according to Lachlan French, global head of transition management at BlackRock.

Investors have become more demanding, not just about transparency of pricing and measuring the end result against estimates, but for what they expect their transition managers to be able to do. “We have expanded our product range,” says French. “We have gone from transitioning just core assets to illiquid securities and dealing with a larger range of alternative investment managers.” He also notes that increasing investor sophistication has required boutique asset managers to rapidly learn the transition management ropes. Geographical diversification of portfolios, increased volatility in markets—and the fear of a counterparty going “pop”—has also led transition managers to expand their trading partner pool, French says.

Investors are more able to keep an eye on what is going on, too. The advent of CIOs having real-time access to data has meant providers have had to keep pace and upgrade their own systems.

And let’s not forget defined contribution (DC). Transition managers’ parent companies—be they investment banks, asset managers, or custodians—have finally embraced the notion that DC pensions are the future. Transition managers, although not immediately a natural fit for the sector, are realizing that they must adapt to this “new normal,” too. Pooled funds, platforms, and unit-holding investors might not be a native hunting ground for transitions teams, but like the rest of their industry, they will have to get used to the idea and run with it.

Therein lies the irony: What a shame it would be for the industry to survive a raft of reputation-damaging scandals only to be killed off by a failure to evolve.