Next time you’re thinking about investing in a hedge fund or managed futures account, you may want to check with your grandmother. Explain what you’re about to do, and if she understands what you’re talking about, you may be on to something.
Altegris Investments, a brokerage firm in La Jolla, California, that specializes in sourcing alternative investments for its high-net-worth and institutional clientele, uses “the grandmother test” when conducting due diligence on hedge fund and managed futures products it is considering recommending to clients as investments. “We like to have managers describe their strategy to us as they would describe it to their grandmother–no offense to grandmothers,” says Executive VP Matthew Osborne, the firm’s CIO. “If you can’t describe to me in layman’s terms what edge you have and what anomaly, or market inefficiencies, you are trying to exploit, how would you expect me to describe that to my clients?”
RIAs and investors in alternative investments apply various tests to evaluate prospective managers; this article will touch on some of these. A previous article in this series explored the reasons RIAs use alternative investments (April 2007, “Plotting Your Course“), while a second article focused on some of the ways advisors gain exposure to private equity, managed futures, and hedge funds for their clients (September 2007, “Getting In“).
For Altegris, there is a great deal of commonality between hedge fund and managed futures due diligence. The firm’s grandmother test is part of the three Ps that encapsulate its approach to investing: pedigree, process, and performance.
Pedigree refers to the professionals involved at a hedge fund or managed futures trading advisory firm, their backgrounds, their expertise, and the kinds of people they are. “When you invest in either a managed futures program or a hedge fund, you should look at that in the same way you think about investing in a business,” says Osborne. “It’s not just track record that you’re buying because past performance is not indicative of future results. You really want to invest in the business.”
Is the business a going concern? Would you want to be in business with the principals in five years’ time? Also very important, do the people involved want to be in business with each other in five years’ time?
Osborne says questions about process are similar for managed futures and hedge funds: Is the manager’s approach to the markets repeatable and robust going forward? This is where the grandmother test comes in. “It’s important that the strategy can be articulated in a clean and concise manner, and then that that articulation can be demonstrated. Oftentimes, that means sitting in the office alongside the managers as they execute on their strategy.” He adds that investors should speak with references, and with other people who might be invested in the product, to get a feel for whether the managers execute their strategy as they say they do.
The analysis of historical performance data is useful to the extent that it provides a quantitative framework for comparing managers to their peers or to suitable benchmarks, says Osborne. That comparison will consist of not only the absolute returns, but also the pathway the manager took to getting there; i.e., the volatility of returns. The comparison of these historic risk-adjusted returns can be relevant for peer-to-peer analysis.
Analysis of correlations (ideally, the lack of it) between managers and against benchmarks can assist with portfolio construction when combining multiple managers into a single portfolio.
“However, we believe that isolated quantitative analysis of historic return streams is flawed, if it is not combined with qualitative analysis of market conditions and the attribution of returns,” says Osborne. He says the ultimate goal of analyzing historic performance is to determine whether luck or skill was the predominant factor in producing those returns. Does the manager’s investment process create a likelihood of repeatable returns?
Managed Futures Due Diligence
Today, many managed futures trading advisors engage in quantitative trading, also known as algorithmic-based trading. A number of these are considered “black box” strategies, which means the advisor is reluctant to reveal what he considers proprietary information about his trading model. Through its research, Altegris has learned much about the construction and what’s required for a robust managed futures quantitative strategy, says Osborne.
Specifically, many managed futures strategies are trend following in nature. Altegris wants to know what timeframe the trend following is trying to exploit. What are the data inputs to the algorithmic systems? Is it just price and time? If so, how far is the look-back period the manager is using to apply to the algorithm? Derivatives of price and time, such as moving averages, are very common.
Asking about how a quantitative system was backtested can generate interesting information about the model, says Osborne. An off-the-shelf program to conduct backtesting may not be as robust as an internally designed C++ program, for example. Then it’s a matter of looking at the system, at the platform, and seeing the inputs/outputs. That still leaves a lot of proprietary algorithm in the hands of the manager, he says, and many times that is all right.
Not all trading advisors are quantitative and black box. Many are discretionary traders, who base their trading decisions principally on supply and demand. (It’s important to note that discretionary traders often rely on computer tools to determine the timing of their trades.)
With discretionary traders, the people factor is perhaps more important than the process factor, says Osborne, because the investor is betting on the advisor’s ability to trade. Also important, says Osborne, is assessing the discretionary trader’s ability to manage an increasing level of assets if he’s successful. Moreover, even if he was successful managing large sums at a bank, for instance, did he understand the monthly rate-of-return objective that many managed futures and hedge fund investors have, or was he managing to a dollar-profitability objective?
Hedge Fund Due Diligence
With assets flooding into hedge funds from a wide variety of investors in recent years, a manager’s business operations, in addition to his strategy and performance, have become a major focus of due diligence. Operational concerns have grown in importance as hedge funds have proliferated worldwide (best-guess estimates put the number at upward of 8,000 funds).