Liquidity, Transparency and Technology“Liquidity is the first line of Defense.” - Daniel MacDonald, CFA, Portfolio Manager, Alternative Investments Ontario Teachers Pension Plan 6 102309CA
Liquidity Matters – Pure & Applied Techniques in Liquidity Management Managed Accounts and Managed Futures: Why Many Pensions Are Insisting on Them National University of Singapore (Institute of Mathematical Sciences & Risk Management Institute) – Workshop on Stochastic Control Problems Presented by: Dr. Ranjan Bhaduri, CFA, CAIA Managing Director, AlphaMetrix Alternative Investment Advisors, LLC Head of Research, AlphaMetrix, LLC Date: Friday, December 18th, 2009.
1 This presentation is solely for informational and discussion purposes only. These materials do not constitute an offer to sell or the solicitation of an offer to buy or sell interests in any financial instrument or any product. Any offer for any investment product will be made solely by a confidential offering memorandum. Information contained herein is confidential and may not be reproduced in any format. 102309CA
Agenda
The Interplay between Liquidity, Transparency and Technology Managed Accounts – What One Should Know The Role of Managed Accounts in an Institutional Portfolio Lintner Revisited – Managed Futures 2 102309CA
Liquidity, Transparency and Technology
Liquidity, transparency and technology are interrelated Investor may be invested in a fund vehicle that offers favorable liquidity terms, but: Lack of transparency leaves the investor vulnerable to Style drift Concentration risk If a blowup were to happen for any of these reasons, the investor could still redeem afterward, but would have to do so after incurring a significant loss 3 102309CA
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Liquidity, Transparency and Technology
Liquidity and model risk and entangled No model is perfect Financial modeling and measurement of risk complicated by valuation of illiquid instruments Infrequent pricing obscures relationship between price and the variables used in the valuation model Often results in hidden risks During a “fire sale” or crisis event, the seller may be forced to accept a deep discount in price to exit an illiquid position Model risk is significantly magnified as a result 4 102309CA
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Liquidity, Transparency and Technology
“You can check in, but you can’t check out.” (Lock-ups, Gates, Side Pockets, Exit Fees) 5 102309CA
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Liquidity, Transparency and Technology
“Liquidity is the first line of Defense.” - Daniel MacDonald, CFA, Portfolio Manager, Alternative Investments Ontario Teachers Pension Plan 6 102309CA
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Liquidity, Transparency and Technology
Know Model Risk “Nothing at MIT had ever reminded me of my lab at home. I suddenly realized why Princeton was getting results. They were working with the instrument. They built the instrument; they knew where everything was, they knew how everything worked.” - Late Nobel Laureate Richard Feynman on why Princeton’s cyclotron was getting better results than MIT’s. 7 102309CA
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Liquidity, Transparency and Technology
“Transparency is the best antiseptic.” Aleks Kins, President & CEO of AlphaMetrix 8 102309CA
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Liquidity, Transparency and Technology
Transparency, however, can be elusive… 9 102309CA
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Liquidity, Transparency and Technology
Transparency via managed accounts comes in the form of large amounts of data Must be parsed Must be cleaned and verified Multiple sources and formats (i.e., different prime brokers/FCMs) Trade information and market prices are constantly changing Reconciliation with administrator and trading manager Technology allows investors to synthesize the information transparency provides so that they can unlock the value of liquidity 10 102309CA
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Separately Managed Accounts - Overview
A separately managed account is an investment vehicle through which an investor opens an account at a prime broker or futures commission merchant in his or her name and provides a trading manager with limited power of attorney to trade the account on his or her behalf in exchange for a fee. 11 102309CA
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Separately Managed Accounts - Overview
Primary strengths Liquidity is controlled by the investor No lockups, gates, side-pockets, or suspension of NAV Transparency of positions Facilitates ongoing monitoring and due diligence Concentration risk, style drift Custody or control of assets Cash is not wired to the trading manager but remains at prime broker or FCM Provides the investor with operational control and reduces the role of the manager to trading Allows for efficient funding of investments 12 102309CA
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Separately Managed Accounts - Overview
Given these obvious strengths, why have separately managed accounts only become popular recently? Financial crisis of 2008 exposed: Liquidity mismatches Gates, lockups, suspension of redemptions, side pockets Fraud Concentration/blowup risk Style drift, strategy drift 13 102309CA
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Separately Managed Accounts - Overview
Challenges to investing via separately managed accounts: Minimum investment is often quite high Often difficult to negotiate; legal costs can be high (Trading Advisory Agreement) Potentially unlimited liability – margin calls Technology necessary to harness data to make use of transparency Operationally difficult to manage Investor must perform middle and back office functions Trade reconciliation, often with multiple counterparties Accruals of fees and expenses Negotiate brokerage commissions Negotiate ISDAs for over-the-counter instruments 14 102309CA
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Managed Account Platforms – A potential solution?
Managed account platforms offer investors a variety of structures and formats: Pooled managed accounts Hybrid managed account/fund structure May offer investors superior liquidity and transparency Third-party custody and control Turnkey access to trading managers Separate structures Investor utilizes platform to consolidate operations Data aggregation and risk monitoring Potential weaknesses Selection of managers (biases and quality) Extra fees Tracking error 15 102309CA
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Comparison of Managed Accounts, Funds and Managed Account Platforms: Institutional Investors’ Perspective
Fund Investment Separately Managed Account Managed Account Platform Convenience Yes No Yes Limited Liability Yes No Yes - If Pooled Liquidity Varies Superior Varies Ability to Liquidate Positions to Protect Investor No Yes Yes Transparency Varies Full Varies Custody/Control of Assets Manager Investor Third Party Investment Minimum Low High Low Operationally Complex No Yes No Tracking Error None Yes Yes Extra Fees (No) No Yes 16 102309CA
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Lintner Revisited
Dr. John Lintner Ph.D., Harvard University One of the co-creators of the Capital Asset Pricing Model Presented “The Potential Role of Managed Commodity-Financial Futures Accounts (and/or Funds) in Portfolios of Stocks and Bonds” at the Annual Conference of the Financial Analysts Federation in Toronto in May 1983. “Indeed, […] the return/risk trade-offs provided by augmented portfolios consisting partly of funds invested with appropriate groups of futures managers (or funds) combined with funds invested in portfolios of stocks alone (or in mixed portfolios of stocks and bonds), clearly dominate the trade-offs available from portfolios of stocks alone (or from portfolios of stocks and bonds). [Lintner, pages 105-106] 17 102309CA
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Lintner Revisited
Objectives of “Lintner Revisited: A Quantitative Analysis of Managed Futures in an Institutional Portfolio” Revisit Dr. Lintner’s analysis of the role of managed futures in institutional portfolios to see if his insights remain true 25 years later Apply techniques previously unavailable to Dr. Lintner, such as the analysis of Omega functions Re-introduce Managed Futures as a group of liquid transparent hedge fund sub-strategies which trade global exchange-traded futures and deep liquid FX forward markets and do not tend to exhibit correlation to traditional or alternative investments Dispel some commonly held misconceptions about managed futures Provide an overview of some more common strategies employed by CTAs Explore the tendency of managed futures investments to perform well during market dislocations Discuss some of the unique benefits managed futures offer institutional investors 18 102309CA
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Managed Futures - Overview
Hedge Fund – A managed portfolio that may trade long and short, employ leverage and is generally not subject to restrictions in terms of investment strategy or the types of instruments traded. Mutual Funds Private Equity 19 102309CA
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Managed Futures - Overview
What is Managed Futures? A group of liquid transparent hedge fund sub-strategies employed by professional money managers who trade a diversified mix of liquid global markets utilizing futures, forwards and options on the foregoing Instruments tend to be exchange-traded; no valuation or accounting issues 20 102309CA
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