Alternative Investment Management Association Representing the global hedge fund industry
AIMA/S3 study on Basel III impact
AIMA has published a member survey on how the cost and availability of financing is being impacted by Basel III. The survey is short and straightforward and will take you no more than 20 minutes to complete. You will be able to view the results later this year when AIMA and S3 Partners publish a research paper on the findings. Access the survey here.
The survey looks at:
o How prime brokerage and financing relationships have changed over the last two years and the reasons for this, covering both cost and nature of service
o How hedge fund managers expect these relationships to evolve further in the coming years as Basel III rules bite
o How the hedge fund industry understands some of the key concepts that underpin banks’ response to Basel III, from “optimization” to “collateral management”
All questions in this survey are fully optional and it is open to any hedge fund manager to complete regardless of whether you are an AIMA member or S3 Partners client. The survey should be completed by an individual within the firm who is familiar with your prime brokerage and financing relationships. For further information, contact Adam Jacobs.
EU – AIMA response and ESMA reports on the EMIR Review
Last week AIMA submitted a response to the European Commission consultation on the EMIR Review. The response set out AIMA’s central positions on possible changes to the EMIR framework as part of the formal review of EMIR currently being undertaken by the European Commission. Among other things, the response called for: (i) the availability of third-country equivalence under Article 13 of EMIR for transactions involving at least one counterparty ‘subject to the rules of’ an equivalent third-country jurisdiction; (ii) the replacement of dual-sided reporting with a robust single sided mechanism; (iii) the abolition of the frontloading requirement currently contained within Article 4(1)(b)(ii) of EMIR; (iv) the development of a fast-track process for the suspension of the EMIR mandatory clearing obligation; (v) an alternative mechanism for direct access to CCPs rather than as a formal ‘clearing member’; and (vi) the swift removal of issues currently experienced around the definition of an ‘OTC Derivative’ under Article 2(7) of EMIR. In addition to industry feedback relating to its consultation, the European Commission last week received four reports published by ESMA on the functioning of the EMIR framework. Three of the reports, required under Article 85(3) of EMIR, cover: non-financial counterparties; pro-cyclicality; and the segregation and portability for central counterparties (CCPs), respectively. The fourth report responds directly to the European Commission’s EMIR Review and includes recommendations on amending EMIR in relation to: the clearing obligation; the recognition of third country CCPs; and the supervision and enforcement procedures for trade repositories. Of particular interest to AIMA are ESMA’s calls for the Commission to provide for the suspension of the clearing obligation upon particular market conditions, as well as the abolition of frontloading and an entire rethink of the EMIR equivalence and recognition process for CCPs.
The European Commission will now use the consultation responses and the ESMA reports to assist in the compilation of a final report that the Commission will submit to the European Parliament and European Council. If members have any questions or comments, please contact Oliver Robinson or Adam Jacobs.
US - SEC Division of Corporate Finance Interprets “General Solicitation”
The Securities and Exchange Commission’s Division of Corporation Finance has recently updated its interpretations related to the scope of the term “general solicitation” as used in SEC Rule 506 of Regulation D under the Securities Act of 1933. These interpretations confirm and reiterate many previously existing views and include some new flexibility around the communications and activities that could be undertaken without being deemed a general solicitation. The interpretations also provide further guidance on the concept of “pre-existing substantive relationships”. If you have any questions in relation to this, please contact Jennifer Wood.
EU – European Commission responds on Article 13 equivalence
The European Commission has responded to the Joint Trade Associations letter AIMA sent alongside a number of other trade associations on 22 June 2015 positing questions on a number of issues around equivalence under Article 13 of EMIR and Article 33 of MiFID. Jonathan Faull of the European Commission, responding on behalf of Commissioner Hill, has confirmed that the wording of Article 13 of EMIR does require at least one counterparty to a trade to be established in an equivalent third-county in order for the transaction to benefit from equivalence of third country clearing, reporting and risk mitigation rules. The response letter also confirms that the European Commission may move ahead with an equivalence determination under Article 13 on a rule-by-rule basis, rather than requiring a single holistic determination of the equivalence of numerous third-country requirements. If members have any questions, please contact Oliver Robinson or Adam Jacobs.
Luxembourg - FATCA deadline postponed to 31 August 2015
On 31 July the Luxembourg tax authority (‘Administration des contributions directes’) issued a circular granting the exceptional extension of the deadline from 30 June to 31 August 2015 for FATCA reporting in Luxembourg. According to the Intergovernmental Agreement (“IGA”) on FATCA signed between the USA and Luxembourg as well as the Luxembourg regulations implementing the relevant provisions this Agreement, each Luxembourg Reporting Financial Institution will have to file a report to the Luxembourg tax authorities prior to 30 June of each year. This report will have to include each US reportable account and must be done in a specific format defined by the circulars issued by the Luxembourg tax authorities. If you require further details please contact Paul Hale or Enrique Clemente.
Global – IBA seeks stakeholder views on proposed changes on LIBOR administration
ICE Benchmark Administration (IBA) has been in touch with AIMA in relation to its work on the evolution of ICE LIBOR to a transaction-based rate, in line with the recommendations of the FSB. IBA recently released a Second Position Paper for which it is seeking feedback from all stakeholders who may be impacted by changes in calculation methodology for LIBOR. A questionnaire is available on the IBA website, to which the latter will be accepting responses until Friday 16 October 2016. If you have any questions, please contact Andrew Hill.
Global – OECD takes further steps for implementing automatic exchange of information
On 7 August, the OECD released three reports to help jurisdictions and financial institutions implement the global standard for automatic exchange of financial account information. The first publication is a Common Reporting Standard Implementation Handbook (here), which will provide practical guidance to assist government officials and financial institutions in the implementation of CRS, and to help promote the consistent use of optional provisions or identify areas of alignment with FATCA. The Handbook is intended to be updated on a regular basis. The other OECD publications are an updated edition of the report on Offshore Voluntary Disclosure programmes (here) and a Model Protocol to Tax Information Exchange Agreements that provides the basis for jurisdictions wishing to extend the scope of their existing TIEAs to also cover the automatic and/or spontaneous exchange of tax information. If you require further details please contact Paul Hale or Enrique Clemente.
India - Minimum Alternative Tax (MAT) – Shah Committee Report and Castleton appeal
On 24 July, the Shah Committee submitted its report on the MAT, which has not been made public by the Indian Government. AIMA submitted a written representation (here) to the Committee on 22 June, arguing that the MAT provisions should not apply to Foreign Portfolio Investors (FPIs) for years prior to 1 April 2015 (the position from that date has been clarified by legislation). We understand that the report concludes that foreign investors are not liable to MAT for that period. However, the report seems to be silent on the position of foreign companies that are not FPIs or Foreign Institutional Investors (FIIs) because its terms of reference as framed by the Finance Ministry did not mandate the Committee to review this aspect, even though many of the MAT dispute cases concern such foreign companies. Given its relevance, the Indian Supreme Court has decided to adjourn to 29 September 2015 the Castleton case appeal hearing so that the court may consider the Shah Committee report. If you require further details, please contact Paul Hale or Enrique Clemente in London, Heide Blunt in Hong Kong or Merima Arleback in Singapore.
EU - ICMA study on evolution of European repo market
ICMA has approached AIMA regarding a study that it is conducting into the current state and future evolution of the European Repo Market. The study will be largely qualitative and based on interviews with a broad range of market participants, including repo trading desks, buy-side users of the product, voice and electronic intermediaries, infrastructure providers, as well as central banks and DMOs. The resulting report is envisaged to be similar in format to the 2014 ICMA study into the European Corporate Bond markets.
If you would be happy to be interviewed for this project, please contact Andy Hill at ICMA. Interviews can be by phone, and should take between 30 and 45 minutes. Ideally ICMA would like to interview the main person(s) responsible for the firm’s European repo/funding activity. All responses are anonymized and will only be presented in aggregate. All participants will also have the opportunity to review the draft report before it is published.
Citigroup Alternative Investments
Managed futures (or CTAs) is an alternative investment strategy characterised by its ability to take either long or short positions efficiently in a wide variety of global markets; by historically low correlations to both traditional and other alternative investment strategies; and by the potential to provide portfolio diversification.
In a fully diversified portfolio, any allocation to managed futures is determined by their potential for enhancing returns, reducing volatility and reducing downside risk.
In this paper, we discuss one aspect of managed futures returns: time-varying and market-varying correlations. We argue that one way of conceptualising managed futures is as an imperfect straddle on the equity markets—one with a higher average return but imperfect hedging.
Managed futures expressed as excess returns to cash
Because managed futures are an active asset management strategy with only a limited correlation to other asset classes, we believe their historical returns and potential future returns can be meaningfully expressed as excess returns to cash.
To demonstrate this, we first break down managed futures1 exposures into a market component and skill component. Beginning with a universe of 33 possible market exposures from 1990 to 2004 that include currency markets, correlations, volatilities, long market exposures, yields and spreads, we use forward stepwise regression to identify the most relevant market exposures in managed futures.
Our analysis shows that the index had a negative exposure to movements in the dollar relative to a broad basket of global currencies. Consistent with the basic managed futures strategy of trend following, the data also indicate a positive relationship to momentum factors—in other words, the managers tend to buy securities which have recently risen in value and sell those that have recently lost value. There is a negative exposure to convertible bonds, which results from a combination of exposure to equity markets, bond markets and the optionality implied in convertible bonds. Finally, there is also positive exposure to US investment grade bond markets, with their characteristically inverse relationship to interest rates.
Figure 1: Historical Market Exposures
Source: CISDM, HFR
Data Period: 1990 to 2004
Perhaps most importantly, our model explains only 19% of the variation in managed futures returns. The remaining variations in performance cannot be attributed to measurable factors and, as is customary in financial economics, are attributed to the skill or choices that active managed futures managers apply in their trading strategies. What this means, in general, is that managed futures have largely been independent of market factors, a result that implies that broadly, managed futures returns are probably best expressed as a spread to cash.
Managed futures’ historical correlations
One potentially attractive aspect of managed futures is a relatively low level of historical correlation to traditional and alternative asset classes. For example, from 1980 to 2004, the correlation between the CISDM dollar-weighted managed futures index and the Russell 3000 was –0.03; the correlation between the CISDM and the Lehman Aggregate Bond Index was 0.07; the MSCI EAFE index –0.05; and the Goldman Sachs Commodity Index –0.01.
Another important characteristic of managed futures is that the characteristics of returns are not constant. In Figure 2, we show the 36 month rolling returns over cash, the 36-month rolling correlation to equity, and the 36-month rolling volatility for managed futures. Notably, both returns and volatilities appeared to be dropping over this period, although both have begun trending upward again. In addition, the correlations, while generally low and negative 60% of the time, exhibit substantial variation, ranging between –0.4 and 0.4 over the period.
Figure 2: Rolling Risk, Return and Correlations of Managed Futures
Resemblance to Equity Straddle
While the correlations are clearly time-varying, are these movements in the correlation dependent on identifiable factors? From a portfolio perspective, in other words, do managed futures correlations change in different market situations?
To analyse this question, we discard traditional regression methods that would relate managed futures to market factors via a linear relationship; that would imply that their correlation is constant.
Figure 3 shows the monthly returns of the Russell 3000 index versus the monthly returns of the CISDM managed futures index. To study varying correlations, we use a method called local regression. Unlike traditional ordinary least squares regression, this method emphasises those points that best help determine the relationship between managed futures and equity markets conditional on the level of equity returns; in other words, it does not force the correlation to be the same over the entire set of cases, but allows it to vary if such a relationship exists in the data. This regression is indicated by the small red dots in Figure 3.
Figure 3: Managed Futures and the Equity Market
Note: The local regression is calculated assuming a span of 30% and the distance function is Euclidean distance, The RMSE of the regression is 4.61%. Returns are total returns. The straddle includes buying one call and one put options of equal exercise and expiry.
Source: CISDM, CAI, January 1980 to November 2004
Figure 3 indicates that managed futures have historically possessed the rather attractive feature of positive correlation during rising equity markets and negative correlation during falling equity markets. As a result, managed futures have given investors positive benefits during periods of market declines. These benefits have been felt most when they are needed most and may serve to reduce possible downside risk. To put it another way, on average, the correlation of managed futures to the equity market has tended, over time, to be slightly negative. When equity markets have been in decline, however, the relationship has decreased even further, thus offering additional diversification when it is needed most.
The straight gray lines in Figure 3 indicate the payoff associated with holding a straddle (equivalent to holding both a long put and a long call option) on the equity market. Interestingly, the managed futures’ historical payoffs, as indicated by the red dots, are very similar in shape to such a straddle. The difference is that whereas managed futures returns are on average positive (even when there is no movement in the equity market), for a straddle the investor pays an option premium indicated by a negative payoff when the equity markets do not move.
This result raises two questions. First, why does such a relationship exist in the data? And, second, from a portfolio perspective, what are the implications?
With respect to the first question, one possible explanation has to do with the nature of the managed futures strategy. Because managed futures managers are generally trend followers, they need the markets to move in order to generate returns (in other words they are long volatility). If the markets are totally flat, there will be no trends. By contrast, if the markets are moving in a consistent manner, managed futures managers may capture value. Since managed futures managers can go both long and short, then, the direction of the moves is not as important as the fact that trends exist. Thus, consistent with our analysis, managed futures have tended to perform better given sustained moves in either direction, with larger volatility leading to larger returns.
From a portfolio perspective—the second issue we raise above—the question for investors thus becomes2: which has been better as a potential hedge against downside risk: buying a straddle directly or investing in managed futures? The answer to this depends on the tradeoffs between risks and rewards.
On the one hand, managed futures may generate a positive expected excess return, as we discussed above3. This can be compared to a straddle on the equity market, which requires investors to pay an option premium. Conversely, even a cursory inspection of Figure 3 indicates that, whereas a straddle is a precise hedge—in other words, it has exactly the property of increasing returns in both down and up markets, managed futures are not. Instead, while managed futures has generated on average straddle-like payoffs and a positive expected value, in some cases of either down or up markets, this relationship will be inexact because moves in managed futures do not exactly match those in the equity market. The choice of which, if either, will depend on the specific objectives of the investor.
In sum, a main way in which managed futures may add value to a portfolio is potential downside protection produced when markets are not performing well because, in contrast to traditional markets, managed futures have in the past performed well in unstable and uncertain times.
Author’s note: this paper draws heavily on a longer Citigroup Alternative Investments whitepaper: “Managed Futures and Asset Allocation,” 2005. Author order is alphabetical and does not reflect contribution to the paper.
1 - Rui de Figueiredo is a research consultant to Citigroup Alternative Investments. He is also Associate Professor at the Haas School of Business, University of California at Berkeley.
2 - As indicated by the CISDM Managed Futures Index.
3 - Past performance is no guarantee of future results
4 - We use the excess return of managed futures here because unlike a straddle, managed futures investments require cash investments (or borrowings). This means that if we compare the two, we must account for this difference to account for any opportunity cost in investing capital.