By Andrew Beer
Special thanks to AQR.
Why? Because it manages one of the few honest managed futures mutual funds out there. AQR has made the bet that if you offer investors a good deal—a managed futures mutual fund (AQMIX) with a very reasonable (1.21 percent) expense ratio—they will flock to it; and flock to it they have. Assets were recently over $12 billion.
What a shock this must have been for many of the other mutual fund companies. “Fair fees” and “managed futures” have been the investment equivalent of an oxymoron. Remember, this is an industry that got away with charging 4 percent management fees in the 1980s. A few years ago, Bloomberg published a great article that showed how fees ate up 89 percent of every dollar made by managed futures mutual funds. One shocking example: a bank was charging trading costs of 4.6 percent to 6.0 percent per annum—cleverly buried deep within its regulatory filings—that never showed up in the expense ratio. No wonder many investors have “mixed” feelings about the whole space.
There are still remnants of this fee gouging bad behavior, and AQR’s rise has driven the worst offenders underground. But first, a little background. There are two types of managed futures mutual funds: directly-managed and sub-advised. AQR falls squarely into the first camp. It has its own team of researchers, portfolio managers and traders who design and implement the strategies. Other firms that don’t have this expertise in house need to find sub-advisors to manage the assets for them. Some choose a single sub-advisor; others spread their bets across several.
The problem for the latter camp is that sub-advisors don’t come cheap. The good ones run hedge funds where they’re used to getting 1/20. Even if you can convince one to do it for, say, 1 percent, there’s literally nothing left if you’re trying to match AQR’s expense ratio. The other obvious alternative—build out your own investment capabilities—is costly and, frankly, not how these guys are wired.
So, what do they do? For some, the strategy apparently is to find clever ways to bury the fees and hope no one notices...seriously. Take the Equinox Campbell fund (EBSIX). EBSIX is little more than a feeder fund into a managed futures strategy run by Campbell & Company, a well-regarded hedge fund manager. The fund’s fact sheet focuses almost exclusively to Campbell’s reputation in the CTA space. Equinox itself makes no real pretense of managing the capital other than deciding where to put the excess cash.
The EBSIX expense ratio? 0.90 percent! Wait… a footnote has a curious caveat: this doesn’t include fees or expenses paid to Campbell. Rather than hiring Campbell as a sub-advisor, Equinox pays Deutsche Bank to do it—in the form of a total return swap—and Deutsche Bank turns around and pays Campbell full hedge fund-caliber fees (those fees are incredibly high). A back of the envelope analysis suggests that the fund’s actual expense ratio is 2-4 times what’s reported. Ergo, we have a fund with a 2-4 percent expense ratio masquerading as a low cost institutional fund.
Equinox isn’t alone, although given that eight of its nine funds (EBSIX, EQIPX, MHFIX, EQCHX, EBCIX, EEHIX, EQCRX, and EBHIX) use these kinds of swaps to hide fees, it qualifies as the poster child. Altegris gets an honorable mention; three of its funds (Managed Futures Strategy Fund MFTIX, Futures Evolution Fund EVOIX, and Macro Strategies Fund MCRIX) all use a confusing combination of swaps and notes to achieve the same result. LoCorr was using a similar strategy for its Managed Futures Fund (LFMIX), but opted to come clean earlier this year.
To be clear, a decent percentage of the managed futures mutual fund space systematically under-reports actual costs and expenses in regulatory filings. Remember, in the sub-advisory model, it’s the sub-advisors that really manage the money. So, investors base their decisions in part on selective (and self-interested) disclosure that seems to fly in the face of the obvious intent of disclosure requirements in SEC filings. You would think language in the prospectus like Total Annual Fund Operating Expenses would mean just that.
Other than the obvious fact that investors should have accurate information, there are two pernicious ramifications. First, in the information age, even inaccurate information spreads unchecked. Take Morningstar: while its own writer has called this “The Worst Practice in Liquid Alternatives,” Morningstar itself makes no effort to calculate the actual expense ratio. Instead merely posts what shows up in SEC filings. Pull up a Morningstar screen of managed futures mutual funds, and six of the cheapest ten funds mask sub-advisor fees—tantamount to rewarding the same funds they criticize.
Second, when advisors don’t disclose sub-advisory fees, they have little incentive to drive them down. The Equinox Campbell fund is a striking example. While EBSIX pays Campbell full (1/20) hedge fund fees, Campbell’s own mutual fund (CCCFX) charges only around 1 percent flat. In contrast, American Beacon, which discloses fees and expenses openly, clearly drove a hard bargain with an equally prestigious hedge fund manager, AHL, and the two firms split a 1.05 percent management fee on a sub-advised fund (AHLIX).
What’s the real cost to investors? It’s not easy to calculate. Even a fund with a 4 percent expense ratio that flips the investment equivalent of four heads in a row can look like a great investment. But the problem, as we’ve seen in the hedge fund industry, is that over time high fees chip away at performance—in a very, very big way. One high cost mutual fund—the State Street/Ramius Managed Futures Strategy Fund (RTSIX)—saw fees eat up an estimated 82 percent of performance since inception. Returns before fees were quite good; after fees, not at all.
Which brings us back to AQR. Managed futures provide valuable diversification; it’s one of the few strategies with consistently low correlation to other asset class. AQR has some great research going back over a hundred years that trend following can help investors to protect capital. Plus, it often goes up when equities are down—something institutions remember from 2008 and retail investors might truly appreciate over the coming year or two. However, when fees are obscenely high, all the benefit goes to managers and not investors.
So, why not just give your whole allocation to AQR? Like any single manager, AQR gets it wrong from time to time, AQMIX was down 8 percent plus in 2016 during the “year of the whipsaw.” In the broader managed futures space, the bottom decile underperforms the top decile by 39% per annum; pick wrong and you’ve killed the point of diversification in the first place. Therefore, any prudent allocator should spread bets across a dozen or more funds. That’s untenable for most retail portfolios. What the market needs is the CTA-equivalent of a sector ETF—low cost but with the predictable performance of a diversified pool of talented managers. It’s coming. Expect to see it this year when “generation two” of liquid alts kicks off in earnest.
Andrew Beer is Managing Partner and Co-Portfolio Manager, Dynamic Beta at Beachhead Capital Management, a hedge fund replication strategist with more than $500 million under management.