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11/04/2005
A Strange and Sensitive Situation, by Victor Niederhoffer

It is curious that one such as I, who has written extensively on the dangers, nay, the disastrous consequences, of grinding for the speculator, should be associated with one of the chief instruments for same: the Fund of Funds. The grinding of the FoF comes in many ways. They pay fees to the winners but don't get an offset from the losers. They often have positions going both ways, and thus are implicitly exposed to double bid-ask spreads, commissions, and slippage costs.

The idée fixe of the FoF is that there are tradeoffs between risk and return, and that by sacrificing a bit of return in exchange for reduced risk, the customers are better off. Part and parcel of this idea is that the FoF will invest in funds that have a higher base return than random selection, and that judicious selection by the FoF will give the investor a better net risk reward structure than a mixture of stocks and Treasury bills. Another advantage is that the FoF acts to certify the propriety, consistency, stability, honesty and integrity of the managers it selects, a function which the investor would not be equipped to perform. They must be doing something right because FoFs apparently account for some 60% of the capital invested in the $1 trillion and growing hedge fund field.

The sensitivity of this subject for me is that I am a fund manager. Many of my investors come to me directly or indirectly through FoFs. Who could blame these customers, with my record of blowing up in 1997 and the inordinate variations that my critics far and wide love to point to as why an investor must have ample diversification to even meet with me, let alone invest. As my friends and associates can guess, I exacerbate this situation by telling investors that they are absolutely right to question a million times when the next great negative variation associated with me will occur.

As if all these sensitivities weren't enough, many of my best friends and relatives are in similar situations, managing funds that have similar customers, although to their credit they do not have to overcome such a disaster as I suffered in 1997. This sensitivity is time-sensitive because I am speaking at a conference of similarly situated purveyors and customers in Europe in two weeks. To create a peaceable atmosphere in such a situation, I will be giving a musical talk, accompanied by the Collab playing the harmonious Blue Danube Waltz (in a transcription of supreme difficulty and beauty by Schulz-Evler) to soothe the savage emotions that might be lurking in an audience confronted by someone such as I.

It turns out that a certain firm has been offering an investable managed futures index* (investable in the sense that the funds that constitute the index are still open to new investors ). The index consists of the combined returns achieved by 14 selected funds of high reputation and excellent past track record. The index began December 31, 2002 with a value of 1000 and it currently stands at 1060, a return of 6 percent in almost three years. Without further ado, I report some correlations of daily returns of the index as follows. The one day serial correlations of daily returns are as follows:

   YEAR     S&P MgdFut
   2003      0.02
   2004      0.00
   2005      0.06
2003:2005    0.02

Concurrent cross correlation of index returns with continuous futures of selected commodities the same day:

   YEAR      S&P      CRUDE     EURO/$
   2003     -0.20      0.37      0.49
   2004     -0.02      0.42      0.52
   2005      0.00      0.48     -0.01
2003:2005   -0.08      0.42      0.37

Note that these cross correlations measure the degree of co-movement between the index and the various commodities. A 40% correlation would correspond to approximately a 70% chance of the fund's moving in the same direction as the commodity. Thus, its about 70% that the index moved in the same direction as oil during these thee years (using a point bi-serial correlation approximation) . On the surface this would seem pretty good, as oil has about doubled during the period and these fund of funds apparently were on the right side of this move. The subject is so sensitive that I will not go further.

*The S&P Managed Futures Index is an investable index designed to be representative of investments in managed futures hedge funds/programs. Specifically, the index aims to track systematic managers employing mainly technical trend-following and pattern-recognition trading methodologies. The S&P MFI includes the four Managed Futures funds represented in the flagship S&P Hedge Fund Index, as well as ten managed futures programs added to create a broader, more representative single strategy index.

Thanks to artful simulator Tom Downing for his calculations and work on the above.

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