(see Greene 2000) heteroskedasticityconsistent standard errors. Table 13.4 presents OLS estimates of regression
TABLE 13.4
Estimation of the Relationship between Compensation Parametersand CTA Mean Annual Compounded Returns and Standard Deviation of ReturnsIndependent VariablesDependent Variables
Intercept
km
ki
ln(At − 1)
Mean Annual Returns
−0.255*(0.075)0.229*(0.057)
0.580(0.583)1.424*(0.482)
0.693*(0.259)0.654*(0.156)
0.016*(0.003)−0.009*(0.003)
Standard Deviation
*Significant at the 1 percent level under H0 = 0.
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coefficients from equations 13.3 and 13.4, along with white standard errorsin parentheses.The results in Table 13.4 show that cross-sectional variation in meanreturns is not related to management fees. This result is in agreement withGolec (1993), and it is good news for investors as it suggests that there areno systematic abuses in management fees that penalize performance. Thecross-sectional variation in mean returns also is shown to be positively associated with the incentive fee parameter. This is also in agreement withGolec’s results, and it is also good news for investors because greater incentive fee parameters lead to greater CTA effort or ability that in turn leads tohigher performance. If the incentive fee parameter ki were to increase from10 percent to 20 percent, performance should be expected to increase by 5.8percent. The magnitude of the increase is roughly half of what was found inGolec and seems like a much more reasonable number. A 10 percent increasein Golec’s study would have accounted for a 1 percent per month increase inperformance or more than 12 percent per year, a very large number. It isimportant to highlight that the performance increase is net of all fees. Otherthings being equal, a CTA with higher incentive fees is likely to deliver largerperformance after fees.We find the amount of assets under management to have a positiveeffect on performance while Golec (1993) finds the opposite result. Ourfinding is likely to reflect a known fact in the industry that successful CTAstend to capture the bulk of assets under management. The amount ofassets under management tends to reflect performance. The newly createdBarclay BTOP50 Index for managed futures is only a reflection of thisknown fact. The increase in performance associated with assets undermanagement is not spectacular. An increase in assets under managementfrom $100,000 to $3 billion is associated with a 16-basis-point increase inperformance. Although the effect appears to be statistically different fromzero, its economic importance is very small. A similar increase in assetsunder management is associated with a decrease in performance of 71basis points in Golec. Figure 13.1 illustrates the annual increases/decreasesin performance as a function of assets under management found in thisstudy and in Golec (1993).1The volatility of CTAs’ track records appears to be positively associatedwith the incentive fee parameter (Table 13.4). The relationship supports theidea that CTAs who charge larger incentive fees take on larger risks. It alsoappears that risk taking pays off as viewed from the relationship betweenmean returns and the incentive fee parameter. The amount of assets under
1Golec’s results were annualized to make them comparable to the results of this study.
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The Effect of Management and Incentive Fees on the Performance of CTAs
40200−20
Basis Points
−40−60–80–100–120–140–1600
5e+08
1e+09
1.5e+09
2e+09
Assets under ManagementThis StudyGolec (1993)
FIGURE 13.1
Effects of Assets under Management on Average Annual Returns
management appears to be negatively associated with the volatility ofCTAs’ track records. Although the effect is rather small, this result is consistent with Golec’s findings. Golec’s explanation of this empirical observation is appealing. Risk aversion is likely to rise with wealth, and this in turnmay induce CTAs to reduce risk levels. Some indirect support for this explanation is found in Diz (2003), where the level of leverage of “surviving’’CTAs (the larger ones) appears to be smaller.One surprising finding is that management fees appear to be positivelyassociated with the volatility of CTAs’ track records. There is no clearexplanation for this finding other than measurement error.Because a substantial amount of relative total compensation is contingent on positive performance (incentive fee), common sense and theorysuggest that all factors associated with performance have a potential impacton total compensation. For example, Diz (2003) shows that CTAs’ level ofleverage is related to performance. CTAs with larger margin to equity ratiostend to have larger returns and volatility. As other variables such as leverage are strongly associated with the performance of a cross section of CTAs,the exclusion of such variables in regression equations 13.2 and 13.3 maysubstantially alter the size, sign, and level of statistical significance of their
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coefficients. In an effort to reduce the omitted variable problem, we fit thisaugmented model to the data:ARORj = b0 + b1km + b2ki + b3ln(At − 1) + b4mdd + b5me +(13.5)+ b6vr + b7surv + b8Diver + b9Syst + b10Disc + ejsj = a0 + a1km + a2ki + a3ln(At − 1) + a4mdd + a5me ++ a6vr + a7surv + a8Diver + a9Syst + a10Disc + uj
(13.6)
where:km = management fee parameter in %ki = incentive fee variable in %ln(At − 1) = natural log of the amount of assets under managementin the previous monthmdd = maximum drawdown variable (drawdown is defined asthe percentage size of an equity retracement)me = margin to equity ratiovr = ratio of “positive” to “negative” volatilitysurv = dummy variable that takes a value of 1 when the CTAis still in business and 0 when the CTA or program isno longer availableDiver = dummy variable that takes a value of 1 when the CTAis diversified and 0 otherwiseSyst = dummy variable that takes a value of 1 when the CTAis systematic in trading approach and 0 otherwiseDiscr = dummy variable that takes a value of 1 when the CTAis discretionary in trading and 0 otherwiseej, uj = error termsThe results in Table 13.5 suggest that management fees are unrelated toboth the level and volatility of CTA returns. The effect of the incentive feeparameter remains positive and statistically significantly different from zerounder the augmented model specification. Moreover, the magnitude of theeffect of the incentive fee parameter on the level of returns appears to bethe same as in the previous model specification. The robustness of theincentive fee parameter to different model specifications lends credence tothe conclusion that CTAs’ incentive fee structure is strongly associated withtheir level of net returns. Under the augmented model, an increase in theincentive fee parameter from 10 percent to 20 percent will increase performance by an average of 6.58 percent annually.Incentive fees continue to be associated with the overall volatility ofCTA track records. Larger incentive fee parameters are associated with
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TABLE 13.5 Estimation of the Relationship between Compensation Parametersand CTA Mean Annual Compounded Returns and Standard Deviation of Returns,Augmented SpecificationS
ARORPerformanceVariable
Coefficient
S.E
Coefficient
S.E.
Constantkmkiln(At − 1)mddmevrsurvDiverSystDiscr
−0.275**0.7900.658**0.009**0.186**0.300**0.051**0.078**0.000−0.0090.004
0.0720.5460.2460.0030.0360.0620.0070.0150.0110.0130.019
−0.076*−0.1830.229*−0.003−0.637**0.247**0.060**0.034**0.008−0.0010.009
0.0380.2830.1020.0020.0290.0420.0060.0070.0060.0070.011
**Significant at the 5 percent level for H0 = 0.**Significant at the 1 percent level for H0 = 0.
larger levels of volatility, although this effect is reduced considerably in theaugmented model. The amount of assets under management continues to beassociated with the mean level of returns. The effect appears to be of thesame order of magnitude in the augmented model. The level of assets undermanagement is unrelated to the volatility of the CTA track record. This isin contrast with Golec (1993), who finds a negative and significant relationship between assets under management and volatility and casts doubtsabout the existence of any relationship between size and volatility once oneaccounts for other volatility variables.
CONCLUSIONThis study examines the effect of incentive contracting on CTA performance and volatility. Evidence of structural changes in incentive compensation is presented that points to a larger reliance on incentive fees as opposedto management fees. Management fees are shown to have no relationshipwith performance. This is good news for investors, as the evidence seems tosuggest that this type of compensation results in no systematic performance
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penalty to investors. Management fees are not associated with systematicvariation in CTA return volatility, either. Both results are in agreement withprevious research by Golec (1993).Incentive fees are found to be positively related to both returns and thevolatility of CTA returns. An increase in the incentive fee parameter from10 percent to 20 percent will increase performance by an average of 6.58percent per year. The performance increase is net of all fees and independent of the amount of leverage used by the CTA. The level of incentive feesmay play a role in the selection of truly outstanding CTAs.Finally, it is shown that CTA size measured by the level of assets undermanagement is positively related with the level of returns. The effect issmall and likely to be caused by money flowing to successful CTAs.
CHAPTER
14
Managed Futures Fundsand Other Fiduciary Products:The Australian Regulatory ModelPaul U. Ali
his chapter investigates the Australian regulatory model for managedfutures funds and other fiduciary investment products whose returns arederived from the trading of futures products. All fiduciary investment products are regulated in the same manner in Australia, under a combinationof the managed investment scheme and financial product provisions ofthe Australian corporations legislation. The difficulties of applying thismodel to the diverse range of fiduciary futures products is discussed, andrecent proposals to reform the regulation of individually managed futuresaccounts are examined.
T
INTRODUCTIONHedge funds and other alternative fiduciary investment products (productswhere investors have provided funds to a professional fund manager toinvest on their behalf) are coming under increasing regulatory scrutiny,especially in the United States. The U.S. Treasury Department has proposeda series of measures under the PATRIOT Act that will require the operatorsof onshore as well as offshore wholesale hedge funds, commodity pools,and private equity funds to provide the department with certain basic information about the fund manager, the investors in the fund, and the value ofassets under management—measures that are likely to undermine the confidentiality now enjoyed by these funds (see Financial Crimes EnforcementNetwork 2002). In addition, the National Association of Securities Dealers(NASD) has expressed concern that its members may not be fulfilling theirlegal obligations to customers, particularly retail customers, when promot-
259
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ing hedge funds and funds of hedge funds to them (see NASD 2003). Morerecently, the Securities and Exchange Commission (SEC) has raised concerns about the increasing retailization of hedge funds, commodity pools,and private equity funds, the unregulated nature of these products and thepotential for fund managers to defraud investors, and the market impact ofhedge fund investment strategies such as short selling (SEC 2003).1 TheSEC’s concerns are usefully summarized in Wider and Scanlan (2003).In Australia, the Australian Prudential Regulation Authority (APRA),the prudential regulator of banks, insurance companies, and pension funds,recently has questioned the increasing allocation of funds by Australianpension funds to hedge funds and other alternative investments. APRA(2003) has explicitly stated that if it “is not satisfied that an investment inhedge funds is to the benefit of [pension] fund members, it will step in toprotect their interests.”This chapter discusses the regulation, in Australia, of fiduciary investment products whose returns are derived from the trading of futures contracts. This is of interest for two broad reasons. First, hedge funds, managedfutures, and other alternative fiduciary investment products are subject tothe retail regime that governs conventional mutual funds. This providesa useful counterpoint to the debate in jurisdictions such as the UnitedStates2 and the United Kingdom3 as to whether the differential status of
1In contrast, the Commodity Futures Trading Commission has recently introduced
rules that have the effect of placing the majority of U.S. hedge funds and offshorehedge funds that invest in U.S. commodity futures outside the scope of the registration and licensing provisions of the Commodity Exchange Act. These rules commenced operation on August 28, 2003, and are summarized in note 2.2The Investment Company Act of 1940 regulates “investment companies,” whichare funds that are engaged primarily in the business of investing in or trading securities. However, funds that have fewer than 100 investors (section 3(c)(1)) and fundswhose investors are “qualified purchasers” (e.g., persons with at least US $5 millionof investment assets and fund managers whose assets under management are at leastUS $25 million) (sections 2(a)(51) and 3(c)(7)) are excluded from the definition of“investment company.” U.S. hedge funds and offshore hedge funds offered to U.S.investors are deliberately structured to take advantage of one or both of these exceptions. The majority of hedge funds also fall outside the scope of the CommodityExchange Act. That act regulates “commodity pools,” which are funds that engagein U.S. commodity futures transactions (booking a single transaction will be sufficient to render a fund a commodity pool: CFTC Interpretative Letter 98-18). However, funds that do not engage predominantly in commodity futures transactionsand whose investors are all “accredited investors” (as defined in Rule 501, Regulation D of the Securities Act) have been excluded by the CFTC from the definition
Managed Futures Funds and Other Fiduciary Products
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such investment products should be continued. Second, the Australian Securities and Investments Commission (ASIC) has recently signaled its intention to distinguish between individually managed accounts and managedfunds for regulatory purposes (2003).
Fiduciary Futures Products in AustraliaFiduciary futures products—where a futures broker or investment managerseeks to generate a positive return on the funds entrusted to it by its clients,by utilizing those funds to trade futures contracts—come in two varieties inAustralia: managed futures funds and individually managed futuresaccounts. Managed futures funds are structured along the same lines asmutual funds and hedge funds in Australia. The cash contributions of several investors are pooled by the fund manager for the purposes of investingin one or more of the classes of futures contracts (as well as options onfutures contracts) listed on the Sydney Futures Exchange. Individually managed futures accounts fall into the broader class of investment productsknown variously as individually managed accounts (IMAs), managed discretionary accounts (MDAs), and managed portfolio services. IMAs are acustodial and administrative investment service, not intermediated investment vehicles as is the case with managed futures funds (Jorgensen 2003).An investor in an IMA deposits funds in a separate trading account with afutures broker and grants the futures broker broad discretion to investthose funds in futures contracts on the investor’s behalf, without the needfor the investor to grant prior approval to individual trades.Of the two types of fiduciary futures products, IMAs are the more common in Australia. Retail investors can open an IMA with a futures brokerwith a minimum investment of A$100,000 (Doig 2003). Managed futuresfunds in Australia typically are structured as wholesale investment funds,open only to institutional and professional investors and requiring minimuminvestments of A$500,000. Nonetheless, the strong growth recently experi-
of “commodity pool”: CFTC Rule 4.13(a)(3). In addition, the operators of fundsthat offer fund interests to only highly sophisticated investors (including “qualifiedpurchasers”) are exempt from registration as Commodity Pool Operators by theCFTC: CFTC Rule 4.13(a)(4).3The Financial Services Authority, which regulates the U.K. financial services industry, has decided for the time being to leave hedge funds outside the regime governing retail collective investment schemes, although it has indicated that it may changeits position depending on the level of demand for hedge fund participation by retailinvestors: see Financial Services Authority (2003).
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enced by the Australian hedge fund sector is likely also to lead to increasedinterest among institutional investors in managed futures funds (Ali, Stapledon, and Gold 2003).Investors also can obtain exposure to the underlying commodities offutures contracts by investing in commodity-linked securities. These aregenerally debt securities with embedded futures contracts or the over-thecounter commodity derivatives, where the value of the principal returned toinvestors on maturity of the securities is dependent on the price performance of the underlying commodity during the term of the securities (Anson2002a). Commodity-linked products, however, remain relatively uncommon in Australia.
Australian Futures MarketFutures contracts and options on futures contracts are traded in Australiachiefly on the Sydney Futures Exchange (SFE).4 According to the SydneyFutures Exchange Corporation (2002), the SFE is the tenth largest futuresexchange in the world, by annual volume of futures contracts traded.5 TheSFE is the second-largest futures exchange in the Asia-Pacific region, ranking behind the Korea Stock Exchange and ahead of the SingaporeExchange, Osaka Securities Exchange, and the Korea Futures Exchange.Trading on the SFE is dominated by financial futures contracts. According to the Sydney Futures Exchange Corporation (2003a) Australian interest rate futures contracts (comprising interbank rate, bank bill, interest rateswap, and treasury bond futures contracts) accounted for 89.4 percent and88.7 percent of the total trading volume in the first half of 2003 and thewhole of 2002 respectively, while the next most popular class of product,Australian equity futures contracts (comprising Australian equity index andsingle stock futures contracts), accounted for 10.4 percent and 11.1 percentin the same periods. Interestingly, single-stock futures contracts, whichreceived regulatory approval in the United States under the CommodityFutures Modernization Act of 2000 but which have been available in Australia since 1994, have remained a peripheral product, with very low trad4Electricity, equity index, grain (barley, canola, sorghum, and wheat), and wool
futures contracts are also traded (in relatively small volumes) on the AustralianStock Exchange.5The nine futures exchanges that rank ahead of the SFE in terms of annual tradingvolume are (in descending order): Korea Stock Exchange; Eurex; Chicago Mercantile Exchange; Chicago Board of Trade; Euronext-LIFFE; Euronext-Paris; BrazilianMercantile & Futures Exchange; Chicago Board Options Exchange; and Tel AvivStock Exchange.
Managed Futures Funds and Other Fiduciary Products
263
ing volumes (Ali 2002). The other classes of product traded on the SFE areAustralian dollar, cattle, electricity, and wool futures contracts.
Rationale for Investing in Fiduciary Futures ProductsInvestment in fiduciary futures products has been justified on two broadgrounds. The first concerns the low correlation between the returns ofcommodity futures contracts and the returns of conventional investmentssuch as shares and bonds. Thus, the inclusion in an investment portfolio offiduciary futures products that have heavily invested in commodity futurescontracts should create a more efficient return profile for that portfolio.The combination of the fiduciary futures product with long share or bondpositions in the portfolio should generate a higher aggregate return forthe portfolio for the same level of risk or reduce the investment risk of theportfolio without changing the level of return (Edwards and Park 1996;Edwards and Liew 1999).Fiduciary futures products offer similar portfolio benefits to hedgefunds. A recent study has concluded that fiduciary futures products will, ingeneral, outperform hedge funds in bear market conditions while marketneutral, event-driven, and global macrohedge funds will outperform fiduciary futures products over all markets (Edwards and Caglayan 2001). Thevarious hedge fund strategies are explained in Ali, Stapledon, and Gold(2003). A second study has concluded that while fiduciary futures productsmay have a lower expected return than hedge funds, they provide moreeffective portfolio diversification benefits than hedge funds (Kat 2002).There is, however, one qualification: The correlation of the price performance of commodity futures contracts to the price performance ofshares and bonds has been observed to be considerably unstable, a fact thatmay erode the claimed portfolio benefits of fiduciary futures products(Jensen, Johnson, and Mercer 2000).The second benefit of fiduciary futures products is that they are considered to be a hedge against inflation, on the grounds that there is a positive correlation between the price performance of commodities andinflation. Again, this depends on the futures contracts in which the fiduciary futures product is invested. The putative hedge against inflation maynot eventuate where the fiduciary futures product is significantly invested infinancial futures contracts (Edwards and Park 1996).
Regulation of Fiduciary Futures Products in AustraliaAll fiduciary investment products, whether fiduciary futures products orhedge funds and whether offered to retail or institutional investors, are
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potentially subject to Chapter 5C of the Australian Corporations Act 2001,which regulates “managed investment schemes,” and Chapter 7, which regulates “financial products.”Chapter 5C of the act is a “bottom-up” approach to the regulation offiduciary investment products. A fiduciary investment product that is amanaged investment scheme or financial product is subject to regulation bythe act, and the onus is then on the operator of the scheme (typically, thefund manager) to explain in the disclosure documentation provided toinvestors the investment strategy of the scheme or product and the classesof assets in which the scheme or product invests. Accordingly, there is noneed for the act to distinguish—and, indeed, the act does not do so—between managed futures products and other fiduciary investment productsor between hedge funds and other fiduciary investment products.
FIDUCIARY FUTURES PRODUCTSAND MANAGED INVESTMENT SCHEMESAccording to the Corporations Act 2001 (Cth), section 9, a fiduciary futuresproduct (or other fiduciary investment product) is a “managed investmentscheme” if it possesses three attributes:1. Investors in the product contribute money or assets (e.g., securities) toacquire right to the financial benefits generated by the product.2. The investors’ contributions are pooled or used in a common enterprise by the operator of the product, to produce financial benefits forthe investors.3. Day-to-day control over the operation of the product (including thedesign and implementation of its investment strategy) is in the hands ofa third party, not the investors.
Managed Futures FundsManaged futures funds clearly satisfy these requirements. Investors in amanaged futures fund invest by purchasing or subscribing for interests inthe fund; the fund manager pools the consideration they provide for theacquisition of such interests and allocates it to futures contracts (or optionsover futures contracts). Moreover, the fund manager decides to invest in orclose out futures contracts, not the investors, thus control over the operation of the fund is in the hands of a party other than the investors.Only managed futures funds that have been structured as noncorporate“funds” can be “managed investment schemes.” Section 9, paragraph (d) ofthe act expressly excludes from the definition of “managed investmentscheme” corporate investment vehicles, for instance, where the investors
Managed Futures Funds and Other Fiduciary Products
265
have subscribed for securities in a corporation and the subscription proceeds have been invested by the corporation in futures contracts. The issueof units or other equity interests by the trustee of a trust to investors wherethe subscription proceeds are invested by the trustee in futures contractswill, on the other hand, constitute the trust a managed investment scheme.The status of debt securities issued by the trustee of a managed futurestrust remains uncertain. Section 9, paragraph (j) of the Corporations Actexcludes “debentures” issued by a corporation (which includes corporatetrustees) from the definition of “managed investment scheme.” Debt securities that have been structured as bills of exchange or promissory notes (inthe case of the latter, with a face value of at least A$50,000) are not debentures, and according to section 9, paragraphs (c)(iii) and (d), this fact shouldrender the corporate trustee of a managed futures fund that issues suchsecurities subject to Chapter 5C. Other debt securities issued by corporatetrustees should fall outside the scope of Chapter 5C. However, the act alsoprovides that debentures do not include debt securities where the issuer ofthe securities is not in the business of borrowing or lending money, and theinvestors have purchased the securities in the ordinary course of a businessthat involves lending money. It therefore can be argued that debt securitiesissued to professional investors by the trustee of a managed futures fund,irrespective of whether those securities are bills of exchange or promissorynotes, are not debentures and thus potentially subject to Chapter 5C (Clayton 2003). (See Corporations Act 2001 (Cth), section 9, paragraph (a).)
Collateralized Synthetic ObligationsRegulation covers also securitization programs in Australia, including theemerging class of collateralized synthetic obligations (CSO). A CSO is verysimilar to a managed futures fund. The issuer in a CSO, like the managerof a managed futures fund, aims to generate profits by trading derivatives.Although the latter trades futures contracts, the former engages in the activetrading of the class of over-the-counter derivatives known as credit derivatives. The different types of credit derivatives and their regulatory status arediscussed by Ali (2000).Credit default swaps are the most common type of credit derivative. Ina credit default swap, one party (the protection seller) agrees with its counterparty (the protection buyer), in exchange for the payment of a premiumor fee, to assume the credit risk on a portfolio of loans or bonds (referenceobligations) made by the protection buyer to, or issued by, one or morethird parties (reference entities). If a credit event (e.g., where a referenceentity defaults on the reference obligations or becomes insolvent), the protection seller will be obligated to purchase the reference obligations for theirface value from the protection buyer (in the case of a physically settled
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credit default swap) or make a payment to the protection buyer of the difference between the face value of the reference obligations and their thenmarket value (in the case of a cash-settled credit default swap).Thus, just as the manager of a managed futures fund seeks to servicethe principal and interest payments on any debt securities issued by it outof trading profits, the issuer of debt securities in a CSO seeks to servicethose securities out of the premiums received by the issuer from sellingcredit risk protection under credit derivatives and any profits realized fromthe trading of credit derivatives (Tavakoli 2003). Corporate trustee issuersin CSOs, in contrast to corporate issuers that are not trustees, are potentially subject to Chapter 5C of the Corporations Act.6
Individually Managed Futures AccountsThe status of individually managed accounts (IMAs) is less obvious. It seemsclear that the attribute of pooling is absent since the futures broker or otheroperator of the IMA manages the investor’s account as a discrete investmentportfolio. Despite the separate management of investors’ funds, there is arisk that an Australian court may nonetheless decide that an IMA involves“pooling” where the investments attributable to each account are held by theIMA operator or a custodian in a single omnibus account.7 The existence ofdiscrete investment portfolios and book-entry segregation of portfolioinvestments may not be sufficient to avoid the characterization of the portfolio manager’s business as involving the pooling of investor contributions.Having said that, ASIC has taken the view that IMAs are managedinvestment schemes on the basis that the operator of the IMA and theinvestor in the IMA are involved in a “common enterprise” (see ASIC2003). This position is also supported by Horgan (2003).This expansive view of “common enterprise” ignores the fact that it is thefund manager or account operator who is solely engaged in the enterprise andthat the investors are merely passive participants. It is the operator of the IMAwho makes the decision as to the selection of futures contracts for theinvestor’s account, not the investor. The characterization of the relationshipbetween an investor and a fund manager as a common enterprise appears tobe predicated on the fact that both parties expect to derive a profit (positive6It remains unclear whether the carve-outs for bills of exchange and certain promissory notes would apply to the limited recourse debt securities issued in CSOs (andother secur