Originally published by www.focuspointpress.com on August 10, 2007.
CTA ConfidentialSM
"An ongoing series of qualitative investigations
into managed futures trading programs"
CASE NO. 0309450
Conquest Capital Group LLC
Marc H. Malek, Principal
Managed Futures Select Fund
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. INVESTING IN FUTURES AND OPTIONS INVOLVES RISK AND MAY NOT BE SUITABLE FOR ALL INVESTORS. THE HIGH DEGREE OF LEVERAGE THAT IS OFTEN OBTAINABLE IN COMMODITY TRADING CAN WORK AGAINST YOU AS WELL AS FOR YOU. THE USE OF LEVERAGE CAN LEAD TO LARGE LOSSES AS WELL AS GAINS. THEREFORE, INVESTORS SHOULD CAREFULLY CONSIDER THESE RISKS AND DETERMINE WHETHER THEY ARE SUITABLE FOR INVESTING IN LIGHT OF THEIR FINANCIAL CONDITION AND INVESTMENT OBJECTIVES.
Conquest Capital Group LLC is the parent company of the Investment Manager and Managing Member of Conquest Managed Futures Select Fund, a Rule 4.7 exempt commodity pool. The fund, which has been registered since May 2001, was founded by Marc H. Malek and Richard J. Silver. Earlier this year Mr. Silver sold his membership interests and Proctor Investment Managers, a private equity buyer of alternative and traditional asset managers, purchased an equity stake. Mr. Malek continues to head up the operations and is the asset manager's main intellect. Mr. Malek's career began at Salomon Brothers in 1992. From there, he was hired in 1993 by KB Currency Advisors, a $400 million hedge fund and financial advisory firm. In 1995, Mr. Malek joined UBS where he held various senior level positions within the foreign exchange department in New York, London and Tokyo. In the course of writing an article on Proctor Investment Managers, Managed Account Research was afforded the opportunity to interview Mr. Malek.
When Proctor Investment Managers, an $8 billion strategic private equity investor, acquired a stake in Conquest Capital Group earlier this year, institutional investors took notice. Conquest offers five investment vehicles specializing in the trading of futures and FX markets globally, and is headed up by Marc H. Malek who is backed by a strong quantitative team. But the key driver in Proctor's investment decision had to do with Conquest's proprietary research in the area of managed futures and beta replication strategies.
Hedge funds are in the business of selling 'alpha.' Increasingly, however, sophisticated investors have been questioning the portion of hedge fund returns attributable to alpha. Taking that line of thinking, the next logical question is how to identify alpha if you don't have an appropriate beta against which to measure certain types of alternative trading strategies?
"That's really the heart of the problem; the 500 lbs gorilla in the room," says Malek, who started his career at Salomon Brothers and later joined UBS to become worldwide head of its Exotic FX Derivatives Group as well as Executive Director in charge of FX Proprietary Trading in Europe. "The whole notion of alpha is kind of funny. My checking account has alpha to my hedge fund, and vice versa... with positive expectancy, hopefully."
It started with Conquest being frequently asked by many of the fund-of-funds what their alpha is. "I ran a derivatives trading desk at banks; no one ever asked me about my alpha. So when I looked up the definition of alpha, it became very evident that you cannot intelligently talk about alpha if you don't have the right beta," says Malek.
With a mathematics degree from Reed College, an engineering and applied science degree from Caltech and a background in neural networks, Malek and team set about figuring out something that described their beta -- in an effort to determine their alpha. When they applied it to the rest of the managed futures world, they were surprised to see that it actually explained the returns of "virtually every single trend following CTA [commodity trading advisor] with the exception of a few," says Malek.
That research caught the attention of a major endowment at an Ivy League University, which was trying to get a foothold in the CTA space. They asked Conquest to build for them a beta program focused on managed futures trend following strategies. "There are various sides of CTAs," explained Malek, "the space is overwhelmingly made up of the trend followers, and then on the periphery you have a few people that do different things."
The idea of hedge fund replication is a hotly debated one in both academic and hedge fund circles, but the real action is in the rush to package these so-called 'exotic beta' strategies. In the past year investment banks such as Goldman Sachs, JP Morgan and Merrill Lynch have also introduced programs designed to "replicate" hedge funds.
There are two questions provoking this new industry phenomenon. First, are supposedly skill-based returns actually just a function of a particular investment approach? Second, why should investors pay 2% management and 20% incentive fees for a trading strategy that is replicable?
"There is a process that every fund within a sector is going through that drives the correlations," explained Malek. "High correlation of all the hedge funds in one sector means something. It means that they are all doing something in common." Yet, while Malek believes that hedge fund replication is feasible, he also thinks efforts such as factor modeling or pay-off distribution, which some of these new hedge fund replication products are derived from, are doomed to fail.
The factor modeling method uses a regression procedure to weight the component factors and construct an algorithm with the goal of replicating a hedge fund index. The approach was originally developed and documented in a series of academic papers by William Fung, principal at Paradigm Financial Products, and David Hsieh, Professor of Finance at Duke University.[1]
Harry Kat, professor of risk management at London's Cass Business School, developed the method called 'pay-off distribution.' His approach "aims to provide returns with predefined statistical properties." Unlike factor modeling which "attempts to generate the same month-to-month returns" as a given fund or index, Professor Kat is looking to produce "returns with the same statistical properties as a given fund or index."[2]
Barclay Capital also recently launched its first hedge fund replication index based on the idea of integrating what they considered the best of both approaches above.[3]
However, Malek argues that these approaches are nothing more than back-fitting, especially when done on a high number of variables. "You cannot take the crème of returns, and have no idea how it was generated, plug it into a matrix, that has the price of oil, stocks, currencies, and come out with some sort of multi-variable equation that give you the weight of the factors historically which would have generated these returns," he explains.
Conquest's approach, on the other hand, is based on what Malek says is a transparent set of "extremely simple trading rules" purportedly suited to replicate, in the case of its exotic beta product, a generic managed futures trend following strategy. "You don't duplicate a strategy being an outsider," says Malek, "you do it the same way that traders in that strategy are doing it... by knowing as much about that strategy as the people who are doing it."
Not surprisingly, each of the proponents of these approaches -- factor modeling, pay-off distribution and mechanical trading -- claim to best capture or replicate the hedge fund strategy they compare themselves to. Conquest states that its mechanical trading replication approach has resulted in it being approximately 90% correlated to the S&P managed futures index. Whereas, in the case of factor modeling or pay-off distribution, back-fitting raises the specter of optimization and makes these methods "very controversial" as far as Malek is concerned. Interestingly, Conquest is not the first with a mechanical trading index product; the concept actually dates back to 1988 with the MLM Index™, a passive moving average futures index developed by Mount Lucas Management.[4]
Conquest's mechanical trading index/product, on the other hand, has only three years of walk forward actual performance. This leaves open many questions, including the veracity of making comparisons against composite hedge fund indices (such as the S&P managed futures index), the validity of the trading methods and the robustness of the parameters used to supposedly define the beta of managed futures, as well as conflicts of interest that result when making claims of having alpha in its other products using a beta index of their own creation.
In response, Malek states that with respect to the development of Conquest's mechanical managed futures trend following system, "you cannot get any simpler than what we have created. It doesn't have any other hard coded parameters. It basically says that trend following happens anywhere between 5 to 200 days," he explains. "We could spend two more hours talking about what makes a good back test and what doesn't. What I can tell you is that this is not a theory anymore, this is something that we have been running for over three years."
This answer is akin to relying on the statistical argument which points to a thirty year track record of managed futures, and then claiming that returns have been large enough for long enough that one cannot argue there is no source of return. Yet, statistical corroboration does not necessarily indicate the presence of something. Further, the standard argument against managed futures is based on a simple premise -- if there were excess returns to speculative capital in futures trading, then since the barriers to entry in this industry are so low, so much capital would flow to this industry that returns would be driven to zero over time -- that is, there is no beta to capture.
All said and done, by only charging a one percent management fee and no incentive fee, it is obvious that Conquest's strategic objective is to become an exotic beta juggernaut by producing exotic beta products for managed futures as well as other alternative investment strategies. "What is interesting about it, now we can allow people, to go long or short a trend following CTA," proposes Malek launching into another cutting edge idea.
The industry has come a long way. "Unlike ten years ago when the hedge fund space was somebody with a bright idea, and dealing with investors that put their own money with you if they like what you said," Malek recalls, "over the last ten years a lot of the risk that use to be taken at prop desks and banks has been outsourced to hedge funds. Institutions like institutions. They don't like two guys and a bright idea."
This is the basis for Conquest's involvement with Proctor Investment Managers. "I'm not a marketer," says Malek, "I have a very quantitative background. They have a very large distribution team that they plan on growing. Meanwhile, I can bounce things off of their legal department; I can rely on them for seed money for some new ideas. It gives us an association with a much larger institution. That I think makes us more stable. It gives us more credibility."
With respect to their managed futures beta product, "if you look at it on a gross basis, some of those trend following CTAs do actually provide some alpha, but no one does after the two and twenty charge," explains Malek, adding that he thinks "trend following by itself is a negative alpha proposition after fees, the same way most mutual funds are negative alpha after fees." That's why Conquest priced their Managed Futures Select Fund product at 1% management fee for the first $250 million. Once that class is filled, however, they plan to open the next class at 2%.
[Readers are reminded that the Conquest Managed Futures Select Fund is a commodity pool and not a managed account product. Accordingly, prospective investors should first carefully review Conquest's Private Placement Memorandum which contains additional discussion of certain risk factors not described in this article. In addition, the minimum initial capital contribution for a Series 1X Interest in this fund product is $250,000, subject to the discretion of the Managing Member to establish different minimums in the future.]
"The market is very simple -- you have risk and return," says Malek. "Only way one gets compensated is by assuming risk. Now every once in a blue moon, you get somebody who knocks the cover off the ball and is a true star. But ninety-nine percent of the time, you basically make the money the market is willing to give you for assuming risk premium."
This article was written by Michael "Mack" Frankfurter and first published by Focus Point Press, Inc. (Emerging Manager Focus) under the title "What the Smart Money's Doing: Conquest Capital Group." It is republished here by permission.
[1] The following is a sample list of papers by William Fung and David Hsieh: Fung and Hsieh (1997), "Empirical characteristics of dynamic trading strategies: the case of hedge funds," Review of Financial Studies; Fung and Hsieh (2004a) "Extracting portable alphas from equity long-short hedge funds," Journal of Investment Management; Fung and Hsieh (2007) "Will hedge fund regress to index-like products?," Journal of Investment Management; Fung and Hsieh (2007) "Hedge fund replication strategies: implications for investors and regulators," Financial Stability Review.
[2] "Professor Harry Kat: Hedge Fund 'Replication' a Misnomer" Article by Christopher Holt. Posted on All About Alpha http://allaboutalpha.com on January 19, 2007 and Seeking Alpha www.seekingalpha.com on January 23, 2007.
[3] "Barclays to Debut Hedge Fund Clone" Article by Emma Trincal, Senior Financial Correspondent. Published by Lipper HedgeWorld http://www.hedgeworld.com on June 22, 2007.
[4] Information on the MLM Index™ can be found at https://www.mtlucas.com/about.aspx.
