Another ‘Black-Box’ Strategy Disappoints Investors

By Paul Jacobs, CFP®, EA Mar 22, 2017, 4:04 PM 

Black-Box - Hedge Fund

There is a good chance you haven’t heard of the Catalyst Hedged Futures Strategy Fund. But this mutual fund, which manages over $3 billion for its investors, just provided a painful reminder on the importance of understanding what you’re buying.

For those who stay glued to market news, the fund’s misfortunes were attention-grabbing. The fund, marketed as seeking capital preservation along with growth, saw its share price fall for seven straight days last month, just as the Standard & Poor’s 500 index was reaching new all-time highs. After a brief plateau, the fund’s share price has continued to fall and, as of the time of this writing, has fallen almost 20 percent from its high in early February.

You do not need to understand the minutiae of what happened to Catalyst’s fund to find its massive losses instructive. Even everyday investors can benefit from the reminder that funds using complex strategies often carry an extra layer of risk.

A few years ago, I wrote an article warning investors to “Beware Mutual Funds Using Hedge Fund Strategies.” Not much has changed since I wrote the article. I still believe that there can be a place for hedge fund strategies in a well-diversified investment portfolio, but that many of the funds available to mom and pop investors raise serious red flags upon analysis. I listed a number of red flags to watch out for with these funds, and after taking a look at the Catalyst fund, I see that it triggers almost every warning sign that we look for.

Lack of meaningful track record. While Catalyst offers performance history as far back as 2005, the fund only became a publicly traded mutual fund in 2013. Before that, it was a private hedge fund. The data prior to 2013 is weak, largely because hedge funds are not required to publish detailed information on their portfolios. As John Rekenthaler of Morningstar explained recently, this means that analysts have no meaningful way to evaluate what went right, and what risked going wrong, in the fund’s strategy. In addition, Catalyst could have had other private funds that performed poorly, but whose track record the company is not required to disclose alongside that of the fund that was opened to the public.

Without more details, it is impossible to know whether Catalyst’s strong early performance was due to luck or skill. So while the fund has a track record going back to 2005, that record should have been examined with extreme skepticism. A better approach would have been to evaluate the fund’s track record only since 2013, when it became available to the public. And a track record going back to 2013 does not qualify as meaningful.

High expenses. Catalyst’s A shares charge 2.26 percent, and the I shares charge 2.01 percent, according to the fund’s fact sheet. These fee levels set a very high hurdle for the fund’s managers to clear year in and year out. While the fees aren’t completely outrageous, they are high enough that we would demand a great deal of justification for them.

A “black box” strategy. The fund’s fact sheet does discuss its investment strategy, but the description offers little in the way of an actual explanation, instead favoring broad statements. It states that “it is reactive in nature,” which can mean almost anything in this context. Such vague language leaves fund managers a great deal of leeway. Unfortunately, that leeway can lead to blowups like this one.

The Wall Street Journal reported that Catalyst Hedged Futures Strategy Fund used a “butterfly spread,” which is a legitimate options strategy designed to make money in a flat market. But in a standard butterfly spread, maximum losses are limited to the cost of the original investment. In other words, there is no way a butterfly spread should have caused losses of this magnitude, even if the market defied the manager’s expectations.

The article also mentions the fund was effectively “left short” against the S&P 500, which is different than a butterfly spread. It appears that the manager intentionally tried to take advantage of a perceived opportunity and it backfired. A vaguely defined investment policy left the door open to this type of mistake. But how many investors really understood that the fund’s managers would take risks of this magnitude whenever they saw fit?

A strategy that is inconsistent with your investment philosophy. At Palisades Hudson, we believe that markets are generally efficient. It appears that this fund sought to take advantage of inefficiencies in the option markets. While there are legitimate options strategies that can have a place in a diversified portfolio, they typically involve reducing risk, not increasing it. We would have been skeptical of the premise that pricing inefficiencies were significant enough to explain the fund’s returns and justify its fees.

Funds managed by “the smartest man in the room.” Many of Edward Walczak’s investors seem to have been counting on his ability as the fund’s lead portfolio manager to outsmart all other investors. Historical returns cast serious doubt on the premise any one person can outperform the markets consistently over time. Instances like this one show why.

Poor historical returns. While we believe investment returns are only one of many data points that should be considered when evaluating a mutual fund, I argued in my original article that an exceptionally poor stretch of returns should give investors pause. However, this fund actually displayed the opposite red flag: returns that look too good to be true. With steady, double-digit returns most years since 2005, and blowout returns of over 50 percent in 2006 and 2008, any investor would have to become very comfortable with just how, exactly, the fund was able to consistently generate high returns with such low volatility. Those who simply expected the good times to continue indefinitely ended up with a painful reminder that if returns look too good to be true, it may very well be because they are.

I do not mean to kick those who invested in the Catalyst fund while they’re down. But for those of us watching from the sidelines, Catalyst’s losses serve as a reminder that all investment strategies involve risk and that it remains important to understand exactly what you are investing in.

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