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Trader John Henry is Featured in Institutional Investor

Institutional Investor

August 1996

John Henrys bid to manage the future
The famed trader aims to revitalize the managed-futures industry by inducing firms to push risk avoidance. Is he crazy or canny?

By Michael Peltz

John Henry is an avid baseball fan. And when your commodity trading earns 40 percent returns, you can indulge your hobbies. In 1989 Henry bought the Tucson Toros, the Houston Astros triple-A team. But that wasnt the major leagues. So in 1991 he purchased a chunk of the New York Yankees.

Like the Bronx Bombers, John W. Henry & Co. has hired a pretty good run over the years. But many other managed-futures players have been in a protracted slump. And somewhat improbably, the soft-spoken, press-shy John Henry has declared himself their champion.

Genuinely alarmed by the state of the managed-futures industry - of which his own firm is not insignificant part - Henry has assumed an out-front leadership role, chairing an industry task force on derivatives investments and giving the keynote speech at last years Managed Futures Association annual conference. To some managed-futures players Henrys provocative message - the managed-futures firms must reduce their fees and play up their risk management capability to attract institutional investors - makes him more crank than savior. They say theyre doing just fine catering to individuals.

Nonetheless, Henrys concern about the future of the managed-futures industry in not unfounded. The mostly retail assets invested by professional futures managers, known as commodity-trading advisers, have plunged from $23 billion in 1993 to $16 billion recently, according to consulting firm Tass Management.

Patchy performance in the tricky trading markets of recent years has further turned off institutional investors already disillusioned with managed futures high fees (up to 4 percent of assets and 25 percent of profits), volatility (standard deviations of 30 to 40 percent are the norm among top managers) and leverage (up to ninefold). The Virginia Retirement System and Eastman Kodak Co. both terminated their managed-futures programs in 1994 (see Pensions). "We dont think managed futures is a real business, " mutters one pension consultant.

Its real enough to John W. Henry & Co. Founded 15 years ago, the firm is the second-largest CTA in the U.S., after Louis Bacons Moore Capital Management. JWHs $1.5 billion in assets account for 9 percent of all managed futures. The firms returns have been consistently among the best in an industry that has, admittedly, experienced helter-skelter performance. Since 1984 JWHs Financial and Metals Portfolio, its most popular offering, with $880 million under management, has netted average annual returns of nearly 45 percent. (Through the end of March, the F&M portfolio was the top-performing CTA program for the past ten years.)* Last year the program earned 38.5 percent, beating the Standard & Poors 500 index, if narrowly.

Like most CTAs, JWH trades a lot more financial futures on equities, currencies and interest rates than it does contracts on commodities, such as gold, corn or oil. (The mild-mannered, conservatively attired John Henry hardly fits the stereotype of the brash, red-faced, perpetually shouting denizen of the commodities trading pits.) JWH currently has 11 trading programs in addition to its bellwether F&M portfolio. Some programs invest in a combination of financial and commodity futures, others in pure financial and foreign exchange strategies. JWH has more than $300 million of institutional money under management (five investors account for $230 million of that).

Over coffee (a commodity JWH sometimes trades in Henrys traditionally furnished office in Boca Raton, Florida - the heavy mahogany desk and chairs contrast oddly with JWHs high-tech trading room 100 feet down the hall - Henry outlines his game plan for the managed-futures industry. "The emphasis in our industry has been on rated of return," he says, "but I feel the risk side of the equation is more important." Most investors, he points out, have forgotten what its like to live through a real bear market - an environment in which skillful CTAs usually thrive. "In the next 15 years, its not going to be so easy [to make money]," Henry argues. "Our industry is [very well] suited to do something about reducing investments risks."

Henry wants futures managers to design expressly for institutional investors products that emphasize risk reduction rather than outsize returns. While theyre at it, he says, managers should lower their fees. This year he created two new businesses - JWH Risk Management and JWH Asset Management - with those aims foremost in mind. "John is trying to change this business from one of returns and fees to one where our chief responsibility is to protect the purchasing power of our investors," says JWH senior vice president David Bailin.

Most managers, although they applaud Henrys intentions, have yet to follow his lead. His critics, moreover, warn that the managed-futures industry risks losing whatever small strides it has made with institutions by trying to change its identity. "What John is saying is that we should try to look more like conventional investments," says Willem Kooyker, chairman of CTA Blenheim Investments. "But we shouldnt change our colors or convey to the institutional market that we are something that we are not."

JWH and other CTAs have long touted the benefits of futures to institutional investors, contending that they created more efficient portfolios. They trot out academic studies purporting to prove that little or no correlation exists between the returns of managed futures and those of traditional equity and bond investments.

This pitch rustled up some institutional interest - and pension money - when stocks were rocked by Saddam Husseins invasion of Kuwait in 1990 and many Wall Street pundits were predicting the end of the bull market. It carried less weight, however, when the bull market proceeded to roar relentlessly into its second decade, particularly after CTAs own performance slipped disastrously in 1994. That grim year Tass Managements CTA index measuring the performance of more than 400 CTA programs, was off 3.5 percent; JWH lost more than 5 percent on its central Financial and Metals Portfolio.

A skeptic might point out that noncorrelations is not a great sales come-on when it means that you do abysmally while everyone else flourishes. In the past five years of surging stock prices, the Tass CTA index has risen an unimpressive 6 percent a year. JWH has earned a far more respectable annual return of 22.7 percent on its F&M program. "The performance [of the industry] has been dreadful," asserts Tass chief executive Nicola Meaden. "At 6 percent youre talking T-bills" No wonder the JWH founder has been telling everyone to forget about playing up returns.

Tired of being a niche player, Henry has little choice but to reach out to institutions if he wants to grow JWHs assets significantly. Retail customers account for 80 percent of the firms assets now, and that client base has been pretty well mined. Most managed futures are sold to customers through limited partnerships or commodity pools organized and marketed by the big brokerage houses. Four firms - Dean Witter Reynolds, Merrill Lynch & Co., Smith Barney and Prudential Securities - dominate the industry, and JWH manages money for all of them. (JWH has gained a certain cachet among investors. It has been Smith Barneys top-performing CTA.) "The John Henry name carries added weight among our brokers and customers, " says Smith Barney executive vice president David Vogel.

John Henry began trading futures in his mid-20s to hedge soybean, corn and wheat prices for his familys far-flung farming operation. Born in Quincy, Illinois, in 1949, he spent most of his childhood 500 miles to the south, in Forrest City, Arkansas, where his father owned some farms. When Henry was 15, he suffered from a respiratory ailment (which has since cleared up), so the family moved to the drier, high-desert climate of Apple Valley, California. (Henrys dad had hired managers to run the farms.) Henry attended several community colleges and took various night courses but never did get his degree.

As a trader, however, this college dropout excelled. One of the firms he relied on to execute and settle his trades, Dean Witter, was so dazzled by its young customers skills that it asked him to manage money for some of its other farmer clients. Henry declined, unsure of what he now calls his "seat-of-the-pants approach" to the markets. But on a visit to Norway in the summer of 1980 with his Norwegian first wife, Mia, Henry experienced a traders epiphany. He explains, "I didnt speak the language, so I was bored quite a bit, and I started working on some ideas Id had for a more mechanical approach to trading." Returning to California, he spent nine months manually backtesting his new theory in every market for which he could get data.

" I was so excited about what I had discovered that you could have a fairly simple philosophy of trends, and trend following, and that it worked so well," he says. In those days he was interested only in the climate-sensitive agricultural markets. But the system would prove remarkably adaptable to other forms of futures. "Our trading methodologies seem to work as well or better for financial markets, because you dont have to worry about rain," notes Henry. (In financial markets, of course, it never rains, it just pours.)

His "system" established, Henry in June 1981 launched an investment program out of a modest office in Newport Beach, California, at first investing his own and his familys money. He officially started trading outside money a little more than a year later. That Original Investment Program has since generated an annualized return of 17.3 percent and now has $120 million in assets. (Doing as he now tells others to do, Henry began seeking to reduce the volatility of all his funds in 1992; remarkably, the original program has returned an even more impressive 24 percent average annual return over the past three years.)

In 1989 Henry moved his entire operations east to an idyllic spot on a bend of the Aspetuck River in Westport, Connecticut (Where its not unusual for visitors to be greeted by a gaggle of geese). Then two years ago, after a particularly miserable winter, he and his traders escaped to balmy Boca, leaving the administrative, compliance and marketing staff to sulk back in Westport.

Henry is whats known as a trend follower: He analyzes price movements to assess where theyre headed (see box). Trend following outpaces discretionary trading among CTAs nearly 3 to 1. Despite the mystique that often surrounds futures managers so-called black boxes, most trend-following systems are remarkably similar. "The 25 or 50 biggest trend followers are essentially going to make money in the same places," says Jeffrey Izenman, president of EMC Capital Management, a CTA thats an aggressive trends follower. "What differentiates them from one another are portfolio and risk management."

Trend-spotter supreme though he may be, Henry isnt infallible, and he knows it. When JWH establishes a position that doesnt go its way, the firm bails out quickly, gladly taking a modest loss. Less successful CTAs tend to be a lot more stubborn. On winning trades, however, Henry also lets profits ride longer than most other managers do. "If we get a profit of 5 to 10 percent, we are willing to give that up in a calculated attempt to earn a much larger profit," he explains. "Our basic philosophy is that real money is made by holding on to successful trades for the very long term." As JWHs systems are designed to send a buy or sell signal only when a clear trend develops, adds the firms R&D chief, Barry Fox, "by definition we never get in at the beginning of a trend or get out at the top."

But its risk management skills that make Henry stand out among CTAs. "Hes the best at managing risk and leverage," Smith Barneys Vogel declares flatly. Henrys primary tool for adjusting risk is leverage. Once, JWHs programs were almost always fully leveraged, ranging anywhere from five to ten times total capital. Now the firm is much more flexible, nudging up leverage when market volatility abates and easing it back when volatility flares up again. (Today leverage can be anywhere between three and six times total capital: Using futures, JWH needs just 20 percent of its capital to achieve sixfold leverage.)

Henry has shown an uncanny knack for gearing up, or down, at precisely the right times. In April 1995 he halved the leverage on all his positions after a big run-up in the firms trading profits, thus limiting the impact of the volatility that plagued many futures markets later that year. "Hes been excellent at reducing leverage during times of heavier risk," confirms Carlton Anderson, vice president of Cargill Investor Services, who has used JWH in two limited partnerships.

Henry kicked off his crusade to save the managed-futures industry a year ago with his address at the Managed Futures Associations annual meeting at the Chicago Hilton. Not known as a dynamic speaker, he nonetheless had several hundred CTAs listening intently as he urged them to do nothing less than remake the entire industry. "Our role, if we are willing to step up to the plate," he said, "is to return for lower leverage and greater assets." Institutions would flock to these new-model managed-futures firms, he maintained, because they would "provide highly liquid, easily discoverable, unleverage or low-leveraged returns that have risk benefits which are so compelling [that] they far outweigh any other issues."

Henrys vision for the industry had begun to gel nine months earlier, during a brainstorming session with JWH senior strategist Jules Staniewicz and vice chairman Mark Mitchell. The firm had just slashed the institutional fees for some of its products from 4 to 1 percent and linked its incentive fee to a return over T-bills. But Henry felt that those concessions werent enough to win over significant institutional money: For JWH (or any other CTA) to become a serious institutional money manager, he and his colleagues had to figure out how to capitalize on the firms risk management expertise.

JWH Risk Management Inc. was launched roughly a year later. RMI began trading with the firms own money this past January and has just begun marketing its products (management fees range from 40 to 125 basis points). Institutions can choose from a menu of products, including an enhanced index series - a concept readily understood by plan sponsors and their consultants. Henry insists that clients can add 200 to 300 basis points over an index without increasing volatility (RMI offers eight major stock, bond and commodity indexes to pick from).

RMI simply replicates the index by using some 15 percent of the assets to buy index futures and puts most of the remainder into cash instruments. RMI tries to add value by putting as much as 10 percent of the assets into JWHs own trading programs, hoping to take advantage of their non-correlated returns. Alternatively, RMI may aim to reduce the volatility of an index - and boost returns - by putting a much larger portion of the assets into JWHs own trading programs. RMI also offers low- or no-leverage versions of JWHs existing core programs. (One staffer jokingly refers to them as "John Henry lite.")

Pension funds barred from buying futures can participate in JWHs trading programs through swaps, a notion dreamed up by vice chairman Mitchell, a lawyer. Through a separately capitalized swap facility, JWH Asset Management, institutions can do a "swap" with JWH, Paying the firm LIBOR and receiving 80 percent of an index pegged to the performance of one of JWHs major programs - provided the index rises. If it falls, the institution pays LIBOR plus 100 percent of the drop in the index. Thats a good deal for investors, the firm maintains: Between January 1984 and December 1995, 80 percent of the financial and metals index would have returned nearly 17 percent above LIBOR annually. As for JWH, whether the index rises or falls, the firm pockets LIBOR less the swap fee it pays to a swap intermediary. But "our real profit," says senior strategist Staniewicz, "comes from the 20 percent of the index we keep when it goes up." Henry hopes to have done the first swap by this fall.

Persuading institutional investors and consultants to consider these products will take patience. In fact, Henrys crusade has yet to register on most consultants radar screens. His task will be all the more difficult because he will also have to reassure them about the stability of JWH. Three of Henrys top executives have quit in the past three years. "Organizationally, it has been a revolving door," says Lois Peltz, managing editor of "Managed Account Reports," which has been tracking CTAs performance going back to 1979.

First to go was longtime CEO Kenneth Tropin, who was allegedly fired over a compensation dispute in 1993 (Tropin didnt return calls). President Bruce Nemirow, who was promoted from head of marketing to replace Tropin, was pushed out in May 1995, reportedly after disagreements with his colleagues over business strategy. Nemirow, now at Paloma Partners, wont talk about why he left JWH, but he says hes still friends with Henry.

Last year Henry hired Peter Karpen, head of CS First Bostons futures group, and James Johnson, CFO at Bankers Trust Asset Management, to take on Nemirows responsibilities. But nine months later Karpen decided to quit (he actually leaves in September). Henry had named him managing director, envisioning Karpen as JWHs emissary to the outside world. He was counting on Karpens standing as a former chairman of the Futures Industry Association and a 14-year career banker at CS First Boston to add legitimacy to JWHs new institutional push. Karpen, say those close to him, wanted a bigger hand in running the firm. "John wanted me to be strictly the outside guy, but I saw my role evolving into something more, " says Karpen.

For his part, Henry readily admits that he demands a lot of his employees. "Were driven to excel," he says, "and thats necessarily going to occasionally create differences of opinion."

Johnson, installed as chief financial officer, is busy building an infrastructure and technology platform for JWH that can handle explosive growth. He has the requisite experience: In his 11 years at BT, assets under management grew from $20 billion to $160 billion. In just one year JWH has grown from 45 to more than 70 employees. One key hire was Bailin, a former institutional marketer with manager-of-managers Global Asset Management. Johnson has also installed an automated trade-entry system for the Boca traders, to enable the firm to handle significantly more volume without increasing its costs.

Plainly, Henry is determined to transform JWH from CTA to institutional money manager. All he needs are clients. Changing the image, style and fee structure of the entire managed-futures industry is a more ambitious task. Other managers have fewer resources to design and market new products. "For the standard manager in this industry, someone with about $100 million or so in assets, it would be a very difficult thing to do [what JWH is attempting]," says EMCs Izenman. He, for one, is still content to focus on the industrys traditional retail market. Nor do all professional futures traders care to force-feed their businesses to achieve growth or change their style to appeal to institutions. Theyre doing dandy, thanks, wringing fat fees from small (and getting smaller) amounts under management.

Henry regards such complacency as short-sighted at best. "The returns in our industry have not been very compelling," he insists. "Its much easier for managers to reduce risk for portfolios." Of course, If JWH, in it new guise as a risk-avoiding institutional money manager, flourishes, perhaps other CTAs will come around to sharing his vision. In futures, profits are never without honor.



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