You’ll be hearing more about managed futures in the coming months and years. Not just because there are many products being launched and promoted, but also because it is a long-standing and consistent alternative strategy.
Managed-futures strategies are run by a heavily regulated and monitored class of portfolio managers called commodity-trading advisors (CTAs).While often considered hedge funds, the correlation of CTA strategies to most other hedge fund types is very low (see “Correlation of alternative strategies to S&P 500).
Managed futures are one of the most accepted alternative strategies in the market today. According to Hedgeweek, they are the largest alternative investment strategy in Europe, accounting for 20% of the nearly $400 billion invested in alternative investment strategies.
The majority of managedfutures strategies are looking to follow trends in a broad range of assets, including: metals, energy, grains, soft commodities, and financials such as equity indices, interest rates and currencies. By and large, CTAs use futures contracts to get exposure to these asset classes, since futures are liquid, transparent, exchange-settled and cleared (no counterparty risk).
CTA strategies are characterized by riskmanagement and capital allocation rules, which are disciplined and often quantitatively executed. CTAs are generally looking to participate in both uptrends and downtrends that occur in the markets.
While investors often crave a fundamental reason for following a given market trend, the simple truth is CTAs are long because a market is going up; or short because a market is trending down.
This combination of systematic execution and trend participation enables managers to separate themselves from market emotion and be agnostic in terms of market opportunities. While some people think CTA strategies are black box due to the use of computerized quantitative strategies and the perceived lack of transparency, a number of advances will hopefully change this viewpoint.
Several managed futures indices now provide full transparency in terms of position and methodology. These indices are linked to ETFs and mutual funds. For the first time, Towers Watson has added managed-futures strategies to its recommended list, citing increased transparency from CTA managers, according to HFMWeek. Moreover, there is greater acceptance of computerized quantitative strategies as we rely on technology to provide consistent risk management.
Correlation of alternative strategies to S&P 500
Source: Hedge Funds and Individual Hedge Fund Strategies: Hedge Fund Research., Inc; Managed Future: International Traders Research, Inc., US Stocks: Standard and Poor’s: US Bonds: Barclays Aggregate Bond Index
Consider how computers have affected the airline industry. If you boarded a flight only to find out the computer systems were down but the pilots decided to still fly using only their discretion, would you stay on the plane? Not a shot. Systematic execution of a process reduces risk.
Everyone follows trends. Identifying and participating in trends is not overly difficult; it’s harder to know when to exit trends. In other words, capturing trends is tougher. To time it right, CTAs base their strategy in disciplined capital allocation.
The idea is you can risk one unit of capital to make two or three or more units, but never lose more than a unit on any trade—similar to buying a call option. Additionally, the risks are spread across asset classes such that the portfolio has internal diversification. By indiscriminately participating in up and down markets, the end result is real diversification as non-correlated returns to traditional investments.
It should be no surprise then that this strategy has widespread institutional usage on a global basis, where many institutional portfolios carve out a portion for managed-futures allocations.
Most myths about CTAs can be dispelled by thinking of three distinct periods in recent market history.
Barclays CTA index vs. TSX 60
|Calendar Year||Barclays CTA Index||TSX 60 PR|
|5 Year Annualized Performance||4.94%||-1.73%|
|Period of Financial Crisis|
|Period of Equity Market Performance|
|Period of Normality|
Source: Barclays Hedge and Standard and Poor’s
Within North America, well-known pensions and endowments using managed futures include CALPERS, Texas Teachers Retirement System, Ontario Teachers’ Pension Plan, and Harvard Endowment Fund.
Myth 1: CTAs only provide returns in markets characterized by high volatility.
While high volatility is one of the most opportune times for managed funds (as in 2008), CTAs can also perform well during normal volatility (2007 and 2010).
The correlation of hedge funds to managed futures remains low during normal volatility (it’s slightly positive) and negative during high volatility. Over the long run there is a slight positive correlation between hedge funds and managed futures.
Myth 2: Periods of equity performance, often characterized by low volatility, are disastrous for CTAs.
If markets don’t have any volatility or discernible trends, it’s hard for most investment strategies to make money. Markets need to move to create opportunity. CTAs are no different.
During periods of lower volatility, like those witnessed in 2009, CTAs may not have delivered eye-popping returns, but they did generally preserve capital. As a result,CTAs did not hurt portfolio performance.
The tough times for CTAs are actually periods of government intervention and policy change like in 2009.
However, unlike periods of financial crisis for the equity markets, disciplined risk management limits losses and is the reason the volatility and drawdown of CTA strategies remain far lower than that of the stock market.
After thorough due diligence, if you find a managed-futures mandate that meets your investment objective, you’ll be able to construct a portfolio that should have a better risk profile and more diversified sources of return.
Tim Pickering is Founder and CIO of Auspice Capital Advisors, a next-generation CTA that offers strategies in active managed futures, passive ETFs, enhanced indices and custom commodity strategies.