Notes From The Trading Desk

Notes From The Trading Desk

Managed Futures: 2018’s Most Frustrating Asset Class

By Longboard Staff
Category: Diversification

After posting above-average returns in 2017 where many managed futures strategies captured strong trends and positive directional momentum, 2018 has seen a different story. Last year’s alternative asset class winner has turned in to this year’s loser.  

To many investors, this up-and-down experience can be frustrating, provoking some to debate the merits of managed futures and question its portfolio diversification benefits.

We hope this discussion may provide some unique insight and help investors see managed futures performance from a different perspective.

WTF Managed Futures?!?

Managed futures can be a difficult asset class to set proper expectations for, particularly relative to more familiar long-only strategies.

Some investors tend to believe that managed futures are negatively correlated to stocks, and therefore will be positive when the stock market is negative. This misperception was largely earned after 2008, when most managed futures funds produced above-average positive returns (SG Trend Index[i]: +20.88%) as the rest of the global market was buckling under the weight of the housing crisis (S&P 500 Index[ii]: -37.00%).

In reality, the “hedge” label is a misnomer. As the table shows, managed futures are up when the stock market is down just 16% of the time since January 2000. That’s an awful hedge by any measure!

And yet, many investors were sold managed futures as just that – something that will be up when the rest of the market is down.

It’s true that managed futures can deliver above average positive returns in a crisis (so-called “crisis alpha”), but it’s an output rather than a feature one should expect as a matter of routine. 

In truth, managed futures are uncorrelated rather than negatively correlated to equity markets. It’s a subtle distinction with major implications for client conversations.

“Uncorrelated” is synonymous with “unique.”

As Modern Portfolio Theory lays out, the best diversifiers of risk are those assets that can produce different returns at different times. So, mathematically, managed futures is a no-brainer. 

The challenge is how different returns feel.

We acknowledge most investors benchmark portfolio performance to the performance of the S&P 500 Index. So, we measured the performance of the S&P 500 Index against the performance of the SG Trend Index from January 2000.[iii] As the table illustrates, holding managed futures as part of a portfolio exposes investors to a wide range of emotions. This makes setting proper expectations particularly important.

20% of the time, managed futures are negative alongside stocks. So, if investors believe they hold something negatively correlated – that is, something that will be UP when stocks are DOWN – this can be extremely frustrating.

Compounding the issue is that most strategies only report the static correlation to the market. Even if the reported number is quite low, the real-time number changes month-over-month. 

Dynamic correlation to stocks is part of what makes managed futures such a valuable diversifier of risk.

To help visualize the difference between static and dynamic correlation, we compared the rolling 6-month correlation of the SG Trend Index to the S&P 500 Index (blue line) with its average correlation (grey line).

Past performance is not an indication of future performance

There is clearly a lot of variance here! The highest reading clocks in at 0.95, whereas the lowest reading drops all the way to -0.90. And yet, the long-term average number reports in at 0.18.

The takeaway: investing in managed futures on the expectation it will be negatively correlated to stocks is misrepresenting the asset class’ true nature. Given this context, hopefully the range of emotions managed futures can provoke makes more sense now, too.

Ok, but why are managed futures uncorrelated?

The key to managed futures strategies’ shifting correlation is that most strategies run a tactical investment process that captures trends[iv] in market momentum, both up and down and across a wide set of asset classes.

The most common managed futures portfolio tracks and trades around 100 different markets spread across global stock indexes, interest rates, currencies, and commodities – and each market often moves differently from the other.

As a result, managed futures managers try to calibrate their entry and exit points to the markets they trade. Some managers believe quick trends are better, where others believe slower, long-term trends yields better results. Each manager will run slightly different models depending on their philosophy.

To summarize: the number of markets traded, plus the tactical ability to go long or short, plus the speed at which the strategy moves, bind together to produce a highly diversified vehicle for capturing opportunities to produce different returns that come at different times from long-only assets.

Ok, But Recent Returns Have Been Below Average - What About Expected Returns?  

The S&P 500 & SG Trend Index rolling returns typically converge every 3 years or so as the two revert to their respective means.

Past performance is not an indication of future performance

Historically, when the difference between the S&P 500 and the Managed Futures widens significantly, that typically indicates an excellent opportunity to tactically rebalance between the two asset classes – that is, selling the outperforming asset and buying the underperforming one on the expectation relative performance will strengthen for one and weaken for the other. In 2009, that would have meant selling managed futures and buying equities; today, it infers buying managed futures and selling equities.

To that point, the spread reached 21.03% at the end of September.  This has only occurred in 4 years since 2001.  In the 12 months following those occurrences managed futures advanced by an average of 12.14%, producing positive returns in 3 of those 4 years.  The chart below further illustrates the cyclical nature of managed futures returns.

Given the recent equity market sell off and the cyclical nature of the relationship between stocks and managed futures, investors may want to consider the benefits of doubling down on diversification

Past performance is not an indication of future performance


Disclosures:

Index performance on this page was sourced from third party sources deemed to be accurate, but is not guaranteed. All index performance is gross of fees and would be lower if presented net of fees except for the SG Trend Index, which is net of fees. Investors cannot invest directly in the indexes referenced in this blog.

[i] SG Trend Index: a basket of the 10 largest managed futures managers, by assets under management, that is open for new investment. Excludes fund-of-hedge funds. Returns are net of management and performance fees.  

[ii] S&P 500: A stock market index based on the market capitalization of 500 leading companies publicly traded in the U.S. stock market, as determined by Standard & Poor’s. In this document, the S&P 500 is presented as a total return index, which reflects the effects of dividend reinvestment.

[iii] The SG Trend Index inception date is Dec 31, 1999

[iv] Put simply, a “trend” is when a market is hitting new highs (to go long) or breaking down to new lows (to go short) after a specific period of time. The length of lookback time one needs to determine a “trend” is a major differentiator of one strategy to another. How fast or slow a strategy enters and exits a market helps determine its sensitivity to overall market conditions.