When you woke up yesterday morning, this was the headline of the lead story on Bloomberg News:
The past week had been really tough, with bonds and stocks both crushed, regardless of locale. There were panic moves everywhere, but particularly in sterling. Third world type emergency action being considered to control the slide. If the Fed’s mission was to break something, well, mission accomplished. Negative skew everywhere. There was, almost, no place to hide.
Almost because there was one place to hide, a well known asset class that advertises success in periods of adversity and volatility. An asset class that exhibits positive skew, or as my partner likes to say, it crashes up. An asset class that is up this year, and up this month, yet is not particularly dependent on manager skill. Simple Alternative Beta indexes capture the returns nicely. Its liquid and easy to access in a variety of formats.
What is it, you say? Its Managed Futures, of course. Now let me warn you. There will come a point when the markets will settle down, Darth Powell will take his foot off the brake, and traditional assets will recover. Managed futures will likely give back some recent gains, perhaps with a vengeance. But if you had it in your portfolio, the profits you gained could have been rebalanced into those cheap equities and credits, primed for the next move higher. It’s a beautiful thing, but you need to be in the game to win.
Here’s a question in everybody’s mind – Have we seen the top in commodity prices? We can see both sides of the argument.
Yes. The Fed is going to move far enough to break things, that will push us into a recession or worse, and commodity prices fall in recessions. It’s global too, with Europe and Japan falling out of bed. China won’t come to the rescue this time either, with the Ponzi bubble that is China real estate deflating and Covid lockdown mania. With the USD on a tear recently, for those overseas buying things priced in USD it’s even worse. Oil in Europe and the UK is through 2008 spike highs already, demand destruction ensued then and will now. Forget it, the commodity trade is over.
No. Virtually every commodity, from grain to oil to electricity to butter of all things is tight.
One great example, beef. Beef is one of the few commodities that has risen very little over the last year. Why is that, you ask. Because US ranchers have been liquidating the herds and putting that beef on the market, as costs have risen. That has kept near term prices lower, but if the economy recovers, the herd will not be rebuilt fast enough and prices will rise rapidly. A classic whipsaw, and it’s happening everywhere. Prices have risen because of supply issues, and raising rates will not help supply as it raises the cost of production. Should the Fed take its foot off the brake, supply will not be replenished fast enough to satisfy instantaneous new demand. Result – higher prices, a bit down the road.
Last week we said – watch rents. Look at this chart. If we have seen peak hawkishness, get bullish commodities.
The reaction to last week’s CPI print was pretty dramatic. We see a couple of related factors:
Given the fall in gas prices, the S&P had bumped off the bottom in anticipation of a soft print. Positioning went from negative to perhaps modestly positive. CPI caught the market on the wrong foot.
Gas prices as reported in the CPI did fall as expected, but just about everything else went up (see graph below). Everyone knows gas fell because of releases from the Strategic Petroleum reserve. That policy is the definition of “transitory” (they will need to buy it back, no less). With everything else going up, inflation fears pulled a Lazarus.
Watch rents. Lagging but steady inflation indicator, closely tied to wages.
The last few months have been a fantastic case for the role of managed futures in a portfolio. Managed futures do well in periods of macro volatility, and this time is no different. What investment, that can be measured passively, has done well this year? Short term treasuries? Nope. The Bloomberg US Treasury 1-3 Year Index is down 1.5% YTD (through Feb 14, 2022). Stocks? Nope, the S&P 500 TR Index is down 7.5% and the Nasdaq-100 TR Index is down 12.5%. Real Estate? The Real Estate Select Sector TR Index is down 13.2% YTD. Some of the tail risk and long vol strategies were also down. How about managed futures? The MLM Index EV (15V) is up 10.3% YTD. So why is it that managed futures have not gained wider acceptance as a portfolio element? There is a lot of blame to go around. Let’s have a look.
All the issues around managed futures arise from the character of the returns. Managed futures have positive skew, the profile of an option buyer. Lots of small losses (like premium paid), with occasional big gains. This is the reverse of the stock market, where the market goes up in small steps and down in a whoosh (negative skew). The attraction to managed futures is that the big gains are often at the same time as the stock market whoosh, like this year, and that they can capture that convexity whether it’s being driven by market moves up or down. Risk parity models try a similar approach – using bonds to diversify stocks, but that only holds when bonds go up. Sometimes its bonds falling that cause the equity whooshes. Sound familiar? Being able to generate convexity on both sides is a big improvement. The character of managed futures returns breeds a lot of behavioral biases on the part of investors. But first, let’s look at the managers.
First, the fees are too high. In its infancy managed futures was sold as a pure skill game (not unlike stock picking prior to some ground-breaking research in the 60s and 70s). Pure skill demands a high price. Index funds, then passive ETFs, entered the equity space and reduced the price for market beta dramatically. Think of it this way – if we pay a high fee for the investment, it increases the premium of the synthetic option we buy with the investment. If we pay high fees waiting around for the investment to pay off, the cost will consume the return. In options lingo, high fees are akin to high theta bleed. Keep the fees down and the outcomes will be better. Index funds are entering the managed futures space now. You shouldn’t pay high fees for beta anywhere, that holds for managed futures as well. The academic research supports this – you can read more here.
Investors love negative skew. They shouldn’t, but the siren song is too much. They love making money most months. Advisors love negative skew. Nothing to explain except in the months where everyone gets whacked. Investors hate looking at the lineup of their investments and see this thing that has been leaking a bit while the stock market has gone up. Advisors take the plunge in managed futures AFTER a big run, when the odds of losing are actually greater. We all look at our financial situation holistically, look at the entire picture. We are unlikely to go through life without homeowners’ insurance, a classic positive skew product. And we would be foolish to buy it after the house burnt down. It would be imprudent to pay a high premium as well. Can you imagine if you looked at your financial situation once a month and said, “this stupid insurance costs me every month, I am going to cancel it”. Managed futures is properly viewed as insurance against macro volatility. Granted, it does not have the contractual nature of true insurance, but it has the same positive skew. When managed futures pays off, like this year, rebalance – rebuild the house. Use those gains to buy cheap stocks. Pump the volatility of your portfolio elements.
Managers over the years have tried to overcome the reluctance to invest in managed futures by improving the Sharpe ratio of the investment. This is generally done in one of two ways. The first to us is a cardinal sin – using that spare cash available to managed futures strategies to try and eke out a few extra basis points in supposedly safe credit pools that turn out not so safe. This is potentially selling away all the positive skew benefits for incremental fractions of pennies on the dollar. Don’t do this, know what you own. The second way is typically achieved by reducing exposure when volatility increases. The direct result of this decision is a truncation of the skew of the return distribution. It may be a good decision for the manager’s business, but it is terrible for the investor. When volatility rises, that is exactly when you want more managed futures exposure, not less. Think about it – your long only traditional investments are seeing bigger price fluctuations, you need your diversifying portfolio elements to show up, not be shrinking away. It is akin to your insurance company reducing your coverage level as the wind picks up. You need to keep the potential payout high. Sure, the drawdown on the other side may be larger, but the increased return in the heat of the moment allowed you to hold your negative skew investments and rebalance into the recovery. We’ve written some more details on this phenomenon here.
Index Descriptions: The Bloomberg US Treasury: 1-3 Year Index measure US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury with 1-2.999 years to maturity. Treasury bills are excluded by the maturity constraint, but are part of a separate short Treasury Index. STRIPS are excluded from the index because their inclusion would result in double counting. The S&P 500 index is an unmanaged index consisting of 500 stocks chosen by the Index Committee of the Standard and Poor’s Corporation that generally represents the Large Cap sector of the U.S. stock market. Returns for the S&P 500 index reflect the reinvestment of all dividends. The Nasdaq-100 is a stock market index made up of 101 equity securities issued by 100 of the largest non-financial companies listed on the Nasdaq stock market. It is a modified capitalization-weighted index. The Real Estate Select Sector TR Index is a subindex of the S&P 500. The Index seeks to provide an effective representation of the real estate sector of the S&P 500 Index and seeks to provide precise exposure to companies from real estate management and development and REITs, excluding mortgage REITs. The MLM Index EV (15V) “Index” serves as a price-based benchmark for evaluating returns available to investors in the futures markets. The Index applies a pure systematic trend following algorithm across a diversified portfolio of 11 commodity, 6 currency, and 5 global bond future markets.All data is through February 14, 2022.
I recently had a conversation with a colleague about the idea that portfolios over the last 40 years have been conditioned for falling interest rates. If that supertanker makes a turn, a lot of money will be on a collision course. He said in 1984 there was an equal and opposite issue … buying bonds for the prior 20 years had been a fool’s errand. The cycle climaxed in June 1984 with a hot GDP, a low inflation print and a collapse in bonds. Even though inflation was low, no one wanted to own them.
I was intrigued and pressed the conversation with our resident bond historian and partner, Paul DeRosa. His response below:
It was the bond buying opportunity of the 20th century. The long period of inflation and the large deficits run by the Reagan administration conditioned people to believe inflation was only temporarily low and that it would return, as it had in 1980. I bought 250 million of the 13 ¾ of May 2014 and was down 10 million on the trade before I wrote the buy ticket. With the funds rate at something like 11.5%, the yield curve actually got steeper rather than flatter. The current situation is something like the inverse of that period. We’ve had a long period of low inflation, and a lot of people still think it is temporary. So, I would expect rates to rise grudgingly and the yield curve to stay flat. The good thing about finance is that illusion eventually has to face reality. By late summer of 1984, the high interest rates had the economy on its proverbial tail. Payroll employment started to sag. I remember buying a boatload of the Treasury 4-yr Note in September, but it still was very hard to get people to accept lower yields. To keep from worrying about it I played squash at the New York AC, but checked the market between games.
Just to finish this up, 1985 was a pretty good year for the bond market, but the big break came in Spring of 1986, when the crude oil price collapsed. It took a big external event to change expectations about inflation. I completely missed that move because I misread the situation. The stock market also rallied, and I couldn’t figure out how bonds could rally with the stock market so strong. Well, the answer, of course, was the stock market was rallying because it saw rates falling.
The chart below is fascinating to us, particularly in light of the fairly modest in magnitude, but quite speedy rise in UK yields. The chart shows the difference between futures prices for sterling 3 month LIBOR expiring in September 2022 and 3 years later, in September 2025. They price at 100 minus the interest rate, so a price of 99.5 equates to a 0.5% prevailing rate at expiry. Roughly speaking, individually the contracts can be interpreted as the markets best pricing for interest rates at those points in time, the spread between them gives a look at how the path is priced to get there.
A year ago, rates were priced to be at about zero in September 2022, and not much higher – maybe 1 hike – by September 2025. At a starting point of functionally zero rates – that’s a pretty poor prognosis for 5 years time. Earlier this year, the spread between contracts increased as the nearer maturity contract dropped a little in price – implying higher yields – while the longer maturity contract fell more in price. The spread widened to a high of 78bps in early summer. That’s the market roughly saying things are a bit better economically – over the next few years we will see about a hike per year.
The interesting part is not even the most recent drop in the September 2022 contract, as the market is pulling forward all those hikes into the next 1 year. Higher inflation and a better economy allowing the Bank of England to hike. So far so good, a bit aggressive maybe, but sure, probably some natural gas inflation in there. The interesting part to our eye is that the spread has collapsed. It is as if the market is saying ‘Sure you can hike now – but you’ll get to 1% and have to stop as the economy can’t withstand it, that’ll be it, maybe you’ll end up cutting again’. Now there are other things at play here in terms of pricing along the curves and longer rates being driven by other things – but as a fairly clean barometer its reasonable. The rubber is hitting the road on markets determining escape velocity. Will we get a self-sustaining recovery and a more normal economy that can sustain these yield levels and maybe higher as things take off? Or not? Its fascinating to watch play out…
“You can eat or you can sleep”. The biggest change I have witnessed over the course of the past 3+ decades is the change in investor preference, particularly hedge fund investors, away from positive skew to negative skew… from sleeping to eating. I sleep well. The quote came from a discussion my partner had with another manager who runs a fund that is often aggressively short volatility. He, like all of Wall Street and beyond, have monetized this preference for negative skew – regular returns most of the time, with the occasional blowup. They are eating well.
The preference for negative skew flies in the face of conventional finance theory and behavioral economics. After all, why would people buy lottery tickets? Smarter people than me have worked these ideas over, and it’s a bit of a mess. Let’s just think about 3 possible drivers (I am not bashful about stealing others good ideas). Some of these thoughts are motivated by a great blog post that can be found here: https://www.macroresilience.com/2010/01/13/do-investors-prefer-negative-skewness/
Falling Yields. Investors will give up positive skew in return for higher yields. In a low rate environment, one can get a higher yield by selling options. The last 25 years have seen persistently lower yields, and a wildly expanding options playground. Man wants a green suit, turn on the green light. Build product that yields well but has negative skew.
Moral Hazard – that thing officials used to worry about. No more. The central banks of the world, and, increasingly, the folks at the controls of fiscal policy, all but guarantee the financial downside. A hedge fund / family office that exploded earlier this year drew only fleeting notice from officialdom. Why? Because it was a garden variety bad trade, housed at one particular fund. There was nothing systemic about it … because it was a positive skew position. It was a classic one-off. Importantly, at the end of the day, they knew what he could lose. Systemic option selling has unlimited downside, and the players will not let that happen. Investors have grown to rely on this protection and have piled in – moral hazard.
Principal/Agent. No one likes to be told they have lost money. Agents know this. They also know that if they have company, it goes down easier with the principal. Join the crowd and count on number 2 above. Early in my career, we were trying to interest a large consultant in our fund. He listened politely, but at the end of the day he said that he was investing in a mortgage fund that made money every month. The meeting ended (as I recall we took him to dinner and a ballgame… I still regret it). That fund blew up a few months later in the first of the many mortgage meltdowns. He survived… in fact sold the consulting firm to a private equity shop. Eating well.
Contrary to these changes in preference, we have no intention of changing our stripes. We understand that our style is a more difficult hold than a steady earning, negative skew manager – that’s why there are very few of us left. But in a portfolio context, there is real value in a strategy that pushes against the prevailing wisdom. And we have demonstrated, over 3+ decades, that we can sleep well.
Managed Futures offers this promise- uncorrelated returns with the potential for crisis protection. How an allocator chooses to allocate to this asset class is important. Do they judge managers by best risk-adjusted performance? Or do they judge managers by how they improve the risk-adjusted performance of the total portfolio? Do they view the asset as an absolute return element, prioritizing Sharpe Ratio, or as a portfolio element prioritizing diversification? Assuming the latter, prioritizing the addition of positive skew is critical to crisis diversification, offsetting the historically negative skew of the equity market and creating a better total portfolio.
Typical Managed Futures managers employ a risk controlled approach called vol targeting (we have written previously on this topic here and here). In essence, vol targeting involves increasing exposure when volatility is low and reducing it when volatility is high. Historically this has improved manager Sharpe ratio at the expense of skew. Our MLM Index EV and MLM Global Index EV are constructed a bit differently. While following similar trend following algorithms, positions are sized on exposure, not vol. The net effect is our indices are long changes in volatility, providing higher skew when needed most; in highly volatile markets. This makes intuitive sense; trend following tends to crash up while equity markets tend to crash down. The last thing you want to do is put the brakes on your diversifier while it is crashing up.
You Shouldn’t Bring a Knife to a Gunfight!
Stocks and credits are negatively skewed and historically have had large drawdowns. Neither asset class is volatility adjusted. If you are optimizing for the whole, and are rebalancing, you ideally need diversifying assets that have a negative or low correlation and positive skew.
Below we compare the MLM Index EV and MLM Global Index EV to the SG Trend Index (index of manager returns) and the CS Liquid Managed Futures Index (vol-adjusted price based index) and show skew and correlation statistics. Note the crisis returns are materially higher, our indices have the highest skew and kurtosis – which pairs most advantageously with stocks and credit that are negatively skewed with high kurtosis.
Correlations below as well.
Cast your mind back to late 2008 into 2009 when things were really going wrong. Stocks were plummeting, credit markets were freezing. At the same time, the USD was going up, crude oil was dropping precipitously, and the US Treasury market was rallying. See the impact at the position level of a representative model that vol adjusts vs our trend following approach, using the Nasdaq as the example.
Volatility adjusting positions reduces the diversification benefit at the worst time. The Nasdaq began to fall, the trend following component of the models moved short. The volatility adjustment process reduces the short as realized volatility picks up on the down move around the Lehman collapse. In this representative example, the short is reduced by some 60%.
In the next chart we compare the volatility adjusted model to the unadjusted model, you can see the unadjusted volatility approach has higher returns when you need them most. When using this approach, it is critically important that that portfolio elements are rebalanced. Even though returns in this example end up in about the same spot, at the portfolio level the sequence matters. The extra gains are monetized, the Managed Futures allocation is sold down, and more stock is bought at lower levels.
Volatility adjusting can also be detrimental, given that equity prices and vol are negatively correlated. In early 2018, volatility collapsed until it didn’t. As volatility adjusting models increased position sizes in response to falling realized volatility, they are making the case that risk is falling, which is dangerous in our view. When the market fell and fell quickly, they took larger losses as they were at max positions. In a portfolio context this reduces the portfolio diversification benefit to the investor, particularly when this is applied to equity index markets.
A Better Portfolio
When modeling a portfolio with stocks and credits, the different approach is clear. In the example below, we start with a portfolio that holds 50% each stocks and credit. Then we add some vol-adjusted managed futures and some leverage to create a portfolio with 40% stocks, 40% credit, and 60% in CS Liquid Managed Futures. For the last two portfolios, we swap in the MLM Global Index EV and the MLM Index EV at the same 60% allocation for managed futures.
Note the skew changes at the portfolio level – typical portfolios are negatively skewed, and adding an uncorrelated positively skewed strategy takes the overall portfolio to zero skew. Drawdowns are much reduced, portfolio Sharpe ratio increases, overall portfolio volatility goes down.
The Covid crisis (Jan 2020 to Mar 2020) provides a complete example in a compact period. Typical trend managers were very long equity December through February, as volatility was still quite low. When markets broke, volatility increased and the exposure of the trend shorts was proportionately reduced. The same was true in other markets like energy. The MLM Index approach, using constant exposure and thus increased skew, provided better returns over this difficult period. If its diversification you want, ignore the siren song of Sharpe, and go for the skew.
We wrote a few times during the depths of March and April on stresses we were seeing in bond, credit and funding markets. It was clear things were not functioning correctly. It was equally clear that both monetary and fiscal policymakers were trying as hard as they could to counteract. Now that some time has passed much more detailed examinations are coming out that are well worth reading to get a better idea of how the plumbing works, and sometimes gets blocked.
One of the biggest challenges in investing is timing a rotation from a style that is currently in favor into a style that is currently out of favor. This was the challenge in 1999 and is so again today. In April 1999, the NY Times had an article titled “Mutual Fund Report; What’s Killing the Value Managers?”; history doesn’t repeat itself but it surely does seem to rhyme.
Back to 2020. Concentration in the equity markets has been a topic of conversation in the past year. Five years ago, Apple, Amazon, Facebook, Google, and Microsoft were 9.5% of the S&P 500. At the end of the second quarter, these five companies accounted for 21.7% of the S&P 500. These same five companies account for 45.7% of the Nasdaq 100 and Amazon itself is 44.4% of the total market of all the companies in the S&P 500 Consumer Discretionary sector. The current average forward P/E of these five companies is over 40, doubling from mid-March. As a result, the forward P/E of the Russell 1000 Growth Index at the end of the second quarter was 32.7. Since 1995, the only other time the forward P/E of the Russell 1000 Growth Index was this at this level was in late 1999 and in 2000, the heart of the dot-com bubble where it reached a peak forward P/E of 43.5 in July 2000. Over the entire 1995 to present period, the average forward P/E is 20.3. While equity valuations in general have increased as a result of low nominal rates, the increase has been more pronounced in the growth factor as the spread of the forward P/E of the Russell 1000 Growth Index is 11 P/E points more than the forward P/E of the Russell 1000 Value index.