2022 has been an awful year for most all assets. Through the end of the 3rd quarter, the S&P 500 is down 23.9%, High Yield bonds down 14.4% and Investment Grade bonds down more at 21.2% (worse than HY due to the longer duration in IG). Over the past few decades, investors have been somewhat accustomed to seeing US Treasuries do well in tough times for equity and credit markets, this year though, 7-10 year US Treasuries are down 15.7%. It’s an ugly scene…not a lot of places to hide.
One bright spot – Managed Futures strategies. We wrote about these earlier in the year here. Our long-held view is that Managed Futures are fantastic portfolio elements. We like them more than most – and execute them in a purer form than most as well – but recognize them for what they are. A Portfolio Element. Most investors, us included, hold portfolios of stocks and credits. To our eye these are also Portfolio Elements. Stocks tend to do well in times of economic stability, growing earnings and rising multiples. Managed Futures tend to do well in periods of macro-economic uncertainty and instability. Combining these two elements makes a lot of sense to us.
As with all portfolio construction, the only thing more important than having a plan is following a plan. Rebalancing is plan-following in action. In the years prior to the pandemic, it had been a fairly fallow period for trend following strategies. Continuing to hold exposure to portfolio elements that are out of favor for a period is not easy to do. A lot of investors start with a great portfolio of undiversified elements, then at the end of every year take a look down the list of line items and chop the bottom few. If you do this a few times in a prolonged cycle, you end up with quite a correlated book – whether you notice it or not. This happened pre 2008 when both energy stocks, emerging markets, commodities and carry strategies were all doing well. If you aren’t careful and you chop the other pieces as they underperformed and didn’t rebalance the winners, you end up with a chunky overweight in those things. As that cycle continued it became fairly clear the drivers were narrowing. Commodities were going up, which helped energy stocks. It also helped emerging markets, which at the time were more heavily raw materials based economies. Hot money flows into the markets amplified the FX component of the returns too, and in currency carry the commodity currencies were outperforming and had higher rates. They all unwound together.
Fast forward to the past couple of years. Tech has been doing incredibly well – fabulous business performance, network effects, buybacks and multiple expansion. Venture capital had been doing well. The broader stock indices became more concentrated along the way, and low rates seem to boost steady subscription type businesses and REITs. We have a common factor forming. The cycle extends and credit spreads tighten, borrowers extend and refinance into new bonds at lower coupons, increasing duration and reducing risk premium. Government bond yields got lower and lower, as they were the perfect component – uncorrelated to negatively correlated positive carry hedge. Managed Futures allocations…some folks maintain in dollar terms, others reduce or cut it, or don’t rebalance into it, letting the weight drop.
This year so far, when everything else has been getting hit as the common Achilles heel – inflation – rears its ugly head at a time when with hindsight, stocks and bonds were priced for perfection. An ugly war in Europe didn’t help either. The definition of macro-economic uncertainty into markets that were priced for stability. Record high SPX at a 23PE, a US30 year yield under 2% and high yield spreads at just 3% – less than most estimates of full cycle default rates. A rare bright spot in a sea of tough market returns? Managed Futures.
Interestingly, at least to us, is the reason why. Managed Futures tend to have commodity exposures, fixed income exposures and currency exposures. Some do stock as well. All instruments that tend to shift with the macroeconomic uncertainty. They don’t tend to do individual stock or credit picking, these are large global macro markets. Inflation impacts all of these. Commodity prices up in the first part of the year helped a lot – oil markets and grains. Short positions in fixed income as bond yields rose across the globe. Currencies are maybe the most direct expression of macro and were large contributors. The Euro fell hard driven by relative interest rates and growth trajectory impact due to proximity to the geopolitical situation. The Bank of Japan continues to maintain ultra loose monetary policy settings through a 25bp 10-year yield curve control policy at a time when the US is raising the front end by 75bps every meeting. The Japanese Yen moves abruptly lower. We show a few of these market moves in the postscript below. Managed Futures has exposure to each of these moves. The uncertainty hurts equity markets, Managed Futures diversifies uncertainty.
So where do we stand now. Well one reason you do different things in a portfolio is that when one set of things is struggling and another is doing well, you can rebalance along the way. Use the gains in Managed Futures to buy stocks and credits when they are more reasonably valued. 2008 was a great example – stocks fell 37%, CTAs had great years. The years after were reversed, with stocks making 26% in 2009. Rebalancing the CTA gains meant one could use the gains to buy equity at lower levels. One has to decide the timing – truth be told it doesn’t matter too much, as long as you do it. Annual maybe a little too infrequent, quarterly or monthly seems about right to us. And if they haven’t moved a lot relative to each other, maybe it’s not worth it and a rebalance threshold approach is more reasonable. That’s fine too. Examples of what this would look like are below – monthly schedule when they have moved a chunk. Rebalancing the CTA as it goes up, and buying equity like clockwork. No fuss, no panic.
If you don’t have exposure to Managed Futures in a portfolio, maybe consider if it makes sense as a way to get exposure to a different return stream that often benefits from uncertainty, in a way that fits your goals. If you already do have exposure and it has performed well while other things haven’t, and the allocation has naturally grown through those performance differences, consider rebalancing. Now timing this is next to impossible. But picking a time, rebalancing mechanically like clockwork is important. If you have a good portfolio plan, follow it.
Below are examples of moves that have worked in Japanese Yen, Crude Oil and US 10YR Notes, respectively.
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