Month: January 2023

Managed Futures – 2022 Review

/ mtlucasmacro

Introduction

2022 was a banner year in the Managed Futures space. Stocks and bonds both had a tough time, something that’s fairly rare. The S&P 500 Total Return Index returned -18.1%, the Nasdaq-100 Total Return Index fell -32.5%. The Nasdaq saw its high for the year on the opening day and the low a couple of days after Christmas. The Bloomberg US Agg Total Return Index returned -13.0%. The chart below illustrates how infrequent negative returns are in both asset classes.

If there was a year when a strong Managed Futures return would be most helpful, 2022 was it.

Below we will examine how investors use the asset class and review the key drivers of returns last year. We will then analyze the various quantitative approaches to trend following, how they explain dispersion among managers, and how they have performed historically and in 2022, when needed most.

Overview – Managed Futures

Many investors look at Managed Futures through a lens of absolute returns over economic cycles, uncorrelated to stock and bond markets. This lens looks at the broader range of markets available in Managed Futures – currencies and commodities typically – and both the long side and short side of return distributions available such that one isn’t reliant on prices always going up to generate positive returns. Either up or down is fine, as long as prices trend. Choppy sideways is bad.

Other investors look for Managed Futures as ‘Crisis Risk Offset’ strategies that they expect to generate returns during equity market declines and recessions, somewhat akin to put options or highly rated government bonds. This lens sees Managed Futures as capitalizing on flows that recessions and panics tend to coincide with – equity markets down, commodity markets down, flight to quality dynamics in currencies and fixed income.

In 2022 Managed Futures certainly delivered on both these counts, providing uncorrelated returns in the worst 60/40 market in decades.

In Part 1, we use the MLM Index EV methodology to examine how Managed Futures generated returns in 2022, looking in detail at the underlying market moves by asset class, highlighting some individual positions that contributed, and showing how some of the different approaches to Managed Futures impact returns. The MLM Index EV does a fine job at explaining and capturing the beta we believe exists in the space and using some different derivations in the parameters can offer some insight, particularly in big, interesting years.

In Part 2, we deconstruct Managed Futures returns into their contributing factors. Performance dispersion for any given Managed Futures strategy is generally driven by some combination of the following approaches by each manager:

  • Volatility – the level of overall strategy volatility that is expected or targeted
  • Trading speed – short, medium, long or blend lookback
  • Trend approach – simple moving average, slope, crossover, breakout, etc.
  • Market universe – more markets, less markets, alternative markets, sector allocation
  • Position/Risk management – how positions are sized, rebalanced, and volatility adjusted

Of course there is more going on, but in the same way equity indices can be constructed to target different styles or factors like growth/value, low volatility or by sectors, Managed Futures returns can be somewhat deconstructed along the lines above. It can be useful to take a look in detail at how each of the changes impacts the nuances of Managed Futures results.

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Inflation Regimes And Return Distributions

/ mtlucasmacro

Below is a great chart from Goldman Sachs. It shows the low or negative correlation between stocks and bonds we have seen over the past few decades has been in part attributable to the low inflationary regime over the period. This makes perfect sense given the way monetary policy has operated over the last twenty-five years, counter cyclical policy is very effective in periods of low and stable inflation. When equity markets start to become concerned about recessions ahead, earnings expectations reduce and valuation multiples contract. Stock prices fall. Bond markets typically would then anticipate the increased chance of the standard monetary policy response; cutting interest rates to spur economic growth. Bond prices rise. That explains the light blue dots below. The dual mandate was really a single mandate on unemployment, as the inflation side of the mandate was not biting.

On the other hand, periods of higher inflation have historically resulted in positive correlation between stocks and bonds, represented by the dark blue dots above. During periods of higher inflation, you tend to see rising interest rates, knocking bond prices down and putting pressure on equity multiples. It is much harder for monetary policy to operate in higher inflation environments to combat slowdowns, as the option of cutting interest rates is less easy. The two sides of the dual mandate are in conflict.

Sounds a bit like 2022. High inflation led to a more rapid rise in interest rates than expected, doing a lot of damage to long term bonds that were trading at very low levels – the US10 year ended 2021 at 1.50%. Equity valuation multiples were repriced lower as rates went higher. Stocks and bonds both went down. Portfolios built using bonds to diversify stocks, sometimes with leverage, saw some of the worst returns in decades.

While the long side of the return distribution has dominated since 1998, a return to higher inflation expectations, as seen from 1970 to 1998, requires the investor to consider the other side of the distribution when considering diversifying strategies.

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