Managed Futures – 2022 Review

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

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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Dirty Portfolios – Managed Futures As A Portfolio Element

Most investors know and understand the traditional 60:40 portfolio of stocks and bonds. There are many other model portfolios, with clever names and metaphors, out there blending different weights and different assets. Almost all benefitted from the low rate, low inflation market environment. So far, 2022 has been difficult across the board for these models as stocks, US Treasuries, and credit have all fallen, and even short-dated bonds have not helped.

To keep things interesting, we illustrate the role of Managed Futures in the portfolio below while having a bit of portfolio naming fun. We start with several of the more popular asset allocation models and garnish them with some Managed Futures. The same way adding an olive to a martini makes a dirty martini, can we enhance a classic by adding a Managed Futures “twist” and creating a “dirty” version? Apologies in advance as we then torture the ‘dirty’ reference with Clint Eastwood quotes.

Background

The primary role of Managed Futures strategies is to diversify the portfolio, and allocators should always strive to evaluate those strategies under that context. When accessed through a pure trend following approach, Managed Futures offers an uncorrelated, positively skewed portfolio element with a positive expected rate of return that can complement the broader portfolios of equities, credit, and real estate.

The risk premium earned by investors participating in Managed Futures inherently has a different driver than equity markets. Think simply about how Goldman Sachs is structured. The investment bank side raises money for everything from companies to municipalities through equity and credit underwriting. The other side manages trading desks to facilitate the risk transfer of exogenous operational price risks that impact the running of a business. Both are risk premiums that companies face; markets exist to transfer them to investors. These two risk premiums are complementary, but they need to be accessed differently. One funds economic activity by investing in equity and credit securities from the long side, directing capital to those who seek to expand and transfers their capital risk. The other takes on exogenous input and output cost risks in commodity prices, currency movements, and changes in interest rates, facilitating hedging that allows businesses more price certainty in operations while focusing on their core expertise. Crucially, this risk premium needs to be accessed from both sides of the market: trend following long and short. The combination of the two risk premiums is very attractive, as one side thrives on stability and rising growth, while the other thrives in times of economic uncertainty and macro volatility that typically hurts equity and credit investors.

Put simply, where the investor premium in equity and credit markets looks for cash flows, the investor premium in the futures markets looks for “crash” flows.

Portfolio Allocation – The Inflation Problem

Traditional portfolio construction generally assumes holding long positions in different asset classes and relying upon low asset correlations to build better portfolios. Over the last few decades, an environment of declining bond yields and low inflation meant that, generally speaking, bond prices would rise any time stock markets fell meaningfully. As markets began to price that, in the event of any serious economic slowdown or episode of poor market functioning, the Federal Reserve would come to the rescue and cut rates. Somewhere during the pandemic this reached a nadir on two fronts. First, bond yields in developed markets reached such low levels that price appreciation on bonds became difficult to envisage. Take a typical 10yr bond with a duration of 8 for example. Starting at 400bps yields and dropping to 200bps would make 16% (simplified for ease). With yields bouncing around 50bps, it is hard for long dated yields to move meaningfully lower. Second, the stock bond correlation of the past 40 years generally relies upon inflation being reasonably low and steady. When inflation is notably higher, the economic link between stocks and bonds starts to break down as the Fed is less willing to reduce rates. Welcome to 2022 – both stocks and bonds have fallen. Those that use leverage to increase the risk profile of stock and bond portfolios have been particularly hurt. Sometimes bonds can diversify stocks, sometimes bond price falls can be the driver of what is hurting stocks.

For the portfolio allocator, the benefit of adding Managed Futures is that it can be either long or short different assets, giving it the ability to adapt positioning across different market regimes, including getting short bonds early this year. How long does the current regime last? No one knows, but as a portfolio element (2022 through the time of writing at the end of Q3), Managed Futures has diversified stock and credit portfolios pretty well, similar to the experience of previous crises in 2000 and 2008 (albeit those were deflationary, not inflationary).

Portfolio Allocation – The Dirty Answer

Yet, decades of complacency have left portfolios underexposed to investments that have historically done well in times of price uncertainty and volatility, and ill-equipped to handle the current market environment. For the allocator looking for exposure to these factors, several questions come to mind when considering Managed Futures. How should they be used? What allocation should they get? Great questions. The tough part- the answer is, as always, client driven. Where you stand, depends on where you sit. Different risk profiles, different asset mixes, different goals lead to different answers on what is right. Returns? Drawdowns? Volatility reduction? All fine ways to frame the approach.

To answer some of these questions, and to prioritize how typical investors allocate capital, we show the addition of Managed Futures to some typical portfolio allocations, creating a “Dirty” portfolio. As many of the portfolios have different asset mixes for which data isn’t always readily available, some go back further than others. Data runs through the end of Q3 2022. For the Managed Futures exposure we use the MLM Index EV (15V). We believe it to adequately represent the beta in the space while having some features that make it particularly useful as a diversifying portfolio element. In short, the MLM Index EV (15V) doesn’t contain equity markets, it does not adjust position sizes for volatility, and it passively represents the beta to pure trend following.

The analysis below uses common interpretations of each portfolio approach and represents them with total return building blocks, shown on a monthly rebalance schedule. Do not underestimate the importance of rebalancing in an asset allocation with uncorrelated, volatile components- closest thing you get to a free lunch in finance.

Summary Data

Much as we like the details and minutiae – some folk want to cut to the chase. What happens when you add Managed Futures to popular portfolios and make a dirty version? The table below shows the top-level stats over the time horizon, as well as 2022 and the Managed Futures allocation an optimizer wants. Portfolio allocations are sourced from http://www.lazyportfolioetf.com/ and re-created with representative asset class indices.

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Correlations, Risk Parity and Trend Following

It is a common refrain that, in a crisis, asset price correlations move towards 1. What was once independent is no longer so, as a large common driver has emerged creating large and often forced flows from leverage unwinds and VaR models that then feed on themselves. This is shorthand – what really happens is correlations move to extremes.

Over the past 40 years or so, generally speaking, stocks and yields have been positively correlated. There were a couple of short-lived hiccups around the taper tantrum and early 2007 which soon reversed. In previous periods of stock weakness, you can see the correlations move decidedly higher.

Source: Bloomberg, Mount Lucas
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As We See It: Yen Intervention

The big story in the past week was the massive currency intervention by the Bank of Japan (BOJ). Hard to know exactly how much went through, but reports were in the range of $70bn on Friday alone. FX interventions by major central banks are less frequent than they were years ago. This was the first BOJ buy side intervention since 1998. There is a pretty simple reason we don’t see intervention much anymore – it does not work. Let’s have a quick look at what’s going on.

Against the trend of most other central banks, BOJ policy has been to maintain low interest rates and keep long term yields under 25bps (a policy called yield curve control, YCC), despite rising inflation and a global backdrop of major economy yields rising substantially. They have been the principal buyer of Japanese Bonds, leading to a crash in liquidity. In recent weeks we have seen multi day streaks when the benchmark ten-year bond (the JGB as it’s known) has not traded. Forcing long-term interest rates to below market levels (the 10y swap market has rates around 70bps) has created massive pressure on the currency, and the BOJ has tried to stem the tide.

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As We See It: Small Markets

Right to the Source ….

The current trend in the managed futures world is … expand the portfolio, trade every little market in every suspect exchange around the world to get the maximum diversification. That’s fine I guess if your goal is to create a standalone investment with the best possible Sharpe ratio. But if your goal is to diversify a broader portfolio, adding many second-tier markets may be counter-productive. Let me explain.

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Managed Futures In The Portfolio – Update

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.

Source: Bloomberg, Mount Lucas

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.

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As We See It: Quadrants

The idea of investing quadrants has been around a long time. Divide the potential environment into 2 planes, basically growth and inflation. Determine the current intersecting box, invest in the things that have done well historically in that box. It’s a great shorthand method of putting order to chaos, most of the time. Thought experiment … Is the economy growing? Real GDP is negative, so no, nominal GDP is on fire, so yes. Weekly unemployment claims are low, so yes, but job openings are falling, so no. You get the point – picking the box is tough. We are in a really inflationary time, so buy gold, right? Wrong, regardless of what the cable ads say.

Check out this chart:

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As We See It: The UK Bond Debacle

Same tune, different words. Every. Single. Time.

Some big pool of money (BPM) would like something for nothing. Large financial institutions (LFI) are happy to help. Heck, they even compete to help the most. As long as X never happens – and of course it never does – we can give you exactly what you want. In the 1980s, pension funds wanted to be long stocks but not the downside tail. Buying puts was too expensive. No problem says LFI! We will give you something called portfolio insurance. Instead of paying implied volatility, you can own an option-like structure at realized volatility. As long as the market does not gap down a lot – which of course it never does – there is plenty of liquidity to execute the hedge. October 1987 put an end to that little fantasy. Then there were those good old sub-prime loans. Some BPM would like some higher yielding debt. No problem says LFI! Each mortgage may be risky, but they are much better behaved when we look at a big basket of them and we’ll spread them out all over the country. As long as house prices never go down, which of course they don’t, and certainly not all over the country, these bonds are golden. We’ve even paid someone to give them a AAA rating! That ended…not well.

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