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.
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.
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.
One opportunity this stay-at-home quarantine has afforded us, sad as it may sound to some, is increased time to work through the pile of academic papers on quantitative finance. It is amazing how much great stuff is out there. When you come across one that happens to be right in your wheel house and makes the case in a MUCH smarter sounding way than we ever can, all to the better. Such as it was with this recent piece – When it pays to follow the crowd: Strategy conformity and CTA performance by Nicolas Bollen, Mark Hutchinson and John O’Brien from Vanderbilt University and University College Cork.
The authors find that contrary to other areas of fund management in hedge funds and mutual funds, where being different is a positive trait (research on active share in the equity space is informative – see here), when it comes to CTAs/Managed Futures being a purist is the right approach. The authors analyzed the data using two different methods. First they sort funds into style groupings and calculate a Strategy Distinctiveness Index – funds that have low correlations to the style. They then look at the performance of portfolios of funds based on the SDI score. Second, they empirically check by rebuilding a simple model for standard trend following and regress funds against that model. Closer to pure trend the better.
We posted a blog on March 2nd discussing the initial reaction of managed futures to the market break as a result of COVID-19, including diversification and position sizing issues around volatility targeting at equity market highs. Today, we wanted to give an update on managed futures performance as the crisis has dragged out. We often tell our clients; building diversification into a portfolio and preparing for crisis events takes a multi-pronged approach. If you want instant protection to an equity market sell-off, long duration bonds provide the best bang for your buck. As a crisis extends bond protection is less reliable; this where managed futures (aka systematic trend following) steps in, accepting directional crash flows.
From the chart below (updated from previous blog), we see after a slow start managed futures has performed well, and more importantly, positive! Managed futures is a tough allocation to hold in good times, when volatility is low, when equity markets make new highs year after year. This is why you own it.
Managed futures is supposed to be a “profitable hedge” – long term positive returns with zero or negative correlation to the equity market. The recent coronavirus crisis highlights one of our core beliefs, namely that the construction of most managed futures portfolios diminishes that critical characteristic in two important ways. First, they include equity futures in the portfolio mix, and second, positions are adjusted for volatility. The combination of these two things is particularly deadly. There is nothing wrong with trend following equity futures. But anyone who watches the markets knows that equity vol is lowest at the TOP! That means that managers will have their largest equity positions at the TOP! Furthermore, when the market breaks, the eventual short position they take will be much, much smaller than the long they had at the top. In non-equity markets, the same can be true. In the recent virus break, crude was previously making new highs, then broke very sharply. Vol adjusted short positions will be tiny. Chart below compares a sampling of large blue-chip futures mutual funds with the MLM Index EV (15V) (which does not vol adjust).
Data source: Bloomberg LP, Mount Lucas
It’s a question of conflicting goals. If you want to maximize Sharpe ratio as a standalone investment, then vol adjust. If the rest of your portfolio is full of stocks and credits already, and you want a “profitable hedge” to maximize total portfolio Sharpe ratio, don’t. (See this blog post for more technical detail).
In light of recent market performance, and the corresponding effect on changes in volatility on CTA returns we thought it important to give our views on the topic. Late last year, we were asked by a prospective client to see how one of our trend following models performed over several different stress environments. We highlight one particular stress that was given- a 20% stock market drop over 3 months, with 40% of move in month 1, 35% in month 2, and the last 25% of the move in month 3. A relatively straightforward exercise, but to really understand the nuances of different CTAs relative to our approach, you must look past just the change in level, but consider the potential price paths and volatility over that stress period. The difference boils down to whether one is viewing CTAs as a standalone investment, or as a piece of a larger portfolio, and the role of volatility targeting in position sizing. Continue reading →