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.
Managed futures checklist: Keep the cost down. Maximize positive skew. Rebalance aggressively.
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.