Sharpe or Skew?
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.
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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.
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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.
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