It’s late 1987. Institutional investors had just lived through the debacle of October 19, when the stock market collapsed, driven down by an idiotic idea … portfolio insurance. Shortly afterward, we had our first meeting with Rusty Olson, CIO of Eastman Kodak’s pension plan. Regardless of what you think of Kodak’s business acumen at the time, the pension plan was a star. Rusty was in the process of turning over every rock in the financial marketplace, looking for diversification for his very aggressive portfolio. He found us. We pitched him on the idea of managed futures as the ideal diversifier. Liquid, leverageable, and systematic. He loved it but with a caveat. We proposed a multi-manager managed account. But he, and his consultant, had no way of knowing how we were doing relative to some benchmark … there was no benchmark at the time. So we built one — the MLM Index. To my knowledge, it was the first rigorous, price based measurement of the risk premia available to futures traders.
Ask any self-respecting trend follower what kind of market environment favors their strategy, and you’ll get the usual suspects: volatility, uncertainty, macro and geopolitical stress, inflation, deflation, recession. But here’s the thing—those are just the conditions. The real driver? Signal versus noise. Trend needs signal.
In 2022, the signal was deafening: inflation fears, war in Ukraine, and ultimately, realized inflation. Since 2023? More like a symphony of noise. Just look at U.S. rates: 10-year yields dipped below 3.5% in April ’23 on recession fears… then hit 5% by October on “higher for longer.” They slid below 4% in Jan ’24 (soft landing), bounced to 4.5% by April (higher for longer again), dipped back under 4% in September (post-Yen carry unwind, recession vibes), then shot above 4.5% in Jan ’25 (pre-inauguration pro-growth Trump trade), and—you guessed it—dropped back under 4% in April (DOGE, tariffs, not pro-growth but outright recessionary).
2022 was a fantastic year for showcasing the benefits of adding Managed Futures to the portfolio. Inflation rears its ugly head after 40 years and commodities rip higher during the Ukraine War. Managed Futures, offering exposure to both the long and short sides of return distributions, got you long commodities and short bonds. No other asset class brought you that kind of protection in 2022. Not Gold, not TIPS, not Bitcoin. However, after down single digits in 2023, and another flat to down year in 2024 amid strong stock market results, the naysayers return.
Managed Futures – computers love us! Humans…not so much. Why is that? Take pretty much any sufficiently long Managed Futures track record, or index, run it through asset allocation models and efficient frontiers, the answer is pretty much always the same. Uncorrelated returns, with strong negative correlations in periods of market stress, lowers overall portfolio volatility and drawdowns. The efficient frontier goes up and to the left, improved returns, lower volatility, better portfolio Sharpe. The quants, and CFAs, and nerds all agree…on paper it works. For the seasoned veteran, the RIA, the institutional consultant, holding Managed Futures in a portfolio through time, not so easy with the clients.
We speak with a diverse range of investors—domestic and international, institutional and retail, alternatives-focused and equity-centric. Typically, they have a variety of questions and concerns driving their current thinking. However, in recent weeks, there’s been a singular focus: the return of President Trump. It’s remarkable how much of a Rorschach test he has become.
For macro topics like inflation or growth, we usually see a fairly narrow range of opinions—around 10-15% of people expecting slightly lower inflation, 10-15% anticipating it to be a bit higher, with most clustered near the target, expecting the status quo. Currently, not a single person thinks we are in a state of equilibrium. On one side, 50% believe we’re headed for runaway inflation fueled by exploding deficits, Fed pressure, eroding confidence in the USD, and soaring commodity prices due to global turmoil. The other 50% foresee a deflationary crisis spurred by the deportation of 10 million immigrants, a $2 trillion reduction in the federal budget, and a rampant USD disrupting emerging markets and driving commodity prices down. Adding to this uncertainty, President Trump, the world’s largest one-man volatility machine, has teamed up with perhaps the only person who could rival him, Elon Musk. Volatility squared.
These factors, among others, have realigned market assumptions, significantly increasing the likelihood of problematic inflation or deflation over the next twelve months. Investors face a FLATION complication.
The past few years have seen large moves in global yields. To (very briefly) recap, at the end of 2018, US 10-year yields were around 3% on the heels of recent rate hikes. Late in 2019, the escalation of trade tensions between the US and China led the Fed to enter a mid-cycle course correction taking yields down under 2%. The pandemic at the start of 2020 prompted emergency cuts everywhere and moves to record low yields close to 0.5%. Yields started rising again as the economy reopened, and as inflation reared its ugly head in 2022 global central banks found themselves behind the curve. The US 10-year touched 5% for a hot second in late 2023 before falling to 4% at year-end. Rates bounced around in 2024 as markets grappled with several rounds of “the Fed needs to cut” to “rates will be higher for longer.” Now, inflation near target and the balance of worries has shifted from the inflation to questions of soft landings and slowdowns.
We’ve highlighted a few times on this blog on how trend following can be helpful in portfolio construction with its ability to access a diverse set of markets as well as both sides of the return distribution (long and short) in those markets. Diversification is driven by both of those features. 2022 saw bond prices fall and commodity prices rise as inflation, war and interest rates rattled through the global economy and asset markets. The ability to get short exposure to bonds and the Japanese Yen as interest rates rose, coupled with long positions directly in the commodity markets that stoked inflationary fears, enabled trend following allocations to cushion traditional portfolios of stocks, bonds and credit. Direct exposure to the factors hurting traditional portfolios is a key benefit of trend following, as well as its adaptability in different environments. Indeed, in previous difficult periods for traditional markets the opposite exposures were the most helpful – long bonds and short commodities in the GFC were the right positions for trend to take.
On the commodity side in particular, we have long thought that owning commodities as a long only investment was a mistake, and that due to human ingenuity and product substitution prices would go down in real terms over time. The short side is too important to ignore. This can be true in financial crises like 2008/09 when crude oil dropped some 75%, but also in quieter times. The risk premium in Managed Futures comes from taking on risks producers and consumers want to shed, making participation on both the long side and short side necessary. Commodities are particularly useful as they are much less correlated to each other than something like bond markets. Crude oil, grains, softs and meats all have their own cycles driven by their own unique drivers and supply/demand curves. Current grain markets are a good example.
In 2022 grain markets spiked upwards as the Ukraine war directly impacted the wheat market. Prewar, Ukraine harvested some 33m tons of wheat as one of the larger global producers. Prices of US wheat had been trending higher through 2021 and were sitting around $8/bushel; by May they were 50% higher at $12/bushel. Wheat competes for acres with corn and soybeans, as farmers optimize a planting mix in part based on market prices. If wheat – which grows like a weed – is trading 50% higher than usual some acres shift to wheat and away from corn and soybeans, reducing expected crop sizes, pushing those prices higher. Long only caught that move. The best cure for high prices though is high prices, and possible crop shortages and fears of the same can be solved with a couple of good harvests. As those fears and shortages abate, prices fall again. This is what we have seen in 2024. Planting conditions were perfect, the growing season weather has been perfect. Seed technology and farming advances keep improving. Record yields for corn and soybeans this year. What happens when high prices meet record yields? Lower prices. It’s times like these you need your shorts.
Source: Bloomberg, Mount LucasSource: Bloomberg, Mount LucasSource: Bloomberg, Mount Lucas
This is an excellent piece from JP Morgan Asset Management and GIC. It presents a different framework for institutional investors looking to diversify away from traditional portfolios, making the case that portfolio starting points play a large role in where you should end up. The paper starts by classifying hedge funds by their risk/return profiles, with Managed Futures strategies going into the Loss Mitigation sub-group. They then examine the optimal allocations to the sub-groups and show that standalone hedge fund allocations should be different than hedge fund allocations that are being integrated into 60/40 portfolios. They conclude a few important things:
Correlations
First, they note that hedge funds classified as Managed Futures, Commodities and Macro have lower equity correlations while Equity, Event Driven and Credit are more correlated to stocks.
This is one of the beauties we see in Managed Futures and Macro and why they work so well in broader portfolios. The economy is cyclical, so fixed income and stock markets inherit that cyclicality. Commodities are rarely in equilibrium, cycling between oversupply and undersupply. Traditional portfolios are dominated by long exposures, which rely only on the right-hand side of a return distribution. Managed Futures and Macro are one of the few places where you can get access to the short side of a return distribution, the down part of a cycle. The other factor that drives the lower correlations – commodities and currencies are just more different from each other than equities are from each other. Sugar is nothing like cattle and nothing like silver or natural gas – completely different supply/demand pictures. While individual companies have their own fundamentals, sales cycles and market wide multiples drive a large part of valuation. The economic cycle is a common factor.
When building multi-asset optimized portfolios, being able to maintain the low or negative correlation throughout regimes and having a positive expected rate of return is the holy grail. The investing world witnessed this in 2022 as the long since forgotten phenomenon called inflation ran through stock and bond portfolios like a bad lunch. Managed Futures? Kept the negative correlation and provided positive returns; it is generally a regime agnostic strategy. More details in this piece. The times it struggles are during periods of particularly low macro volatility, typically quite good for traditional assets that prefer the stability of cash flows and abhor the instability of crash flows, which Managed Futures craves.
The chart from the piece that highlights the performance in equity drawdowns is also important – while Managed Futures is generally uncorrelated most of the time, in stress periods it has been negatively correlated and produced positive returns.
The chart below illustrates the remarkable consistency Managed Futures has shown during equity drawdowns relative to other alternative investments. This is a fairly high hit rate for Managed Futures and Macro strategies, certainly compared to Event Driven, Credit and Equity strategies.
The second conclusion that jumps out is that optimal allocations to underlying hedge fund strategies are very dependent on whether there is a broader portfolio concern in the background. Standalone hedge fund portfolios will likely want more exposure to stocks and credit than hedge fund portfolios that are being built to complement or diversify broader portfolios that already contain equity and credit. We completely agree. Equity and credit portfolios are generally thought to be negatively skewed. In our view, the right thing to do when adding hedge fund exposure to an existing portfolio is to look for strategies that can be negatively correlated, aim at the highest positive skew possible, and then rebalance fairly aggressively.
For many investors, Managed Futures are a portfolio element, slotting into broader portfolios. As we built our Managed Futures strategies over the years we have stayed investor focused, always keeping the broader portfolio goals in mind.
Over the past couple of decades many public pensions have reduced public equity exposure in favor of private equity, private credit, real estate and fixed income. The volatility laundering debate notwithstanding, if one believes they have less equity beta, then having a Managed Futures strategy that takes equity exposure may be a fine decision. If one has a portfolio that is already heavy public equity, then skipping additional long equity exposure inside the Managed Futures strategy may be more appropriate. It is the same with volatility targeting positions. In a standalone hedge fund allocation that is optimizing solely for that portfolio, volatility targeting positions may be a fine thing to do. We are not against it in all circumstances – our view is that where you stand depends on where you sit. If you sit with a large equity portfolio that doesn’t volatility target itself, you likely want a Managed Futures strategy that doesn’t volatility target either. In that world, one should optimize for the broader portfolio and make decisions that most help the whole. We have written more on that skew maximizing approach here.
Some quick background on the macro. Let’s look at the potential impact on a Trump re-election if he does what he is talking about on tariffs. Roughly speaking to set the stage, in President Trump’s first term he placed a set of duties on Chinese products in the America First economic policy to shrink the trade deficit and rebuild the U.S. manufacturing base. The world generally operates under large multilateral trade deals; he wanted to move to more bilateral deals and renegotiate the large deals. Exit TPP, redo NAFTA for example. Tariffs were planned/enacted on a variety of goods imports across finished products and raw materials: steel, washing machines, solar panels, flat screen TVs, batteries and many more Chinese goods in response to IP theft. Retaliatory measures from partners ensued, escalations etc. At the same time, he leveled lots of (correct) charges of currency manipulation by trading partners. Short version that underpins President Trump’s thinking – countries that keep their FX weak increase the attractiveness of their products at the expense of others, cause large trade surpluses, encourage overproduction/under consumption in the country with weak currency and underproduction/overconsumption in the strong currency country. In single product basic terms – if China keeps its currency very cheap it makes washing machines produced there unfairly cheap vs those produced in the U.S. Over time it is the currency naturally strengthening that should close that gap – keeping it weak on purpose as China does/did prevents that natural correction. When you zoom out to the macroeconomic level – the important part is China’s currency manipulation leads to not just exporting cheap washing machines but exporting unemployment from China to the U.S. as manufacturing jobs slowly leave the country due to U.S. products being unnaturally uncompetitive. Clearly it is impossible for all countries to run trade surpluses, someone must run the corresponding deficit, so the practice is damaging. At the same time, Trump discouraged companies from moving production overseas with reduced tax incentives via BEAT and GILTI, reduced domestic corporate tax rates, and used the bully pulpit to shame those that did. Some deal making ensued.
The turn of calendar years are interesting times to take stock of how market prices evolved compared to what was expected to transpire a year or two ago. This can serve as a great lesson in humility and an appreciation in the uncertain nature of the world. We also think it makes the case for investment strategies that can adapt and navigate uncertainty to shift allocations in broader portfolios.
Remember the end of December 2021? Interest rates were at rock bottom pandemic levels (itself an exercise in who-knows-what-can-happen) while the S&P 500 was around 4800, riding high on free money forever. Fed Funds futures markets at that time expected December 2023 rates to be about 1.4%….by December 2022, those forward looking interest rate expectations had moved to 4.65%, CPI had hit 9% in the summer of 2022 and the stock market had fallen 20%. Inflation and interest rate fears were everywhere. Over the course of 2023, interest rates actually went up higher than expected – currently 5.33% – and as of December 31, 2023, the stock market is within a whisker of 4800 again.
When it comes to markets and the economic environment, nobody knows anything for sure. The NY Fed puts out forecasts for output growth over the next few years, the most recent one is below. With 90% confidence, four quarter percentage change in output growth in the US over the next year should be between -6.9% and +9.6%. That’s a 16% band! So, the smartest people in the room are sure of at least one thing – the world is very uncertain and there are no crystal balls.
Source: newyorkfed.org, The New York Fed DSGE Model (12/22/2023)
Portfolios need to have elements that can adapt to diversify across a wide range of outcomes. A popular framework is the quadrants approach – balancing risk in assets that do well in different combinations of inflation and growth. After decades of low and steady inflation in developed markets – even after periods of incredibly loose monetary policy and decently tight labor markets – many portfolio constructs ignored the high inflation box and just focused on protecting against the low growth outcome, relying on bonds alone to diversify. When inflation came roaring back, these portfolios struggled. Managed Futures shined for a couple of reasons related to inflation. First, it allows short exposures in fixed income. Second, it has a bigger toolbox of assets to allocate to, including commodities and currencies. This combination allows Managed Futures to adapt to the changing environment.
Keeping in mind that there is no crystal ball, what sources of uncertainty do we see on the horizon as we look ahead to 2024? And how does that create opportunity for Managed Futures? Big questions. Markets tend to move aggressively when things don’t turn out as expected and Managed Futures can be framed as exposure to this uncertainty.
Let’s start with the big markets.
Stocks
The stock market is close to record highs and trading at fairly expensive multiples – assuming 2023 SPX earnings come in at the 215 currently expected, we are at a 22 PE. Using 2024 expectations of 240, you get a forward PE a little under 20. Over the last few months, the valuation multiple has expanded. This has been driven in part by the expectation of interest rate cuts over the next couple of years being sooner and greater than previously expected, as inflation normalizes, and the Fed reaction function is being reassessed. We will see how that plays out, but stocks are not cheap right now and priced for a smooth, soft landing. It sure seems like a good time for the diversification Managed Futures can provide.
Fixed Income and Currency
Rates look to have peaked and markets assume inflation is solved but markets have sure been wrong before on the pace of inflation reduction as well as the Fed reaction function. These are complex, reflexive systems. If they are right, Managed Futures will move to long positions in fixed income. If inflation is stubborn, however, and doesn’t continue to come down as quickly or the Fed is spooked by the rapid loosening of condition, yields could go back up. The USD implications of a shifting monetary policy landscape are also large, as the past few years have seen a strong dollar against major currencies driven in part by rate differentials. Witness the large move down in the Japanese Yen over the past few years. US rates went up 500bps, at 75bps a clip for a time, while the Japanese maintained the Policy Balance Rate at -10bps. Should the Japanese decide to end the period of extraordinarily low rates while the US is cutting rates by 150bps, we could see large shifts in the yen. FX moves are often driven by diverging monetary and fiscal policy stances – the last mile of inflation may well be bumpy and experienced differently in different countries. We also have elections in the US and the UK that could usher in very different policy. Chinese stimulus measures and the subsequent impact on the ‘commodity’ currencies of Australia and Canada could also drive currency volatility and uncertainty. Managed Futures offers exposure to these different countries and currencies.
Commodities
We see similar potential for moves in commodity markets, where there are growing imbalances. Copper is a great example. The world may be sliding into a Copper deficit over the coming years, impacted on the demand side by the continuing shift to a renewable energy infrastructure and electric vehicles as well as on the supply side through political disputes in producing countries. That this worsening deficit picture is happening amidst the downturn in Chinese property makes us wonder what happens if stimulus measures are enacted there. Oil markets are also likely to be in focus as the forces of incredible US supply growth creates tensions with OPEC production cuts and continuing Russia sanctions…and heightened tensions in the Middle East. It only takes a couple of million barrels a day either way on supply and demand to move markets a big way. Grain markets also may be coming off a period of low supply and see the high prices of the past couple of years dissipating. Managed Futures offers exposure to these uncertain commodity markets.
Summary
In our view, portfolios benefit from being adaptable and need to make the most of the tools that are available to best navigate uncertainty. Direct commodity exposures. Long exposures AND short exposures. Managed Futures gives that flexibility. The charts below show two different periods of maximum uncertainty – the GFC years and the inflation/war in Ukraine/rates years. This uncertainty was not good for traditional assets. Managed Futures was able to navigate the uncertainty and diversify. The color coding details the strategy exposures through the periods – the most interesting thing to us is that it shows the adaptability. In the GFC, the right thing to do was long bonds and short commodities. In the inflation years, the right thing was short bonds and long commodities. Managed Futures offer maximum flexibility to adapt to a wide range of outcomes.
Data from Bloomberg and Mount Lucas as of 12/31/2022. Past performance is not indicative of future results. This presentation is for informational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy securities or futures. Any offer for an interest in a fund sponsored by Mount Lucas will be made only by the offering memorandum of that fund. The performance shown for the MLM Index EV is based upon a historical index. Results reflect the reinvestment of dividends and other earnings. Results do not represent actual trading and do not reflect the impact that material economic and market factors might have had. A description of Mount Lucas’ investment advisory fees can be found in part 2 of its form ADV. 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. Trend Signal strength represents the strength of the trend signal in each of the MLM Index EV constituent markets ranging from -100% to +100%.
About a year ago we wrote about Inflation Regimes and Return Distributions. The piece referenced an excellent chart we first saw from Goldman Sachs showing the Equity/Bond correlation vs realized US CPI. The negative correlation in the period since the late 1990s occurred in a world of low and stable inflation. The prior period in the chart, from 1970 to 1998 showed a period of higher than target inflation and a steadily positive correlation of stocks and bonds. Many portfolio strategies have been built with this negative correlation as the bedrock. It worked as the dual mandate acted like a single mandate on unemployment- the inflation side of the mandate could be safely ignored. Economy weakens, equity markets weaken, Fed cuts rates, bonds rally. Became self-fulfilling for a long period of time.
When inflation came back with a vengeance driven by pandemic supply chains getting overwhelmed with fiscal and monetary stimulus, then exacerbated by geopolitics and war, stocks and bonds fell together, partly as the starting point for yields was so low and durations so high. It depends exactly where you draw your lines, but long duration bonds – a diversifying asset relied upon to cushion equity markets – hit a drawdown approaching 50%. Traditional portfolios, built on that bedrock regime, only had one side of the distribution in one asset class to help diversify stocks – positive bond returns.
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