Managed Futures

You Can Eat Or You Can Sleep

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“You can eat or you can sleep”. The biggest change I have witnessed over the course of the past 3+ decades is the change in investor preference, particularly hedge fund investors, away from positive skew to negative skew… from sleeping to eating. I sleep well. The quote came from a discussion my partner had with another manager who runs a fund that is often aggressively short volatility. He, like all of Wall Street and beyond, have monetized this preference for negative skew – regular returns most of the time, with the occasional blowup. They are eating well.

The preference for negative skew flies in the face of conventional finance theory and behavioral economics. After all, why would people buy lottery tickets? Smarter people than me have worked these ideas over, and it’s a bit of a mess. Let’s just think about 3 possible drivers (I am not bashful about stealing others good ideas). Some of these thoughts are motivated by a great blog post that can be found here: https://www.macroresilience.com/2010/01/13/do-investors-prefer-negative-skewness/

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What Did Skew Do for You?

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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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With Trend Following – Beta Is Not Just Fine, It Is Preferable

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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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Managed Futures and the Virus: Update

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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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Managed Futures and the Virus

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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).

Where has all the alpha gone?

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Where has all the alpha gone (to paraphrase a 60’s protest song)? Roughly, alpha is the ability to consistently outperform a well-defined benchmark. Alpha is notoriously hard to measure as most managers do not have records long enough to establish “consistently.” That matter aside, there are at least three forces compressing our notion of alpha – better benchmarks, better information and better liquidity. The traditional long only investing world has been wrestling with this issue for years, but the notion is now moving to the alternative space.

In the 60’s and 70’s, academic research on mutual fund results indicated that a better benchmark definition (compare a manager to a small cap index if she owns small cap stocks) diminished the perceived value added in fund results. Over the last 20 years or so, there has been an unknown quantity of permutations of alternative beta, hedge fund replication, liquid alts, and other repackaged versions of the same theme – to figure out if there is beta in the macho alpha alternative space. Continue reading →

Benchmarking Alternative Beta

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The year 2015 will mark Mount Lucas’ 30th as an alternative investment manager. We formed as a CTA in the halls of Commodities Corporation in Princeton, New Jersey. Our particular mandate was to attract managed futures assets from the institutional marketplace. In doing so we became the first managed futures manager to register with the SEC as a Registered Investment Advisor. Just two years later our we created the MLM Index – the first price based index for Managed Futures – and possibly the first attempt at measuring alternative beta.

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