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Managed-Futures Category Handbook

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Managed-Futures Category Handbook Managed-Futures Category Handbook By: Samuel Lee and Nadia Papagiannis, CFA Managed-futures funds posted eye-popping returns during the financial crisis, when nearly every other strategy and asset class went down. Are managed futures the holy grail of diversification? Probably not. But that hasn’t stopped the strategy from gathering hundreds of billions in assets since the crisis. There’s a lack of independent, third-party information for advisors and individuals on this exotic strategy. This handbook attempts to plug the gap. Let’s start with the basics. I Strategy Overview By Samuel Lee and The term “managed futures” generally refers to a human judgment rather than computers to Nadia Pagagiannis, CFA set of trading strategies that rely on derivatives, read charts or to divine global supply/demand especially futures, to express market views across imbalances from volumes of fundamental commodity, bond, currency, and equity markets. data. In the Morningstar categorization schema, Managers who run such strategies are commonly these non-trend-followers and the discretionary called commodity trading advisors, or CTAs, traders fall under the heading of “global-macro,” which is typically the registration status held by rather than managed futures. these managers under the National Futures Association and the Commodity Futures Trading Momentum, the Juggernaut Commission, the organizations which regulate Simple futures-based trend-following strategies futures trading in the United States. have posted unbelievably good results for a long time. Contrary to any efficient-market theories, Most CTAs are trend-followers. This means that there aren’t any obvious sources of risk that their strategies, which are typically systematic would justify this performance. Moreover, trend- (or automated) in nature, attempt to identify and following’s best returns have come during bad profit from upward or downward price momen- times, like a seemingly impossible insurance policy tum in futures contracts. If the algorithm sees the that pays you to own it. Academics have bent price of a particular futures contract trending over backwards trying to explain the momentum upward (downward), the program will take a long phenomenon. The best explanation is a simple (short) position. Managed-futures strategies behavioral story of investors’ underreaction and measure trends over a wide range of timeframes— overreaction. from intraday to more than 12 months—and assume a diverse array of calculations (moving In light of surprising or extreme news, investors averages or breakout indicators, for example). anchor new price estimates to old prices, Most trend-followers are diversified, meaning they preventing prices from fully reflecting new deploy their trend-following systems over many information. Investors are also loath to different types of futures contracts. Many also realize losses, preferring to keep dogs until they offer the same strategy with differing amounts of break even, and are too quick to sell winners. leverage. Because of the diversity of strategies, Both biases prevent prices from instantly reflecting trend-following managed futures funds’ returns new information; instead, prices slowly adjust exhibit wide dispersion. to fair value, creating sustained price movements. Performance-chasers hop on the trend, There are, of course, non-trend-followers. These overextending it. The trend eventually collapses traders can bet on anything from volatility to mean after the market realizes it has overshot. This reversion (the opposite of a trend). Furthermore, behavioral theory behind momentum is just that — some CTAs, termed discretionary traders, rely on a theory. But a wealth of experimental data Managed-Futures Category Handbook 2 supports the irrational or bounded-rational view of differences in the way cash collateral is managed. man. We’re not homo economicus, after all. This behavioral story implies that the growing Even though managed futures are new to capital dedicated to managed futures will reduce structures like mutual funds and exchange-traded its profitability going forward, possibly to the funds which have historically tracked index point where it offers little reward. One pundit benchmarks, managed futures indexes have existed estimates that the strategy’s equilibrium Sharpe for quite some time. The first such well-known ratio (annual excess return over cash divided index, the Mount Lucas Management Index, by annualized volatility) is about 0.30, which is launched in 1989 and has served as a benchmark approximately the historical risk-reward trade-off for many hedge funds. More recently, Victor for stocks and bonds. This may be optimistic: Sperandeo, better known as Trader Vic, created the Impossible creatures don’t survive for very long. Diversified Trends Indicator, the benchmark Even with a relatively low but positive Sharpe ratio, used by several mutual funds and ETFs. (This index, however, managed futures should still provide which dates back to 2003, was subsequently investors with decent portfolio diversification. The licensed to Standard & Poor’s). JP Morgan and key is that managed futures provide little or no Credit Suisse have also developed indexes for trend- correlation to traditional assets. following mutual funds. Even Morningstar offers a managed futures index, the Morningstar® In 2009, Asness, Moskowitz, and Pedersen Diversified Futures Index. published a paper entitled “Value and Momentum Everywhere,” which pointed out that value and Managed-futures indexes typically diversify across momentum factors exist across all asset classes futures markets and use relative simple models and geographies, as far back as the authors tested to measure momentum, such as seven-month (1975). Furthermore, these factors are negatively exponential moving average. When evaluating correlated to each other. Finally, the study points index-based strategies, investors should consider out that, in and of itself, momentum has provided that back-tested index returns may not reflect attractive, long-term, positive risk-adjusted returns. actual trading conditions. In contrast to index strategies, actively managed strategies often use The Options more than one measure of momentum and Not all managed futures funds are created equal. may calculate momentum across several different There are distinct differences in the way these timeframes. Actively managed strategies may also strategies are constructed. First, some funds track include a countertrend (mean reversion) strategy indexes, while others take more actively managed that serves to profit from or reduce losses of trend approaches. Next, of the actively managed following when contracts do not exhibit price strategies, some are advised by a single manager, trends. AQR Managed Futures Strategy AQMIX is while others are funds of funds. Finally, there are one actively managed example. Managed-Futures Category Handbook 3 Despite the fact that active strategies tend to be Finally, investors should also consider if the cash more complicated than index-based strategies, collateral in the fund is actively managed and what they will likely produce similar outcomes. When exactly the underlying investments are. Because Morningstar first categorized its hedge fund futures contracts require relatively low initial database in 2006, it found that trend-following margins (as low as 5% for 100% exposure, for strategies exhibited one of the highest cross- example), the majority of a managed-futures fund’s correlations (on average 0.7) of all hedge fund assets are cash collateral. This cash can be strategies. Furthermore, in 2008, 80% of the invested or it can sit in Treasuries. Historically, category made money. This is due to the strong managed-futures strategies earned a decent presence of a longer-term momentum “beta” interest rate simply by holding Treasuries, but this in most of these strategies, which is captured by is no longer the case. In response, some funds managed-futures indexes. have hired outside advisors to invest this cash into higher-quality, slightly higher-yielding debt Once an investor has decided to invest in instruments. Some managers, however, are taking an actively managed strategy, he must decide on much more risk than others to boost returns, between a single manager or a fund of funds/ investing in nonagency mortgage securities, asset- multimanager structure. The median backed securities, 144A restricted securities, single manager managed futures hedge fund in master limited partnerships, or even real estate Morningstar’s database (as of Sept. 30, 2011) investment trusts. requires a $250,000 initial investment, while the median hedge fund of funds needs only $50,000. (A few registered commodity pools take minimum investments of as little as $1,000, however.) The average fee is much higher for a fund of funds, which typically charges a 1% management fee and 10% on top of standard hedge fund performance and management fees. Even managed-futures funds of funds available in mutual fund structures, such as Altegris Managed Futures Strategy MFTAX, charge a double layer of fees. Investors must consider if the actively managed returns can surmount the fees. Managed-Futures Category Handbook 4 II Managed Futures Stategies Across Structures The first publicly available managed futures fund database, managing a total of $83.7 billion. The started in 1948 and operated until the 1960s, database lists another 129 non-trend-follower trading agricultural commodities (Anson 2006). It hedge funds under
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