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Cyclical Trough Or Structural Impairment? Analysis and Proposed Solutions

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Cyclical Trough Or Structural Impairment? Analysis and Proposed Solutions FEATURE | MANAGED FUTURES MANAGED FUTURES Cyclical Trough or Structural Impairment? Analysis and Proposed Solutions By Ryan Davis, CAIA, and Barclay Leib ystematic trend-followers, commonly Figure 1: 2008 Returns—HFRI Indexes referred to as managed futures Sfunds, long have been an important 30 component of institutional and high-net- 20 worth portfolios. These strategies’ unique ability to go both long and short in a vast 10 array of global financial markets histori- 0 cally has produced a return profile highly –10 uncorrelated to traditional markets. More Return (%) –20 recently, however, many investors have –30 come to question the asset class amid poor –40 performance in the post-global financial crisis period. In this article, we explore the recent struggles of the managed futures industry, discuss what the future may hold for such strategies, and offer suggestions for navigating this space. Source: FactSet Background The events of 2008 were a startling develop- On the heels of 2008, investors who previ- post-2008 as demand surged for tail-risk ment for many hedge fund investors; fol- ously shied away from these quantitative protection. Contributing to the growth in lowing a near-30-year period of few if any strategies poured into managed futures. managed futures assets since 2008, how- losses, double-digit declines in most hedge Assets in those strategies grew by 120 per- ever, was the fact that retail investors also fund strategies shattered an aura of abso- cent from 2007 to 2011 while the broader were given access to these funds for the first lute-return performance. When the dust hedge fund industry increased just 7.5 per- time, primarily through 1940 Act struc- settled on 2008, only two segments of the cent. As a consequence, the share of man- tures. Only one managed futures mutual industry generated substantial positive aged futures funds as a percentage of total fund existed before the financial crisis; that returns: short biased and managed futures hedge fund assets more than doubled to 9.3 number has swollen to 51 today. Total funds (see figure 1). More specifically, in a percent by the end of 2011, or $188 billion assets in the managed futures mutual fund calendar year in which the broad universe (see figure 2). Data aggregator BarclayHedge universe now stand at $8.6 billion—still a of hedge funds fell by 19 percent, the aver- estimates the current size of the managed fraction of its hedge fund peers, but not age managed futures fund rose 18 percent. futures market is even larger, at $260 billion insignificant. Many individual managed futures funds (although those figures are skewed by one were up 40 percent or more as they capital- extremely large hedge fund, Bridgewater Unfortunately for new entrants post-2008, ized on the sell-off in equities and extended Associates, which BarclayHedge classifies as the timing of their new allocations was trends in bonds, commodities, and curren- a commodity trading advisor or CTA). anything but optimal. Managed futures cies. This performance opened many inves- funds collectively posted negative absolute tors’ eyes to an asset class previously over- A spate of industry reports indicate that performance in three of the next four looked because of its intensely technical both high-net-worth and institutional cli- calendar years—the worst performance and quantitative nature. ents entered the managed futures space stretch in the recorded history of the asset JULY / AUGUST 2014 37 © 2014 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved. FEATURE | MANAGED FUTURES (1996), for example, found that an equally Figure 2: Assets under Management weighted portfolio of either CTAs or com- modity pools “increases the portfolio’s 200 Sharpe ratio by as much as 28 percent. The 180 HFRI Macro: Systematic Div. primary reason for this result is the low 160 correlation between managed futures 140 s ($) returns and the returns on other portfolio on 120 illi assets …” More recent studies such as one 100 by Ibbotson Associates (Chen et al. 2005) 80 ets, B of CTA data between 1980 and 2005 illus- ss 60 A trated an asset class that generated superior 40 returns to U.S. equity markets with similar 20 volatility levels. Because of the uncorrelated 0 nature of this performance, however, the authors concluded that layering in an allo- cation to managed futures to a traditional Source: FactSet stock-bond portfolio improved the overall risk-adjusted return, i.e., improved the effi- cient frontier in a mean-variance Figure 3: Managed Futures Calendar-Year Returns framework. 30 In practice, the performance of popular HFRI Macro: Systematic Div. 25 indexes of managed futures funds supports 20 the academic research. Using a common 15 period since the inception of the Dow Jones UBS Commodity Index in February 1991, 10 the managed futures industry as repre- Return Return (%) 5 sented by the HFRI Macro: Systematic 0 Diversified Index has generated the second highest Sharpe ratio of the major asset –5 classes, save for the broad category of hedge –10 funds. Its annualized return of 10.7 percent exceeds that of the S&P 500, and achieves it with approximately half the volatility. Source: FactSet Managed futures’ performance over this time period exceeds every major asset class class (see figure 3). Between 2008 and the Portfolios of Stocks and Bonds.” Lintner except that of hedge funds and real estate first quarter of 2013, managed futures funds concluded that “the combined portfolios of investment trusts (REITs). The average vol- generated an annualized performance of stocks (or stocks and bonds) after including atility of CTAs is also lower than every asset 0.4 percent, compared to 10.9 percent for … managed futures accounts (or funds) except hedge funds and bonds. the S&P 500 and 3.6 percent for the broad show substantially less risk at every possi- hedge fund composite. If one invested in ble level of expected return than portfolios The comprehensive risk management managed futures immediately following of stocks (or stocks and bonds) alone.” inherent to CTAs results in this mitigated 2008, the impact was not devastating on a Managed futures strategies proliferated in volatility profile, but its impact is most evi- stand-alone basis; but in the wake of strong the 1980s with the success of trend-follow- dent in the return distributions. Next to double-digit equity market returns, the ing investors such as John Henry and David fixed income, managed futures display the opportunity cost certainly has been high. Harding. most attractive drawdown characteristics of the major asset classes (see table 1). During Historical Review Since then, a range of academic studies the measured time period, only managed Managed futures investing received its first have validated the historical efficacy of futures and bonds experienced a maximum major academic backing in John Lintner’s managed futures investments and the bene- drawdown in the single digits. Although 1983 classic working paper, “The Potential fits of including them in diversified, tradi- hedge fund strategies generated a superior Role of Managed Commodity-Financial tional portfolios (McCarthy et al. 1996; return with less volatility than managed Futures Accounts (and/or Funds) in Edwards and Park 1996). Edwards and Park futures, they were not necessarily less risky, 38 INVESTMENTS&WEALTH MONITOR © 2014 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved. FEATURE | MANAGED FUTURES Table 1: Risk/Return Statistics, February 1991–March 2013 Annualized Annualized Max Portfolio Return St. Dev. Sharpe Ratio Drawdown Skewness Kurtosis HFRI Macro: Systematic Div. 10.7 7.5 1.00 –9.3 0.15 –0.3 S&P 500 9.3 14.8 0.41 –50.9 –0.63 1.3 Russell 2000 10.4 19.2 0.38 –52.9 –0.53 1.2 MSCI EAFE 5.9 16.9 0.16 –56.4 –0.57 1.1 MSCI Emerging Markets 10.3 23.6 0.30 –61.4 –0.69 2.0 Barclays US Aggregate 6.7 3.6 0.96 –5.1 –0.28 1.0 HFRI Fund Wtd Composite 11.2 7.0 1.15 –21.4 –0.70 2.6 DJ UBS Commodity 4.9 14.9 0.12 –54.3 –0.58 2.7 Dow Jones US Select REIT 11.5 20.1 0.41 –70.5 –0.74 9.0 Source: FactSet as evidenced by a maximum drawdown of more than 20 percent. This is due to the Figure 4: Three-Year Annualized Rolling Returns negative skewness and positive kurtosis of 40 the hedge fund category’s return distribu- HFRI Macro: Systematic Div. tion, indicating there are fatter tails for 30 such strategies. Of the major categories, S&P 500 only managed futures strategies featured 20 positive skewness. This suggests that man- aged futures is one of the few asset classes 10 that mitigate left tail risk effectively. Return (%) 0 One remarkable feature of managed futures –10 strategies is consistent performance over time. These strategies in isolation typically –20 run with volatility levels comparable to tra- ditional equities—and experience year-to- year drawdowns in accordance with their Source: FactSet standard deviation—but the asset class exhibits steadier results when viewed on a some structural changes in financial mar- June 2012 illustrate this phenomenon: longer-term rolling basis. Observation of kets and the CTA industry could be Following several decades of consistently three-year rolling performance, for exam- grounds for a more persistent degradation low correlations among assets, correlations ple, illustrates the relative ability of CTA in alpha generation. Differentiating moved sharply higher in the fall of 2008 strategies to consistently generate positive between a cyclical trough in performance and have yet to recede (see figure 5). This returns (see figure 4).
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