By Richard Morey
Why Have Managed Futures Been performing so well?
The answer has to do with:
Managed futures are contracts to buy or sell, within four broad asset classes:
1. Equities (stocks)
2. Fixed income (bonds & interest rates)
There are over 150 futures markets. A managed futures fund may have 100 long positions which profit when the underlying market advances, and an equal number of short positions for when it falls – or any combination of long and short in all 150 markets. The funds will typically also have most of their holdings (around 75%) in high-quality, short-term positions held for risk-control purposes.
How do the funds decide which markets to own or sell? As you might expect, methods and rationales may differ in practice, but all such funds employ highly complex trading programs based on massive amounts of market history, often incorporating mathematical algorithms based on behavioral psychology. In other words, decisions on what to buy and sell are based on the recurring market patterns indicated by each fund’s proprietary and constantly refined body of research.
Most managed futures funds are centered on trend following. They attempt to spot actionable market trends as early as possible, and to exit those positions as early as possible when one trend is broken and it’s time to move onto a new trend or set of trends. They change their positioning with the markets, following them up or down.
Of course, this must involve just the right amount of “patience.” If a given program sells at the first hint of a trend change, it couldn’t benefit from longer, sustained trends. But if the program sells too slowly, it may incur unnecessary losses during market transitions.
Again, each managed futures fund approaches these questions using its own historical research. Each will program a corresponding volatility level and time frame for their fund which determines the speed and frequency it enters and exits markets.
This programming doesn’t mean humans aren’t operating the system. To the contrary, especially when markets experience large disruptions, fund managers will oversee and closely evaluate each trade before it goes through.
The most pronounced trends tend to happen during periods of market volatility, and that is why managed futures funds require volatility to perform well. A representative mutual fund, called the Altegris Systemic Trend Fund, tells us they “…may experience the best conditions for profitable outcomes across multiple sectors and markets in multi-week and multi-month sustained trends.”
The most volatility occurs during turbulent financial crises, with the most sustained trends, and largest profitable outcomes, when the entire world economy and markets suffer most significantly.
However, you will note the above quote from Altegris doesn’t tell us they expect to have the best conditions for profit when the U.S. stock market goes down. To accurately do so would mean they had a high negative correlation with the stock market, and their value would rise most days stocks went down, but then fall nearly every day they went up. A simple, rigid formula like this couldn’t achieve the ultimate goal of managed futures funds, which is to deliver risk-controlled profit regardless of the direction of any specific market.
As they say, “The proof is in the pudding,” meaning results are the best evidence. Historically, managed futures funds have typically delivered excellent returns when markets have fallen precipitously– especially when volatility spikes in markets around the world. Throughout its history, the managed future industry has outperformed during financial crises, market crashes, and periods of inflation. Managed futures also tend to do well in both quickly rising and falling interest rate regimes.
Although since their inception these funds have not yet encountered a serious deflationary economic landscape, there is every indication this volatile environment should also present excellent opportunities for profits in futures trading
In recent history, the managed futures industry roared when the black swan called Covid-19 first struck markets in March of 2000, and has done the same as inflation has appeared to begin spiraling out of control. Since the managed futures index began in 1980 (Barclay’s CTA Index*), the industry has successfully provided protection and profit during periods of extreme market swings.
Can Managed Futures Profit when Stocks & Related Risk Assets Rise?
This is an important question. Any fund manager who answers “yes” to this question may claim to have achieved the “holy grail” of investing – a system that invariably profits when stocks rise AND when they fall.
There is, unfortunately, no such magic bullet in investing. No matter how good a managed futures system is, there are always factors that can conspire to make success impossible within any given time frame. The following conditions always apply:
WHEN DO MANAGED FUTURES TEND TO PERFORM WELL?
Why more profits when markets fall? It’s because these funds always devote some of their total allocation into protecting their downside. When stocks/risk assets rise, this money is a drag on performance – a drag which ceases to exist when those assets are falling.
WHEN DO MANAGED FUTURES TEND TO UNDERPERFORM?
When volatility is suppressed or unusually low, every single managed futures fund in the world will suffer. The best funds, and the industry as a whole, have historically not experienced drawdowns outside their expected risk limits when low volatility settles over markets. But low volatility means little to no opportunity for managed futures profits.
If you Google “Managed Futures Funds,” one of the first items you will likely see is Investopedia’s definition:
“Managed futures are alternative investments consisting of a portfolio of futures contracts that are actively managed by professionals. Large funds and institutional investors frequently use managed futures as an alternative to traditional hedge funds to achieve both portfolio and market diversification.”
“Futures, in and of themselves, are not any riskier than other types of investments, such as owning equities, bonds, or currencies. That is because futures prices depend on the prices of those underlying assets, whether it is futures on stocks, bonds, or currencies.”
Although most websites provide similarly accurate descriptions, you may come across some online financial pundits giving the impression that Managed Futures are inherently risky. However, the fund managers themselves would never use such a meaningless word as ‘risky,’ applied so broadly. Risk is part of investment. What matters is how carefully and successfully the investment is being managed, both currently and historically. Is the risk-management system robust enough to withstand rare or “tail” events?
The long track record of successful futures funds through past periods of instability and market turmoil should carry far more weight than superficial and uninformed bias the investor may come across while doing research across the Internet.
First, keep in mind these funds have 75% of their holdings protected in short-term Treasuries and comparable securities. They combine their remaining long and short positions in dozens of markets, putting typically no more than 3 to 4% in any one market (i.e soybeans, silver, yen). They then calculate their risk level, setting their portfolio at the selected level of volatility over their preferred time periods.
Second, by not tying themselves to the stock market, or any other single market or preselected combination of markets, they are able to create funds with the best diversification features of any asset class. They only have a modest correlation to any other asset – in fact, nearly zero for both the U.S. stock and bond markets.
To put this into some simple numbers, the S&P 500 has had volatility of 20.70 (Standard Deviation) over the last three years (through 6/30/22 – all data from Ycharts using 3-year standard deviation calculations), while the Vanguard Target Retirement 2025 Fund (targeting 60% in stock/40% in fixed income) comes in at 13.26.
In contrast, a managed futures portfolio, consisting of an equal weighting of five of the best open-ended managed futures mutual funds, has a score of 9.12. This means they are assuming only 46% as much volatility as stocks, and 20% less risk than one of the “safest” Vanguard target retirement funds. (The list of the funds is available upon request.)
How Much Can You Overweight the Best-Performing Managed Futures Funds?
In a crisis era the answer may be that you can’t overweight them. This is especially true when markets all around the world experience unusually high volatility over extended time periods.
Yet this is a matter of individual preference. Conservative investors can set the dial to their own comfort level. Capping managed futures at 72% lowers the risk level, from an STD of 9, down another 20%. A portfolio with only 50% in managed futures still provides an attractive overall portfolio STD of just over 4.
2022: Another Example of Managed Futures Outperforming
This year, rising commodity prices, inflation, monetary tightening, falling asset prices, the Chinese lockdowns, and the war in Ukraine appear to be an especially inauspicious combination for traditional portfolios, many of which are losing value at an alarming rate. Confusion and uncertainty, in markets and corresponding media narratives, only seem to be increasing.
This is precisely the environment described above, with the largest profitable outcomes expected when the entire world economy and markets suffer most significantly. Here is the scorecard through the first half of 2022:
Many managed futures funds use probability theory to control their risk, and to design key parts of their trading programs. The same probability theories can also be used by portfolio managers to control portfolio risk and to calculate likely outcomes based on the most trustworthy historical data. Reversion to the mean is the single most important principle which guides most markets over time, and fundamentals suggest that most stocks are still overvalued, and in fact have a long way to fall before they again reach fair value.
All these factors, combined with the burgeoning crises in global markets, seem to indicate that the time for “the largest profitable outcomes” for managed futures may be just beginning.
*Barclay CTA Index inception: 1980
SocGen CTA Index inception: 2000
These are the two more prominent managed futures benchmarks. The latter tends to be more representative of the larger CTAs, though it has a more limited history.
PLEASE NOTE: Investing in mutual funds and unit trusts involves risks. Fund prices can go up or down, and even become worthless. Under normal circumstances, trading funds may not be able to make a profit and may suffer losses.
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Before subscribing or purchasing any fund products, investors should refer to the fund prospectus or sales documents of the investment products, especially the risk disclosure statements of the fund prospectus or sales document