Managed futures and exploiting inefficient markets

Graham Hand outlines managed futures and the role they play in the investment sector.

The global financial crisis taught many investors new lessons. In particular, 2008 shocked seasoned fund managers and advisers, and some investment rules that were once cast in stone turned to dust.

It was not only that the All Ordinaries Index peaked at 6,783 points on 1 November, 2007 and fell to 3,112 by 6 March, 2009 (a loss of almost 55
per cent in 16 months.

It was equally disturbing that the benefits of traditional portfolio diversification were also lost in some financial quarters, since all asset classes except cash fell in value.

There was nowhere to hide. It did not matter whether an investor held bonds, credit, equities or property – in October and September 2008, all the 16 asset classes monitored by US-based asset allocator, Research Affiliates, fell in value for the first time in 20 years.

Flight to safety

In Australia, retail investors reacted by reducing their equity exposure, and the flow into the safety of bank deposits was rapid. Initially, the strongest of the major banks benefited most, placing the funding of other financial institutions in jeopardy.

In October 2008, the Government placed a guarantee on bank deposits of up to $1 million, and while this eased funding pressures for smaller banks, it exacerbated the outflow from some managed funds – especially cash and mortgages.

Redemptions from mortgage funds were suspended, and for the first time in the history of investment platforms, the options with the largest inflows were bank deposits.

According to CoreData in its Australian Cash Report for Quarter 4 2010, there is no evidence that the overweight cash allocations have begun to unwind, and there is $155 billion more sitting in bank deposits now than there was three years ago.

Although 2009 produced better equity returns, investors remained cautious, and the Australian market was flat over 2010 – despite the strength of the resources sector feeding the local economy.

The Wealth Insights Adviser & Investor Sentiment Series for November 2010 reported that 62 per cent of clients were either ‘unsure’ or ‘not at all confident’ about investing, while only 36 per cent were ‘somewhat confident’ and 2 per cent were ‘confident’.

While the prospect of a major second dip appears to have reduced at the start of 2011, it certainly cannot be ruled out.

As the legendary US basketball coach, Yogi Berra, said: “It is tough to make predictions, especially about the future.” To paraphrase the man who made black swans famous, Nassim Taleb, we are blind to the randomness of unexpected events.

Many investors and their advisers are therefore looking for alternative investments where the performance correlation to traditional asset classes is low, but which offer better growth prospects than cash or term deposits.

One of the few shining lights of 2008 were managed futures, sometimes called Commodity Trading Advisors (CTAs).

The industry benchmark, the Barclay’s CTA Index, gained 14 per cent in that year, building on its growing reputation.

Managed futures involves systematic trading in a wide range of global futures markets, including equities, currencies, interest rates and commodity markets.

It uses a technical approach to capture price trends and directional movements, which occur persistently in global markets.

Well-established and well-regulated futures markets are predominantly used because they offer liquid investments, price transparency, tight oversight, relatively inexpensive trading, and the use of a clearing house to mitigate counterparty risk.

There are currently over 150 liquid futures markets worldwide, and managed futures have over US$250 billion under management across the globe.

Origins

Managed futures can be traced back to the 1970s. By 1982, Michael Adam and Martin Lueck had built a computerised trading model to identify and exploit price trends.

They co-founded AHL with David Harding in 1987, which was acquired by Man Investments in 1994.

They were the pioneers of managed futures, as Harding went on to establish Winton Capital, and Adam and Lueck were among the cofounders of Aspect Capital.

These three companies are distributed in Australia (Aspect by Colonial First State, Winton by Macquarie and AHL by Man) and are available in retail form on numerous platforms.

The majority of managed futures funds are trend-followers, looking for non-random price momentum across a wide range of financial markets.

Trend-followers believe crowd behaviour drives identifiable price movements.

They attempt to recognise the beginning of a trend, take a buy or sell position depending on whether the trend is rising or falling, and then exit the position as the trend ends.

Positions can be built up over a period of days, weeks or months and can be reduced quickly during periods of increased risk.

Why might such price momentum exist?

There is widespread, if not yet universal, acceptance that markets are inefficient, and do not capture all available information accurately in their prices.

Opportunities can be exploited before prices find a fair value.

Martin Lueck of Aspect Capital recently stated in The Economist (6 January, 2011): “Trends occur because there is a disequilibrium between supply and demand. The asset is trying to get from equilibrium price A to equilibrium price B.”

Once a trend becomes established, it can benefit from the bandwagon effect.

Behavioural finance provides considerable evidence of investor herding, market over-reactions and under-reactions, and cognitive biases that can all accelerate market momentum.

Managed futures do not attempt to make forecasts. Rather, they reacts dispassionately to price movements, identifying trends in what has already happened.

Gaining traction

Managed futures are becoming more popular among major fund distributors in Australia, due to past strong long-term performance and uncorrelated returns. Quoting from Standard & Poor’s Press Release of 12 January, 2011 on its strategy ratings:

“Alternative investments within fixed income, global macro and CTA peer groups continue to offer investors double-alpha producing managers with the largest opportunity sets for investment ideas.

The largest value proposition for investors is the ability of these managers to generate positive returns in negative markets through the ability to hold short positions.”

The breakthrough research on the ability of managed futures to reduce overall portfolio volatility, as measured by annualised standard deviation, was produced in 1983 by Harvard professor Dr John Lintner, who demonstrated that portfolios of equities and fixed income exhibit less variance at every possible level of expected return when combined with managed futures.

Although futures contracts are derivatives and use leverage, and are often considered volatile, the long-established managed futures funds have demonstrated to date a performance record generally no more risky over the long term than a traditional stock portfolio.

The skill comes from portfolio construction, finding the right risk allocation across various sectors, and recognising when a price trend has run its course.

Failure to identify a reversal may lead to negative returns and a give-back of some previous profits.

Historically, managed futures have experienced a loss one year in five, although the draw-downs have not normally been as severe as losses in equity markets.

As can be seen below, managed futures have outperformed equities and bonds since December 1989, with significantly smaller draw-downs.

In addition, in the three periods of crisis, managed futures produced strong positive performance while equities fell.

Market crises are generally periods of prolonged trends, and managed futures can benefit from flows out of risky assets into gold, government bonds and the US dollar, all actively traded on futures markets.

The challenge for financial advisers

Recommending managed futures to clients obviously presents challenges for advisers.

It is an alternative investment process unfamiliar to most, and systematic trading programs developed over decades by mathematicians, statisticians and engineers are complex for anyone to understand.

Ultimately, the performance is driven by the quality of the research, trading execution and risk management. While managed futures performance has little correlation to equity markets over the long term, it is possible that it will move in the same direction for some periods (usually short periods).

Therefore, managed futures should not be considered an instantaneous ‘hedge’ for equity prices in all circumstances.

In addition, an adviser will not know what to expect from a managed futures fund until after the event. Exposures are taken in commodities such as oil and gold, interest rates such as money markets and bonds, foreign exchange rates and equities, and positions can vary moment by moment at any time of the day (or night).

The strategy is therefore most appropriate for experienced investors who will understand the nuances of the returns.

Increasingly, professional investors are constructing multi sector portfolios with an allocation to alternatives, and where liquidity and non-correlated returns are of paramount importance, managed futures is gaining a foothold to improve overall risk-adjusted performance.

Graham Hand is general manager, funding and alliances at Colonial First State.