The algorithms underpinning managed futures strategies may be complex, but the strategy’s purpose is simple. In a single word: diversification.
The following article shares the basics about managed futures strategies, explaining what they are, how they work, and most importantly, their role as a diversifier within a broader portfolio. It also explores why the current market environment makes it more challenging—and more important—to find truly diversified assets.
Managed Futures Strategies Exploit Broad Market Trends
Managed futures strategies seek directional market trends, relying on proprietary, quantitative signals to identify when different asset classes are poised to rise or fall. The strategies use futures contracts to take long positions when signals indicate an asset class will rise, and short positions when signals indicate the asset class will fall. A managed futures strategy can take advantage of directional trends in nearly any asset type, inclusive of fixed income, currency, equity and commodities markets.
The strategy’s ability to track different assets and take advantage of both rising and falling markets has led to a substantially different return profile from most other asset classes. That uniqueness has its benefits.
Uncorrelated Assets are Hard to Find
Market crises often deliver a painful lesson: Diversification may not always work when investors need it most. That’s because most asset classes within a “diversified” portfolio are highly correlated, and don’t really behave that differently. If equity markets experience large losses, returns from most other assets are often equally disappointing.
Managed futures strategies are a rare and welcome outlier, however. The indexes in the table below show how correlated most assets are, and how few stand out as different.
As the chart shows, bonds and managed futures strategies, represented by the indexes above, are the only assets with low correlations to equities. Typically, bonds have played the role of the uncorrelated asset in a traditional portfolio, and have done an admirable job. But in today’s market environment, their returns may not be enough to meaningfully offset a downturn in equities. The 10-year Treasury is currently at 2.48%, as of December 31, 2017, well below its historical average. Low yields imply little room for further price appreciation, and correspondingly, little protection if equity markets sell off.
High correlations among most asset classes have serious implications for investors. If a portfolio carries only the highly correlated assets, the supposed diversification will do little to reduce portfolio volatility. For example, an equally weighted portfolio of two assets with like volatilities and a correlation of 0.7 would still exhibit 92% of the volatility of either asset in isolation. Translation: Unless multiple assets with truly low correlations to each other are included in a portfolio, diversification will offer scant protection in a market downturn.
Crisis Alpha: Capital Protection at Critical Points
One of the main reasons investors maintain a long-term allocation to managed futures is the strategy’s potential to provide what is referred to as “crisis alpha,” or positive returns when other assets, especially equities, are struggling. As the chart below shows, managed futures strategies have a history of serving investors well during those critical pain points.
The performance of managed futures strategies during equity market corrections may offer some long-term advantages. First, holding a strategy that produces stronger returns when equities are in free fall reduces portfolio drawdowns. Lower drawdowns make it easier for the portfolio to recover from losses and improve compounded returns over time. There is also a psychological advantage: By reducing large swings in a portfolio’s performance, investors are more likely to stay the course with their asset allocation, and avoid dropping out of the market and missing its rebound.
To reap these potential benefits, investors need to allocate a meaningful portion of their portfolio generally 10% or more—to managed futures strategies. With a smaller allocation, investors are less likely to experience an impactful reduction in volatility or drawdown.
Managed Futures Strategies Require Commitment and Understanding
While managed futures strategies dampen total portfolio volatility, that doesn’t mean they aren’t volatile. Historically, the downside tends to be significantly less than for equities, but the risks are still present. The key is again, low correlation. The strategies will suffer losses at times but typically provide ballast to portfolios in volatile or falling equity markets.
Another point to remember is that different managed futures strategies have different aims. Some trend following strategies seek to exploit longer-term market trends. Other strategies, such as counter-trend strategies, seek short-term trends to capitalize on volatile markets with a lot of back-and-forth price movements. Before selecting a managed futures strategy, investors need to understand how the strategy fits within the rest of the portfolio and what it seeks to provide.
Current Market Climate Calls for Better Diversification
U.S. equities are experiencing the second-longest bull market in history. For much of the past year, volatility has remained historically low. In such periods, it’s easy to get complacent. No one can predict when volatility will pick up, or a bear market will begin, but long-term investors should always be prepared for it. Preparation starts with diversification.
Unfortunately, many investors may not be as diversified as they believe. Most asset classes are highly correlated. The one traditional diversifier—fixed income—may provide less protection going forward. After four decades of declining rates, the upside in fixed income markets is limited. Going forward, investors will need to add assets that not only provide diversification, but that also improve upon the paltry return potential of investment grade debt. Managed futures strategies can help.