In a recent article, Morgan Stanley cautioned investors that returns on a traditional 60/40 portfolio “could slide to century lows over the next decade”. This warning highlights the importance of diversification in the traditional 60% stock/40% bond portfolio. While the algorithms underpinning managed futures strategies may be complex, the strategy’s purpose is simple. In a single word: diversification.
Given the current market environment with low growth prospects and declining yields, we thought it would be good to revisit the basics about managed futures strategies; explaining what they are, how they work, and most importantly, why their role as a diversifier within a broader portfolio makes sense now.
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 benefits.
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 outlier, however. Bonds and managed futures strategies 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 1.68%, as of September 30, 2019, well below its historical average of 4.10%. Low yields imply little room for further price appreciation, and correspondingly, little protection if equity markets sell off.
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. Plus, 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.
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 movement. 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.
Unfortunately, many investors may not be as diversified as they believe. Most asset classes are highly correlated. The only true diversifiers are managed futures and fixed income. With uncertainty over interest rates, the upside in fixed income could be limited. Going forward, investors will need to add assets that not only provide diversification, but that also improve upon the return potential of their portfolio.
Read more in our article, What are Managed Futures? >