Increasing correlation between bonds and equities, rising interest rates, increased geopolitical risk and potentially overheating markets appear to have eroded many of the diversification benefits of the 60:40 balanced portfolio. The traditional asset management portfolio, long considered a low risk, default option, may no longer be a match for today’s markets.
As the traditional portfolio framework looks increasingly vulnerable, uncorrelated strategies such as managed futures are now considered by many to help provide the necessary diversification to achieve long term investment goals. Among the strategies employed by managed futures managers, also known as CTAs, by far the most popular is trend following which may protect against downside risks, reduce portfolio volatility and create opportunities for generating improved risk adjusted returns.
A recent paper published by AIMA and CAIA supports this theory. Portfolio Transformers: Examining the Roles of Hedge Funds as Substitutes and Diversifiers in an Investor Portfolio describes managed futures as demonstrating excellent “diversifying power for equity markets, and that they are able to offer crucial liquidity to investors.” The paper also verifies that they were of significant benefit to investors during the credit crisis which saw liquidity dry up in both equity and credit markets.
Low correlation, directionally unbiased
A traditional portfolio of stocks and bonds can be transformed by an allocation to managed futures. While managed futures may lag during periods of strong equity performance, they can provide stability to a portfolio, reducing risk whilst enabling any drawdowns to recover more quickly than a traditional stocks and bonds portfolio.
One of the main benefits of managed futures strategies is that they are directionally unbiased. In periods of turmoil, managed futures strategies have the ability to take short positions, meaning that the strategy can capture profits from negative price trends as well as positive ones. With low correlation to equities it also means that they can perform well in adverse market conditions. Because the strategies are highly liquid; the underlying instruments usually being traded on international listed exchanges simultaneously, they can take advantage of periods of market stress, generating what some would call ‘crisis alpha’.
Looking back at some specific periods of financial turmoil; after the dot-com bubble burst (2000-2002), during the global financial crisis (2007-2009) and during the eurozone sovereign debt crisis (2010-2012), it is possible to track the correlation between equities and managed futures. On each occasion, the correlation between them plunges sharply and managed futures showed strong positive performance.
(Source: Garraway Capital Management LLP/Bloomberg; Equities – MSCI World Total Return Net USD Index, Bonds – Bloomberg Barclays Global Aggregate Total Return Index Value Unhedged, Managed Futures – SG CTA Index; Traditional Portfolio = 60/40/0, Diversified Portfolio = 40/30/30, Managed futures = 0/0/100)
As the charts show, managed futures strategies have historically offered an attractive return and correlation profile in falling and rising markets, and in times of market stress they also took advantage of significant price moves driven by the flow of bad news and investors’ fear.
Therefore, replacing part of a long-only allocation equity or credit position with an allocation to managed futures, not merely as a substitute but as a strategy can reduce the volatility of the overall portfolio holding and improve risk adjusted returns.
Designed for Ucits
The features of managed futures, such as being benchmark unconstrained, non-correlated and well-positioned for opportunities in times of market stress, have historically been available only to sophisticated investors. But via the Ucits structure, they are now becoming more accessible to investors looking for growth but needing a greater level of liquidity and transparency.
There are some distinct advantages for a fund selector to allocate to a managed futures strategy with a Ucits structure: Improved liquidity (fortnightly, weekly or even daily); lower minimum investment levels; limits on leverage and concentration; as well as limited counterparty risk, all provide a safeguard within a highly regulated format.
Additionally, if a strategy is specifically designed as a Ucits, because of the regulated structure, there should be no style drift or deterioration in performance. However, as many strategies were not originally designed for the Ucits structure there are some notable red flags. Systematic managed futures funds, by definition, have stringent risk controls and monitoring systems embedded in their models, but strategies that are effectively shoehorned into a Ucits can lead to over-complicated use of swaps and certificates, potentially resulting in increased costs and greater regulatory and operational risk.
Darran Goodwin is a partnership member at Garraway Capital Management and the manager of Garraway Financial Trends