Crisis Alpha

Managed futures may provide shelter from storms and diversified returns in calm markets
Key Takeaways:
  • The flexibility to invest across a broad set of asset classes and take short positions has proven to be beneficial during periods of market crisis.
  • Managed futures strategies can be effective diversifiers in traditional portfolios as they generally have very low correlations to both stocks and bonds.
  • By using only highly liquid instruments, Managed Futures strategies avoid liquidity challenges that other alternative strategies can be exposed to.
Robert W. Sinnott

Senior Research Scientist, Co-Portfolio Manager AlphaSimplex Group, LLC

Memories fade fast

Given the strong performance of both equities and fixed income and the relative calm in the markets since the financial crisis, many investors are relaxed about the risk of a negative market event. But things can change quickly, and from unanticipated sources. While some claim they foresaw the clouds of the financial crisis forming, few actually adjusted their portfolios before the storm hit. Will they react in time if the apparent serenity of the current seven-year bull cycle and historically low interest rates is disturbed? For those in doubt, some protection against volatility is worthy of consideration.

Enter crisis alpha

One of the most compelling attributes of managed futures strategies has been their return during equity crisis periods. Managed futures outperformed the S&P 500 Index on a relative basis during all 10 of the largest quarterly declines in the S&P 500 Index between 2000 and 2015. They even posted positive absolute returns in 7 of the 10 periods, earning them the moniker that some have described as “crisis alpha”.1

How do managed futures work?

Most managed futures strategies (whose managers are commonly referred to as Commodity Trading Advisors or CTAs) are systematic and trend-following. That is, they seek to identify price momentum in futures markets including equities, fixed-income, currencies and commodities. CTAs typically have the flexibility to go long or short, giving these strategies the potential to profit even when traditional asset classes are falling.

Managed futures strategies are considered to have time-varying correlations that have the potential to be positively correlated to equities in rising equity markets and negatively correlated to equities in falling equity markets. Over the longer term, managed futures strategies generally have very low correlations to both stocks and bonds, making them effective diversifiers in a traditional portfolio.

Managed futures strategies have historically relied on three characteristics to provide positive returns during a crisis. Firstly, they can short an asset or asset class. Secondly, by trading a wide variety of assets and asset classes – stocks, bonds, currencies, commodities – they’re able to earn returns from other trends in other asset classes. So if one trend is reversing, the strategy can still provide positive returns by profiting from other trends taking place simultaneously.

Some strategies focus on very short-horizon trend signals, while others track long-horizon trends. Others still, such as those managed by AlphaSimplex, follow short-, medium-, and long-horizon trends, for a more diversified approach. “At AlphaSimplex, we believe that strategies should be adaptive to changing markets”, said Rob Sinnott, Senior Research Scientist and Co-Portfolio Manager at AlphaSimplex. “That is why we not only use a number of fixed horizons in our managed futures strategy, but also have signals that can adapt to give more or less weight to different horizons.”

Finally, because managed futures strategies mainly trade futures, which are highly liquid and exchange-traded, they are not generally exposed to the illiquidity risks of many other alternative strategies. While it is possible that a futures market might become illiquid, this is much less likely to occur than in most other markets.

Putting tail risk to the test

The test of a crisis alpha or “tail risk” strategy is twofold:

  • Does it provide effective protection when it is most needed?
  • Is the cost for the protection affordable over the long term?

The first question is addressed above. The second focuses on the overall portfolio costs that the investor must bear. While some tail risk strategies – such as put options – can provide effective protection during equity declines, the cost of keeping the strategy in place, particularly over long periods, is prohibitive. “Since the launch of our strategy in 2010 through the end of 2015, we have generated positive absolute returns on a cumulative basis,” said Rob.

“We achieved this during a time period when we have not seen what I would call an equity crisis, so in my view, that is a pretty cost effective approach to providing some diversification to a portfolio.” By reallocating just 10% of a 60/40 portfolio of stocks and bonds to managed futures between 2000 and 2015, the portfolio’s risk was lowered and its risk-adjusted returns were improved. The portfolio’s maximum negative month and maximum drawdown were also reduced. 2

What’s the catch?

Critics of managed futures strategies point to their performance since the financial crisis and question whether the strategy has become less effective over time. The market environment since 2009 has generally not been helpful to many trend-following strategies, including managed futures. The risk on/risk off market has led to a dearth of discernible trends and frequent trend reversals. This has led managers to enter trades only to exit them shortly after at little profit or even at a loss.

Managed Futures, especially trend-following strategies are best used as a long-term diversifier for overall portfolios. “I think having a strategic allocation approach, rather than a tactical allocation approach makes more sense. If you try to time it, you have a good chance of missing the benefits,” said Rob. “For example, in January of 2016 the S&P 500 was down 4.96%, while the SG Trend Index was up 3.76%. By the time an investor sees this and invests, current holders of managed futures strategies may already have accumulated most of the gains from that market event.”

Confidence in benign markets remains high. Is it justified?

Many investors have bet that Fed policy is likely to stay accommodative for the foreseeable future, greatly reducing the odds of another liquidity crisis. In this type of environment, trend-following strategies like managed futures may deliver only modest returns. However, anything that upsets this vision of the world may work to the benefit of managed futures strategies, potentially providing investors with a rare source of alpha.

Written on 13 May 2016

1 Source: Source: SG Trend Index (Managed Futures) and S&P 500 Index (Stocks), 2000–2015. During the 10 worst quarters for the S&P 500 Index, the SG Trend Index posted positive returns in 7 of those quarters.

2 Source: SG Trend Index (Managed Futures), S&P 500 Index (Stocks), and Barclays Capital Aggregate Bond Index (Bonds), 2000–2015. During this time period, a portfolio comprised of 60% stocks and 40% bonds had an annualised standard deviation of 9.15%, a risk-adjusted return (Sharpe ratio) of 0.56, a maximum negative month of –11.02%, and a maximum drawdown of –32.54%. A portfolio of 54% stocks, 36% bonds, and 10% Managed Futures had an annualised standard deviation of 8.21%, a risk-adjusted return (Sharpe ratio) of 0.67, a maximum negative month of –9.19%, and a maximum drawdown of –28.18%. All portfolios rebalanced monthly. For simplicity, Sharpe ratios have been calculated with the riskless rate set equal to 0%. It is not possible to invest directly in an index. Past performance is no guarantee of future results.

Published in June 2016

AlphaSimplex Group, LLC
255 Main Street
Cambridge, MA 02142
www.alphasimplex.com/

This communication is for information only and is intended for investment service providers or other Professional Clients. The analyses and opinions referenced herein represent the subjective views of the author as referenced unless stated otherwise and are subject to change. There can be no assurance that developments will transpire as may be forecasted in this material.

Copyright © 2016 NATIXIS GLOBAL ASSET MANAGEMENT S.A. – All rights reserved



Indices in Hot Water

The carbon footprint of the major equity indices exceeds the +2°C objective of the Paris Climate Agreement (COP 21).

US Municipal Bonds

Non-US investors could benefit from allocating to US municipal bonds

Finance and climate change

French institutional investors are bound by the Energy transition law to take action.

Aviation Letter

Annual outlook of aircraft industry

French Election

What does the outcome mean for global financial markets?

It’s Time for Real Assets

Private debt can be a lower-risk, higher-yielding alternative to traditional bonds

Real Estate Debt

An alternative to conventional fixed income investments

Green Bond Principles

Mirova discusses market standards and the lack of a regulatory body for Green Bonds

Real Estate Alchemy

Transforming non-core assets into prime property requires skill and resources

Referendum in Italy

Our expert’s insights into the 4th December's Italian referendum and its impact on financial markets.

U.S. Election

Americans elected their 45th U.S. President on November 8. What does the outcome mean for global financial markets?

Crisis Alpha

Managed futures may provide shelter from storms and diversified returns in calm markets

Credit Migration

Worse than you think, not as bad as you fear

Active Share

How passive is your active manager?

Hop Aboard the U.S Growth Engine

Mid-market private companies have the potential to expand rapidly while avoiding high exposure to volatile public markets

2016 Global Retirement Index

4 key trends shaping the future of retirement security: access, incentives, engagement and economics.

Insurance Survey:

companies grapple with new regulatory constraints, capital rules and increased risks

Diversified Growth Funds

Seeking to respond to rapid shifts in markets while reducing risk.

Institutional Investors Outlook:

Institutional investors bullish on stocks, alternatives in 2016, wary of global political tensions

Worldwide Currency War, Who Wins?

Implications of China’s surprise yuan devaluation, a strong U.S. dollar and weak emerging market currencies.