Our purpose in writing Managed Futures for Institutional Investors in 2011 was to help clear the way for the possibility of doubling the size of the industry. While ambitious, the goal seems well with- in reach. Since then, the industry has grown somewhat and now manages roughly $330 billion. At the same time, the industry finds itself in a drawdown that is, by the industry’s standards, relatively deep and relatively long. The current drawdown at this writing is two years long. And at its worst (so far), the drawdown was -9.3%. The growth in assets combined with the current drawdown has prompted investors to ask three related questions. What is the industry’s capacity to deliver uncorrelated returns with a reasonably high Sharpe ratio? How large can an individual manager be? And, a truly interesting question for a large institutional investor, how large an investor can I be? This note mainly addresses the first question, although the framework we work with allows one to think about the second two questions as well. To do this, we explore the position sizes that an in- dustry dominated by trend following would require to meet a return volatility of 15% and compare them with open interest in a wide range of markets. Probably the most use- ful insight gleaned from this exercise is that if open inter- est constrains the industry’s positions, we can conclude that the first thing to suffer from growth in assets under management would be the industry’s Sharpe ratio. But, as shown in Exhibit 1, the degra- dation of the industry’s Sharpe ratio would bottom out once maximum position sizes had been reached in all tradable markets. At this point, increas- es in the size of industry would serve only to dilute the industry’s returns and, as a result, its return volatilities. Every dollar added to the denominator of the industry’s return calculation, with no in- crease in the returns that constitute the numerator, simply spreads the industry’s returns over a broader asset base. The work described here is meant to be a framework for thinking about the problem of capacity. The final product should be useful in a number of ways. q We illustrate the fluid and complex structure of open interest in futures markets. We discuss the relatively large importance of over-the-counter currency trading for CTAs. q We describe the kind of portfolio that a typical trend following CTA would build given vola- tility and diversification targets that are within reasonable bounds for the industry. q We reveal the likely stress points for the industry and identify those markets that are more likely to constrain the industry than others. We also explore the way a large and growing CTA would deal with capacity constraints by reallocating risk to less constrained markets. Capacity of the managed futures industry newedge.com Exhibit 1 Performance of trend following portfolios 0% 2% 4% 6% 8% 10% 12% 14% 16% 2 25 100 300 600 Portfolio size (billions) Volatility 0.00 0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40 Sharpe ratio Portfolio volatility Portfolio Sharpe ratio Source: Newedge Alternative Investment Solutions newedge.com Prime Clearing Services | Advisory Group Galen Burghardt [email protected]Ryan Duncan [email protected]Alex Hill [email protected]Chris Kennedy [email protected]Lauren Lei [email protected]Lianyan Liu [email protected]Jovita Miranda [email protected]James Skeggs [email protected]Brian Walls [email protected]Tom Wrobel [email protected]ALTERNATIVE INVESTMENT SOLUTIONS AlternativeEdge ® Note Galen Burghardt [email protected]Ewan Kirk [email protected]Lianyan Liu [email protected]July 31, 2013
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Transcript
Our purpose in writing Managed Futures for Institutional Investors in 2011 was to help clear the way
for the possibility of doubling the size of the industry. While ambitious, the goal seems well with-
in reach. Since then, the industry has grown somewhat and now manages roughly $330 billion. At
the same time, the industry finds itself in a drawdown that is, by the industry’s standards, relatively
deep and relatively long. The current drawdown at this writing is two years long. And at its worst
(so far), the drawdown was -9.3%.
The growth in assets combined with the current drawdown has prompted investors to ask three
related questions. What is the industry’s capacity to deliver uncorrelated returns with a reasonably
high Sharpe ratio? How large can an individual manager be? And, a truly interesting question for a
large institutional investor, how large an investor can I be?
This note mainly addresses the first question, although the framework we work with allows one
to think about the second two questions as well. To do this, we explore the position sizes that an in-
dustry dominated by trend following would require to meet a return volatility of 15% and compare
them with open interest in a wide range of markets.
Probably the most use-
ful insight gleaned from this
exercise is that if open inter-
est constrains the industry’s
positions, we can conclude
that the first thing to suffer
from growth in assets under
management would be the
industry’s Sharpe ratio. But, as
shown in Exhibit 1, the degra-
dation of the industry’s Sharpe
ratio would bottom out once
maximum position sizes had
been reached in all tradable
markets. At this point, increas-
es in the size of industry would serve only to dilute the industry’s returns and, as a result, its return
volatilities. Every dollar added to the denominator of the industry’s return calculation, with no in-
crease in the returns that constitute the numerator, simply spreads the industry’s returns over a
broader asset base.
The work described here is meant to be a framework for thinking about the problem of capacity.
The final product should be useful in a number of ways.
q We illustrate the fluid and complex structure of open interest in futures markets. We discuss
the relatively large importance of over-the-counter currency trading for CTAs.
q We describe the kind of portfolio that a typical trend following CTA would build given vola-
tility and diversification targets that are within reasonable bounds for the industry.
q We reveal the likely stress points for the industry and identify those markets that are more
likely to constrain the industry than others. We also explore the way a large and growing CTA
would deal with capacity constraints by reallocating risk to less constrained markets.
Capacity of the managed futures industry
newedge.com
Exhibit 1Performance of trend following portfolios
0%
2%
4%
6%
8%
10%
12%
14%
16%
2 25 100 300 600
Portfolio size (billions)
Vola
tilit
y
0.00
0.05
0.10
0.15
0.20
0.25
0.30
0.35
0.40
Shar
pe
rati
o
Portfolio volatilityPortfolio Sharpe ratio Source: Newedge Alternative Investment Solutions
Source: Newedge Alternative Investment Solutions, Barclay Hedge
CapaCity of the managed futures industry 3
Newedge alterNative iNvestmeNt solutioNs
Open interest
Open interest in futures markets measures the
open long (or short) positions at any given mo-
ment and represent, in a sense, the amount of risk
that traders – both long and short – choose to take
in the form of futures contracts. Before embarking
on the work of seeing how CTA returns might be
affected by a substantial increase in assets under
management, we would like to touch on three
matters that merit consideration. These are: (1) the
fluid nature of open interest; (2) the varied distri-
butions of open interest across contract months;
and (3) the CTA industry’s preference for trading
currencies in the over-the-counter forward market.
The fluid nature of open interest
In practice, the number of open positions is fluid
rather than fixed and varies over time as new po-
sitions are taken or old positions are offset and
closed out. Unlike a market for equities or bonds,
where the total amount of risk that must be taken
is determined by the value of equities or bonds
outstanding, the amount of risk taken in futures
markets – as measured by open interest – is a mat-
ter of choice. And any given trade can produce
either an increase, decrease, or no change in open
interest. For example, if someone who is already
long futures buys futures from someone who is
already short futures, open interest will increase.
If someone who is already long futures sells to
someone who is already short futures, open inter-
est will decrease. And if someone who is already
long futures sells to someone who is also already
long futures, the result will be no change in open
interest. 2
To illustrate this point, we have provided open
interest histories for four commodities in Exhibit 4 – one for crude oil, one for British pounds, one for
the S&P500, and one for 10-year treasuries. All four have been normalized so that open interest in 1995
is indexed at 1.0.
Notice first that open interest in all four markets has grown substantially over the period shown,
although the path taken by 10-year treasury futures has been radically different from the other three.
With the exception of the equity futures contract, open interest today is substantially larger than it was
ten years ago. It is a bit odd that open interest in equity futures has fallen over the past five years, but
as we will find, equity futures markets will prove to be the least constraining in this exercise.
The distribution of open interest across contract months
In government bond, equity index, and currency futures, nearly 100 percent of the open interest will
be either in the “lead” contract (i.e., the contract that is about to expire) or in the “first deferred” contract
(i.e., that contract that is about to become the lead contract). An example of what the distribution of 2 Perhaps the closest analogy one can find in securities markets is the practice of shorting stocks or bonds. These trades
create the appearance of a larger quantity of the security. It is not possible, however, to reduce the apparent supply
34 British Pound 6,244 4,722 29,484,910 35 Canadian Dollar 6,416 4,595 29,483,157 36 Euro 13,421 2,197 29,485,436 37 Japanese Yen 11,720 2,516 29,488,368 38 New Zealand $ 8,209 3,592 29,487,885 39 Mexican Peso 3,889 7,582 29,485,372 40 Swiss Franc 11,032 2,673 29,488,874
Inte
rest
Rat
e
41 German 2-Y SCHATZ 963 20,764 19,988,564
140,987,233
42 US 3-M Eurodollar 469 42,602 19,988,559 43 Euro 3-M Euribor 923 21,654 19,988,263 44 US 5 Year 2,639 7,575 19,989,096 45 UK 10 Year Gilt 12,682 1,576 19,987,218 46 Australian 3 Month 1,875 10,662 19,989,336 47 Japan 10-Y JGB 30,346 659 19,998,268 48 UK Short Sterling 768 26,021 19,988,607 49 German 5-Y BOBL 5,093 3,925 19,989,008 50 German 10-Y BUND 11,332 1,764 19,989,053 51 US 2 Year 832 24,027 19,988,354 52 US 10 Year 5,679 3,520 19,988,537 53 US 30 Year 13,114 1,524 19,986,286 54 Australian 10-Y 12,756 1,567 19,989,370 55 Japan 3 Month 196 101,862 19,988,590
Source: Newedge Alternative Investment Solutions, Bloomberg
CapaCity of the managed futures industry 4
Newedge alterNative iNvestmeNt solutioNs
open interest in e-mini S&P500 futures looked like on
March 28, 2013, is provided in Exhibit 5. This pattern
will hold until market participants want to shift their
risk taking to the next most active contract month. In
the case of equity index and currency futures, this shift
typically takes place in the week before the lead con-
tract expires. In government bond and note futures, the
shift depends on the market. In the case of U.S. Treasury
futures, the shift takes place during a few days toward
the end of the month before the lead contract expires –
chiefly because most futures participants want to avoid
any possibility of taking delivery of actual bonds. In the
European and Asian markets, where delivery rules are
different, the shift tends to take place closer to the lead
contract’s scheduled expiration.
Commodity futures, on the other hand, make much
fuller use of deferred contracts. Exhibit 6 provides an
example of the distribution of open interest in crude oil
futures across contract months. As you can see, there
are ample open positions in many of the deferred con-
tracts. And it is apparent that this market concentrates
much of its trading in contract months such as De-
cember and, to a lesser extent, in June. One also finds
a broad distribution of open interest over contract
months in money market contracts such as Eurodollar
and Euribor futures.
A summary of these patterns is provided in Exhibit
7, which shows the ratio of total open interest to lead
contract open interest for the 55 markets traded by the
Newedge Trend Indicator. In the work that follows, we
use each market’s total open interest.
Foreign currency markets
Perhaps the only market in which transaction econom-
ics favor over-the-counter trading over futures trading
is the currency market. For this reason, the greater part
of currency trading done by CTAs is done in the forward
market. This raises a practical problem for us because
there is no analog for open interest in the over-the-
counter market. At least no analog for which there is a
useable measure.
To deal with this, rather than trading the currency
market as a boundless source of trading positions, we
applied the following logic. First, we can compare open
interest and trading in the futures market. Exhibit 8 pro-
vides average values for 2012. Second, we can compare futures trading with spot and forward trading
using a survey that BIS coordinates once every three years. Exhibit 9 shows the April 2010 ratios of
over-the-counter spot and forward trading to futures trading for the currency markets in our model
portfolio. Then, with these two sources of data, we apply the ratio of open interest to trading volume
that we observe for futures to the trading that we observe in the over-the-counter forward market.
The result is a synthetic open interest value for over-the-counter currency trading that we can express
Exhibit 4Growth of aggregate open interests of futures markets
Source: Newedge Alternative Investment Solutions, Bloomberg
Ind
ex o
f im
plie
d b
id/a
sk s
pre
ad
Exhibit 24Index of implied bid/ask spreads
CapaCity of the managed futures industry 12
Newedge alterNative iNvestmeNt solutioNs
Newedge does and seeks to do business with companies that may be covered in its research reports. As a result, investors should be aware that Newedge might have a confl ict of interest. For the avoidance of doubt, investors should note that this research report is not objective and is a marketing communication as defi ned by the Markets in Financial Instruments Directive (“MiFID”). For more details, see MiFID policies on our website at www.newedge.com.
This report is for information purposes only, subject to change without notice and not to be constructed as a solicitation or off er to buy or sell any fi nancial instruments or securities. Newedge makes no representation or warranty that the information contained herein is accurate, complete, fair or correct or that any transaction is appropriate for any person and it should not be relied on as such. Subject to the nature and contents of this report, the investments described are subject to fl uctuations in price and/or value and investors may get back less than originally invested. Certain high volatility investments can be subject to sudden and large declines in value that could equal or exceed the amount invested. Futures and options, as well as certain other fi nancial instruments, are speculative products and the risk of loss can be substantial. Consequently only risk capital should be used to trade futures and options and other speculative products. Investors should, before act-ing on any information herein, fully understand the risks and potential losses and seek their own independent investment and trading advice having regard to their objectives, fi nancial situation and needs. This report and the information included are not intended to be construed as investment advice. Any forecasts are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.
Newedge accepts no liability for any direct, indirect, incidental or consequential damages or losses arising from the use of this report or its content. This report is not to be construed as providing investment services in any jurisdiction where the provision of such services would be illegal.
The opinions and views expressed in this report refl ect the personal views of the author(s), are subject to change without notice and do not necessarily refl ect the views of Newedge. Newedge, its offi cers, directors and employees may from time to time have positions, make markets or eff ect transactions in any investment or related investment covered by this report. All information as well as references to prices and yields are subject to change without notice. Past results are not necessarily an indication of future performance. This communication is intended only for use by the individual or entity to which it is addressed and may not be used in any way by or provided in whole or in part to any other person or entity.
Please note that this analysis or report is not meant for distribution to retail clients domiciled in Singapore (i.e. a person who is not an accredited investor, expert investor or institutional investor as defi ned under the Financial Advisers Act). For matters relating to these analyses or reports, Singapore recipients should contact the Singapore offi ce by email to [email protected].
If these reports are prepared by a Newedge entity outside of the United States these reports are issued solely to major US institutional investors pursuant to SEC Rule 15a-6. Any US person wishing to discuss this report or eff ect transactions in any security discussed herein may do so with or through Newedge USA, LLC, 630 Fifth Avenue, Suite 500, New York, New York 10111 (646) 557-9000. Only Newedge USA, LLC is a member of FINRA and SIPC (although SIPC only pertains to securities-related transactions and positions). Newedge USA, LLC is a US Broker-Dealer and Futures Commission Merchant. Newedge USA, LLC does not guarantee the settlement of any trade executed pursuant to SEC Rule 15a-6.
THE DISTRIBUTION OF THIS REPORT IN CERTAIN JURISDICTIONS MAY BE PROHIBITED OR RESTRICTED BY LAW AND PERSONS WITH ACCESS TO THIS REPORT MUST OBSERVE ANY SUCH PROHIBITIONS AND RESTRICTIONS. BY ACCEPTING THIS REPORT YOU AGREE TO BE BOUND BY THE FOREGOING.
“Newedge” refers to Newedge Group SA and all of its worldwide branches and subsidiaries. Newedge Group SA and its branches are lead regulated by the Autorité de Contrôle Prudentiel. Newedge Group SA is also regulated by the Autorité des Marchés Financiers in France. Newedge UK Financial Limited is authorized and regulated by the Financial Conduct Authority (FCA). Newedge Group (Frankfurt, Zurich and Dubai branches) and Newedge UK Financial Limited do not deal with, or for, Retail Clients (as defi ned under MiFID, FCA rules and Dubai Financial Services Authority). Only Newedge USA, LLC is a member of FINRA and SIPC (SIPC only pertains to securities-related transactions and positions). Only Newedge Canada Inc. is a member of the Canadian Investor Protection Fund. Not all products or services are available from all Newedge organizations or personnel.