MANAGED FUTURES, PAST AND PRESENT · 2019. 9. 12. · MANAGED FUTURES, PAST AND PRESENT 2 THE BIRTH OF A NEW INDUSTRY Organized futures exchanges, where individuals could agree on

H E A LT H W E A LT H C A R E E R

M A N A G E D F U T U R E S , P A S T A N D P R E S E N TS E P T E M B E R 2 0 1 9

1M A N A G E D F U T U R E S , PA S T A N D P R E S E N T

Managed futures, a type of hedge fund strategy, have been around for a long time. They are valued by many investors for their highly diversifying return profiles and, at times, for their counter-cyclical performance during capital market crises. However, we have observed that the investment approaches taken by this group of managers have begun to diverge materially. Given that any successful manager appointment centers on the manager delivering on expectations, it is critical that those expectations be clear and correct from the outset. As a result, we are changing the way we think about the available investment strategies in this space.

This paper sets out a brief history of the industry, including how we got to where we are today, before introducing our new investment category, systematic macro, and its three new subgroups.

2M A N A G E D F U T U R E S , PA S T A N D P R E S E N T

T H E B I R T H O F A N E W I N D U S T R Y

Organized futures exchanges, where individuals could agree on a price for a fixed quantity of a commodity at some point in the future, say a koku of rice at the next harvest, have been around for hundreds of years.1 However, it wasn’t until the 1970s that other types of futures contracts, such as interest rate, currency, bond and equity futures, began to emerge.

This development created a highly liquid (and inexpensive) market where investment managers could place trades based on their own forecasts of where commodity prices, interest rates and exchange rates were heading. This type of investing has a very low correlation with more traditional investments, making it highly diversifying, and investor interest grew quickly.

1 The koku is a Japanese unit of volume originally defined as the volume of rice required to feed one person for one year. Futures contracts for these were traded at the Dojima Rice Exchange in Osaka, Japan, the world’s first commodity futures exchange, established in 1697.

Figure 1: Growth in Managed Futures (Assets Under Management)

$400

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ions

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$50

$0

1980

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199

0

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199

5

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200

0

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4

200

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200

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Growth for the industry was further fueled by a broader understanding of behavioral biases that inspired greater confidence in adopting an approach based on price data analysis rather than fundamental inputs (information relating to the intrinsic or economic value of an investment). Investor behavior can be a powerful force in markets. This became evident in the way assets in managed futures strategies increased in the years following the market downturns, when managed futures performed most strongly. There was an initial surge in assets after 2003, when the dot-com bubble burst, and again in 2008, when a number of (trend-following) managed futures strategies produced strong performance in a year that was negative for many traditional investments. Managed futures largely invest in highly liquid markets and thus were able to meet redemptions at a time when other strategies struggled. This provided additional comfort for investors seeking liquidity in the wake of the 2008 global financial crisis.

Source: BarclayHedge

3M A N A G E D F U T U R E S , PA S T A N D P R E S E N T

A T R E N D F O R T R E N D I N V E S T I N G

Early managed futures strategies used a wide variety of discretionary and systematic investment styles. But thanks to the liquidity, reduced costs and high speed of trading available to investors on futures exchanges, higher-turnover strategies based on technical investing (that is, trading based on patterns of price movements rather than interpreting an asset’s underlying value) and trend following, in particular, quickly became dominant.

A key difference between a technical and a fundamental, or value-based, investment approach is the time horizon of investment decisions. The price and the underlying value for a given investment can seem detached for extended periods of time, providing an opportunity for technical investors.

But any difference between these is expected to eventually disappear. This is the basis of fundamental investing.

Trend investors aim to make money from buying assets in markets where the price is going up and selling assets in markets where the price is going down. The instruments used provide economic leverage, and the low cash margin requirements mean strategies can run with additional leverage. When markets are trending up or down, these strategies tend to be profitable, but in market environments where the direction of prices is less persistent, they can struggle. Overall, returns have historically been strong but cyclical.

Figure 2: Managed Futures Perform Well in Trending Markets

… but can struggle with a lack of directionality

$130

$120

$110

$100

$90

$80

$70

$60

$50

$40DEC 2007 APR 2008

SG CTA Bloomberg Barclays Global Aggregate

AUG 2008 DEC 2008 APR 2009 AUG 2009 DEC 2009

MSCI World

+5.9% p.a.

+4.0% p.a.

-11.7% p.a.

$130

$120

$110

$100

$90

$80

$70

$60

$50

$40DEC 2010 APR 2011

SG CTA Bloomberg Barclays Global Aggregate

AUG 2011 DEC 2011 APR 2012 AUG 2012 DEC 2012

MSCI World

+5.0% p.a.

-3.7% p.a.

+5.2% p.a.

Note: The SG CTA Index calculates the rate of return for a pool of commodity-trading advisors (CTAs) selected from larger investment managers that are open to new investment. This is a common benchmark used to assess the performance of managed futures funds.

Source: Thomson Reuters Datastream

4M A N A G E D F U T U R E S , PA S T A N D P R E S E N T

R E C E N T P E R F O R M A N C E C H A L L E N G E S

Since 2008, the performance of managed futures has been disappointing by historical standards. As quantitative easing by central banks became established, a convergence of returns lifted most asset prices in a sustained bull market for equities and bonds. This was punctuated by a series of risk-on/risk-off episodes in markets that were difficult for trend followers to navigate.

Although trends were still evident, markets became more correlated than they had been previously, reducing the impact of diversification across markets — historically, a key contributor to trend following returns.

Finally, the reduced volatility in markets meant that gains from any trends were more limited, although 2014 proved a powerful exception, spurred on by a late rally in the dollar and further collapse in bond yields.

Figure 3: Worst Equity Drawdowns in the Last 20 Years

MAR 2000– SEP 2002

OCT 2007– FEB 2009

DEC 2013– JAN 2014

AUG 2014– JAN 2015

MAY 2015– FEB 2016

JAN 2018– MAR 2018

SEP 2018– DEC 2018

Managed futures Bond Equity

40%

30%

20%

10%

0%

-20%

-10%

-30%

-40%

-50%

-60%

Source: Thomson Reuters Datastream

During this period of challenging performance (and perhaps partly because of it), many managed futures managers have been gradually diversifying their investment approaches to reduce their reliance on trend investing.

5M A N A G E D F U T U R E S , PA S T A N D P R E S E N T

I S T H E T E R M M A N A G E D F U T U R E S S T I L L A P P R O P R I AT E ?

Increasingly, as we speak to investment managers in the universe historically referred to as managed futures, we are finding this categorization to be less appropriate.

In the past, hedge fund managers without a clear asset-class specialty (such as equities or distressed debt) that didn’t use a multi-strategy approach mostly grouped themselves into two groups: managed futures and fundamental macro.

Today, managed futures means many different things, and the line between these two categories is blurring. As a result, we are changing the way we categorize these hedge funds and the language we use to talk about them. Where we used to refer to managed futures, we now use the term systematic macro, which we believe more accurately describes the nature of these managers.

Systematic macro encompasses a broad range of approaches. To better clarify the nature of individual strategies, we also consider three sub-categories: pure trend, diversified trend and multi-strategy systematic macro.

We have used allocation to trend following as the primary differentiator, as this has the biggest single impact on return characteristics for each group. We have defined pure trend as having a 90%+ allocation to trend following, diversified trend as having between 50% and 90% allocated to trend and multi-strategy as having 50% or less. On the whole, we expect these strategies will retain the diversifying attributes they have demonstrated previously, but pure trend is most like the strategies that contributed to past returns. There is less commonality across diversified trend and multi-strategy, so the return profiles for these strategies may vary considerably.

In terms of expected returns, we see pure trend as offering the lowest expected long-term information ratios (alpha per unit of active risk), as they are relatively straightforward. However, fees are also much lower. Diversified trend and multi-strategy are broader approaches that should provide higher quality returns and generate better expected information ratios over time — but after higher fees.

Figure 4: Allocation to Trend

M U LT I - S T R AT E G YD I V E R S I F I E D T R E N DP U R E T R E N D

This divergence in styles is clear when we look at the average correlations for investment strategies in each group with a trend-investing index. We expect this divergence to continue as the most recent changes in approach we have observed begin to take effect.

90%+ 50% to 90% ≤50%

6M A N A G E D F U T U R E S , PA S T A N D P R E S E N T

Figure 5: Systematic Macro Sub-Universes Rolling Three-Year Correlations Versus Trend Sub-Index

Pure trend followers Diversified trend Multi-strategy macro

DEC2012

JUN2013

DEC2013

JUN2014

DEC2014

JUN2015

DEC2015

JUN2016

DEC2016

JUN2017

DEC2017

JUN2018

JUN2019

DEC2018

0.90

0.85

0.80

0.75

0.70

0.65

0.60

0.55

0.50

Source: MercerInsight

Note: Correlations shown are for the median strategy in each period within each sub-universe.

7M A N A G E D F U T U R E S , PA S T A N D P R E S E N T

H O W A R E M A N A G E R S D I V E R S I F Y I N G AWAY F R O M T R E N D I N V E S T I N G ?

The changes we’re seeing managers make in how they manage investments to diversify away from trend investing can be separated into four categories:

N O T J U S T I N D E X F U T U R E S , B U T S T O C K S , T O O

Several managers have begun to incorporate allocations to equity stocks (or baskets of stocks) based on an amalgam of technical and fundamental analysis. This is a substantial departure from the derivative investments typically used (buying futures on the broad equity market, for instance) and greatly increases the investment opportunity set for these managers. However, different markets require different expertise, presenting a challenge for investors diversifying in this way. Investment in credit is another new area that is proving even more demanding.

N O N - T R E N D T E C H N I C A L S T R AT E G I E S

Although we have focused on the dominance of trend as a technical (price-based) investment strategy within managed futures historically, there are other technical strategies in use as well. These can all be considered as types of pattern recognition, with trend following simply the most well-known and widely adopted style.

Counter-trend or mean-reversion strategies aim to profit from a market trend reversing. These can struggle at times unless they have a particular niche, such as short-term trading, which tends to be very capacity constrained. Breakout strategies can have a similar return profile to trend investing, but they aim to capture the early part of an investment trend. Pattern recognition approaches can’t easily be categorized, and the return profiles can vary considerably, as they range from relatively simple to more sophisticated strategies that incorporate machine learning.

T E C H N O L O G I C A L I N N O VAT I O N

The managed futures industry was an early adopter of data-driven approaches to investing and the use of algorithmic decision-making processes — innovations that are now widespread within investment management. Many of the same managers continue to lead the way today with the research and application of machine learning and artificial intelligence. These tend to make up only small allocations due to the challenges involved in understanding and interpreting trading signals, although some managers have made a more significant commitment.

I N C O R P O R AT I N G F U N D A M E N TA L S

The distinction between technical investors (comparing prices with their own history to make investment decisions) and fundamental investors (comparing prices with some estimate of intrinsic or economic value) is not as clear as it once was. Managed futures investment managers are traditionally technical investors, but, increasingly, they use fundamental factors as signals within trend strategies or build valuation-based models that have a separate allocation.

8M A N A G E D F U T U R E S , PA S T A N D P R E S E N T

A S P E C T R U M O F I N V E S T M E N T S A N D A S P E C T R U M O F F E E S

Among the characteristics that differ between these new subcategories of hedge fund are fees. Many investment managers without a more diversified investment style have been forced to lower their fees in the face of disappointing performance as investors challenge the costs associated with an investment strategy that — on the surface, at least — appears relatively straightforward.

We find that pure trend managers tend to charge management fees in the range of 0.5% to 0.8%, often with no performance fee. Diversified trend fees are around 1% management with 20% performance, and multi-strategy fees are similar — although these can be higher, especially for more niche, capacity-constrained strategies.

M U LT I - S T R AT E G YD I V E R S I F I E D T R E N DP U R E T R E N D

B A S E F E E B A S E F E E B A S E F E E

P E R F O R M A N C E F E E P E R F O R M A N C E F E E P E R F O R M A N C E F E E

50–80 bps c. 100 bps >100 bps

Typically 0%

Up to 20%

May exceed 20%

Figure 6. Fee Differences Among Managers

9M A N A G E D F U T U R E S , PA S T A N D P R E S E N T

S Y S T E M AT I C M A C R O A N D I T S R O L E I N P O R T F O L I O S

Strategies that would have been referred to historically as managed futures cover a broad spectrum of investments. Some continue to focus primarily on trend investing, but others have diversified substantially. This spectrum (which we refer to as systematic macro) is continuous and, as we have seen, strategies can move along this spectrum in either direction as they continue to develop and investors seek new ways to achieve investment returns.

Although the strong returns seen in past capital market crises are far from guaranteed, strategies with a strong focus on trend investing often prove to be defensive during extended, diverse market environments. Strategies with a more diversified investment approach, however, have the potential to offer more consistently positive returns.

All types of systematic macro strategies have powerful diversification characteristics. They can also play a positive role in a growth portfolio, either alongside traditional assets as a diversifying return source or as part of a broader hedge fund portfolio.

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