Finding Stable, Predictable Returns in Times of Extreme Stress
Roland P. AustrupPresident & Chief Investment OfficerIntegrated Managed Futures
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Important InformationPast Performance is not indicative of future results
This communication is not and under no circumstances is to be construed as an invitation to make an investment in the IMFC Global Investment Program nor does it constitute a public offering to sell the program. Applications for IMFC Global Investment Program will only be considered on the terms set out in the Disclosure Document (for U.S. resident investors ) or Offering Documents (for Canada-resident investors). Terms defined in the Disclosure Document and Offering Documents shall have the same meaning in this material. Potential investors should note that alternative investments can involve significant risks and the value of the investment may go down as well as up. There is no guarantee of trading performance and past performance is not indicative of future results. Investors should review the Disclosure Document and Offering Documents in their entirety for a complete description of IMFC Global Investment Program. An investment should only be made after consultation with independent qualified sources of investment and tax advice. The information contained in this material is subject to change without notice and IMFC will not be held liable for any inaccuracies or misprints.
Risks of InvestingThere are risks associated with an investment in the Program, as a result of, among other considerations, the proposed nature and operations of the Program. An investment in the Program should only be made after consultation with independent qualified sources of investment and tax advice. An investment in the Program is speculative and involves a high degree of risk and is not intended as a complete investment program. It should be borne in mind that risks involved in this type of investment are greater than those normally associated with other types of investments. There is a risk that an investment in the Program will be lost entirely or in part. Only investors who do not require immediate liquidity of their investment and who can reasonably afford a substantial impairment or loss of their entire investment should consider investment in the Program. Capitalized terms not defined in this document are defined as set forth in the Disclosure Documents and Offering Documents.
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AIC 2003
•Hedge funds do not provide protection in periods of equity market stress
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AIC 2003 – Conclusions Revisited
Managed Futures are a better stand-alone diversifier than hedge funds over all timeframes
Managed Futures are a significantly better diversifier when S&P 500 monthly returns are up or down more than 3%
Hedge funds are a slightly better diversifier when S&P monthly returns are between –3% and +3%
Managed Futures and hedge funds together are a better diversifier than either asset class alone
Managed Futures are a regulated industry offering high liquidity, full transparency, minimal credit risk and daily mark-to-market
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AIC 2006
Passive long-only commodity indices do not necessarily profit in periods of equity market stress
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4th Quarter 1987 Iraq Invades Kuwait(June-Sep'90)
LTCM Mess July-Sep '98
South East Asian $Crisis Aug'97-
Aug98
Market Selloff Oct'00-Sep '02
Barclay CTA Index S&P 500 Total Return Index Gorton & Rouwenhorst
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AIC 2006 – Conclusions RevisitedLong commodity indices are uncorrelated to equities, but …
Passive long only commodity futures are not a good source of uncorrelated return
• Limited protection against major market downturns• Undesirable Skewness
Managed Futures have demonstrated alpha over long commodity indices for over 25 years
• Over 500 bp per annum
• History of solid protection against major market downturns
• Desirable Skewness
• Elimination of negative commodity skew
Commodity exposure better achieved through Managed Futures
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The Recent Environment
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The Recent Environment
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The Recent Environment
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The Recent Environment
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Returns from October 2007 (S&P 500 Peak) to Present
Asset Class Index ROR
S&P 500 Total Return Index - 36.1%
HFR Global Hedge Fund Index - 21.8%
Goldman Sachs Commodity Index (S&P GSCI) - 26.2%
Barclay CTA Index + 11.2%
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2008 Returns
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Updating ‘Profits Under Stress’ Data
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Stable & Predictable Returns in General
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The Source of Stability and Predictability
Broad Diversification
Managed Futures trade futures on multiple uncorrelated asset classes
Industrial and agricultural commodities, currencies, fixed income instruments and equity indices
Average correlation of assets and markets traded is less than 0.10.
Active Long and Short Strategies
Potential for profit in both rising and falling markets
Managed futures managers have generally been long fixed income, USD and Yen, and short equities and, since August, commodities.
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The Source of Stability and Predictability
Controlled Volatility
Focus on managing as opposed to accepting market risk
Position sizes dynamically calibrated based on portfolio volatility and VaR targets, market correlations and market volatilities
Truly Uncorrelated Returns
Uncorrelated in general
Negative correlation to equity market returns during periods of equity market stress
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Controlled Volatility
Managed futures focused on targeting volatility as opposed to blindly accepting market volatility
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Correlation when you don’t want it
Hedge funds exhibit high tail risk dependency with equity markets
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Uncorrelated but Bifurcated
Commodities hedge periods of inflation (negative correlation) Commodities are correlated to equities in periods of slowdown
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Uncorrelated and Negative Correlation when Needed
Managed futures are negatively correlated to equities in periods of equity market stress
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Sources of Return
Source of return to managed futures is market pricing of risk premia
Risk premia structures tend to persist
Causes autocorrelation of basis, carry and spot currency data
Risk premia by definition positive in fixed income and equity markets
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Risk Premia and Managed Futures
Managed futures strategies capture risk premia and shifts in risk premia
Need to understand how and where various assets price risk premia
Generally systematic, quantifiable and diversified
Objective is to capture persistent risk premiums and manage spotvolatility across a diversified portfolio of asset classes and markets, and NOT to speculate on specific markets
Often momentum or trend-based strategies because of underlying autocorrelation in and from the pricing of risk premia
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Pricing Risk Premia
Commodity markets price risk premia (convenience yield) in the futures market
Unlike futures, spot prices exhibit no autocorrelation or trending tendencies
Futures prices are rarely equal to spot prices plus known and quantifiable carry factors (cost of capital, storage and transportation costs)
The ‘convenience yield’ of holding or not holding commodity inventories is also priced into futures prices
Difficult for investors to transact in spot commodity markets
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Risk Premia in Commodities
Convenience yield of holding or not holding commodity inventories
Shows up in the ‘Basis’ or shape/slope of spot-futures price curve.
A measure of risk of supply shock (or glut) versus cost of carrying inventory
Existence of Basis creates ‘Roll Yield’ and autocorrelation in futures prices
Excess returns from owning a portfolio of low inventory commodity futures and shorting a portfolio of high inventory commodity futures
Excess returns from owing a portfolio of high basis commodity futures and shorting a portfolio of low basis commodity futures
Excess returns from owing a portfolio of high momentum commodity futures and shorting a portfolio of low momentum commodity futures
Return Correlations of these strategies is 0.87
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Sources of Managed Futures Return
Backwardation – Positive Roll Yield
Contango –Negative Roll Yield
Rolling long futures contracts in backwardatedmarkets continually locks in profit by selling the higher expiring contract and buying the cheaper forward contract.
Rolling long futures contracts in contangoedmarkets continually locks in loss by selling the cheaper expiring contract and buying the more expensive forward contract.
Capturing Roll Yield
Buy
Sell
Time
Rolling short futures contracts in contangoedmarkets continually locks in profit by buying the cheaper expiring contract and selling the more expensive forward contract.
Price
Sell
Buy
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Risk Premia in CurrenciesCovered interest parity
Forward price is based on yield differentials
Higher yielding currencies trade at a forward discount to lower yielding currencies equal based on the yield differential
Assumes absence of riskless arbitrage
The carry-trade
Forward and futures prices do not accurately forecast future spot price
Significant empirical evidence for autocorrelation of interest rate differentials
Excess returns from investing in the direction of the carry
Risk of carry-trade is that spot moves against the trade by more than the interest-rate differential.
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Risk Premia in Currencies
Unlike the case in commodities though, momentum and managed futures strategies in currencies bear little correlation to carry strategies.
Why?
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Pricing Risk Premia
Currencies also price risk premia in the spot market
Forward prices directly priced off of known carry factor … interest rate differentials
Spot currency prices exhibit autocorrelation
Implies evidence of additional risk premium priced into cash markets.
Some evidence of time-varying risk premia associated with sovereign macro-economic risk factors (measured by equity dividend yield, bond default and term spreads)
No barriers for investors to transact in spot currency markets
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Risk Premia in Fixed Income
Fixed Income Markets
Risk premia is cost of capital
Yield curve (shape, slope) determines risk premia over time horizons
Most opportunities are, as with traditional strategies, on the long side
Short opportunities in longer duration instruments generally based onon inverted yield curves and rising interest rate environment ( increase in required risk premia by investors)
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Risk Premia in EquitiesEquities
Risk premia is cost of capital
Discounted stream of expected future cash flows
Required equity risk premium assumed in discount rate
Most opportunities are, as with traditional strategies, on the long side
Existence of Negative skew (fat left tails) in equities creates short opportunities
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Managed Futures ImplementationProfessional managers known as Commodity Trading Advisors (CTAs)
CTAs invest in futures on multiple asset classes that trade globally
Equity indices, fixed income instruments, currencies andphysical commodities
Average correlation of asset classes less than .1
Active long and short strategies ; no long or shot bias in many markets
Source of return varies by asset class
Common source of return of all asset classes is market pricing of risk premia
A set of strategies for systematically capturing risk premia priced into various asset classes and managing spot risk and volatility
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SummaryManaged Futures hedge periods of economic and equity market stress
Commodities indices are uncorrelated to equities but only hedge inflation
Hedge funds and commodity indices become highly correlated to equities during periods of economic slowdown or recession
Managed futures hedge both inflationary and deflationary economic environments
Managed futures have provided stable and predictable returns for over 25 years and across many market environments
Source of managed futures returns is market mechanism of pricingrisk premia into all asset classes
CTAs generally use systematic strategies to identify and capture risk premia across a diversified portfolio of assets and markets, and to manage spot price risk.
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What to Do ?
Learn
Understand
Commit
Invest
Enjoy the reward
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Selected Sources• Gary Gorton, and K. Geert Rouwenhorst (2007), “The Fundamentals of
Commodity Futures Returns”, Yale ICF Working Paper No. 0708
• Hilary Till (2007), “Term Structure Properties of Commodity Investments”, Presentation to Opal Financial Group FX & Commodity Summit for Institutional Investors, Chicago
• Derek Bond, Michael J. Harrison, Niall Hession, and Edward J. O’Brien (2007), “Some Empirical Observations on the Forward Exchange Rate Anomaly”, Working Paper
• Christopher F. Baum and John Barkoulas (1996), “Time-Varying Risk Premia in the Foreign Currency Futures Basis” Boston College Working Papers in Economics
• Nikiforos T. Laopodis (2007), “Noise Trading and Autocorrelation Interactions in the Foreign Exchange Market: Evidence from Developed and Emerging Economies”, Journal of Economics and Finance
