Monday, 24 April 2017
Last updated 5 hours ago
Mar 29 2012 | 1:05pm ET
Managed futures as an asset class has long been touted for generating the holy grail of all investment strategies: uncorrelated returns. The professional money managers known as commodity trading advisors who make up this roughly 30-year-old industry invest long and short across a wide variety of markets, trading strategies and time periods. But while managed futures have performed well over the past decade, there have been significant differences between the returns of individual CTAs.
David Kavanagh, CEO of the $1 billion Grant Park Managed Futures Mutual Fund, says this is because within the managed futures arena, different CTAs have different investment objectives, and “each CTA’s core attributes and trading philosophies result in a unique return profile.”
Grant Park classifies CTAs into four distinct categories, one of which is focus—the specific futures or currency markets in which the CTA trades. A CTA’s trading universe “could include all or a subset of six market sectors: currencies, energies, equities, fixed income, grains/foods and metals,” says Kavanagh.
Greg Anderson, chief investment officer of Princeton Fund Advisors, which runs the $1.6 billion Princeton Futures Strategy Fund of funds, says focus affects CTA performance. Portfolios that are “heavily weighted towards the financial complex (interest rates, currencies and stock indices) will perform differently than a portfolio that is concentrated in the traditional commodity markets (agriculture, metals, energy, and industrials)," he says.
Another factor to consider, according to Anderson, is that many strategies involve some aspect of trend-following while others focus on "reversion-to-the-mean" or contrarian approaches. “While both can be profitable, the trend-following strategies will generate higher rates of return during predominately trending periods.”
Timeframes, another CTA differentiator, refer to the target holding period for trades and typically range from short-term (several days) to long-term (several months). Depending upon the market environment, says Anderson, each timeframe can generate positive returns. “Historically the intermediate, trend-following strategy has probably performed best. However, in 2009, this strategy under-performed, while the longer-term trend followers generally posted positive returns during that year.”
A final factor to consider, says Anderson, is the differing methodologies used by CTAs to generate their trading signals.
“Some are based upon mathematical patterns and probabilities while others involve an analysis of the economics of supply and demand. Some strategies are anticipatory, while others are reactive. Others utilize chart patterns, support/resistance levels, pattern recognition and even artificial intelligence to select their trades. Each approach will have its own risk/reward and absolute return characteristics depending upon the specific markets traded and the market conditions.”
Given the variety of performance-determining factors in play, it’s not surprising that Anderson considers CTA evaluations as “probably the most difficult, but most important aspect of our business.”
While track record is important, both Anderson and Kavanagh agree it’s simply one factor in an overall assessment. It can also, says Anderson, be misleading.
“For example, one of our CTAs has an extremely long track record, but it is evolutionary, meaning that there were several very distinct changes in the advisor’s strategy during his trading history," he says. "In order to make an effective evaluation of the track record, it is important to determine what portion of the record is pertinent to the strategy the advisor currently employs. This is necessary to be able to determine how the strategy would likely perform in the future under varying market conditions.”
Kavanagh says his firm’s CTA assessment process includes “extensive qualitative analysis regarding a firm’s operational infrastructure, the experience of its principals and the program’s ability to enhance the diversification and performance of our current products.”
Anderson says their analysis includes such things as “the impact of interest income, commission rates and other costs as these variables can turn a seemingly good record into a mediocre one and an average record into a very attractive one.”
Anderson says it’s also important to consider the nature of trading results, such as the profit/loss ratio, to insure profitability is not just dependent upon one or two large trades. Finally, he says, the performance record should be audited and, if not, the track record should be “verified and compared to the statements of the oldest managed account.”
Funds like Grant Park and Princeton must also decide how many individual CTAs they will invest with. At any given time, says Kavanagh, Grant Park is invested in about five CTAs. That number may change, he says, as the fund “continually strives to achieve the best long-term results.” Portfolio allocation and rebalancing is accomplished by way of “two distinct avenues.”
The first is tactical. Tactical allocations, he says, are “smaller in nature and are intended to adjust CTA allocations to account for recent performance and client inflows/outflows from the fund,” says Kavanagh. They are made approximately twice per month.
Strategic allocations, the second avenue, are made once or twice a year “to incorporate new research into the fund’s allocation process, add/remove CTAs to the fund, or perhaps to take advantage of a specific market environment.”
Grant Park allocates directly to the CTAs in its portfolio.
The Princeton Futures Strategies Fund casts a wider net, investing directly or indirectly in 20 CTAs employing 31 distinct strategies. The fund is rebalanced as new assets flow in and the firm also undertakes periodic rebalancing “depending upon the profitability of specific strategies, the elasticity of run-ups and drawdowns for differing strategies and our proprietary risk analysis.”
Anderson says management of the portfolio is not tactical, in that they “do not invest in a particular CTA or alter the respective allocations based upon an anticipated market move or environment.”
How long an advisor remains within Princeton’s portfolio depends upon “performance characteristics being consistent with our expectations, the continued ability to accept additional assets, relative peer performance and other factors such as strategy and personnel changes.” Some advisors have been in Princeton’s portfolios for more than six years and some for over 10, says Anderson. However, he says, “if there are violations of our monitoring criteria or significant and unquantifiable changes in strategy or personnel, we will move to the sidelines following the old trading adage of ‘when in doubt, get out.’”
The Princeton Fund works with a sub-advisor, 6800 Capital, and attempts to replicate the futures strategy 6800 has run for over 16 years. To this end, it has made 6800 responsible for identifying, selecting, allocating to and monitoring the underlying CTA managers in the fund of funds. Currently, all of the CTA managers Princeton works with are included in the 6800 managed futures strategy.
For Anderson, there are four chief risks associated with investing in managed futures: poor selection of a single CTA, improper design of a multiple-CTA portfolio, systemic changes in market trading that render particular CTA strategies unviable, and catastrophic events that introduce greater-than-expected "tail risk" or large losses.
On the subject of catastrophic events, he says many crises have affected the financial markets over the years: hyper-inflation in the late ‘70s, the implosion of $4.6 billion hedge fund Long Term Capital Management in 1998, the Russian debt crisis of the same year, the tech bubble in the early 2000s and the post-2008 recession and credit crunch.
“Despite these events,” says Anderson, “managed futures as an asset class have produced far better risk-adjusted returns than many other investment alternatives. However, during such periods, particular strategies have encountered some very difficult times and have produced large ‘tail risk’ which is why we believe in a multi-advisor/strategy approach for investing in managed futures.”
Kavanagh, for his part, considers lack of understanding of the asset class one of the biggest risks to investing in managed futures. In this space, he says, it is “important to understand that all products are not created equal. Knowledge of the core attributes that separate an investment product from its peers and competitors is a critical component to making informed investment decisions.”
Both men, needless to say, agree on the value of adding managed futures to an investment portfolio.
“As it is generally not correlated to equities and fixed-income markets, a managed futures investment has the potential to reduce overall portfolio volatility and provide alpha,” says Kavanagh. “The benefits of the diversification are normally most prevalent when other asset classes may be having difficulty.”
But what size allocation to managed futures is necessary to realize these benefits? Kavanagh says an investment as small as 5% to 15% of an investor’s overall portfolio—and Anderson agrees.
“When you look at an efficient frontier model of a portfolio of stocks, bonds and managed futures,” says Anderson, “you can see that the diversity of managed futures continues to be accretive up to a fairly high weighting in the portfolio. Because most portfolio models that we see include other options for diversification besides managed futures, the normal percentage range of allocations to managed futures that we see being used for client portfolios is between 5% to 15% of a client’s overall portfolio assets."
“If the allocation weight is too small to managed futures, then the weighting will have little impact to the overall portfolio regardless of the performance of managed futures as compared to the rest of the portfolio. While a review of the efficient frontier model for a stock and bond portfolio would indicate a much higher allocation to managed futures, we think the use of other asset classes to help diversify an investor’s portfolio is prudent.”
Kavanagh says Grant Park doesn’t like to forecast performance on any individual market, but “remains bullish on the long-term diversification benefits of a managed futures investment in traditional portfolios.”
Anderson is also hesitant about making predictions.
“We wish we had a crystal ball, but unfortunately don’t," he says. "The industry has been through a year or so of flat to negative performance, as a result of the tremendous uncertainty created by the European debt crisis and concerns over the rate of economic growth in China, Brazil, India and Russia—the principal drivers of international economic activity over the past several years."
"Assuming that (1) a world-wide recession can be avoided—and we believe it will be; (2) the measures taken by Europe to restore confidence are successful—and there are signs that this is happening; and (3) the steps that many emerging nations are taking to stimulate their economies bear fruit; we believe that the stage is being set for some major trends."
“Inventories for the most part are low, production is subject to the vagaries of Mother Nature and potential demand could grow rapidly as economic growth returns. These factors long with geopolitical uncertainty and inflationary concerns may again put pressure on available supplies. If so, the drought in managed futures returns may be coming to an end with the potential for some significant price movements.”
But whatever the future holds, says Kavanagh, “It is always a good time for investors to begin exploring ways to diversify their portfolios, and 2012 is no different.”