Sunday, 28 August 2016
Last updated 1 day ago
Jul 15 2013 | 5:15am ET
By Matt Osborne
Managing Director of Altegris Advisors
The historical record on the benefits of managed futures investing is indisputable, but some advisors are understandably skittish. The strategy has, after all, suffered negative calendar-year performance in three of the past four years and in 2011 and 2012 delivered back-to-back losing years. However, an examination of market behavior over the past 20-plus years may help to put the recent performance of managed futures into perspective, and provide investors with some comfort that current returns are not somehow a proverbial new normal.
All asset classes, including managed futures, are cyclical to varying degrees. However, underperformance by managed futures has been infrequent and relatively painless when compared to traditional long-only asset classes. A key aspect of managed futures’ long-term profile is the strategy’s strong track record through a wide array of market cycles, as demonstrated by the positive returns it has generated in 19 of the last 23 years.
Managed futures have historically been dominated by trend-following managers, whose performance is largely driven by capitalizing on trends as they develop. Choppy markets and a lack of price trends, as experienced over the last few years, generally make it difficult for trend-following managers to deliver strong risk-adjusted returns. However, not every market needs to trend for trend followers to be successful. The emergence of just a few sustainable trending markets can allow managers to build greater positions as trends gather strength.
The good news is that all prior periods of exceptionally trendless markets have been short-lived. Many were followed by conditions punctuated by more durable trends — and the latter period of 2012 brought signs that such a transition might be in store. Accordingly, we believe that trends could very well move off their historic lows, allowing medium and longer-term trend followers to take advantage of more sustainable trends that could emerge.
This scenario becomes particularly important if markets start to trend downward, as trend followers (and managed futures managers in general) can profit from falling markets just as easily as rising ones. At the same time, not all managed futures managers are trend followers — a significant subset are specialized managers, pursuing a wide variety of trading approaches, including discretionary macro, short-term systematic, countertrend and other strategies.
Unlike traditional long-only investments, managed futures have typically performed well in environments where volatility is expanding. In fact, high volatility can be quite friendly to managed futures managers because it can simultaneously create trends in stocks, bonds, currencies and commodities. Such was the case in 2008, a positive environment for managed futures in which the strategy as measured by the Altegris 40 Index®, returned 15.47%, while US stocks, as measured by the S&P 500 TR Index, were down (-37%). The Altegris 40 Index® monitors the performance of the 40 leading managed futures programs based on month-end equity as tracked by Altegris. Conversely, as volatility across markets starts to diminish or compress, managed futures managers usually find a more challenging environment and performance suffers — as they have in recent years.
Volatility expansion or compression over the past few years has been “amplified” compared to the previous 20-plus years. While markets could continue to experience diminishing volatility, we believe it is more likely that they will start to see an expansion, given the recent historically low volatility levels. Such a shift would, of course, augur well for managed futures managers, particularly those pursuing trend-following strategies. But as long as volatility simply stops compressing, the environment should be more favorable for managed futures.
Our research reveals that times of positive performance in managed futures are typically driven by sustained periods of either risk-on or risk-off environments that supply markets with ample price trends. From a historical perspective, extended risk-off regimes from 2000 to 2003 and in 2008 saw managed futures deliver total returns of 56% and 15%, respectively. Meanwhile, a persistent risk-on period from 2004 to 2007 saw that same group of managers produce returns of 23%.
A bedrock principle of managed futures is that they simply require persistence of trends — in either direction — in order to deliver strong returns. What presents challenges for managed futures managers is constant flip-flopping between risk-on and risk-off — as has been the case recently. Time frames that we characterize as risk-on are defined by periods in which the stock market is generating positive cumulative returns while fixed income markets exhibit declining cumulative returns. Risk-off environments typically occur when fixed income markets are generating positive cumulative returns while the stock market exhibits negative returns.
The constant back-and-forth between risk-on and risk-off environments has obviously been problematic for managed futures, and trend followers in particular. While we are unsure if a transition to a risk-on or risk-off environment will occur, we think it’s likely that a sustained environment in one direction or the other will soon emerge — which would provide a welcome opening for managed futures managers, as trends may begin to develop as a result.
With a sustained upward trend in bond prices (as a result of the extended downward trend in rates), fixed income has served as an important and profitable trend for managed futures managers to capitalize upon. A commonly held belief is that managed futures only deliver strong returns when interest rates go down. But managed futures have also experienced positive monthly returns during periods in which rates have risen and bond prices have fallen. This is because managed futures managers are agnostic to the direction of interest rates, and simply require a trend in either direction to potentially profit.
Positive benefits can also be derived from the yield on the cash collateral of a managed futures portfolio. For example, a managed futures manager might have to put down 20% as collateral for margin requirements to gain 100% exposure to futures contracts. The remaining 80% is generally invested in 3-month US Treasury bills, which earn the risk-free rate. A higher interest rate, then, means a higher return generated by the cash portion of a managed futures portfolio — which in turn means a higher contribution to the total managed futures return. Of course, the opposite is also true: A lower rate means a lower return from the cash portion of a managed futures portfolio.
The past few years have been undeniably difficult for managed futures with a dearth of trends, amplified volatility compression, whipsawing between risk-on and risk-off market environments, and low interest rates. Yet the damage has been minimal, especially when compared to the history of other investments. Over the 24 months ended December 31, 2012, managed futures performance is down -7.82%. To put that into context, the worst 24-month period for US stocks produced a negative return of -45%. So perhaps any currently perceived “crisis” in managed futures is not really a crisis at all. In fact, we would suggest that now might actually be a particularly opportune time to invest in managed futures, due to the themes we have discussed — the prospect of strengthening trends, heightened volatility, a more consistent perceived risk environment, and rising rates.
One additional reason for optimism: Managed futures have historically performed strongly following large drawdowns — just like its recent period of underperformance. In fact, over the previous 23 years ended December 2012, there were four periods in which the strategy generated returns of 25% or more over the 12 months following the troughs of these drawdowns.
All of which begs the question: Could we be poised for another such period?
We recognize that past performance is no guarantee of future results. No one can time a market’s top and bottom perfectly — and those who maintain a long-term allocation to managed futures, in our view, have the opportunity to experience the most complete range of potential benefits offered by the strategy. And yet, we would be remiss if we didn’t at least acknowledge that, after such a challenging period, the simple investment philosophy of “buy low, sell high” may never ring more true for managed futures than it does today.
Matt Osborne is Executive Vice President and Managing Director of Altegris Advisors and a Director of Altegris Funds. He is also co-portfolio manager of the company’s mutual funds and a member of the Altegris Investment Committee, responsible for qualification, approval and on-going review of all investment strategies and managers on the Altegris platform.
It is important to note that all investments are subject to risks that affect their performance in different market cycles. There are substantial risks and conflicts of interests associated with Managed Futures and commodities accounts, and you should only invest risk capital. The success of an investment is dependent upon the ability of a commodity trading advisor (CTA) to identify profitable investment opportunities and successfully trade, which is difficult, requires skill, and involves a significant degree of uncertainty. CTAs may trade highly illiquid markets, or on foreign markets, and the high degree of leverage often obtainable in commodity trading can lead to large losses as well as gains. Returns generated from a CTA’s trading, if any, may not adequately compensate for the business and financial risks assumed. Managed Futures and commodities accounts may be subject to substantial charges for management and advisory fees.
Past performance is not necessarily indicative of future results. The analysis herein is based on numerous assumptions and past market conditions. Different benchmarks, market conditions and other assumptions could result in materially different outcomes. Unless otherwise noted, Altegris is the source for all data cited. This material does not provide all the information necessary to make an investment decision and should not be relied upon as such, nor should it be considered a recommendation to buy or sell any specific securities or investment product.