Does Volatility Targeting In Managed Futures Add Value For Fund Managers, Investors?

Jun 9 2015 | 5:06am ET

By Matt Dority
Partner, QES LLC

Managed futures strategy benchmarks like the Newedge CTA Index rose sharply in late 2014. As in 2008, these strategies that ply global markets for buying and selling opportunities pieced together gains from a mosaic of turmoil. This exemplifies managed futures funds’ ability to gain despite little or no correlation to any particular market, a quality attractive to investors concerned about lofty market levels.

But investors who look beyond the benchmarks will find that managed futures strategies are as diverse as the markets they trade. Even funds that share a common strategy like trend-following may generate disparate returns due to volatility targeting, an asset allocation technique that aims to keep most performance within a prescribed range.  Although volatility targeting can help managers deliver a smoother ride for investors, it may also prevent investors from getting the most out of a managed futures strategy.

Traditional investments tend to be unleveraged: investors expect an indexed fund to gain 1% when the index gains 1%. Futures contracts, when partially collateralized, are leveraged: a 1% gain in contract price might generate a 20% gain in managed account value.

Instead of exploiting partial funding to make targeted bets on a particular market, most managed futures strategy portfolios are highly diverse, participating in any market showing opportunity. Although diversified and offsetting exposures can reduce risk, managers must carefully determine whether and how to leverage account positions, keeping watch over how segments of the portfolio interact.

Having decided which markets to be long, short, or flat, and in what proportions, a managed futures strategy cannot be implemented until a manger also determines its notional exposure per dollar of funding, or leverage. Deploying an unleveraged managed futures portfolio typically adds little value and severely reduces participation across markets. With partial funding and leverage typically warranted, the question of degree depends on risk tolerance.

To gauge risk, managers often consider more than just the ratio of exposure to funding. For example, a $100,000 futures contract funded with $5,000 of collateral always reflects 20:1 leverage, ignoring whether its price might typically change 1% or 5% per day.

This explains why managers often rely on risk measures tied to contract- and portfolio-level volatility. Given a range of likely outcomes for a portfolio – based on its market positions and relative weightings – a manager can estimate its dollar value at risk. For a given dollar value of fund assets, its notional exposure, and thus number of futures contracts held, can be scaled to align the (re-sized) portfolio’s dollar value at risk to that targeted for each dollar of funding, thereby targeting volatility.

What does this mean for managed futures investors? Portfolios with above-target value at risk are downsized across the board, while less-volatile portfolios are levered up towards generating the volatility targeted. Either scenario plainly decreases or increases exposure – yet both increase the strategy risk of realizing smaller gains in high-volatility periods (e.g., during a crisis) and bigger losses during low-volatility periods.

Beyond resolving asset allocation within a futures portfolio, volatility targeting can sound prudent. Indeed, it may help managers market a strategy as predictable and risk-controlled. Yet volatility targeting creates three major challenges for managed futures investors:

  • Exposure is always off-target. Because past performance does not predict future performance, exposure sized ex ante typically generates too much or too little portfolio volatility ex post.
  • Exposures can grow arbitrarily large. Declining market volatilities, correlations, and projected portfolio volatility imply volatility-targeted portfolios with higher exposure levels, magnifying risks of sudden changes.
  • Exposure tends to decline as market volatility increases. As directional market volatility can generate crisis alpha, suppression of exposure (but not management fees) during volatile periods may seem perverse.

Although these side effects of volatility targeting can weaken an otherwise potent alternative investment strategy, investors can opt for managed futures strategies that avoid it. Especially alongside traditional investments – whose volatilities naturally change over time – strategies that accommodate floating value at risk are better positioned to deliver on the promise of managed futures.

Matt Dority is a partner at QES, LLC, which co-created the index underlying the Aspen Partners Managed Futures Strategy Fund.

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