Managed-futures strategies--now available to normal investors--can diversify traditional portfolios.
This article first appeared in the August/September 2011 issue of Morningstar Advisor magazine. Get your free subscription today!
Portfolio management has never been easy. But the events of 2008 made it more complicated. Headlines declaring that "diversification is dead" plastered the financial media, as every asset class, with the exception of government bonds, took a beating. Besides Treasuries, however, there was one other largely overlooked exception to the 2008 economic bloodbath, one that has recently gained much recognition--managed futures.
Managed futures are automated, momentum-based trading strategies that take long and short positions in futures contracts. Hedge funds following managed-futures strategies gained an average of 9.9% in 2008, when the S&P 500 lost 37%. Until about 2008, only the wealthiest of investors could gain access to managed-futures strategies, which were typically offered in hedge funds or private accounts. Investment terms often included initial lockups, monthly redemptions, minimum allocations of at least $100,000, and worst of all, high management and performance fees. Recently, however, these strategies have migrated to more-investor-friendly vehicles such as mutual funds and exchange-traded funds and are being offered with much more reasonable terms. Today, an average investor with $2,500 (or even less in some cases) can gain access to managed-futures funds with daily liquidity and reasonable fees. Billions have flowed into these funds over the past two years, and according to the Morningstar/ Barron's annual alternative investment survey, managed-futures strategies are slated to be the biggest area of investment over the next five years. But what is the case for managed futures, and are these strategies worth all of the hype? Furthermore, how does one choose among the many managed-futures alternatives?
Managed Futures, Deconstructed
Managed-futures strategies take advantage of momentum, or price trends, across many different asset classes, using systematic, rules-based trading programs. If a particular futures contract exhibits a positive price trend, a managed-futures trading program will take a long position in that futures contract, anticipating a continued upward trajectory. Conversely, if a futures contract exhibits a negative price trend, the trading program will take a short position, expecting the price to decline further.
Trading programs measure momentum differently. Several funds and ETFs that track the S&P Diversified Trends or Commodity Trends Indicator calculate momentum by comparing the current (front-month) futures contract's price to its exponential seven-month moving average. Some active strategies incorporate multiple measures of momentum. They might pair a long-term measure (12 months or longer) with a short-term measure (three months or shorter). Some funds attempt to identify mean reversion, or the opposite of a price trend, as a way to make money when there are no price trends, or to protect against losses if the price trends reverse.
Managed-futures funds also differ in their choices of underlying futures contracts. Most strategies limit trading to the most liquid contracts, but some funds choose to focus only on financial or commodity futures. Others attempt to diversify across many types of futures contracts, including equity indexes, government bonds, commodities, and currencies.
Despite all of the seemingly different types of managed-futures strategies out there, the results are surprisingly homogenous. Morningstar tracks managed-futures hedge fund strategies in its global trend hedge fund category, which was established in 2005 based upon the relatively high average correlations among its constituents (about 0.7). In 2008, 80% of the funds in the category made money. From this result, it's pretty clear that managed-futures and momentum strategies gain access to some sort of market risk or style factor, similar to small-capitalization and value-driven equity strategies. But does this risk and style factor deliver returns, and will it help with diversification in the future?
The Case for Momentum
In 2009, Asness, Moskowitz, and Pedersen published "Value and Momentum Everywhere." The paper argued that value and momentum factors exist across all asset classes and geographies, as far back as the authors tested (1975, when the first financial futures were introduced). Furthermore, these factors are negatively correlated to each other. Finally, the study said that, in and of itself, momentum has provided attractive, long-term, positive risk-adjusted returns. An equally weighted (across asset classes), passive, long-short, momentum strategy delivered a Sharpe ratio of 0.9 (through 2008). It's extremely difficult to find two strategies that run opposite to each other but that both make money over time.