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.
Most people understand why value stocks might be able to deliver outsized returns over time--they are cheap to begin with, often because of some sort of idiosyncratic risk. Most people, including academics, don't understand exactly why momentum works. The explanation most likely lies in the unexplainable--human behavior. For some reason, people tend to anchor their views of the future on the recent past and are slow to adjust to news. Furthermore, investors of all sophistication levels tend to move with the herd.
Regardless of the reason why these strategies work, the proof is in the pudding. From the January 2003 inception of the Morningstar Global Trend Hedge Fund Index through March 2011, managed-futures strategies have delivered a 6% annualized return, with an 11% annualized standard deviation, for a Sharpe ratio of about 0.4. The S&P 500 delivered a similar return, with a higher standard deviation (15%), resulting in a lower 0.4 Sharpe ratio. The Russell 2000 Value Index returned 10% annualized, with a 20% standard deviation, resulting in a similar Sharpe ratio to that of managed-futures strategies. The correlation between the Russell 2000 Value Index and the Morningstar Global Trend Hedge Fund Index is not negative, but it is low, at about 0.12.
How to Gain Access to Managed Futures
Eyeing a new market, fund firms have launched a slew of managed-futures funds since 2008 (Exhibit 1). There are at least 19 managed-futures funds, including one ETF and one exchange-traded note. The average prospectus net expense ratio of the funds is 1.65%, but the cheapest option, ELEMENTS S&P CTI LSC, charges 75 basis points. The options range from index-tracking funds to active single-manager strategies and funds of managed-futures hedge funds.
Investors should be aware that the expense ratios of funds of managed-futures hedge funds do not account for the underlying management fees and even performance fees (which can exceed 2% and 20%, respectively). Also, the Commodity Futures Trading Commission may pass rules that require registered investment companies (such as mutual funds and ETFs) trading futures to register as commodity pool operators. It's not likely that the commission will do away with these funds, but some of the terms may change (depending on how the commission coordinates with the SEC). For now, these funds are still viable investments.
To choose among the many options, investors should consider how much they value diversification. A commodities-only managed-futures strategy may have more volatile performance than a diversified, cross-asset-class strategy. Furthermore, investors should ask themselves how much they are willing to pay for active management. Because a large portion of these managed-futures funds' returns can be attributed to some type of momentum factor, even a passive strategy will likely provide adequate diversification.
Making It Work in a Portfolio
Finally, the most important question is how to allocate to managed-futures strategies. Because managed-futures strategies aren't correlated to stock or bond investments, it's hard to figure out which sleeve of a portfolio to pull assets from. A prudent and simple strategy would be to allocate assets from the portion of the portfolio that presents the most risk. In a traditional 60%/40% stocks/bonds portfolio, this means the equity allocation. To illustrate, we created three hypothetical portfolios (Exhibit 2). The first was weighted 60% in the S&P 500 Index and 40% allocation in the Barclays US Aggregate Bond Index. We replaced part of the stock allocation with a 5% and a 10% allocation to the S&P Diversified Trends Indicator Index. (The index is the oldest diversified trend-following index that is publicly available.)
From Jan. 1, 2003, through May 31, 2011, which encompasses both good and bad years for stocks and managed futures, each of the three portfolios had very similar returns (about 6.8% annualized), but the standard deviation of the 60%/40% portfolio was reduced by about 70 and 150 basis points for the 5% managed-futures and 10% managed-futures portfolios, respectively, resulting in better Sharpe ratios.
As with any hypothetical model, past results may not predict the future, but the lesson of diversification is timeless. Diversification was not dead in 2008; it was simply misunderstood. And an investment in managed futures may help improve the future prospects of your clients' portfolios.
Nadia Papagiannis, CFA, is an alternative investments strategist with Morningstar.
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