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A Bargain Managed Futures Mutual Fund

A cost-efficient way to achieve managed-futures exposure.

Terry Tian, 05/31/2012

AQR Managed Futures Strategy had a rough 2011, but its investment process is sound.

This price trend following the managed-futures fund sank with its peers last year, posting a 6.4% loss, while the managed-futures category average declined 6.9%. 2011 was an extremely difficult year for most managed-futures funds as the lack of price trends and frequent price-trend reversals in most asset classes produced an undesirable market environment.

The fund's negative performance last year was partially due to its equal-weight methodology. AQR equally weighs four asset classes (equity, fixed income, currency, and commodity) by risk, while some managed-futures funds concentrate in single asset classes, or in the case of funds following the S&P Diversified Trends Indicator, avoid equities altogether. However, it turned out that fixed income was the only asset class that exhibited a clear trend last year. Furthermore, funds can track momentum based on various time horizons. This fund equally weighs long-term (12 months) and short-term (one to three months) signals, although only three-month signals generated positive returns in 2011. Failing to overweight winning asset classes and signals was unfortunate, but management believes that as it is impossible to predict the future, the fund has a better chance to deliver consistent performance by sticking to its equal-weight model.

Capture Momentum in Futures Markets
The fund, through an automated program, identifies upward (for long positions) and downward (for short positions) price trends in all four futures asset classes (equities, bonds, currencies, and commodities) based on two different time horizons: long-term (12 months) and short-term (one to three months). The asset classes and time horizons are equally weighted. In addition, the fund employs an overextended trend model, which attempts to detect when a short- or long-term trend might reverse.

The fund diversifies both across and within asset classes. As of March 31, it invested in 108 liquid futures and forwards markets across four asset classes. The asset classes and underlying futures contracts are equally weighted by risk, meaning that more volatile assets, such as equities, receive relatively smaller weights in the portfolio. The fund determines its long and short positions based on the strength of its equally weighted long-term and short-term momentum signals, combined with an "overextended trend" signal. The fund does not take interest rate or credit risk on its cash collateral (futures require small, up-front margin) and holds money market funds and short-term U.S. Treasuries.

The strategy boasts a complicated risk-management system. Overall, it targets 10% volatility on the fund level and has achieved 9.2% standard deviation since inception, using weekly data. Models forecast short-term volatility (for next few weeks) and adjust each position size according to the projected risk environment. In the event of a large drawdown, the program systematically cuts risk in as much as five (equal geometric) slices (about 13%), re-evaluating the risk in the portfolio after each cut. If risk has been sufficiently reduced, the fund will increase risk in up to five 15% (equal geometric) steps to get back to its full risk position.

A Short and Mixed Track Record So Far
Although AQR has been running a trend-following strategy since 1998 in private investment vehicles, this mutual fund launched in 2010. Therefore, it missed the strategy's spectacular performance in 2008: Managed-futures hedge funds in Morningstar's database returned more than 19% that year on average, and the single mutual fund that existed throughout 2008 returned 8.5%. Since 2008, however, managed- futures strategies have struggled, as the strong, extended upward and downward price trends that existed in 2008 failed to repeat themselves. This fund is no exception. The fund delivered decent performance in its first year--5.4% since its early January inception, but trailed a few of its peers. In 2011, it lost 6.4%, slightly better than the category's 6.9% decline.

When comparing managed-futures funds, it's important to note that the category is small, the constituents have short-histories, and the funds are not homogenous. This particular fund equally weights (by risk) all asset classes, while some other managed-futures funds avoid equities or concentrate on commodities. Furthermore, managed-futures funds calculate momentum differently. Although this fund's asset allocation and momentum signals did not prosper in 2011, its focus on equal weighting is likely to deliver a smoother ride over the long-term.

Terry Tian is an alternative investments analyst at Morningstar.
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