Before attempting to cash in on managed-futures funds, understand how these funds use cash.
This article originally appeared in the June/July 2013 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.
Managed-futures mutual funds introduced the concept of momentum-based futures trading strategies to many investors. Before the first such mutual fund launched in late 2009, managed-futures strategies were only accessible to those who had the wherewithal to open a futures trading account and several hundred thousand dollars to invest. Now, 50 different managed-futures mutual funds are available to all types of investors, with minimum investments as low as $500. These funds often lure investors with statistics such as the near-zero long-term correlations to stocks and bonds, as well as the amazing historical returns of various managed-futures industry indexes. What the fund marketing materials, and even academic literature, fail to explain, however, is how many of these historical returns were attributable to high interest rates. After all, since short-term interest rates dropped to near-zero levels at the end of 2008, managed-futures strategies have languished.
In this article, we estimate the proportion of cash returns of managed-futures trading programs (both private pools and separate account composites) in the Morningstar MSCI Systematic Trading Hedge Fund Index (which had 128 constituents as of January 2013) and the relationship between interest rates and managed-futures returns.
Unlike traditional investments, such as stocks and bonds, futures contracts are traded on margin. This means that an investor needs only a small percentage of the total (notional) value of the contract up front (about 5% for the E-mini S&P 500 contract, for example). Margin requirements are higher for more-volatile assets, such as some commodity contracts. Often, managed-futures trading programs only use 15% of their assets for margin (this is called the margin/equity ratio).1The rest of the assets sit in cash-like instruments, typically short-term U.S. Treasuries.
This special structure enables managers to easily adjust a managed-futures fund’s leverage to match their clients’ risk appetites (a two times leveraged program, for example, would use 30% of the total account assets for margin purposes, instead of 15%), and it also frees up the capital to earn additional short-term interest-rate returns aside from the futures strategy returns.
Excess Returns of Managed Futures
Many studies touting the benefits of managedfutures returns often fail to mention that these returns come from both futures trading as well as from interest earned on the cash collateral. For example, Schneeweis, Spurgin, and Szado (2012) studied the return drivers of three indexes—Barclay CTA Index, CISDM CTA Asset Weighted Index, and CSFB/Tremont Managed Futures Index, each of which had returned more than 6% annualized between 1994 and 2009—but do not delve into the effects of interest rates on the funds’ returns.2In today’s near-zero interest-rate environment, the returns on cash seem negligible, but over the period studied, short-term interest rates were much higher.
Looking at our own data, the Morningstar MSCI Systematic Trading Index returned an annualized 8.6% between January 1994 and December 2012, while three-month U.S. Treasuries returned an annualized 3.1%. If we assume that the index constituents invested 85% of their assets in three-month Treasuries and 15% in futures contracts (which results in a notional exposure of more than 100% of assets), the cash portion would have contributed 2.6% of the returns over the time period (30% of the total return). If we assume the interest rate had been zero throughout the time, the Morningstar MSCI Systematic Trading Index would have returned 5.82% annually from January 1994 to December 2012.3
That is still a decent return, although it trails equities over the same time period. One must remember, however, that the purpose of investing in managed futures is not just for the absolute return, but also for the low correlation to stocks and bonds (negative 0.09 and 0.19 to the S&P 500 and the Barclays U.S. Aggregate Bond Index, respectively, between 1994 and 2012). When added to a 60% stock/40% bond portfolio (as represented by the S&P 500 and Barclays U.S. Aggregate Bond Indexes, respectively), a 20% investment in the Morningstar MSCI Systematic Trading Index (out of equities) would have improved both the return (from 7.79% to 7.97%) and the standard deviation (13.69% to 9.42%) (Exhibit 1).
If interest-rate returns consist of such a large portion of managed-futures index returns, does the movement of interest rates explain the returns of managed-futures strategies? We examined the performances of managedfutures strategies’ in rising and falling interest-rate environments. We identified the peaks and valleys of the three-month U.S. Treasury bill rate over the studied period and define the periods in between those dates as rising and falling interest-rate environments. In Exhibit 2, rising and falling interest-rate environments are shaded in green and orange, respectively.
It’s apparent from the chart that managedfutures returns tend to move with interest-rate levels, and the peak and valley points of the two tend to coincide with one another. The actual correlation (0.12) and R-squared (0.01), however, are relatively weak as the variation in managed-futures returns is largely explained by factors (momentum) other than interest-rate movements.
Investors should be mindful when being presented with historical managed-futures returns, as these strategies are no longer receiving a boost from interest rates, which have largely benefited them in the past.
Some funds, such as the Altegris Futures Evolution Strategy EVOAX, have tried to solve this problem by introducing credit and interest-rate risk into the cash sleeve of the portfolio. But active cash management only slightly improved this fund’s return over its more traditional managed-futures strategy, Altegris Managed Futures Strategy MFTAX, in 2012 (negative 3.2% versus negative 3.9%).
When interest rates do eventually rise, these risky strategies will likely buckle, and more pure managed-futures strategies will probably outperform.
1 Based upon commodity-trading-advisors programs that disclose this information in Morningstar’s hedge fund database.
2 “Managed Futures: A Composite CTA Performance Review,” by Thomas Schneeweis, Richard Spurgin, and Edward Szado. 3 The difference between 5.82% and 6% results from the rounding and compounding effect of 228 monthly return data.