Thu, 18 Feb 2016
As their relatively strong returns this year illustrate, managed-futures funds can add diversification to a portfolio--in moderation, says Morningstar's Jason Kephart.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Amid a sliding equity market, managed-futures funds have actually posted gains. Joining me to take a closer look at the category is Jason Kephart--he is an analyst with Morningstar's manager-research group.
Jason, thank you so much for being here.
Jason Kephart: Thanks for having me.
Benz: Jason, before we get into what has been driving these funds' relatively strong performance recently, let's get into what they do because they are quite different from plain-vanilla equity and bond funds.
Kephart: Yes. Of all the alternative categories at Morningstar, managed futures is probably the most alternative. These funds are basically pure momentum vehicles. They are going to bet on trends in equities, bonds, currencies, and commodities, and what really makes them unique is that they can follow trends down as well as up. So, when equity markets are crashing, these funds could be short those asset classes.
Benz: So, they make these bets using futures?
Kephart: Yes, using futures contracts. They tend to be pretty high turnover because trends obviously can change pretty quickly, and they will get more invested in a trend the longer it runs. And yes, it's definitely something that's a little bit different from what someone is probably used to.
Benz: So, are most of these funds quantitatively driven? They have managers, but are the managers relying on quant models to help determine which way the wind is blowing?
Kephart: Yes, it's all systematically driven. They are getting new data every day, and that's kind of informing the portfolio positions. There is no manager overlay saying, "We think this is going to happen." It's all based on what's already happened. They are basically betting that what's gone up today will go up again tomorrow and what's gone down today will go down again tomorrow.
Benz: And there is some academic research that supports momentum as a persistent factor in market performance?
Kephart: Yes, it's something that's steeped in behavioral finance, and it's been observed in every market that it's been looked for. Basically, the idea is that people like to buy things when they are going up and when things are scary, people tend to sell. It's kind of the classic "buy high, sell low" problem that we try to encourage investors not to do. This is trying to take advantage of that kind of mistake that people tend to make.
Benz: Let's discuss what has been behind managed-futures funds' recently strong performance--not just in 2016 but actually dating back a little further than that. Let's talk about some of the bets that have been driving these funds' relatively strong performance.
Kephart: Ever since 2014, there has been a strong trend in energy prices. As I'm sure everyone is well aware, energy prices have kept falling and falling, and these funds have been short energy-related commodities. So, that's really been helpful through 2014. In 2015, we saw the trend get a little bit choppy. In the second quarter of 2015, oil prices bounced back a little bit, but they have continued to steadily go down. Also benefiting the funds recently is the trend of equity markets steadily falling. Those long-developing trends like what we are in equities where they're going down, down, down, that's right in the wheelhouse of these funds. So, that's really helped.
Benz: Performance has been quite good recently. But let's talk about some of the risks that are embedded in these types of products. One obviously is that the fund is going to get caught leaning the wrong way. These trends, as you said, can change really quickly.
Kephart: Yes, that's something we've definitely seen before; I think 2011 is a great example. If you remember, the markets got really choppy, and we had big moves up and down every day. The market fell almost 20% at one point. By the time it was getting to that 20% threshold, a lot of these funds were short. And then when it quickly reversed, a lot of these funds got really hurt because they were just positioned wrong. We have seen that these long trends can turn really quickly, and these funds are going to be on the wrong end of that. They also play a lot in the currency markets, and currency markets with more central-bank intervention can really move unexpectedly and in different directions than maybe a lot of people are expecting.
Benz: That's a good example. You mentioned that a lot of these funds have been betting on the dollar. The dollar has been strong, but it recently has been giving up some of those gains. So, that's maybe an example of how those trends can switch around.
Kephart: Yes, in 2014 and 2015, the long dollar was a trade that really worked for them. As that started to kind of unwind a little bit, that's definitely hurt returns; but they have been balanced by the equity markets and energy markets. That's kind of one of the benefits of the funds. They tend to be really well diversified globally across many different equity markets, bond markets, commodities, and currencies.
Benz: Anytime we're talking about an alternatives category, you've got to wonder about costs. When I look at the return pattern of these funds--and it's not a big sample at this point--it has been a fairly low-returning asset class, but costs are certainly high.
Kephart: Yes, the performance has been a little boom and bust. From 2009 through the middle of 2014, there weren't a lot of big trends for them to latch on to, so a lot of them were negative or barely positive. Then, after 2014, we've obviously seen performance pick up a lot. But the fees are definitely something to consider. I think the category average is around 2%, which is one of, if not, the highest category averages at Morningstar. So, that's definitely something to consider.
There are also a small handful of funds that are hiding some performance fees by using total-return swaps. They are using these swaps to access the net-of-fee return of managed-futures hedge funds. So, they are not actually hiring the subadvisor directly; they are using a derivative contract to get the returns of a hedge fund. That includes the performance fees; there is another fee for the swap. So, even though some of these funds might have stated fees of 2%, the all-in cost could really be closer to 5%, and there is really no way for an investor to actually know that. There are only a handful of funds that do it. You could find it by looking in the footnotes of the prospectus in the expense box. That's something you definitely would want to keep an eye on.
Benz: That's one of the reasons I'm glad you and the team are taking a closer look at these funds. Let's talk about role-in-portfolio considerations. When you think about 2016 so far, for example, if you have some high-quality fixed-income exposure, you're probably getting a little bit of a positive return. What do managed-futures funds bring to the table? What do they add to a portfolio that's maybe primarily anchored in plain-vanilla equity and bond holdings?
Kephart: Well, the real benefit of the strategy is as a diversifier. Over time, we've seen that they have very little correlation to equity markets and the bond markets. So, you wouldn't want to get rid of your high-quality bonds, which are going to be your most trustworthy ballast when stock markets aren't doing that well. But you might want to take a little bit away from equities or maybe higher-risk bonds like high yield to give this strategy some room in the portfolio to really help round out the portfolio and give it another stream of returns that isn't going to be dictated by the direction of markets.
Benz: But you would tend not to recommend investors go overboard with this category.
Kephart: No, I think something in the 10% to 15% range--
Benz: At the high end?
Kephart: At the high end. Maybe even start small just to get comfortable with how it's going to act and how it's going to affect the overall portfolio performance. But you definitely wouldn't want to get rid of things like high-quality bonds. Those are things that we know we could count on even if you're a little worried about interest rates. When stock markets are doing really poorly as we've seen, that's the one true alternative you can really count on.
Benz: There is one fund in this group that you and the team highly recommend. It's Silver-rated AQR Managed Futures (AQMIX). Let's talk a little bit about that fund and why you think it's better than some of the competitor funds in this group.
Kephart: Yes, we really like the AQR Fund. We think it's one of the best funds they offer. Cliff Asness, the founder of AQR, has been very instrumental in research into the momentum factor. We feel really comfortable that they truly understand not only how to find momentum and track it but also how to implement it in a mutual fund. They have a very solid background in trading futures and making sure the funds are very liquid. The fund is also very well diversified across the four asset classes. And they don't get too cute with the strategy. They are basically trying to give you pure momentum exposure. They're not trying to rewrite the rules as we've seen some other funds try to do--attempting to differentiate themselves from AQR by doing something different. That doesn't always lead to good returns. The fees are also very low. So, it's definitely a very cheap product. It's proven itself through different markets, and we're very comfortable with the team there.
Benz: AQR probably runs some sort of alternative-hedgy strategy based on this same approach. How is the mutual fund different from a hedgelike product?
Kephart: I think the main difference is going to be the volatility level they are targeting. In AQR's managed-futures mutual fund, they target 10% volatility. So, you wouldn't expect to see, over any given year, volatility much higher than that. If you start getting higher than 10%, it gets really hard for people to own.
The hedge fund is going to be run at a much higher volatility level--something around 17% or 20%. So, the biggest differences are going to be how much risk they are willing to take and leverage.
Benz: Jason, it's an interesting topic. Thank you so much for being here to discuss it with us.
Kephart: Thanks for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.