Thu, 3 Jan 2013
AQR's Brian Hurst discusses why trend-following strategies have struggled recently and how his firm is positioning its managed futures portfolios to offer investors a smoother ride.
Terry Tian: Hi. My name is Terry Tian. I am alternatives investment analyst with Morningstar. Today, I have Brian Hurst, portfolio manager of AQR Managed Futures Strategy. Brian, thank you very much for joining me today.
Brian Hurst: Thank you very much.
Tian: Brian, you know a lot of investors are attracted to managed futures because of their spectacular performance in 2008, but since then the strategy has struggled. Could you offer some insights on the performance of trend-following strategies after 2008?
Hurst: Absolutely. So, I think we see this historically through time, strategies have good peer performance--and managed futures certainly had a very great 2008--a lot of people rushed into it expecting that same kind of performance going forward, and they are always invariably disappointed. What's happened since 2008 has been an unusual environment certainly. It's been, as people call, the risk-on and risk-off environment.
Effectively, you've seen a lot of choppy markets, which are tough for managed futures funds. Managed futures funds are betting on trend following, which means betting that trends will continue to keep going. They have tough periods of time when markets go one direction for a few months then turn around and go the other direction for few months. That choppy environment can cause losses for trend-following strategies. And we've seen that happen in episodes in both 2009 and 2011, and a little bit [in 2012]. So, it's caused anemic or disappointing results for investors. So, at AQR what we've done is, we said, "Let's look at the long horizon. Is this an unusual period of time? Is this an anomaly? Does this mean that the strategy is no longer working?" I think those are the kind of the questions that we're getting.
We did a study where we took 110 years of data trading on trend-following strategies a little over the past century, and we can show that decade-by-decade the performance for trend following shows up and there is a reason for that. With trend following we're taking advantage of investor behavioral biases. And the existence of market participants, they are trading in the markets but are trading not with profit as the goal, but trying to solve some other goal. An example of that would be like a central bank, where they're trying to guide interest rates, or guide their currency from appreciating. They're actively trading in the market to keep prices from going to true value. Those enable trends to exist, enable trend followers to buy and sell at prices they shouldn't otherwise be able to, and that's really that the premium that we're taking advantage of.
Then you have things like corporate-hedging programs, when prices move up and producers or airlines or what not, they start losing money, they'll go out there and hedge. Those hedging trades tend to exacerbate the price direction of trends. This again enables trend-following managers to make money. But it's not a perfect strategy just like any. When there are choppy markets, trend-following strategies do lose money and that's happened many times in the past and the last few years are no different.
That said, the main reason we think investors should follow a trend-following strategy or invest in trend-following strategies is the diversification purposes. On average, over a long period of time it has produced good returns because of the differences in the markets that you're trying to take advantage of, but it's provided zero correlation to traditional markets. But behind that zero average correlation, there is positive correlation in up markets and negative correlation in down markets.
Tian: You mentioned about this risk-on, risk-off environment, and the market has seen sharp and frequent reversals in recent years. Could you talk a little bit about how does your fund deal with these trend reversal risks?
Hurst: Absolutely. So trend following is a great strategy. We believe in it wholeheartedly at AQR. It's been one of the most long-sought-after and pursued investing strategies out there just like value investing has been. It's not as popular or as well-known. That said, the problem with trend-following strategies is that they tend to lose money when markets are choppy or reversing. So, we incorporate into our model what we call signals that are looking for over extended trends, trends that maybe have gone too far or too fast.
What we find is that, having these signals in the portfolio enables us to take more risk in our trend-following strategies, which are really the money makers. These signals tend to make money when the markets reverse. By having that blend of both trend-following signals and reversal signals in your portfolio, you can give investors a little bit of a smoother ride. But the strategy is still predominantly a trend-following strategy. It's there for the diversification benefits and you get that from the trend-following piece. So we want that to be in there. We also have some piece in there to help with the choppy markets, as well.
Tian: There is another factor that investors tend to overlook when they evaluate a managed futures fund--the cash collateral returns in managed futures strategies. A portion of the managed futures index returns actually come from higher interest rates, which we had in the previous decade. And right now in the near-zero interest-rate environment, are we expecting a lower expected return for managed futures strategies?
Hurst: That's a great question and a question we often get from clients. So, when you invest in managed futures fund, let's say, you put a $100 in, well, what happens is, you put a bunch of futures business on long and short. Putting those positions on doesn't really require much capital to be put up. So, the vast majority of your money is either sitting at your futures commission merchant, which is holding your margin for your future decisions, and it's sitting in money market funds or your cash investments.
So, of the $100 you have effectively $100 of exposure to your managed futures strategy and a $100 is invested in cash. How you manage that cash is an important decision therefore. At AQR, right now, we're taking a very conservative approach. We are investing our cash in short-term Treasury bills. That's an active decision; that's an important decision. We want the returns investors are getting to come from the trend-following component and the strategy itself and not from the cash collateral piece. We don't want that to be affected by interest rates rising or a credit blow-up of some sort because they're looking for that hedging benefit in the portfolio and taking those credit and duration risks in the portfolio is something that I don't think our investors are looking for.
Tian: Despite all the benefits of managed futures strategies, they are also one of the most expensive mutual funds in Morningstar's categories. What's your thought on the fees of managed futures mutual funds?
Hurst: At AQR when we think about fees--and I think for any investment manager, I think this is an important topic--at the end of the day, you can charge an overly high fee and maybe you can get some fee income early on, but ultimately if you are charging too high of a fee, the investor on a long-term basis is going to have a bad experience. Even if your strategy happens to do well initially, eventually it's going to revert to the mean, and it's going to have its average performance.
So, at the end of the day, you have to think about how much of the fee you are sharing between yourselves as the manager and the investor. If investors are not getting a good enough slice of that pie, the alpha pie, they are ultimately not going to be satisfied. So, at AQR we always try to look at what's available, and so, capacity comes into consideration, the expected returns of the strategy come into consideration, and then [we're] making sure that the investor at the end of the day is getting a good enough portion of that pie.
Tian: Thank you very much, Brian, for your insight today.
Hurst: Thank you very much.