Monday's Lessons

Rain Delay This column was advertised as part two of a three-part series, on the merits (or not) of leveraging. That topic will wait. Big stock-market losses usually offer investment lessons, and Monday's plummet was no exception. It's best to address these issues while the memory is fresh.

Diversify the Hedge! Managed-futures funds protected beautifully against the 2008 financial crash. Not that retail investors benefited. With one exception, the managed-futures funds that existed at the time were hedge funds, meaning that they weren't available for the rank-and-file. Too bad. Between late 2007 and early 2009, from the stock market's peak to trough, the average managed-futures hedge fund gained 12% while stocks dropped 41%.

The fund industry rapidly filled the gap; today, there are 43 managed-futures funds (124 counting all their share classes). To date, those funds haven’t helped their investors—not necessarily through mismanagement, but rather because there hasn’t been any point in cushioning stock-market exposure. The more equities, the better. Hedging against downturns has meant leaving money on the table.

On Monday that changed, with the S&P 500 dropping by 4.1%. At least for the one day, managed-futures funds had their opportunity. And they… declined by an average of 3.1%. This showing would have come as no surprise to careful Morningstar readers. Last week, Tayfun Icten published an article entitled, "Managed-Futures Funds Vulnerable to Market Turbulence," because, he wrote, they currently have a long position in equities. Four days later, he was proven correct. Good timing! (And good smarts—clever people, these physics majors.)

Managed-futures funds owe no apologies. Although they typically have not behaved much like the stock market, that was never a promise. Managed-futures funds invest mainly in the futures of stocks, bonds, the dollar, and commodities. At any given time, they could collectively favor (being trend followers, managed-futures funds tend to behave similarly to) long equities. That is what they did in January, along with owning energy, and they were spot on—the category had a great month.

The point instead is the danger of owning one flavor of alternatives fund. This time, market-neutral funds did their job (being almost flat on the day), long-short equity wasn’t bad, and managed-futures and options-based funds disappointed. Next time, the reverse might be true. Except for bear-market funds, which are a terrible long-term holding, no alternatives fund will reliably rise if the market falls. Thus, best to own the whole group, through a multi-alternative fund that samples among the different strategies. (One example:

Be Careful While Picking Up Nickels Shorting stocks or futures contracts is different than shorting out-of-the-money options. The first two strategies have symmetrical payoffs: If a stock or futures contract were to rise by $5, the loss to the portfolio manager who shorts would be match the gain, should that stock or futures contract rise by $5. The math is different when shorting (that is "writing") options that are out of the money. The returns are no longer symmetrical—and could possibly be disastrous.

In Wall Street parlance, the investor who writes out-of-the-money options picks up nickels, at the risk of being squashed by a steamroller. The profits that accrue from selling out-of-the-money options are frequent and small (understandably, buyers don’t pay much for options that are unlikely to pay off). The losses are infrequent, and sometimes huge. In fact, if the positions are not monitored carefully, a surprise market move can be ruinous.

As was the case this week with

, failed on its name. As of this writing (Thursday, Feb. 8), the fund’s one-week trailing total return is negative 81%. This is an inauspicious result for a fund that puts “preservation” on the wrapper. Also, this wasn’t a case where a fund lost a lot of money on paper, but nobody actually owned it. The LJM Fund had almost $800 million in assets at last report. Not so much anymore.

Specifically, the LJM Fund shorted stock-market volatility. That was not a good place to be this past Monday. Once again, Tayfun called it, only this time back in July 2017: "Track records [from option-writing funds that short volatility] can look very attractive for a while, with high income and high Sharpe ratios. But hidden tail risks can cause large unexpected losses during the next big spike in volatility." Indeed they did.

These comments shouldn’t be taken as a blanket condemnation of option-writing strategies. The LJM Fund, despite its preservation promise, practiced that approach very aggressively. Most option-writing funds are considerably more careful, and are highly unlikely to ever lose anything like 81% of their assets. However, the LJM example does indicate that care is required. These funds can bite if aggressively managed.

A Failure to Communicate The so-called robo-advisors—for example, Betterment and Wealthfront—were denounced because their websites crashed on Monday. Frustrated customers would attempt to check their accounts, only to have the sites freeze. Such problems have occurred before. Robo-advisors' technology suffices under ordinary circumstances, but can become overwhelmed by high volume.

While true, such criticism often overlooked an important point: So did most other investment sites. As several Morningstar employees can relate, having attempted several times during the day without success, Fidelity’s site was often down. So were those of many, if not most, of the other major brokers.

Technology has lagged demand. The stock market doesn’t often plunge, but when it does investors pay keen attention—and in this day and age, they expect instant access. Traffic soars, causes the websites to become temporarily overwhelmed. They then shut down, which only leads to higher traffic, as those people who were denied access try again.

This could be regarded as a good problem. Perhaps locking out investors during a market downturn will prevent them from doing something stupid. Perhaps. But it might also prevent them from doing something intelligent. At any rate, neither investor confidence nor the financial markets are well served by operational glitches. These problems need to be fixed.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.