Addressing the Fable of the Death of Managed Futures

By Bernhard Steiner

As most readers of this article very well know, the past five years have been difficult for traditional managed futures strategies. The asset class as measured by Barclay Hedge CTA Index has posted losing years in three out of the past four years and 2013 is shaping up to potentially be another down year. This is the longest negative period in the thirty-four year history of the index. However, the actual cumulative loss of the Barclay CTA Index since January, 2009 is still less than 1%, which is quite a bit better than most would have expected. Granted, when compared to the recent stock market returns over the same period it becomes clear as to why some investors are frustrated with their managed futures allocations.

World equity markets (MSCI World Index) returned a profit of approximately 60% between January 2009 and September 2013, US equities (S&P500) even returned 80%.

These excellent results are of course painful for all Managed Futures investors suffering losses in the same period. And it is understandable that many investors have increasingly come to believe that trend-following is no longer profitable.

There are plenty of reasons why this could have happened: Some argue that the space has gotten too crowded with the biggest players supposedly throwing billions of dollars into the commodity space. Others will say that high-frequency trading has killed traditional market dynamics, while again others point to government intervention, to market-moving rhetoric of politicians, regulation, quantitative easing, the suppression of interest rates and changes to central bank policy with its always-on money printing press causing the underperformance.

Have Managed Futures as an asset class finally died?

It’s undeniable that all of the above mentioned factors have influenced the markets. It even may be that the market regimes have not been easy to trade for trend-following strategies either. But to claim the final demise of the Managed Futures industry is likely too farfetched.

There are a few aspects that we would like to elaborate:

The past five years may have been challenging and disappointing for trend-following strategies. But, these poor annual results have to put in context. If we go back just one more year and compare the Barclays CTA Index with the MSCI World over the period from January 2008 to August 2013 the picture changes completely: For this period, including the crisis in the financial markets in 2008, Managed Futures returned a positive 13% approximately while global equities are down by 7%.

Maybe some of the investors that claim the death of managed futures today only entered their positions in January 2009 after noticing the strong negative correlation of Managed Futures to equities in 2008.

Jeff Eizenberg from Attain Capital Management explains the state of Managed Futures: “Trend-following is at its core a long volatility strategy which suffers frequent but small losses in exchange for infrequent but large gains. The strategy attempts to keep its head above water until some market movement provides a large outlier move in which the strategy can profit. To say the periods between these large outlier moves equates to the strategy not working is akin to saying your car isn’t working when going slow in traffic.”

Trading styles beyond Trend-Following

When we talk to successful trading managers today this is exactly what we witness: They don’t blame the markets for having changed. They discuss if their risk management did work fine and if the signal generation was able to adapt the market flows. This flexibility is an important advantage of Managed Futures as asset class. By reducing Managed Futures to trend-following only investors ignore some key benefits of the investment style.

Managed Futures managers offer flexibility and adaptability in signal generation and portfolio construction.

Flexibility in portfolio construction

Managed Futures are much more than just medium- to long-term trend-following strategies. Managed Futures are a conglomeration of different trading approaches including pattern recognition, very short-term trend-following models as well as intraday, mean reversion or counter-trend systems and many others. But more important is the idea generation process that determines the trading model of a CTA as Mathilde Franscini, Fund Manager at Argos Investment Managers explains: “You can tackle traditional and very liquid markets like equity indices but differentiate your strategy through a totally orthogonal trading approach. This is achieved for instance through a behavioral finance approach detecting and capturing Mr. Market’s core behavioral biases which systematically impact market prices.”

The ability of Managed Futures to tap into different return sources is the driving force behind their de-correlation power with respect to other more traditional strategies, which are affected by single macro risk factors.

Adaptability in risk taking and signal generation

When we talk about Managed Futures we basically talk about rule-based trading strategies. A key characteristic of these trading strategies is their approach to risk management. Unlike the traditional relative return investment concepts such as benchmarking and indexing, the CTA trading style tends to be an asymmetric return concept. Being able to achieve an asymmetric return profile presumes a dynamic and flexible risk management process and an open minded entrepreneurial mindset for the identification of trading opportunities. It is as John Maynard Keynes was stating: “When circumstances change, I change my view. What do you do?”

Good trading strategies are able to deal with changing markets. They do not only adjust risk to changing markets they can adapt the exposure to different traded systems as a function of input factors as recent results, money flow between asset classes or fundamental data.

The bemoaned market regime changes may be long or short lived but it is not a fundamental change that should affect high class trading strategies in their core. It is rather a touchstone for trading managers how they weather such awkward market situations. We think that outcomes in the current market regime might be a good indicator to identify the leading edge strategies.

From this arises the question:

“Mirror, mirror on the wall, who’s the fairest of them all?”

As analysts, we don’t look into the mirror and we don’t believe in magic. We analyze numbers and try to understand what they could tell us.

We asked our colleagues from Attain Capital Management to analyze in their database over the last 36 and 60-month periods to find out if there is any indication of what sort of trading styles had been doing better recently. Here is a summary of the findings:

As of end of May 2013, one third of all 1448 CTAs in the Attain database had been positive for the three years period since May 2010. For the five-year period from May 2008 until May 2013, only 25% are still positive. When we look just at the CTAs that are labeled as systematic traders the number of positive programs increases to 42% for the three years period and to 50% for the five years period.

This is at last an indication that systematic programs can weather unfavorable markets much better compared to the whole universe.

As a second approach, we took 55 strategies out of the trading manager universe that we follow regularly and ranked them by annualized returns and Omega values since 2009. In the first 20 positions we find 16 strategies that are dealing with volatility. The approaches to  trading volatility are totally different. Some do it with options, some with futures like CBOE VIX. Some of them have a more long-volatility profile some more short. The two most successful managers in our ranking trade options with very short-term approaches. These strategies are predominantly uncorrelated to CTA Indices and equities. Number 9 and 20 can be classified as trend followers based on their correlation to CTA indices. The remaining three trade short-term strategies on futures and currencies. After position 20 we find the bulk of trend followers.

source and © 2013 – Bernhard Steiner

This analysis shows the benefits of the diversity of the different trading approaches in the CTA universe. Even if they trade similar phenomena like volatility they show different return patterns and they are mostly uncorrelated among each other. The real potential of Managed Futures is the result of systematic trading processes, a stringent risk control, and diversification in return generation and the ability to adapt changing market regimes.

How Managers explain their outperformance

For a deeper understanding of these aspects we talked to some of the top-ranked managers in our overview to find out their opinion on why they were able to beat typical trend-following in the last few years.

Luc Van Hof from Capital Hedge runs a short-term trading model with exposure to the FX and equity markets. He explains: “Our trading systems are able to extract profit from markets that may be directionless and challenging to longer-term traders.” And one reason for this may be that they make extensive tests at the end of every trading month do determine which trading systems have performed well over the recent months. According to this analysis and some additional proprietary factors they determine the allocation of every subsystem for the forthcoming month.

The explanation from Bruno Gmür for the outperformance of his peers of his trend-following program at Quantica Capital Management is: “What our managed futures program is detecting, like any other trend-follower, is market trends. However our process for detecting trends differs from most trend-followers in that we analyse relative risk-adjusted trends between different assets, rather than absolute trends of different assets in isolation. We usually refer to this as detecting global asset class rotation, caused by large global money managers shifting their asset allocation, and believe our approach is well suited to detect those money flows early, and earn a premium if these trends are confirmed.”

“We believe that this is an edge versus more traditional type of trend followers that depend largely on isolated trends in various assets to generate profits. We also believe that our approach is well suited to cope with challenging and changing market conditions, like e.g. periods of draw-downs or reversals, because our process takes into account the dynamic change of market-risk characteristics and changes in the correlation structure between different markets.”

Arne Schmidt, CIO of Systematic Absolute Return explains the positive returns achieved by their Liquid Equity Alpha Strategy over the period with the following words: “Learning from the events of 2008, we decided to focus on highly liquid, uncorrelated strategies with a long volatility profile, adapting to imminent behavioral patterns and only trading intra-day. As a result, we have been able to find a small, but attractive niche in the market enabling us to generate a steady Alpha, at the same time profiting from rising volatility and providing a natural hedge during equity down markets. Notable as well is that we are able to avoid non-tradable overnight risks by being 100% in cash at the end of every trading day. Our strategy is very unique in this regard. It does come at a price though – limited capacity.”

In summary, these managers understand changing behavior as a basic condition of market dynamics. Their systems try to adapt to such market changes. There is another important aspect that Bastian Bolesta from the award winning SINGULARITY fund elaborates: “In contrast to classical trend-following programs which generally trade a small number of strategies across as many markets as possible to benefit from cross-market-diversification effects, SINGULARITY’s primary focus lies on intra-market-diversification. Cross-market-diversification is generally fueled by the idea that trading many different markets at least allows identifying tradable trends in some markets. However in times of high market correlations this approach shows clear weaknesses as one can suffer from non-trending periods in many markets at the same time. Employing a multitude of different and individual strategy elements in every single market allows SINGULARITY to tap into various sources of return and to reduce overall dependency on market correlations.”

We offered the last statement to Thomas Foertsch, who is Chief Operating Officer of Surveryor Management one of our highest ranked managers with three digit returns over the last three years. This is how he explains what makes their program different: “At Surveyor we offer a volatility strategy that by its nature is non-directional. The option market has become the central clearinghouse for equity risk, globally. Our short term volatility strategy utilizes the S&P 500 options complex in the US. Inefficiencies exist in the option market because of the variety of participants and the purposes behind their options use. This variety of supply and demand functions for different parts of the S&P 500 option universe can create pricing distortions that are opportunities for the Strategy’s relative value process.” It is particularly notable that Surveyor Management has real conviction that they can perform better during more turbulent times in the market place. Foertsch explains that this is not because they have a short bias, but they find more opportunity due to increased trading activity-therefore more pricing inefficiency.

Conclusion

The analysis of recent trading manager returns shows that there are many programs with excellent results in the last few years. The interesting finding is that these strategies are vary considerably between them. They trade diverse phenomena with different approaches and they generate uncorrelated asymmetric return streams.

This overview is a demonstration of the immense diversification power within the Managed Futures space. It is very important for investors to understand that Managed Futures are much more than just trend-following. To achieve the full potential of Managed Futures a diversification in different trading styles is recommended. To be able to detect the differential quality in managers a sound due diligence is needed.

Of course, only time will be the true test, but based on our research and many discussions with trading managers we think that all the reports on the death of Managed Futures may be greatly exaggerated. A good diversified basket of uncorrelated trading strategies is a perfect addition to a traditional portfolio and can still play an important role in dampening volatility and providing positive uncorrelated return in market crisis. But as in many cases the best fruits are not always the lowest hanging. The very-easy-to-access programs are not always the very best.

About the author

Bernhard Steiner is one of Switzerland’s well versed experts when it comes to managed futures. For more than ten years he has advised investors in the selection of trading managers, and the design and monitoring of multi-manager portfolios. His expertise is based upon his long term experience with allocations with dozens of managers, innumerable discussions with CTAs, his due diligence know-how and his extensive sector network. He is trading advisor and due diligence provider for a UCITS fund of funds that allocates to trading strategies in equities, bonds and futures.

You can contact him on bernhard.steiner@aipag.com

Managers mentioned in the article

Argos Investment Managers S.A., Mathilde Franscini, Geneva, Switzerland, contact m.franscini@argos-managers.ch

ATTAIN CAPITAL MANAGEMENT, LLC., Jeff Eizenberg, Chicago, IL 60601, USA, contact: jeizenberg@attaincapital.com

Capital Hedge, Luc Van Hof, Rijmenam, Belgium, contact luc@capitalhedge.be

ISATYS Advisory AG, Bastian Bolesta, Horgen, Switzerland, contact: bastian.bolesta@isatys.ch

Quantica Capital AG, Schaffhausen, Switzerland, contact: bruno.gmuer@quantica-capital.com

Surveyor Management, Thomas Foertsch, Gran Cayman, Cayman Islands, Contract: thomas.foertsch@surveyormanagement.com

Systematic Absolute Return AG, Arne Schmidt, Zurich, Switzerland, contact arne.schmidt@sar-ag.ch