by Seth Bancroft, Research Consultant, Hedge Funds at NEPC
If abrupt shifts in prices are what keep CTA (or managed futures) investors up at night, then they are likely sleep-deprived, given the recent market volatility.
Up until recently, equity markets have been on a tear. Thus, not surprisingly, most CTAs–strategies designed to capture trends in asset prices across liquid markets, including stocks, bonds, commodities and currencies–have consistently been long equities, substantially so in some cases. While the February/March selloff likely has trend-followers trimming their long-equity positions, losses are inevitable.
Our advice for investors: This is a small price to pay for the benefits provided by CTA strategies over the long term. If the drawdowns continue in the coming weeks or months, expect CTAs to capitalize. This is the true downside protection offered by trend-following strategies. Exhibit A: the financial crisis in 2008. The equity drawdown that accompanied the crisis occurred over several months, from November 2007 and to February 2009. Over that time period, the S&P 500 Index declined over 50%, while CTAs returned over 13%, according to the HFRI Macro: Systematic Diversified Index. The stark contrast in returns was, in part, due to the extended length—around 14 months—of the downturn, which allowed most trend-followers to build short equity positions and reap major rewards.
To be sure, CTAs have lagged in recent years amid prevailing low interest rates, uncooperative price movements, and low-volatility across asset classes. Still, the economic and behavioral rationale supporting trend strategies is alive and well. Reversals have always been a part of trend investing and represent a primary risk of investing in a CTA. Reversals can occur as a result of the release of new data, central bank activity, political uncertainty, or idiosyncratic events.
At NEPC we believe managed futures strategies have a positive expected return over the long-term and provide substantial benefits when a downturn persists over several months. That said, the diversification benefit offered by CTAs must be viewed as conditional and not a given in all markets. This is especially important to remember now. When reversals occur, as witnessed recently, do not be surprised to see some red ink on your performance report. It comes with the territory.
(reproduced with permission – note this article was originally published on the NEPC website on 12th February 2018)