By James Skeggs, Senior Director, Global Co-Head of Advisory Group at Newedge
In the last two years, the CTA industry has grown to manage about $330bn in investor capital. Concurrently, the industry has found itself in a drawdown that has lasted 29 months, which at its worst was 11.7% below its peak in 2011.
James Skeggs
Some commentators see this as proof that the managed futures space is now over capacity, and too big to deliver uncorrelated risk-adjusted returns.
The argument goes that once the CTA industry becomes too large, the ability of futures traders to both transact and hold their positions in the futures markets reduces due to constraints imposed by the size (open interest) of those markets.
In this scenario, once a manager that targets a certain return volatility hits their limit of allowed risk, they would need to move from one market to another, searching for capacity, first within the same sector and second to other sectors.
At a certain level of assets under management, it would be possible for CTAs to become ‘maxed out’; first in different markets, and then in different sectors, and have nowhere to turn as portfolio diversification is limited by the ability of a market to accommodate its positions.
In this case, we can conclude that the first thing to suffer from growth in assets under management would be the industry’s Sharpe ratio, but this would bottom out once maximum position sizes had been reached in all tradable markets.
However, our analysis indicates that there is no reason to suggest that at its current size the CTA industry is suffering from material capacity constraints.
First, open interest in many futures markets represents a very small fraction in the vast majority of the markets they represent.
A good example is that at the end of April 2013 the total notional value of Treasury futures across all maturities was $914bn. The value of outstanding Treasury notes and bonds of all maturities was $9.6tn. Treasury futures therefore represent about 10% of the total value of the market, which in turn represents only 25% of total marketable debt in the US.
For equity index futures, the same picture exists. In April 2013, the notional value of S&P500 futures stood at $315bn, yet the total market capitalization of the index and the US stock market as a whole was $15tn and $19tn respectively. Either way you look at it, S&P500 futures represent around 2% or less of the market they represent, suggesting plenty of room for growth.
A notable exception to this is that commodity futures likely make up a larger fraction of the markets they represent. The lack of reliable cash market information makes it difficult to say for certain, but we believe that the futures markets are where most of the world’s trading in commodities takes place.
Second, futures markets tend to be very liquid and would actually have no trouble accommodating the industry’s positions, even if it was larger than it is today.
Futures markets are ultimately built for speed, and since 2000 the industry has gravitated towards electronic trading platforms, which have improved transparency and liquidity.
This is illustrated in Fig. 1, which shows the ratio of average daily volume to average open interest in 55 different futures markets. These markets have open interest that turns over on average once every 2.3 days – and in some individual markets, the rate is even higher.
Fig. 1: Volume/open interest ratio for 55 futures markets in 2012
For example, the markets for commodities futures like crude oil, natural gas, corn, soybeans and gold are all renowned for being highly liquid.
Finally, the impact of over-capacity on risk-adjusted returns and returns volatility would not necessarily be an Armageddon scenario.
In an over capacity scenario, we would expect that the CTA industry’s Sharpe ratio would drop as assets under management grew. Our work suggests that in actual fact the industry’s Sharpe ratio would bottom out once maximum positions sizes had been reached in all tradable markets.
At that point, every additional dollar added to CTAs would serve only to dilute industry returns and return volatilities. There would be a decline in Sharpe ratio and a decrease in the overall volatility of the industry’s returns, but neither of these things is the worst thing in the world.
So, our research shows that the managed futures industry is not over capacity. Futures markets have grown in size and liquidity in the last few years and we see no reason that this cannot continue.
And as long as the CTA industry can promise uncorrelated returns, with even a modest overall Sharpe ratio, institutional portfolios will continue to derive substantial benefits from including managed futures in their portfolios of stocks and bonds.