Capital markets suffered a troublesome yr in 2022. Amid an inflationary bear market, the normal investing playbook proved woefully insufficient. The NASDAQ and high-yield debt, the darlings of yesteryear, have, with few exceptions, fallen from grace. US Treasuries, the most typical hedge in opposition to inventory volatility, have suffered their worst drawdown in at the very least the final 70 years — and it’s not even shut.
10-Year US Treasury Drawdown
Times equivalent to these are good alternatives for reflection. Portfolio managers and allocators should construct various portfolios that steadiness progress and capital danger over an intermediate-to-long time horizon. Treasuries have historically crammed the function of diversifier and risk-off asset. But what in the event that they develop into much less efficient hedges in opposition to danger property? Portfolio development may look very completely different. That’s why we have to ask the query: If Treasuries now not fulfill their conventional function, what different methods or asset lessons can improve diversification and ship constant returns?
Managed futures could also be simply such an asset class — one with the potential for engaging efficiency, particularly amid excessive volatility.
The Trend Is Your Friend
John Lintner, a co-creator of the capital asset pricing mannequin (CAPM), can inform and encourage our exploration. In The Potential Role of Managed Commodity-Financial Futures Accounts (and/or Funds) in Portfolios of Stocks and Bonds, he wrote:
“Indeed, the enhancements from holding effectively chosen portfolios of managed [futures] accounts or funds are so massive — and the correlations between the returns on the futures portfolios and people on the inventory and bond portfolios are surprisingly low (generally even unfavorable) — that the return/danger trade-offs offered by augmented portfolios consisting partly of funds invested with acceptable teams of futures managers . . . mixed with funds invested in portfolios of shares alone (or in blended portfolios of shares and bonds), clearly dominate the trade-offs out there from portfolios of shares alone (or from portfolios of shares and bonds). Moreover, they achieve this by very appreciable margins.
“The mixed portfolios of shares (or shares and bonds) after together with even handed investments in appropriately chosen sub-portfolios of investments in managed futures accounts . . . present considerably much less danger at each doable degree of anticipated return than portfolios of inventory (or shares and bonds) alone. This is the essence of the ‘potential function’ of managed futures accounts (or funds) as a complement to inventory and bond portfolios advised within the title of this paper.
“Finally, all of the above conclusions proceed to carry when returns are measured in actual in addition to in nominal phrases, and likewise when returns are adjusted for the risk-free fee on Treasury payments.”
This passage affords a number of tantalizing clues on the doable function managed futures may play in a portfolio: They could enhance the danger/return profile of inventory and bond portfolios, exhibit meaningfully low correlation with these conventional property, and enhance returns on each an absolute and risk-adjusted foundation. Let’s consider every of those claims in flip.
The Economic Rationale
The major driver of returns for managed futures is trend-following or momentum investing — shopping for property which have just lately risen and promoting or shorting property which have just lately declined. These methods are sometimes utilized to liquid futures contracts throughout fairness indices, rates of interest, commodities (power, agricultural, and industrial), and currencies, amongst different markets. Since most traders haven’t any commodities or FX publicity, even from the straightforward perspective of traded devices, managed futures may introduce new sources of danger and return.
Momentum investing has a wealthy educational historical past and is acknowledged as an important issue that may clarify inventory portfolio efficiency. Trend-following is equally strong. Brian Okay. Hurst, Yao Hua Ooi, and Lasse H. Pedersen analyzed a time-series momentum technique over 137 years and located that it carried out nicely throughout completely different macroeconomic environments and tended to outperform throughout instances of macro-stress.
The Barclays BTOP50 Index (BTOP50) seeks to copy the all-around composition of the managed futures business in buying and selling type and general market publicity. The chart beneath depicts BTOP50’s quarterly returns from January 1990 to April 2022 relative to these of the MSCI World Index and options the fitted line for a second-degree polynomial. The plot exhibits a particular “smile” attribute of trend-followers. This means that managed futures methods are usually “lengthy volatility” and outperform in each excessive up and down markets.
Barclays BTOP50 vs. MSCI World Index
Set Up and Approach
The BTOP50 serves as our benchmark for the efficiency of managed futures methods. We calculate returns and abstract statistics both on a month-to-month or quarterly foundation over the January 1990 to April 2022 remark interval.
The abstract statistics for the BTOP50 together with indices for different key asset lessons are offered within the desk beneath and are derived from quarterly whole return information. Confidence intervals (95%) for skew and extra kurtosis are proven in parentheses.
|Barclay’s BTOP50||MSCI World Total
Total Return Index
|ICE BofA Corp Total Return
|US Dollar (DXY)||Goldman Sachs
|Skew||0.771||-0.569 (-.967, -.199)||0.224 (-.112, .619)||-0.147 (-.807, .544)||0.285 (-.086, .802)||-0.275 (-1.143, .717)|
|Excess Kurtosis||1.815 (-.209, 5.82)||0.728
|-0.1085 (-.538, .790)||1.471 (.512, 2.86)||0.2367 (-3.91, 2.005)||2.2816 (.962, 4458)|
|Shapiro-Wilk Test||<.0001; Reject||<.0001; Reject||.5627; Fail to Reject||.0253; Reject||.7556; Fail to Reject||.0014; Reject|
According to the information, managed futures have, on common, produced constructive returns and exhibited roughly half the volatility of world shares over the past 32 years. The 95% confidence interval for skew means that the BTOP50 has distinctly constructive skewness, which is exclusive among the many asset lessons in our evaluation. Even “safe-haven property,” like US Treasuries and the US greenback, throughout risk-off intervals don’t exhibit statistically vital constructive skewness.
The visible proof of this impact is illustrated within the histogram beneath. The confidence interval for extra kurtosis isn’t fairly conclusive on the 95% degree, but it surely nonetheless implies heavy tails for the BTOP50. Moreover, the Shapiro-Wilk take a look at disproves the speculation of usually distributed returns. The Shapiro-Wilk fails, nonetheless, to reject normality for 10-year Treasury and DXY returns. That signifies that these sequence are comparatively nicely behaved.
Barclays BTOP50 Quarterly Returns Distribution
The cumulative return of the BTOP50 and comparative property over the pattern interval are offered within the following chart. The BTOP50, our managed futures proxy, is the third-best performing asset class, barely edging out Treasuries and falling simply shy of investment-grade corporates. Over the 1990 to 2010 subperiod, which options the dot-com bubble and the worldwide monetary disaster (GFC), trend-following was the highest performer largely as a result of the technique prevented each these massive drawdown occasions and really posted constructive returns in 2008 and 2009.
Index Cumulative Return
However, since then — and till pretty just lately — methods constructed to revenue from value developments have struggled. Since the GFC, markets have lagged beneath their historic norm. This presents a problem to trend-followers. The underperformance of the 2010s interval could also be due partially to the deluge of cash that flooded right into a historic bull market. A interval of imply reversion was inevitable.
Managed Futures AUM (Billions $)
Another vital facet of managed futures, in response to the cumulative return plot, is the low correlation they’ve with the opposite “conventional” asset lessons. The chart beneath particulars the rolling 12-month correlation of the BTOP50 with the 5 different asset lessons. The stable black line in every plot exhibits the typical correlation over the whole remark interval.
BTOP50 and Other Asset Classes : Rolling 12-Month Correlations
While the correlations range over time, trend-following demonstrates structurally low correlation with the opposite asset lessons. Let’s look at every sequence in flip. The correlation with equities is statistically indistinguishable from zero. Equities are sometimes probably the most dangerous asset in diversified portfolios, which is why they’re usually hedged with property that carry out nicely when shares wrestle. Over the previous 20-plus years, Treasuries have crammed this function and, up till 2022, carried out it nicely. But 2022 revealed vital gaps in portfolios that rely solely on bonds for draw back safety. Amid right this moment’s high-inflation, sagging progress, and excessive volatility, trend-followers have excelled. When it involves diversification, managed futures have achieved exceedingly nicely.
When Things Get Extreme
Between the smile-plot and correlation diagram, we’re constructing the case that managed futures have an important function to play in portfolio development. Specifically, managed futures methods have produced persistently constructive returns throughout market regimes and carry out notably nicely within the tails. Let’s dig a bit deeper into this latter level.
The first panel within the plot beneath exhibits the typical rolling 12-month return for the BTOP50 and MSCI World over the complete pattern interval. The MSCI World has offered a median return of ~9.75% since 1990, whereas the BTOP50 has returned ~5.80%. Over a protracted sufficient time interval, the sequence with the very best anticipated return will in all probability outperform all different property. However, because the cumulative return plot demonstrates, the trail to such returns will doubtless be punctuated by probably lengthy intervals of great underperformance and volatility.
In the second and third panels, we kind the returns into deciles based mostly on the MSCI World’s efficiency and display how managed futures fare when the MSCI World did notably nicely or poorly. The third panel reveals the typical 12-month return for the tenth and greatest decile. During intervals of “good” returns for the MSCI, the typical prime decile return for the MSCI World is an excellent ~34%. On the opposite hand, the typical return for top-decile managed futures is barely ~7%. So, when fairness markets are in an actual bull run, shares are by far one of the best funding.
The second panel exhibits the typical 12-month return for the primary and worst decile. During intervals of “dangerous” returns for MSCI, the typical backside decile return is roughly –24%, whereas the typical return for managed futures is a constructive ~12%. This is the vital level: Managed futures have a constructive expectation in each up and down markets, however it’s in down markets when their hedging advantages are strongest: Just once they’re wanted most.
Mean 12-Month Return by Decile
Now, easy averages are one factor, however what in regards to the excessive circumstances? The subsequent chart depicts the utmost and minimal return for the highest and backside deciles of the MSCI World and the corresponding efficiency of the BTOP50.
Maximum and Minimum 12-Month Return by Deciles
The second panel exhibits the utmost return for the tenth and top-performing decile. During its greatest 12-month return interval since 1990, the MSCI World returned ~55% whereas the BTOP put up ~24%. In a ripping bull market, managed futures can produce stable returns, although they in the end gained’t preserve tempo with shares. Since the BTOP50 has a lot decrease volatility, that is hardly a shock.
The first and third panels visualize the “dangerous instances” for shares. The first exhibits the utmost return for the primary decile, the ninetieth percentile, of the MSCI. The least quantity that the MSCI has misplaced over a 12-month interval is roughly –13.5%. In distinction, when the MSCI was down ~13.5%, the BTOP50 was up ~30%. Likewise, the third panel exhibits the worst, or one centesimal percentile, 12-month return for the MSCI: a cruel -47%. Over this era, the BTOP50 additionally misplaced cash, however solely a manageable –2.6%.
Bringing all of it collectively, now we have two necessary observations:
- Trend-following has a long-run constructive anticipated return and, furthermore, a constructive anticipated return in each bull and bear markets.
- Managed futures have an uneven return profile. They usually fail to maintain tempo with equities in bull markets however can nonetheless produce stable returns. In bear markets, nonetheless, they considerably outperform shares, producing constructive returns or, at minimal, a lot much less draw back.
The elevated volatility of 2022 left few asset lessons unscathed. We want to know what labored nicely, what didn’t, and the way we will higher place our portfolios for the longer term. Managed futures/development following is one technique value contemplating. Trend-following sits on a basis of robust empirical proof and a long time of constructive returns. Moreover, the historical past of managed futures means that the technique works notably nicely in instances of macro-economic volatility: It acts as a supply of non-correlated returns proper when traders want it most.
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All posts are the opinion of the creator. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially replicate the views of CFA Institute or the creator’s employer.
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