The World is Not What You Think It Is

The World is Not What You Think It Is

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By Robert Rotella, CEO, Rotella Capital Management, Inc.

The Myths and Realities of Managed Futures. There are many reasons why investors still do not allocate to managed futures versus stocks and interest rates. We will attempt to dispel some of the myths surrounding managed futures and also show some of the reasons an investor may want to consider implementing them in their portfolio. We will investigate the three main asset classes using the Barclays (formerly Lehman) Aggregate Bond Index for interest rates, the S&P500 total return for stocks, and the Newedge CTA Index (formerly Calyon Financial Barclay Index) for managed futures. Please note the returns for the Newedge CTA are hypothetical from 1990 to 1999 but are included as this period had one of the greatest bull markets in both stocks and bonds.

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Myth – Managed futures are risker than equities and interest rates. There are various ways to measure risk but two that are the most popular are volatility and drawdown. In this example we will look at drawdown. (We will consider volatility when we address returns in the second myth discussed below.) We need to normalize drawdown to appropriately compare the three asset classes and will do so by dividing the maximum drawdowns by the corresponding volatilities as shown in Figure 1. Equities clearly have the first and second worst drawdowns in 2007–2008 and 2000–2002. We can distill the information more succinctly in the following table which provides the 3 worst drawdown-to-volatility figures for the respective asset class. Here the drawdown-to-volatility ratios for their respective 3 worst periods are shown to be 2.43 for equities, 1.82 for interest rates, and, 1.87 for CTAs. Using this period and measure, it is hard to understand how one can argue managed futures are any riskier than equities or interest rates.

Figure 1

Myth – Managed futures offer poorer returns versus stocks and interest rates. We again need to normalize returns to compare performance and to do so we will divide return by volatility which will give us the familiar Sharpe ratio. We see in Figure 2 that interest rates exhibited the highest Sharpe of 0.90, followed by managed futures with a Sharpe of 0.86, and then equities with a Sharpe of 0.75. This suggests that managed futures have offered competitive risk-reward ratios versus interest rates and stocks in one of the greatest bull markets for equities. Interest rates beat both equities and managed futures but we will have more to say about this in the second to last point below.

Figure 2

Myth – Futures are riskier because you can lose more than your investment. This point needs to be better understood. An investor can lose more than their investment usually by two means: one of which is going short and the other is leverage. As both of these are possible in futures as well as other investments like interest rates or stocks it should be apparent that futures are not necessarily riskier. If one is concerned about losing more than the principle of the investment then a fund investment should be considered where the loss is limited, although it should be pointed out that there have been a few instances of investors losing 100% of their money in properly managed futures investments. However, there are far more instances of bond defaults as well as stocks becoming worthless.

Myth – There is no fundamental basis for returns from managed futures. The gist of trading managed futures is detecting and profiting from trends. In the excellent book Trend Following with Managed Futures, Greyserman and Kaminski apply a simple trend following method and backtest it on markets from over 700 years ago to the present with reasonable results. This at least suggests that markets are not random but have exhibited orderly trends over an exceptionally long period of time. Will they persist? Perhaps an equally compelling question is will the bull market in equities and interest persist?

Figure 3

Myth – Futures contracts are relatively new and unproven. Au contraire. Equities have a history dating to around the 1500’s. Interest rates and futures go back to ancient Mesopotamia to the code of Hammarubi and possibly even further. Many of the wise ancients saw an important need for futures that many “financial experts” still now do not understand.

Myth – Managed futures fees are high. The Newedge CTA Index includes all fees charged by the respective managers. Since the performance numbers after fees compare favorably with equities and interest rates then the fee issues should be a moot point.

Have we missed the great move in managed futures? Many managed futures programs have had above average returns in the past 12 months. Investors are loathe to buy the top in any market. However, if we look at Figure 3 and the rolling Sharpe of the Newedge CTA Index versus stocks we see periods of over as well as underperformance. Stocks tend to outperform managed futures during strong bull market runs which should not come as any surprise. Overall the periods of outperformance can be brief or extended. Therefore it is possible managed futures may return to weaker performance but no less possible it may continue to outperform stocks. Furthermore even if managed futures underperform equities in a raging bull market it does not necessarily imply negative performance. We see similar results in Figure 4 with managed futures versus interest rates. Curiously if an investor is concerned about buying the top in managed futures after a 12 month run is there any more concern for being long equities after a 6 year run or interest rates after a 30+ year run?

Figure 4

Correlation – In Figure 5 we note that the Newedge CTA Index correlation with equities is less than zero and only slightly correlated with interest rates. This slight positive correlation is probably partly due to the generally long position in interest rates many CTAs have had in the past 15 years. However, this may soon come to an end if the bull market in interest rates ends.

Figure 5

Figure 5

Managed futures had a slightly lower Sharpe versus interest rates as noted in the second myth discussed above. However, is it reasonable to assume that interest rates will continue to provide similar returns in the next 25 years that they have provided in the past 25 years? For example ten year notes were yielding around 8% in 1990 and now hover in the 2% region. Where is the upside from here – negative rates? Rates have gone from high double digits to sometimes negative depending on the country and term. And that does not even include the real possibility of default.

Combining managed futures with interest rates and equities, in Figure 6 we see a definite improvement in performance by including an allocation of managed futures to a portfolio of interest rates and equities. Each allocator needs to adjust the exact percentage to fit the investor’s needs.

We hope you find this analysis helpful and look forward to hearing your comments about this topic.

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