Managed Futures: The Search for Non-Correlation
Traditional wisdom suggests that diversifying among asset classes will smooth out returns and reduce overall risk in an investment portfolio.
Unfortunately, most traditional asset classes have recently become highly correlated. That is, they have been moving up or down in tandem, diminishing the benefit of diversification. In a quest for non-correlated assets, sophisticated investors frequently look beyond traditional stocks and bonds to include alternative investments. One such alternative with favorable correlation characteristics may be found in managed futures strategies.
Managed futures strategies can improve the risk-return tradeoff in a long-term asset allocation portfolio, yet few investors consider it as an asset class. Their obscurity is perhaps owed to a lack of understanding of the specific role they can play in diversified portfolios, but managed futures strategies have historical performance characteristics that make them highly relevant in a market environment of relatively low returns and generally rising asset class correlations.
Initially, managed futures strategies focused solely on metals and grain futures, but became commonplace in the 1970s after futures exchanges expanded to include new types of futures contracts. Presently, managed futures strategies encompass both long and short investments across commodities, equities, currencies, interest rates, and government bonds futures. Popularity of the asset class has increased since its strong performance during the dot-com collapse of 2000-2002 and the financial crisis in 2008. Despite a successful track record, however, managed futures remain an asset class unfamiliar to many investors.
The primary driver of most managed futures strategies is trend-following or momentum investing; that is, buying assets that are rising and selling assets that are declining. This type of strategy’s most powerful attribute is the potential to do well in either extremely strong or extremely weak markets. By doing well when most traditional asset classes are suffering, a compelling statistic results. Historically, managed futures have displayed virtually no correlation to the S&P 500 Index or the Barclays Capital Aggregate Bond Index, offering strong portfolio diversification potential.
Momentum investing is supported by modern behavioral economics theory, which links human behavior to under- and over-reactions in market prices. You may ask, “How can a price trend be predicted and profited from?” Consider, for example, a positive catalyst that justifies a higher intrinsic value of an asset. As the behavioral economics theory proposes, investors’ anchoring biases may mute their reaction to new information causing new price estimates to remain tethered to old prices. After the initial under-reaction and once the catalyst has been widely accepted and disseminated, herding behavior can push prices beyond the asset’s fundamental value. The same example can apply to negative catalysts where the behavioral pattern would simply be inverted. This behavioral explanation implies that investors may be less rational than many market theories assume, a conclusion supported by a growing group of behavioral economists.
Since the prerequisite for positive performance of such managed futures strategies is a sustained and consistent trend in market futures prices, they tend not to perform as well in other market conditions. These environments include periods without sustained moves in one or more of the markets traded, so-called whip-saw markets, in which trends appear to develop but then quickly reverse. Other environments where these strategies may underperform are markets that are driven by factors or events not reflected in technical analysis. In 2011 and 2012, political aggravations, natural disasters, global central bank policies, and a general “risk-on, risk-off” investor mentality left markets choppy and directionless. These conditions produced negative returns for most managed futures strategies during that time period.
For many years, hedge funds were the only vehicles through which investors could access managed futures. However, this strategy has become considerably more accessible now that it is also available through mutual fund vehicles with reduced fee structures, increased liquidity, greater transparency and simpler tax compliance. As of May 31, 2012, there were 31 managed futures mutual funds comprising total assets under management of nearly $9 billion.
Despite the perceived complexities, managed futures strategies should warrant further exploration. With the ability to invest both long and short across multiple assets classes, managed futures strategies have characteristics that may help investors address the problem of rising asset class correlations. As recent events have illustrated, geographic diversification may no longer be sufficient to help investors reduce portfolio risks. Those seeking new and potentially more effective ways of diversifying may wish to consider adding managed futures strategies to their portfolios, given the strategy’s track record of low correlations coupled with its upside return potential.