For the investment management industry, last year was memorable but for all the wrong reasons. Most growth-oriented asset classes experienced significant falls in 2008 but, in contrast, managed futures provided strong
performance. This reinforced the reputation of managed futures for not only protecting capital during crisis periods, but delivering solid risk-adjusted returns.
If we go forward to 2009, managed futures have moved sideways and, in some instances, lost ground compared to equity markets, which have staged a recovery since March.
A managed futures strategy will typically outperform other asset classes in periods where markets are showing sustained price trends in either an upward or downward direction. There are certain market conditions where managed futures will be less profitable, which can be classified as either range-bound or trend reversing. The occurrence of range-bound markets is an interesting dynamic for managed futures and generally means that investors should adopt a long-term time horizon when investing in the strategy.
Managed futures, also called Commodity Trading Advisors (CTAs), are programs that primarily trade futures contracts across a variety of markets and sectors, including currencies, stock indices, bonds, interest rates, energies, metals and agriculturals. They trade on regulated futures exchanges around the world and can cover around 200 markets. While there are a number of trading approaches used within managed futures, most programs focus on systematic trading rules that use technical data to anticipate future price movements.
This approach is known as ‘trend following’. The underlying philosophy supporting the approach is that market behaviour is not random and that there are statistically predictable movements that can be identified and exploited.
Price trends stem from changes in the amount of return investors will demand to compensate for the risks they are taking. This return varies significantly over time in response to new market information, changes in the economic environment or intangible factors such as shifts in investor sentiment.
A managed futures program will achieve diversification by investing over a number of timeframes or trading speeds, which are then ‘blended’ to create a net position. These speeds can be classified into short, medium or long-term trends.
The ‘Moving average — WTI Oil — 2008’ chart (Graph 1) illustrates a short, medium and long-term trend using West Texas Intermediate (WTI) Oil, which is the underlying commodity for the benchmark oil futures contract traded on the New York Mercantile Exchange.
The simplest approach to capturing a trend is to apply a moving average, which is calculated as the mean of a price for a security over a specified number of days or months. In the chart, the following moving average periods are included:
Fast — five days (denoted by the dark blue line);
Medium — 20 days (denoted by the grey line); and
Slow — 30 days (denoted by the light-blue line).
A manager may use a combination of signals to build a diversified trading model.
The blending of these models, sectors, markets and instruments helps to reduce risk and widen the scope of returns.
To generate profits, managed futures seek to identify and take advantage of both upward and downward price trends across a wide range of markets, which means they can generate positive returns, regardless of the performance of traditional asset classes.
Systematic managed futures programs are best suited to sustained price trends in either rising or falling markets. Periods of market stress and high volatility, such as in 2008, generally provide a profitable trading environment as investor sentiment takes over as the principal driver of asset prices which, in turn, creates exploitable opportunities for managed futures.
The positive performance of managed futures in crisis periods is generally derived from the spectrum of markets it trades, including currencies, bonds, commodities and stock indices. To illustrate this point, the ‘AHL Sector performance — 2000 to 2008’ chart (Graph 2) highlights a performance breakdown on a calendar-year basis (2000 to 2008) for managed futures program, AHL (AHL is the largest constituent of the Barclay CTA Index).
Currencies and energies were the largest contributors in 2008, while stock indices made only a small contribution. During the equity market correction of 2002 and 2003, interest rates and currencies were the largest contributors and, again, stock indices provided a minor contribution to the overall performance.
The chart demonstrates that a diversified managed futures program has the ability to generate profits across a broad cross-section of markets, particularly during periods of equity market weakness. These periods generally coincide with strong trends across a wide range of markets.
Challenging conditions
Managed futures require the existence of trends throughout the markets in which they trade to generate profits. There are certain market conditions where managed futures will be less profitable, which can be classified as either range-bound or trend reversing.
The ‘WTI Oil Price and Profit/loss — 2004 to 2009’ chart (Graph 3) illustrates the price of WTI Oil from 2004 to 2009, and the positions a managed futures program would take.
1. Range-bound markets These markets can potentially have a negative impact on performance as buy and sell signals are consistently generated as the trend fails to materialise. Under this scenario, a managed futures program will establish long and short positions only to be ‘stopped out’ and in the process incur transaction costs.
Over the period 2005 and the first half of 2006 (Period 1), trading in WTI oil was unprofitable as the managed futures program was whipsawed between long and short positions. Through this environment, a managed futures program will actively reduce its investment exposure to this market until there is statistical evidence supporting the formation of either an upward or downward trend.
Range-bound markets can persist for a number of years, which means that a managed futures program must utilise its capital management skills to ensure capital is preserved in anticipation of the next wave of trends.
2. Trend-reversing markets Managed futures will experience losses as trends reach reversal points, that is, the market reaches a high or low point and subsequently reverses in direction. Generally, a managed futures program is positioned for a continuation of the trend.
Looking at the charts, the managed futures program employed a long position in WTI oil in early 2007 and profited from the strong rally in the price of oil up until mid-2008.
At the reversal point (Period 2), the managed futures program will give back some of the profits. As the downward trend emerges over the second half of 2008, managed futures programs employ a short position to profit from the downward trend in the WTI oil futures contract.
The timing of trends can be unpredictable and emerge quickly, with profit opportunities available only briefly.
Historically, the majority of returns are generated during those periods where markets are exhibiting strong trends. This makes trying to time an ideal entry point for an investment in managed futures a risky, and often unsuccessful, strategy. The number of markets traded and the ability to diversify across trading timeframes creates additional challenges for timing an investment.
Statistical modelling has shown that as a holding period extends beyond three to five years, the probability of returns in line with longer-term averages is greatly increased.
