Financial markets and economic systems have faced periods of corrections and systemic imbalances that generate accelerated price movements and volatility. These are impossible to ascertain ex ante with certainty. While anecdotal evidence can be found in financial systems of such build-ups and potential imbalances, the timing and extent of the adjustments are difficult to predict as the triggers are numerous. They range from geopolitical tensions to macro-economic imbalances, asset bubbles, terrorist attacks or other undisclosed risks.

Years like 1987, 1998, 2001, 2008 and the one we now face, all point to how different triggers can lead to exaggerated moves in the broader markets and in asset price volatility. In 1987, we saw the October stock market crash follow a five-year bull market that commenced in 1982. Then 1998 saw bond default in Russia and the blow up of the famous hedge fund, LTCM, creating widespread contagion effects in liquidity and financial markets. In the midst of a bear market in September 2001, the US witnessed terrorist attacks causing authorities to interfere with rates by injecting liquidity.

Later, 2008 saw the start of the worst post-depression global financial crisis as credit markets froze and the housing bubble that burst in 2006 caused severe bankruptcies. And in the last few months fears of global economic stagnation surfaced again with downgrades of sovereign debt in Europe as Greece, Spain and Portugal stood on the brink of default.

Managed futures give investor protection
Commodity Trading Advisors (CTAs), as a group of leveraged alternative asset managers targeting non-correlated absolute returns, run liquid and transparent managed futures strategies across a broad set of asset classes. These include financials, commodities and foreign exchange. Positions in markets are taken through regulated exchange-traded futures at low transactions costs with efficient funding through margins. The strategies have long been known to provide necessary protection during such periods of upheaval as they opportunistically and nimbly scoured markets to take advantage of accelerated moves. Seeking to benefit from such price persistence amidst large-scale directional volatility leads the managers generally to reward themselves with an asymmetric payoff during such periods. CTAs have been demonstrated to be particularly good at this. They are, therefore, a strong source of portable alpha.

At the core of its investment strategy, CTAs look to time a diversified basket of markets looking mostly for trends in various time frames. While no two are alike, there is sometimes significant differentiation amongst managers in their approaches. These often reveal themselves through differences in the distributions of returns. However, at the heart of all of this lies the desire to exploit persistent trends. And it is this that leads to participation during excessive adjustments in the markets following systemic shocks or imbalances.

Challenging conditions for managed futures
At the core, CTAs generally model themselves to take active risk at all times in a diversified portfolio of markets. They don’t want to miss out on the early phase of a directional move. Such a miss, they fear, may force them to wait for larger price moves that can be rare or take a long time to come about. The action of committing early, on the other hand, exposes CTAs to the risk of underperformance during times of low volatility, or in sideways market conditions. During such fragile and uncertain times, a CTA tends to have numerous false whipsawing signals. While CTAs use both diversification by markets as well as strategy to deal with periods of underperformance, they also face at the other extreme, tail correlation risks where all risk assets reverse together.

While CTAs try different means to combat such tail risk, the objective is the same. How should a CTA reduce activity and the level of participation in risk assets during such periods without explicitly going into cash? After all, managers are not paid to sit on cash. How long must the CTA stay in cash, if that were possible? It is near-impossible, a priori, to predict the length of such conditions persisting in the markets. A CTA will inevitably end looking to re-commit to a trade again in the expectation that the tail event has passed when, in hind sight, slowing down activity effectively would have proved more effective.

Hedging managed futures
Typically in portfolio construction with alternative investments one is more likely to combine directional characteristics of managed futures and macro strategies with non-directional hedge fund strategies that employ convergentor mean-reversionary activity. As the styles and statistical distributions are different in the two genres, risk is mitigated by such action. The problem is that although portfolio efficiency is enhanced by this it does not lead to an understanding of how the sources of risk in one strategy are hedged by another. You are truly comparing apples to oranges by combining the two. Systemic risk can be common to both strategies. But deciphering the risk factors is more challenging. With CTAs, given the general consistency in style primarily through market timing, we believe it is possible to create a well understood and replicable component to hedge the risk profile of this strategy. We will call this a ‘flight to quality’ of FTQ hedge portfolio.

Building a risk-averse FTQ (Flight To Quality) portfolio
Our objective in this is to highlight that over-activity for investors or managers through multiple factors can often be costly. Instead of changing allocations in and out of CTAs to deal with systemic shocks or periods of under-performance, trying to decide when to have portfolio insurance or not, it may be better for an investor to combine a long-run portfolio of CTAs and a separate futures-based ‘flight to quality’ proxy through a dedicated portfolio such as the FTQ. This brings about a robust balance between risk-taking through CTAs and risk-aversion through the FTQ. It keeps costs of timing errors to a minimum for the investor as he would not have to frequently adjust his portfolio for the CTA content in the face of a changing performance environment. To demonstrate the efficiency of the above, we first construct the FTQ as a risk-averse long-term hedge portfolio. We ensure that we have a high degree of ‘flight to quality’ attributes in this portfolio that can be easily replicated. It is then used in conjunction with a CTA portfolio to improve performance both (i) during times of excessive volatility, or (ii) general sideways market activity with very low volatility. The combined portfolio gives a more efficient risk-adjusted asymmetry in the long run by balancing activity dominated by market timing factors with a static risk-averse portfolio that addresses specific risks when CTAs show weaker performance. It therefore avoids excessive costs of market-timing through entry and exit into CTAs or necessarily varying styles of trading between short and long term strategies by trying to time the decision.

The FTQ portfolio shown in Table 1 is futures-based and created with risk-aversion in mind. Hence component assets used in the form of futures contracts, are those that are empirically observed to correlate well with ‘fear’ or ‘anxiety’ in the market place. The composition of the FTQ is somewhat subjective but does make the general case for a long-run hedge portfolio that looks to be risk-averse and proxies a ‘flight to quality’ protection when required. A relatively small proportion of a risk asset in the S&P 500 at 25% is assumed to be defensively held in the FTQ at all times.

Due to lack of data for the VIX contract pre -April 2004, we have used 27.5% for S&P 500, 17.5% for Gold, 17.5% for US Ten year Notes and 37.5% in Euro dollars, thus reallocating the 10% VIX weight evenly amongst the rest.

The FTQ consists of assets that are more risk averse. The VIX performs when equity markets slide in fear. Gold is a general store of value and is a safe-haven asset particularly during inflationary or crisis periods. On the yield curve we leaned towards short term interest rates through Eurodollars with some exposure in the US Ten-year yield to have some incremental duration risk. But we still tried to be mainly risk averse and cash-heavy through a higher allocation to short rates. The FTQ has been constructed with costs of trading incorporated and replicated using the underlying futures contracts on a notionally funded basis. As such this portfolio is tradable and the FTQ numbers where used are based on this hypothetical portfolio using notional amounts.

Risk-taking vs. Risk-aversion portfolios
Table 2 shows the yearly returns of the FTQ versus the QCM GDP and the BTOP50 CTA Index from 2001.

From Table 2 we see that the FTQ has out-performed the GDP and the BTOP50 during the most difficult years for active risk taking through choppy volatility as shown in 2004, 2009 and 2010 to date. During these periods markets have exhibited a higher negative incentive for active risk taking. On the other hand in periods of systemic shocks like 2001, 2007 and 2008 as well as through persistent conditions of volatility like 2005 and 2006, the GDP and the BTOP50 have produced the asymmetrical payoff that investors should look for in CTAs.

Table 2 demonstrates that the risk premium is sometimes overpriced by CTAs engaging in active risk taking in all market conditions. In 2009, it shows that the FTQ benefited from being more risk-averse by slowing activity. For 2010 to date, it has also shown market characteristics when active risk taking is not rewarded as the risk premium is overpriced whilst we are in the midst of anaemic global growth prospects.

Most years, however, show a healthy balance of risk-taking opportunities whereby the FTQ underperforms relative to GDP and the CTA index. Clearly CTAs and investors have priced the premium profitably in all of those years. Indeed, 2008 was a year when systemic risks were paid off handsomely by taking active risk in the markets and volatility was persistent. Excess returns compared to BTOP 50 Managed Futures Index give a measure of the premium paid by managers typically to take active risks.

A hypothetical combined portfolio
From the monthly returns of the period January 2001 to May 2010 we plot in Table 3 a hypothetical portfolio of active risk-taking in CTAs through BTOP50 and the risk-averse FTQ. The risk adjusted ratios have been plotted for combinations of the two.

We see that the portfolio improves in efficiency with addition of the hedge component through the FTQ. All the above three risk adjusted ratios, show an increase in portfolio efficiency. Looking at the Sortino ratio (annualised return to annualised semi-deviation) we could argue that a 50:50 allocation between the CTA portfolio and the FTQ could result in an asymmetric payoff but without much compromise on the absolute returns.

Conclusions
Using a 50:50 allocation to CTAs and the FTQ, the runs show a pickup in efficiency at the margin where all the three risk adjusted ratios give a fairly consistent conclusion. While changing the subjective portfolio composition for the FTQ may alter the 50:50 allocations somewhat, the central message remains the same. Rather than trying to time CTAs through activity for risk-taking, it is better to slow down this investor activity by having a concurrent almost passive risk-averse portfolio. The combination would not involve market-timing and avoid facing the risk for an investor of being wrong as to when to invest or not to invest in CTAs. The payoff in the combination portfolio still looks attractive.

Aref Karim, FCA, is the founder, CEO and Chief Investment Officer of Quality Capital Management and Ershad Haq, is Director of Research. QCM has run managed futures portfolios for investors since 1995 and is based in Weybridge, Surrey.