A spanner has been thrown in the works of the international financial markets. Since the turn of the century, events that statistics and statisticians claim should only occur every few hundred years have become more frequent. While volatility and setbacks in the context of the burst technology, media and telecommunications bubble from 2000 to 2003 were initially considered as significant within the normal parameters, this assessment has now changed. The events from 2007 to today urge us to take a closer look at their causes and effects. It is undeniable that certain parameters within which investors make their decisions appear to have changed. If this is the case, investors’ behaviour will need to change too. Even if it is individually weighted, the search for a desired return with seemingly acceptable risks attached remains the primary goal.

What were the drivers of growth in the past decades? One of the first points to mention is surely the steady reduction of global interest rates since the 1980s. This continuous interest rate cut led to never-before seen profits on the bond markets, and one of the side effects of falling interest rate levels is reflected in continuously rising equity markets. Companies gained access to affordable credit lines and more investments became more worthwhile. This process of ongoing interest rate cuts was accompanied by three key drivers: a removal of restrictions on capital transactions between the key global markets; an increasing speed of transactions due to the use of new computer systems and the worldwide web and, thirdly, globalisation. China joined the World Trade Organisation in 2001, laying the last essential stepping stone to link the world’s largest economies and allow a continuous transfer of goods and capital.

The changes in the geopolitical landscape that were driving growth were supported by liquidity provided by the large global central banks. As we know today, excessive supply of liquidity since the 1990s has contributed to the emergence of asset bubbles, and therefore the basis for rising volatility, as well as comparatively more severe and frequent drawdowns. Up until the beginning of this century most investors considered an individually balanced portfolio of bonds and equities the best of all allocation options. The global mega-drivers (interest rate reduction and globalisation) provided a stable increase in value – but this seems to have come to an end. Global trade has collapsed following years of rapid growth. It seems appropriate to wonder whether it will ever return to the past high levels of growth once the current financial crisis and crisis of the real economy is overcome.The driving force of interest rate cuts will permanently disappear. Optimists work under the assumption that a low interest rate level will be maintained globally. Pessimists, however, see inflation risks surface at least in the medium to long-term. There are uncertainties as far as the eye can see.

This is bad news for traditional investors. To complete the picture we should also look at the statistics. How did individual asset classes perform? In the past twelve months to the end of May 2009 the MSCI World (EUR) registered a loss of 24.9%. The FTSE 100 was down 27.2% and the DAX 30 retreated by 30.38%. The data for the maximum drawdowns presents an even clearer picture: MSCI World –49.01%, FTSE 100 –43.02% and DAX –52.35%. These indices provide an example of how most others performed, similar in direction and scale. Annualised, the losses are unacceptable to institutional investors. How did the bond market fare? As measured by the Barclays Aggregate Bond Index, the last twelve months have generated a return of 5.37%, the EONIA yielded 2.62%. The German bond index REX recorded 8.93%. Is this sufficient for institutional investors to build a lasting strategy for their distribution policy? I can only presume that is not the case. In light of implied risks of an interest rate increase, there is chatter among German investors that bonds do not offer risk free interest, but interest free risk for their portfolio.

No one-way street
The times when investors drove profits down a one-way street are over. Uncertainties have soared and volatilities reflect this. Two major crises in the last 10 years and a third one currently developing with governmental bail-out-programmes worth billions, ask for alternatives. Asset classes that can form a hedge against portfolio exposure to equities, but are also able to generate significant results in times of positive stock markets, are sought after. A look at the historic development of various asset classes since 2001 shows the following ranking: if invested in the US equity market (S&P 500) one has to accept a loss of 37.45% (as of the end of May 2009). The German DAX lost 28.97%. Positive results start in the emerging markets, which saw equities gain 25.45% since 2000. Government bonds performed even better with 31.11%, which was only surpassed by commodity investments (gaining 38.82%) and typically German open real estate funds (up 47.94%). At the very top of the ranking are hedge funds (HFRX) with a 69.61% gain. Now investors merely need to look at the characteristics of each specific investment option within the group of hedge funds. How do the individual strategies perform in phases of equity drawdown? A look at the 10 worst equity market phases since 1980 demonstrates it (see Fig. 1). During phases of sharp decline of the MSCI World, managed futures (represented by the Barclays Commodities Trading Adviser (CTA) Index rose in most cases. In the few cases in which the Barclays CTA also fell, the steep declines of the stock markets were followed only sub-proportionally.

It is also worth noting that the Barclays CTA Index showed a positive correlation to the MSCI World in times of rising equity markets. When the global climate is positive and results in rising prices on the equity markets, managed futures will also profit from these trends. A look at the drawdown phases reveals another advantage of managed futures: our review of MSCI World and Barclays CTA shows that the maximum losses of the CTA index are at 15%, significantly lower than the maximum losses of the equities index, which went down 53%. An analysis of the time the asset class needs to recover to its previous highs also points to a distinctly positive result for managed futures: while the MSCI World took up to 70 months to reach new highs, the Barclays CTA-Index only required 19 months.

At this point a preliminary conclusion is appropriate – managed futures or CTAs offer a variety of positive features that, in times of uncertainty and increased volatility, have a positive effect on returns and risks in a portfolio. A number of studies have come to this conclusion. One of the earliest statements came from Dr John Lintner of Harvard University, who wrote: “Portfolios…including judicious investments…in leveraged managed futures accounts show how substantially less risk at every possible level of expected return than portfolios of stocks (or stocks and bonds) alone.”1 Harry M. Kat, Cass Business School, City University, London, commented: “Apart from their lower expected return, managed futures appear to be more effective diversifiers than hedge funds. Adding managed futures to a portfolio of stocks and bonds will reduce that portfolio’s standard deviation more and quicker than hedge funds will, and without the undesirable side-effects of skewness and kurtosis.”2

Though managed futures have existed since 1949, they only came to significance in the 1970s. In the early 1980s the first CTA indices were launched. The Barclays CTA Index started with just 13 CTAs – now it contains almost 500. Today, an investor can monitor a number of indices, including the CASAM/ CISDM and the Stark Index. These are divided into a multitude of sub-indices. It can be observed that while the individual indices are divided by a number of criteria (industry, interest rate, agricultural, currency, financial only, non-financial and many more), they are not arranged by the maturity of the trading approaches they are based on.

Trading systems that are based on managed futures tend to be built on rule-based systems. Various approaches working with break-out and break-in-signals generate the order flow. Most managed-futures-systems are so called long-term-managed-futures. This means that relatively long time periods – from a couple of days to a number of weeks – pass until the system identifies a trend. The risk is obvious – in market phases that contain a distinct sideward movement and frequent changes of direction erroneous signals are repeatedly generated, impeding the overall performance.

Where do we stand?
Returning to our initial observations, my thesis is that the predictability of future developments on the capital markets will worsen. Where will the S&P 500 stand in a year’s time? How are interest rates going to develop in the Euro-zone in the next 36 months? Will the Chinese renminbi partially substitute the US dollar as the reserve currency? I don’t know. I don’t think anybody knows.

Our response to growing uncertainty and unpredictability is the AC Pharos Evolution Fund, an extremely short-term orientated managed futures fund that currently trades on 15 liquid markets intraday. De facto this means that the trading day begins with the opening of the Asian markets, continues throughout Europe and closes with Wall Street. On average, 22 hours of effective trading stand against two hours downtime, which means the fund does not face overnight risk. The trading system was launched in 2001 and has generated double-digit average annualised returns. The annualised return stands at 17.15% and the annualised volatility is 14.88%. The maximum drawdown occurred seven years ago and amounted to –19.08%, with the time to recovery lasting nine months (see Fig. 2). The correlation to all major indices, including hedge fund indices, moves around the zero line.

Due to the extremely short trading approach of the fund, we are able to take advantage of very short-term trends. One of the essential requirements for the Pharos strategy is an average to high daily volatility. This generates considerable positive results in volatile years such as 2003 and 2008. In 2003 the strategy delivered an return of 46.26%, in 2008 24.70%. In times of lower volatility the Pharos strategy performs less well. For example, 2004 closed down 3.30%. Let’s take a brief look at the latest times of falling volatility: from mid-2006 until the beginning of 2007, shortly before the current crisis, the daily volatility of the financial markets decreased to – at time – historically low levels, as already seen in 2004 and 2005. Volatility is one of the traditional measures of risk control in the financial markets. A case of falling volatility normally sparks the assumption among market participants that the economy is in a phase of low fluctuation and sensitivity. However, as we know today, this was a completely false conclusion, at least in the years 2006 and 2007.

Volatility is part of any globally used value-at-risk-model. Decreasing volatility causes a widening of the risk budget. Investors were ready to accept higher risks (leverage) and increasing investment budgets encountered investment forms with low interest rates. The willingness to purchase different asset forms such as collateralised debt and mortgage-backed securities increased. Consequently the correlation between various financial investments and the tendency of decreasing volatility and falling interest rates continued. In addition, willingness to conduct carry trades increased.

Low market volatility is not a favourable environment for the Pharos Strategy. If the volatility is too low, the profitability of a short-term trading model is reduced. There are fewer significant intraday trends. In these moments an increased correlation of underlyings is disruptive. The emergence of the financial crisis (first imbalances can be dated back to March 2007) saw volatility on the equity markets skyrocket, opening the rally for the fund.

In conclusion, we can say that given newly mounting global imbalances, we do not know how the individual markets will develop. We have learnt from the latest crisis that low volatility can also give the wrong signals to market participants, which can lead to an erratic increase in volatility. Our short-term trend following approach benefits from this. Phases of low volatility represent good entrance points into short-term trend followers for long-term oriented investors and those who want to partially hedge their equity exposure. The only predictable fact is the realisation that we cannot credibly predict the development of the markets. Asset management of the future needs to take this into account, otherwise for many participants, the next crisis will be their last.

NOTES
1. Lintner, John: The Potential Role of Managed Commodity Financial Futures Accounts (and/or Funds) in Portfolios of Stocks and Bonds, Annual Conference of Financial Analysts Federation, May 1983.
2. Kat, Harry M.: Managed Futures and Hedge Funds: A Match Made in Heaven, Alternative Investment Research Centre Working Paper Series, Cass Business School, London.

Dr Dieter Rentsch is a managing partner of Aquila Capital and in charge of its investment strategy. As Chief Investment Officer he specializes in identifying global trends and turning these into intelligent investment solutions. He is the former head of Macroeconomic Research at MEAG with more than 20 years of experience in the industry.