The Case for Managed Futures

This asset class has earned its stripes

JOHN WAREHAM, ASPECT CAPITAL

For everybody involved in the financial services industry, 2008 was truly memorable. The number of events that unfolded last year that had hitherto been viewed as of very low or perhaps even zero probability was unprecedented.As a consequence, during 2009 almost everything has appeared to be up for review – the efficacy of mean variance based risk models, the aptness of the light touch approach to financial market regulation and even the entire globalisation model of world economics. Unsurprisingly, many of the fundamental assumptions that have guided investment decision-making are also being reconsidered. It would seem that the majority of institutional investors have spent much of this year locked in a strategic review of these and other portfolio construction issues in this new investment world.

For many observers, the review of 2008 will inevitably focus on what went wrong. Many investment strategies saw unexpectedly large negative returns. However, that is not to say that every investment strategy performed poorly last year. Managed futures, a strategy built around the quantitative identification and systematic capture of price momentum in a wide range of highly liquid, listed futures and currency markets, performed very strongly.

This article intends not to simply highlight the strong absolute and relative performance by managed futures in 2008 per se, but more significantly, to explain this level of performance in terms of the persistent return-generating features of the strategy and also to reflect upon the non-investment benefits of transparency, liquidity and operational resilience that are associated with managed futures. The approach is currently attracting a lot of attention; interest is being seen from a wide variety of investors including many who have previously not allocated to the strategy – in other words, the case for managed futures is also being re-examined.

aspect1a

Managed futures is one of the oldest alternative investment classes and at $200 billion-plus of assets under management, it represents approximately 10% of the overall hedge fund universe. The strong positive returns seen in 2008 were, in part, driven by the strong negative trends in equity markets. This represents the second such occurrence in less than a decade that managed futures have provided strong positive returns at a time of sharp falls in equity markets – in 2001 and 2002 the S&P500 fell 33% whilst managed futures, on average, were up 18% (see Fig.1). Since then, while global stock markets produced returns of 11% per annum between 2002 and 2007, managed futures managers produced strong returns as well. Therefore, while the strategy has often been sold as being either one or the other; the truth is managed futures has demonstrated an ability to deliver both:

• absolute returns through many different macro and market environments; and
• a return stream that is uncorrelated to both the markets traded within the strategy – and also the returns seen from many other investment strategies (see Fig.2).

aspect2a

Persistence and non-correlation of returns – these are the two reasons to have a long-term allocation to managed futures.

Because the strategy is agnostic both to the direction and the location of trends, the systematic identification and capture of momentum in more than 100 highly liquid markets produces returns that are not biased by sector, by trend direction, or even economic cycle; the overall effect is a return stream that is both diversified in its drivers but also diversifying in relation to many other investments. So a valid question at this point could be: if it is so good, then why doesn’t everybody invest in quantitative momentum strategies? The answer is that many large and highly sophisticated institutions have been investors in managed futures for many years. Equally, however, many remain to be convinced. It is therefore interesting to observe that many long-term sceptics are currently revisiting the strategy. It appears to be that the current reappraisal of the managed futures strategy has been triggered by the events of the last year and by a consequent interest in the persistent nature of returns that can be systematically generated from deeply liquid and transparent financial markets.

The persistence of returns from any strategy is a function of the assumptions that must remain true for the strategy to remain valid. Given the apparent failure of some investment strategies last year, investors are increasingly, and unsurprisingly, keen to further investigate the validity of the assumptions of market behaviour inherent in all investment strategies. In order to develop and maintain a long-term absolute return stream, the assumptions behind an investment strategy need to be both clear and not easily falsifiable. They must be robust to changing market conditions and, to that end, a simple strong philosophy without unnecessary complexity may provide a source of greater longevity.

While the implementations themselves are complex and evolving, the two critical assumptions underlying the managed futures strategy are, by contrast to many alternative strategies, relatively simple. First, the managed futures strategy assumes that trends (directional volatility) are a persistent feature of markets: these trends need to be evident for the strategy to generate returns. The ability to predict trends does not form part of the strategy and therefore does not form part of the underlying assumptions.

Trading in the direction of the recent momentum in markets provides a small edge that, if traded across only a small number of markets, would be overcome by the vagaries of those markets. Therefore the second key assumption made by the strategy is that by simultaneously trading a large number of independent sectors and markets, the small edge that can be generated by a momentum-based strategy in a single market is both magnified and made more robust by repetition of process across many markets. The nature of the return stream is therefore clear from the outset – the quantitative approach allows for a targeted level of volatility to be achieved and the returns generated in any short time period are, in large part, governed by the market environment at that specific time. When existing trends accelerate, as in 2008, so do the returns from the strategy. When many markets trends reverse, as we have seen in 2009 so far, there is a period of profit give back – this is, and has always been the nature of the return stream from the strategy.

Although the short-term returns of managed futures are driven by the market environment, the returns generated by an individual manager are also a function of the degree of continuous development seen in the models used. The strong relative performance of managed futures last year is clearly explained by the higher opportunity set seen through the increased level of trending activity in a broad range of markets. However, the differentiation between manager returns is a reflection of the differences in the methods of trend capture.

It is a matter of central conviction for us that managers must commit to the continuing evolution of their quantitative investment processes in order to continue generating competitive returns.

Over the past 10 years rapidly changing market structures have provided tremendous challenges for all managed futures managers. By way of examples, the rapid evolution of direct market access technology has changed the way managers are able to access the markets and the increasing frequency of sharp and correlated market reversals has demanded a review of the way managers control the risks of holding directional positions in markets whose correlations are inherently unstable.

Leading managers invest very heavily in the research-driven evolution of their programmes in order to remain competitive and to stay ahead of changing market structures. Developments in computer technology and in particular processing power in the 1980s and early 1990s drove the first stage of explosive growth for managed futures. Since that time, the strongest managers have sought to retain a competitive edge by consistently improving the systems used to identify and exploit market trends in a risk-controlled manner.

The last few years, even the last few decades, have demonstrated the continuing ability of leading managed futures managers to deliver strong and diversifying absolute returns. These returns are, we believe, the result of the simplicity of the underlying investment assumptions and the growing sophistication of the leading trend-capture engines. Taken together, these realities provide strong and tangible reasons for a continued belief in the persistence of managed futures returns.

The investment case may continue to be powerful and may help to convince many previously sceptical investors; however, 2008 emphasised more than just the alpha case for the strategy. The failure of Lehman Brothers, the collapse of the Madoff scheme, the effective failure of many leverage-based hedge funds and the gating of redemptions by many others, also demonstrated that how a hedge fund organises its business and trading is at least as important as how well it performs.

The reason why interest in managed futures appears to have broadened is perhaps that it also speaks convincingly to the other key areas of concern in a manager due diligence process – the issues of transparency, liquidity and operational resilience.

With regards to the matter of transparency many high-profile institutional investors and their consultants have historically adopted clear positions on this issue – the opacity, real or presumed, of the process has been used as a catch-all reason to declare against quant as an investment approach. Quantitative managers should be able to offer a transparency premium. Our position has always been that with a systematic and quantitative approach come the overwhelming investor benefits of predictability and resilience of returns – but also an obligation for the manager to explain the drivers of both. Unlike many other quantitative managers, we have always taken a balanced approach to transparency – seeking to allow investors to understand our quantitative investment process while protecting the commercial interests of our investors and ourselves.

The liquidity of managed futures has become a source of critical strategic advantage. There are arguably three dimensions to liquidity: contracts traded in the programme are highly liquid, investors can access the strategy in a highly liquid manner, and finally the ability to offer a managed account structure may appeal to those investors who require complete oversight and financial control.

Finally, given the relative simplicity of the instruments being traded, managed futures managers should be relatively well-placed to speak to issues of operational control. A complete set of operational controls has now it seems become a non-negotiable prerequisite for an institutional investor seeking to award mandates (segregated account or otherwise). The average operational due diligence process has become substantially more robust and this reflects the reality that has been seen in many managed futures businesses for many years.

The events of the last year have clearly demonstrated the need for an amended approach to risk assessment in financial markets – an approach which seeks to step beyond a narrow understanding of investment related risks. We have observed that an increasing focus on a broader range of risk assessments is strongly aligned with the very nature of the managed futures strategy. This, and the strong returns generated in 2008, will help to attract new investors, who are drawn to long-term, diversifying returns and reassured by the transparency, liquidity and operational robustness of the process.

John Wareham leads Aspect’s company’s sales, marketing and client service teams. He has more than 20 years of senior-level experience in the financial markets at companies including AIG, Atriax Ltd, Merrill Lynch and Goldman Sachs.