Managed futures are performing well so far in 2019. But years of underperformance prior to this year’s gains have fueled a debate on whether the model for the complex strategy is broken.
PivotalPath, a research and hedge fund data firm, says managed futures funds — which are designed to provide returns in good markets and protect investors during downturns — found that for all the debate, interest rates can simply explain the strategy’s performance.
“Managed futures are presented to investors this way: we trade equities long and short, trade fixed income long and short, invest in currencies and commodities and follow trends to make money on both sides of the market,” said Jon Caplis, CEO of PivotalPath and former co-head of portfolio allocation and risk management at systematic firm Campbell & Co. “Regardless, the reality is that interest rates can predict performance more than anything else, and almost to a T.”
Caplis said managed futures don’t make money being short anything. In 2008, the strategies were short equities, but they did so well because of their fixed income holdings, which rose in price as interest rates fell lower and lower.
“There’s a misunderstanding of how managed futures work, but all the complexity can be boiled down to one thing: rates,” added Caplis. “When rates are high and falling that is a great environment for them. When rates are falling steeply, that’s even better. When rates are rising, that’s a bad environment for the strategy.”
[II Deep Dive: CTAs Are Losing Money and Investors Are Fleeing]
PivotalPath’s model shows that its managed futures index should be up about 8.5 percent year-to-date through July 2019, given the 50 basis point (0.5 percent) drop in the 3-month T-bill this year. The index represents 82 funds and $100 billion in assets. The actual average performance of the index was close to that number, coming in at 7.9 percent for the same period.
Pivotal Path looked at data between January 1, 1997 and December 31, 2018. When rates were between 0 and 1 percent, the managed futures index returned 4.1 percent. The Standard & Poor’s 500 stock index returned 15.7 percent, with alpha at 2.0 percent. (Most managed futures funds use the S&P 500 as their benchmark, even though Caplis believes it’s a flawed comparison). When rates were higher — between 1 and 3 percent — the index returned 13.5 percent, while the S&P 500 dropped 4.8 percent on average. Alpha in that case was 6.1 percent.
Looking at rate movements was more telling. When rates moved up more than one percentage point, the index returned 2.3 percent and alpha was negative, at -0.7 percent. If rates went up by 0 to 1 percentage point, the index returned 5.5 percent and alpha was -3.5 percent.
But if rates moved down by 0 to 1 percentage points, the index returned 17.1 percent and alpha was 16.1 percent. That was the ideal situation. When rates moved down by more than one percentage point, the index returned 18.1 percent, but alpha went down to 10 percent.
Managed futures performance is also heavily influenced by the volatility of the strategy. Between 1997 and 2008, the average volatility of the index was almost twice as much as between 2009 and 2019. In the earlier period, the index returned 14.5 percent and volatility was 12 percent. In the later period, the index returned 3.8 percent and the vol was 7.8 percent.
Caplis said during that time the investors in the strategy shifted from high net worth to institutions. Pensions and other big investors hate having to explain big drawdowns that result from the volatile strategies they’ve chosen for the portfolio. As a result, asset managers have significantly reduced the risk, size of bets they’re placing, and the volatility of the strategies.
Not everyone agrees with PivotalPath’s findings that rates are the best predictor of performance for managed futures funds.
“Given that managed futures funds can go both long and short, there is reason to believe that the funds will make money in a rising rate environment as well,” said Andrew Beer, managing member of Dynamic Beta Investments, a liquid alternatives manager that runs the first managed futures ETF. He said PivotalPath’s analysis is limited since it only looks at the last 20 years, a period when rates have steadily declined.
In any case, Caplis contends that the strategy didn't suddenly break down after several successful years. The problem is that it was misunderstood all along, he argues.
“People are questioning whether trends still work. They never stopped working. Investors just misunderstood how the strategies worked,” he said. “If your view is that rates can only rise, that’s a poor environment for managed futures.”