Since its inception, the managed futures industry has offered investors liquidity, non-correlation to standard asset classes, and absolute returns based on the ability to go long or short. The benefits of adding managed futures to a portfolio of stocks and bonds are generally well known and have been detailed by Newedge in an article for Futures Industry magazine titled ‘Managed Futures and Pension Funds: A Post-Crisis Assessment’ and published in November 2011.
A look at the returns of the industry from 1990-2008 illustrates what the industry offers investors with exposure to traditional stock indices. The Concatenated Newedge CTA Index (The Barclay CTA Index 1990-1999, Newedge CTA Index 2000-2008) returned 7.54 percent annually during that period, compared to 6.6 percent for the S&P Total Return Index with a correlation of -0.03. The negative correlation increased during sustained down periods for the S&P index, further exhibiting the diversification that managed futures provide to a well-constructed portfolio.
It is clear that return on cash plays an important role in the overall returns of the managed futures industry
But since 2009, the managed futures industry’s performance has suffered. The Newedge CTA Index has returned -0.64 percent annually from 2009-2012 despite market swings – sparked by the European debt crisis and quantitative easing – upon which managed futures have historically capitalised. During this period, the S&P gained over 70 percent and continues to rise. Gold gained over 80 percent, although it has fallen from those highs in 2013. The US 10-Year Bond has seen its yields go from around two percent at the end of 2008 to four percent in early 2010 and back to 1.4 percent by the middle of 2012. Since then the yield has more than doubled to 2.85 percent in August of 2013.
Managed futures returns remain uncorrelated to the returns of these individual asset classes post-2008, but the returns are no longer positive. This has prompted investors and managers to ask why the industry is facing its current difficulties.
Bigger and better?
Many explanations have been offered for the current struggles of the industry, perhaps the most prominent of which is its larger size. The managed futures industry now manages over $300bn. With asset levels this high, some question the industry’s ability to produce the same returns as it did pre-2008. In July, Newedge performed an extensive investigation into capacity and the ability of managed futures to continue their delivery of uncorrelated returns with a reasonably high Sharpe ratio. In this study, Capacity of the Managed Futures Industry, Newedge found no evidence that the industry is suffering from constraints related to its current capacity and that the futures markets have grown in both size and liquidity since 2008. Furthermore, they found no reason why this growth would not continue in the future, thus increasing capacity. Although the increased size of the managed futures industry is correlated with its diminished returns as of late, current evidence suggests that the correlation is not causal.
High volatility in the post-2008 markets has also been blamed for the inability of commodity trading advisors (CTAs) to sustain strong performance since the crisis. The US’ 10-year treasury rate has yo-yoed back and forth since 2009 due to QE1, QE2, and most recently, the Fed’s indications that it may begin to taper its unprecedented stimulus policies. Similarly, the European debt crisis has roiled government bond markets throughout Europe. Traditional thought suggests, however, that an industry dominated by trend-followers would flourish during times of volatility. In fact, volatility was quite high in 2001 and 2008 – years in which CTAs earned average or above-average returns.
Certainly the current period of below-average returns for the industry cannot be attributed to volatility.
Others have argued, and the Newedge CTA Trend Index performance since 2008 may support this, that there are simply no trends to capture in the post-2008 environment. Although the performance of the Newedge CTA Trend Index remains below its long-term average, a cursory examination of the major markets seems to negate this idea: as mentioned above, there have been large gains in the S&P and in gold, while US treasury bonds, the Japanese yen, and grains have all experienced significant and sustained price variations. One might expect that trend-following strategies should have been able to capture performance during these moves.
So if the size of the industry, high volatility, and lack of trends are not to blame, what could be the cause of the current underperformance of the managed futures industry? One possibility is that the change in risk controls enacted by managers in the face of institutional pressure after the crisis have stifled the efficacy of certain strategies. Since most firms in the industry are secretive about their methodology and the risk controls built into their models, it is difficult to examine the validity of this theory in great detail.
One area more easily examined is the interest CTAs earn on excess cash. Since CTAs typically control their overall risk using margin-to-equity constraints, they end up with a large amount of their assets (sometimes upwards of 90 percent) in cash. Historically, the excess cash not being held at the FCMs for margin has been invested in safe, liquid bonds that return close to the risk-free rate. From 1990-2008, that model worked well for managed futures and bolstered the industry’s yearly returns. But in our current zero rate environment, the excess cash held by CTAs has not been able to produce supplemental returns.
Newedge published an interesting review of the role that return on excess cash plays in the managed futures industry in January of 2013 titled Well, it’s much better than it looks! In it, they argued that when one removed the interest earned on cash, the current downturn is not the worst the industry has seen in its history and actually fits well within the statistical confines of historical performance. For our purposes, we would like to examine how the differing returns on cash in the pre- and post-2008 world should affect the way managers use excess cash in the best interest of their investors.
The role of cash returns
From 1990-2008, although the Concatenated Newedge CTA index returned 7.5 percent annually, when interest earned on excess cash is disaggregated, the actual return on futures trading is 3.9 percent annually. From 2009-2012, although the Newedge CTA Index returned -0.6 percent annually, when the interest earned from cash was removed it returned -0.7 percent. Although it is evident the managed futures industry is going through a period of poor performance relative to its historical average, it is important to note the role of the return on cash. With the relatively high risk-free rate pre-2008, the industry generated around 3.5 percent annually outside of its futures trading strategies. Since 2008 this return has disappeared. If the industry still had the average return on cash seen in the 1990-2008 period, it would not outpace the annual returns of the S&P post-2008, but CTA returns would be positive rather than negative.
It is clear that return on cash plays an important role in the overall returns of the managed futures industry. Even though the zero rate environment will not persist forever, it is increasingly important for CTA managers to augment their returns on futures trading strategies by using their excess cash in more clever ways. Managers who find a way to do this going forward will have a leg up on those that continue to wait for the excess cash returns to revert back to their historical averages. They must be certain, however, not to degrade the noted historical strengths of the industry by either reducing their liquidity or increasing their correlation to traditional equity and fixed income markets.
These requirements greatly restrict the options for investing excess cash. High-yield bonds or any type of credit investment are likely to suffer from constrained liquidity and/or liquidation at poor prices during a crisis. An investment in individual equities or in equity indices, while liquid, is likely to increase a manager’s correlation to traditional equity markets, which would devalue the industry as a diversification tool. If managers can implement individual equity strategies which complement their futures strategies while maintaining market neutrality via a hedge, they could further diversify their investment universe, gain more substantial returns on excess cash, maintain valued liquidity, and continue exhibiting a low correlation to traditional equity markets. This is the option we at FORT (Financial Opportunities in Research and Trading) have chosen.
In late 2008, FORT finished research and began testing an index-hedged, market-neutral, fundamental value equity strategy using proprietary capital with the goal of implementing this strategy using excess cash from our futures trading programmes. Not only is this a viable option in terms of the returns, providing more than traditional cash management, but it also achieves further diversity in our investment strategies by combining a fundamental, systematic equity strategy with our technical, systematic futures-based strategies. Importantly, it does not increase our correlation with the S&P, while still allowing us to provide daily liquidity to our clients.
Traditionally, CTAs have earned supplemental returns from their excess cash. Though this return has disappeared, the cash remains, and it should be put to work in a way that enriches the managed futures industry and its investors. Evolution in the face of change is paramount and at FORT this is our future.