Last year’s choppy, sideways-moving markets were hard on returns for managed futures accounts. Yet their diversification benefits and good risk-return profile still spurs institutional – and soon, possibly retail – interest. To avoid a repeat of 2011’s underperformance, funds are devising strategies that do not depend on trends.
It is commonly assumed that market volatility is good for managers of derivatives portfolios. But for many Commodity Trading Advisors (CTAs), last year’s market swings were anything but a boon. The BarclayHedge CTA Index, representing 565 CTA programs, ended the year down three percent, its largest drop ever.
The Chicago Board Options Exchange’s CBOE Volatility Index (VIX) hit a record 191.59 in three-month realized volatility at the end of October 2011, as the Greek debt crisis came to a head. But the S&P 500 Index began and ended the year more or less at the same level, confounding many CTAs’ attempts to profit from directional views.
“The trends have disappeared,” says Monty Agarwal, founding partner and chief investment officer at Palm Beach Gardens, FL-based MA Capital Management. “Increased market efficiency, central bank interventions – the whole landscape of investing has changed. Trend following is the strategy of yesteryear,” he states.
Even with last year’s woes, the momentum firms that represent the main constituents of the CTA Index looked good last year when compared with other alternative asset classes. The BarclayHedge Hedge Fund Index ended 2011 down 5.46 percent. And, when highly leveraged hedge funds took a beating in 2008, and the Hedge Fund Index fell 21.63 percent, CTAs, which normally have no leverage other than what is embedded in futures contracts, saw a 14.09 percent gain.
“Despite the past year not being the best for managed futures, investors are still willing to invest, and our pipeline is still growing,” says Troy Buckner, managing partner at Parsippany, NJ-based NuWave Investment Management, a $1.04 billion CTA. BarclayHedge’s data bear him out. While still dwarfed by the $1.7 trillion-plus hedge fund industry, CTA assets under management grew 10 percent in the first three quarters of 2011, to $320.3 billion.
CTA Index Performance By Year
Source: BarclayHedge Ltd.
A New Investor Base
“Public and private pension funds and endowments are becoming more interested, and there’s the possibility that some mutual funds will begin investing in managed futures,” Buckner says. “That’s really exciting.”
A number of mutual fund companies are offering managed futures products for retail; others, such as MA Capital Management, are creating hedge funds with low minimums, so retail investors can access them.
The different approaches reflect the regulatory treatment of mutual funds and hedge funds. The Investment Company Act of 1940 bars mutual funds from investing more that 25 percent of their capital in managed futures, while hedge funds have no such limitation.
MA Capital’s Agarwal notes that even with a solid double-digit return on a managed futures portfolio, being limited to devoting only a quarter of your capital to that asset class cuts its return sharply, and fees can erode it further.
But Dave Kavanagh, president of Chicago-based Grant Park Fund, an $890 million managed futures investment firm, argues that the 25 percent cap is not really a problem. Grant Park runs a mutual fund and a commodity fund for retail. Kavanagh notes that since the margin on futures contracts is typically 20 percent, even with the ’40 Act’s 25 percent cap, fund managers can be fully invested.
Another innovation that may become more visible in 2012 is the advent of algorithmic trading technology in the managed futures space. Algorithmic, high frequency trading is now said to account for about three quarters of all U.S. equity trading. But this technology is relatively new to managed futures.
The driver for its growth is the current lack of a consistent market direction, which CTAs can exploit profitably. The algorithmic managed futures approach does not rely on long-term directionality.
MA Capital’s new retail hedge fund is one example. It will use artificial intelligence to anticipate trends and recognize. The computer will pick the best variables to capture the salient aspects of a market phenomenon, and will dynamically adjust them as well as setting the appropriate tolerance levels – that is, the thresholds at which each variable will trigger some sort of action, such as a trade.
Although the approach is new, Agarwal expects it to catch on, which over time could affect volumes in the futures markets in a similar way to algorithmic trading’s effect on the equity markets. In fact, the greater transparency and efficiency of the futures market, compared with equities, could make the strategy more effective when applied to managed futures.
Aggregate CTA Index Performance Since January 1980
|Compound Annual Return||11.13%|
|Correlation vs S&P 500||0.01|
|Correlation vs US Bonds||0.12|
|Correlation vs World Bonds||0.00|
Source: BarclayHedge, Ltd.
The big drivers of CTA returns this year are, unfortunately, anyone’s guess. The Eurozone debt crisis, which has been anticipated for years, was not the proximate cause of the spikes in volatility in the spring and summer. These were set off by the Japanese nuclear crisis and the U.S. government’s downgrade and near-default – both of which were not anticipated. While the Euro crisis was certainly the fundamental cause of the volatility, those two shocks started the market roiling.
Some CTA managers think the drama over the Greek bailout has been priced into the markets already, so it would take a further unexpected deterioration in the Euro situation – say, Germany pulling in its horns – to create an unexpected, directional market environment that could be gainfully exploited.
Of course, that wouldn’t be good for everyone. “If a Greek default happened, we would profit, since we’re currently running a neutral book,” says NuWave’s Buckner. “But many CTAs have been putting more risk on,” he says. “They would have to reverse quickly.”
The fact that the managed futures index suffered only a modest loss in 2011, combined with its 11 percent-plus compounded returns over the past 30 years, and its near-zero correlations with equities and bonds (see CTA Index Performance table), continues to draw investors, despite the uncertainty.
With the potential for a significant new base among retail investors, strategic innovations like algorithmic trading, and growing interest among institutions like pensions and endowments that are looking for an effective source of diversification and a low risk-return profile, the managed futures space will be one to watch the rest of the year. And, if the market develops a reasonably persistent theme, last year’s lagging returns could end up viewed as little more than an unfortunate bump in the road.