The Raisons d'être of Managed Futures

The Federal Reserve has an explicit dual mandate. Managed Futures strategies have an implicit one—specifically, 1) deliver positive returns on average and 2) generate especially attractive returns during large equity market drawdowns. 1 1 Close Managed futures is pretty unique among strategies that seek to perform well during equity drawdowns. For instance, Put-buying strategies also have the second mandate, but not the first (i.e., positive returns on average). The main reason puts have trouble with the first mandate is that option premiums can cost a lot over the long term, which makes a lot of sense if you think about how insurance works. This also helps explain why puts tend to do best during short, sudden market crashes. Granted, managed futures aren’t a perfect hedge, particularly when a crash comes out of the blue (i.e., without some early warning in terms of market trends), but it tends to work pretty darn well in longer-term bear markets and protracted drawdowns (e.g., the first half of this year) which, by definition of being protracted, are the kind investors should be more worried about anyway.    This dual mandate is one of the big reasons managed futures strategies can be valuable in a portfolio. Unfortunately, by and large, the industry—intentionally or not—has been optimizing for one at the expense of the other. Admittedly I have a self-serving axe to grind here as we believe we stuck to the dual mandate and suffered for it for quite a while (but not lately!).

Exhibit 1 shows what I’m talking about, using the SG Trend Index as a proxy for the industry (“Industry Trend”), and the AQR Managed Futures Composite as a proxy of “Pure” trend-following (more on what I mean by that later). Both pass Mandate #1 (positive average returns), but not Mandate #2 (especially attractive returns when most needed). How can this be? The rightmost set of bars—performance when equities did especially well—is the smoking gun (I know it may seem odd for me to crow over the periods when we underperformed, but I think it will make sense soon).

An Industry That Got Carried Away
Let’s go back a decade or so. Managed futures were a rare bright spot among alternatives in the Global Financial Crisis (GFC). However, since then—and until fairly recently—strategies built to profit from price trends have had a hard road to hoe. Since the GFC, markets have trended less than their historical norm. Also until fairly recently, while there have been some scary times, markets have generally been quite strong. Markets trending less than normal (i.e., a challenge for Mandate #1) and few tails to hedge (i.e., little need for Mandate #2) 2 2 Close The big tail event that did occur, March 2020, indeed did come out of the blue and reversed practically instantly—a pretty lousy roundtrip for managed futures, but also a time that most portfolios ended up not needing much help at all.   has been a desultory combination for the managed futures industry. 3 3 Close It’ll shock none of my regular readers that a desultory decade doesn’t change our opinion by much. Though it clearly moves so many others’ opinions. Great minds in investing are always devoted to coming up with ex post reasons for anything disappointing (or anything amazing for that matter). These reasons are grist for the mill of those who always want to sell what’s not working and buy what’s working. And a decade seems like an eternity (including to me!) when statistically, it’s not that long a time. The result for managed futures: a strategy beloved after the GFC when it was needed is then slowly sold out of portfolios over the next decade, and when a rainy day (OK, a rainy six months) hits, it’s not there for many. It’s a bit ironic that I’m complaining about people essentially using trend-following to enter or leave a trend-following strategy. I think I can square this circle by considering the time horizon used. Trends on average have been effective from the short term out to about a year. But longer-term trends, particularly once you get out to the three- to five-year horizon, have tended to be a contrarian signal. People chasing returns are what I’ve often called “momentum investors at a value time horizon.” I elaborate on this here.   

But bad times happen to good strategies. Everybody knows that. So, what’s the right thing to do when a good strategy with over 100 years of evidence across a very wide range of markets and with solid economic intuition has a decade of tepid performance for reasons that are quite easy to explain? Naturally, you change it, right? This (in an admittedly snarky nutshell) is what seems to have happened to much of the managed futures industry.

Let’s look at the facts. The first thing we’ll want to analyze is exposure to equities, 4 4 Close This has been my “first thing to look at” for over 20 years now—because equity market risk is the most important risk for most portfolios. That said, if we turn to the other common concern du jour, inflation risk, it would be easy to show that trend-following has done well during large inflation moves. This is not surprising because trend-following likes large moves, especially when they are protracted, and major inflation news tend to be gradual rather than sudden. A topic for another day.   as during a bull market, exposure to markets should be a boon to average returns and a detractor in bad times. I use two versions of managed futures: the first is AQR’s version of trend-following (“Pure Trend”), and the second is the industry in general, proxied by the SG Trend Index (“Industry Trend”) and regress each on the global stock market.

Over the whole period it looks like a behind-the-scenes victory for Pure Trend (i.e., AQR). If anything, we have been a slight hedge against market moves (though not statistically significantly), 5 5 Close Above we showed that we have done very well in extreme (worst decile) equity drops. That is not inconsistent with having a small negative beta. Linear beta is not the same thing as how you do in extremes. Managed futures strategies are designed to be somewhat “convex” in this way.    and the SG Index the opposite. Thus, the “problem” for Pure Trend isn’t its alpha—it’s that markets have gone up spectacularly. But we think it means we’ve stuck more to what managed futures is supposed to do.

Let’s add one more thing to the regression. Anecdotally (from lots of sources) many managed futures managers try to improve their Sharpe ratios and realized total returns by adding carry strategies. That’s fine if you’re trying to improve Mandate #1, but carry is often a “risk on” strategy. Thus, it can become a real problem when it comes to Mandate #2. So now we’ll add a simple carry strategy 6 6 Close This is a hypothetical carry strategy applied across multiple asset classes, net of estimated transactions costs.    to our regression.

The alpha gap has widened once more, with AQR now adding near double the alpha net of these exposures (exposures you don’t want in managed futures if its job is to save you in a downturn). Which brings us to the betas—what about the exposure to stuff that compromises Mandate #2? The above table shows a 1.53 t-statistic on carry for the industry, and that doesn’t pass traditional hurdles of statistical significance. So maybe there’s really nothing there?

Actually, there is something but you can’t see it in the above regressions. Below is an easier way to see it. It’s the same table we just saw, but in the last column I take Industry Trend minus Pure Trend to show how far managed futures as an industry have strayed from what they purport to do. 7 7 Close Specifically, I’ve volatility-scaled Pure Trend to match Industry Trend, then taken the difference to make things more apples-to-apples comparable.

This last table is why we feel pretty good about the choices we’ve made compared to the industry. The differences hurt us when things were mostly very good for the world—i.e., when market beta and carry strategies were doing well. But we didn’t stray from our purpose. Our version of managed futures has been competitive, though slightly behind the SG Trend Index over the past five or so years of a raging bull market. And unfortunately, that’s a horizon over which much of the world compares managers. However, adjusted for the industry’s general bullish equity and carry exposures, we’ve actually won (albeit by a statistically weak amount) over our full history (and we argue that adjusting for these exposures fits the point of managed futures). 

Tattle-Tail Hedgers
We’ve now seen how “Pure Trend” and “Industry Trend” have differed on average. Industry Trend, in seeking to look better on Mandate #1 (positive returns on average), picked up exposure to things we’d expect to weaken its ability to deliver on Mandate #2 (especially attractive returns when most needed). We can see this more directly, and perhaps more relevantly—regression averages are nice, but huge drawdowns for traditional assets are more to the point—by comparing their performance during the three worst drawdowns for traditional portfolios since the GFC. 8 8 Close We do this starting “intra-GFC” as that’s the period of live returns. If we looked over the full GFC I promise the victory of pure trend vs. “trend plus beta plus carry” would be better (though it’s possible that back then the industry hadn’t added as much beta and carry as they have over the full period).

These are not inconsequential numbers. The average drawdown of 60/40 across the three above is -22%. The average return of Pure Trend is 34%, meaning a 10% allocation to Pure Trend saved 5.6% on average in these drawdowns (and if it were a nice 20% allocation, you know you could double that, because math!). In contrast, Industry Trend saved you a bit more than half that.

I’ve got nothing against exposure to equities and carry strategies— but when wrapped into managed futures it can be a problem, as it is contrary to part #2 of their reason for living. In good times (e.g., most of the post-GFC period), the kinds of managed futures everybody likes best are the ones with the highest average return (as opposed to ones having the best defensive characteristics). However, what that can mean is the investors themselves 10 10 Close Whether they know it and like it, or their managers have made this trade-off and they don’t know it.   have traded off one mandate for the other. Whether they’ve done that intentionally or by chasing returns too much is another question unanswerable with the data.

A weakened ability to deliver on Mandate #2 may be especially problematic today. One of the biggest areas of growth in the “alternatives” industry is in illiquids, such as private equity. I’ve cathartically written about how “great” smoothed returns can be for the investment manager—but for the investor, what you often get is a mirage of lower volatility 11 11 Close My phrase for this is “volatility laundering.”    and lower market risk, even though the underlying economic exposures are pretty much the same. 12 12 Close Or even more in private equity, as they are in general non-trivially levered.   Smoothing returns helps conceal market drops that quickly recover, like the COVID shock. However, it can’t help against a very protracted bear market where eventually you need to mark your positions. The bright side for managed futures strategies, though, is that they are designed to do well in exactly these types of slow-moving train wrecks. In other words, tough times for private equity tend to be great for trend-following. Thus, Mandate #2 is likely especially important for investors who’ve increased their allocations to privates and illiquids since the GFC.

Stand By Your Mandates
Like others, we always want to improve our process. But improving something that you already believe is a long-term good strategy is fraught, especially when in reaction to a period of weak returns. Biases can come in. Grizzled veterans like tried-and-true strategies; newer market participants are biased toward the cool and new— and these are often at odds with each other (guess which one I am 😀). 13 13 Close And even if the right investment answer for the client is “we’re not changing a damn thing!”, it’s often not the right business answer if that same client wants to hear something else!   And regardless of when you decide to add something new to the process, something to always worry about is data mining. 14 14 Close And the “right” amount of worry to have for it.    

But too often “innovation” is taken to mean “something totally new”. It doesn’t have to be; for strategies like managed futures, we think innovations can be—and ideally should be—firmly tied to the core thesis of the strategy itself (i.e., investors systematically under-react to information). This can help ensure changes don’t come at the expense of Mandate #1 or Mandate #2. 

At a very high level, here are two innovations that we think of as the “right” kind of improvements for managed futures. Both strategies have return characteristics that achieve the dual mandate on their own. 15 15 Close Compared to conventional forms (i.e., price trend) of managed futures, these aren’t as easy to implement efficiently, which is why I feel OK describing them here! Also, to nobody’s shock I am touting innovations we have already implemented and are paying dividends.  

• “Alternative” Trends: Admittedly, this one is pretty obvious. If you find trend-following to be a pretty persistent and pervasive strategy, then you would expect to find evidence for it even in places you didn’t originally check. And not just in different asset classes, but even in factors themselves. Trend-following in these harder-to-access or harder-to-implement contexts is a natural extension of the core thesis of managed futures strategies, and as such not surprisingly has also shown the ability to meet the dual mandate.

• Economic Trends: This one is less obvious but I think is pretty cool. Managed futures is all about capturing the tendency of markets to gradually incorporate new information. This creates persistent price trends— but it also implies that positioning on the basis of recent news should also be profitable, which means trend-following based on economic fundamentals is worth taking a look at, too. The gist of this strategy is to go long assets for which fundamental macroeconomic trends are improving, and short assets for which fundamental macroeconomic trends are deteriorating. 

You might expect “price trend”—and “economic trend”-based strategies to be correlated but still complementary: sometimes markets can seem disconnected from fundamentals 16 16 Close The value premium today is probably the most glaring example of how markets can become disconnected from fundamentals for an extended period.   and sometimes they seem more driven by fundamentals 17 17 Close Take this year as an example: There are times when the economy zigs and markets zag; the two seem disconnected. 2022 has decidedly not been one of those periods. If you stopped paying attention to markets at the end of last year, but I told you today the macro developments we’re seen so far in 2022, you’d probably be able to correctly guess the direction of all major markets.  —so having both in a process makes intuitive sense. You’d be right.

Can these more novel approaches actually improve “tried-and-true” managed futures? Below I compare the two versions, with “Price Trends” being traditional managed futures and “Combined Trends” being one that—you guessed it—combines Price Trends with the two innovations described above (one essentially being more, and more esoteric, price trends, the other being economic trends). Since these are somewhat recent improvements, we’ve left the world of live returns and are looking at backtests below.

What the Managed Futures Industry Can Teach All Investors
The managed futures story is a microcosm of the alternatives industry in the post-GFC era—a decade-or-so stretch in which traditional assets were enough to reach many investors’ return objectives. Arguably, with these same traditional assets now even richer than they were a decade ago, investors need to be careful to take away the right lessons. 18 18 Close Kudos to Antti for a near-perfect timing on that second book. Though even the Oracle of Helsinki would admit he’s been sounding the low-expected-return alarm for a while now :)  

The first is that when it comes to alternatives, “above-average returns” doesn’t always mean “better for your portfolio.” Going back to the regression tables earlier, investors need to look beyond raw average returns to evaluate how much value a strategy is actually adding. This is especially true amid a bull market, where “beta” can easily be sold as “alpha,” leading investors to add to risks they already have. 19 19 Close Don’t get me wrong, beta isn’t a bad thing—you just need to know how much you’re getting (and at what fee!).  

Similarly, even an investor who wants to stick with the strategy, whose heart and brain are in the right place, often implicitly ends up sorting on and choosing the versions of the strategies that aren’t really doing what they’re supposed to. To be even more explicit, say you are disappointed with your existing managed futures manager because he or she has underperformed the peer group, but you’re worried about the market environment going forward, so you want to stick with the strategy. If you search among all managed futures managers and switch to the one that has performed the best over the last five or ten years, you will very likely choose one that has traded off mandate #2 for mandate #1. 20 20 Close This is ubiquitous, and we’ve seen it in value investing, too. Picking a value strategy that didn’t lose in 2018-2020 (or just lost less) may be choosing skill, but it’s often far more likely choosing the version that doesn’t actually really do the strategy you want to stick with!   This is like the alternatives equivalent of selling at the bottom. 

The second, and more general takeaway, is that good strategies have bad times. Maybe paradoxically, if they didn’t have bad times, they probably shouldn’t be expected to work going forward. Prolonged good times attract large flows and eventually strategies become over-capitalized, and whatever expected return advantage they had is driven down. 21 21 Close You could argue that’s what we’ve seen in bullish strategies and markets themselves. Also, this might be too defensive of me, but we do not believe this is what happened to managed futures (as some assert). While they grew a lot after the GFC they always traded very liquid, deep markets and they never got to a size where they could plausibly arbitrage themselves away.   In contrast, bad times drive flows away from strategies and leave them less capitalized but with better expected returns going forward. 22 22 Close Sometimes a weak period can be hard to explain. That can happen with truly alternative strategies (paradoxically the most truly uncorrelated strategies are often the hardest to explain, precisely because they’re doing something so different—which is what you often want!). On the other hand, sometimes—as with managed futures until recently—a weak period can be very easy to explain (less trending, no need for investors to be saved from a long bear market). It’s hard to see how it’s a good idea to abandon a strategy in this latter case.   This cycle of good times and bad times is precisely what allows positively-rewarded strategies to persist over very long periods of time.

It’s always a noble (if fraught) effort to improve a good strategy. Doing so without harming the strategy’s reason for living is even harder. We believe adding market beta and carry is the wrong way to do it for managed futures. Instead, we think adding strategies like Alternative Trends and Economic Trends that preserve (and improve upon) the dual mandate is the better way to innovate. 

The bottom line is we think the long-term evidence is that trend-following delivers on the “dual mandate.” It can have tough times, sometimes for years, if markets don’t need their diversification and if trends reverse more often than normal. But these few years are a drop in the bucket versus the longer-term evidence and logic. Even over one of the tougher decades you’ll see for managed futures, it did what it’s supposed to do. It delivered non-trivial positive returns and excelled when it was supposed to and was most needed.