March 30, 2015 01:00 AM

Optimistic outlook for managed futures

Lawrence Kissko

After a challenging few years for managed futures, 2014 was a welcome change with a positive year for the investment style; the Barclays BTOP50 index returned 12.3%. Many investors question whether this will continue. We believe there are several reasons to be optimistic. Our outlook considers two factors that historically have played a significant role in managed futures' performance: correlation and trends.

A key feature of managed futures strategies is the ability to invest across a wide range of global markets, thereby seeking a diverse set of alphas.

We believe that to fully realize the diversification benefit of investing in a wide array of markets, correlations across these markets need to be low. When markets behave more idiosyncratically, managed futures programs have the ability to maximize the number of independent trades they put on at any one time, which should allow for increased return potential.

Conversely, when correlations either spike or persist at elevated levels, as they generally did for the period since the financial crisis through early 2014, we believe the number of truly differentiated trades a managed futures strategy can put on greatly decreases.

As a result, instead of having a collection of independent trades, a managed futures manager might, only in essence, have a single trade because all markets are behaving in much the same way.

This does not necessarily make for a bad result, if the reduced set of independent markets exhibits strong trends. For example, the initial correlation spike in 2008 was very beneficial for commodity trading advisers. Despite the dilution in portfolio diversification, the heavy sell-off in risk assets and the associated flight to quality after the collapse of Lehman Brothers Holdings Inc. presented a clear trend from which CTAs could potentially profit. However, correlations remained high between 2009 and 2013, which we believe was much more troublesome for CTAs as markets experienced the “risk-on, risk-off” environment and associated market reversals that became all too familiar during this period.

Without the driver of diversification, we think there might be a greater chance of seeing losses occurring across multiple markets at the same time.

Chart 2 tracks pairwise correlation among certain markets. The analysis breaks the time period from January 1989 through December 2013 into two distinct periods: January 1989 through August 2008 (pre-financial crisis) and September 2008 through December 2013 (financial crisis and aftermath).

The trend

In the pre-crisis period (blue bars), 95% of months saw average pairwise correlations of less than 0.15 with a monthly average of 0.11. For comparison purposes, the Barclays BTOP50 index generated an annualized return of 7.98% between January 1989 and August 2008. Conversely, during/following the financial crisis (gray bars), all months showed average pairwise correlations of greater than 0.20 (not a single pre-crisis month had pairwise correlation above this level). The monthly average in this time period was 0.24 — a more than doubling of pairwise correlation from the pre-crisis period. Again, by means of comparison, the BTOP50 annualized return from September 2008 to December 2013 was only 0.86%.

Chart 1 highlights why we believe the current market environment is looking more positive for managed futures performance. In this chart, we see a different depiction of pairwise correlation —rolling pairwise correlations. Note the huge spike in correlations corresponding with the financial crisis of 2008 and the sustained elevated levels in 2009 to 2013. As the chart shows, correlations have dipped back to the pre-crisis levels, creating what we believe is the potential for more productive market conditions for managed futures.

In the post-financial crisis period of 2009-2013, global central bankers broadly coordinated intervention efforts to calm markets, keep funding rates low and to provide the market with liquidity. While this has been important for the global recovery, it has created a challenging environment for managed futures funds. In our view, much of the government rhetoric and many of the policy initiatives over this period were last-ditch efforts to reassure nervous investors and thereby reverse trends that were undesirable.

In Chart 3, we see the cumulative performance of the BTOP50 since 1999. We have overlaid periods of significant intervention, quantitative easing or rhetoric. While difficult to prove precise causality, we observe that these instances of intervention seemingly coincide with difficult performance environments for managed futures funds.

As the financial crisis of 2008 fades into the past, economies are displaying varying degrees of health and marked divergences. For example, the U.S. and U.K. are growing at 3%-plus GDP rates, while Japan and parts of Europe are in recession. Global economies and central banks are no longer working in concert. While the U.S. Federal Reserve halted its bond-buying program (quantitative easing) at the end of October, Europe and Japan recently announced new rounds of stimulus and China cut interest rates in November.

With global economies now moving in different directions and speeds, we believe there is a potential for diverse trends to develop more naturally than they did following the credit crisis. We believe that trend-following programs are well positioned to take advantage of this changing environment.

To consider whether markets have indeed begun to exhibit more trends, below we examine 2014 market activity for three major markets: WTI Crude Oil, German bund, and Japanese yen.

Beginning in mid-2014, one of the strongest trending markets was WTI Crude Oil, which likely comes as no surprise. From its 2014 high of $104 per barrel, crude was trading at $54 by year-end, a decrease of more than 48%. Much of the decline occurred in November and December, largely on the back of OPEC's decision not to cut production.

Fixed-income markets strengthened in 2014, particularly in Europe given growth and deflation concerns in the eurozone. At left is a chart of the German bund. Following a choppy 2013, the bund saw significant increases in 2014.

Lastly, within currencies we highlight the recent trends in the Japanese yen. The relative economic strength in the U.S. compared to the technical recession in Japan has contributed to the recent highs of the dollar vs. the yen.

With the environment becoming less correlated and government intervention subsiding, we believe prospects for sustainable and distinct market trends have improved. If the environment continues to display these attributes, which it has in early 2015, we believe managed futures are well positioned to benefit.

Lawrence Kissko is client portfolio manager, Man AHL, New York.