Commentary: Managed futures and risk mitigation

Many traditional investment portfolios tend to have a significant allocation to equity markets and are therefore vulnerable to experiencing large losses during times of equity market crisis. Since the global financial crisis, the need to mitigate this risk and find diversifying investments has become increasingly apparent to investors. Investors' portfolios can benefit from the risk-mitigating characteristics of managed futures and in particular from systematic trend-following strategies, which offer the ability to capture trends, both upward and downward, in a wide range of the world's most liquid markets. The managed futures industry has a long history of providing risk-mitigating properties to investors' portfolios. There are several features that make managed futures a valuable risk-mitigating, and performance-enhancing, part of a portfolio. A key concept is crisis alpha: the ability to generate strong performance during traditional crisis periods.

Managed futures is a class of alternative investment strategy that trades primarily in the world's most liquid and diversifying markets. Typically managed futures follow a systematic, trend-following approach across a wide range of asset classes, including commodities, fixed income, currencies and stock indexes. It is important to understand how different strategies can perform during difficult periods for traditional portfolios. The concept of crisis alpha is commonly referred to in the managed futures industry, and refers to the ability of trend following strategies to generate strong performance by exploiting persistent trends, both upward and downward, that tend to occur across asset classes and markets during times of crisis.

It is important to differentiate between short-term crises, such as "flash-crash" events that can happen within the course of a day, and longer more persistent crises that can last for a month or more. Here we are concerned with the latter. As managed futures strategies typically seek to exploit effects over several weeks or months, they are less reactive to short-term, short-lived crashes. Indeed, managed futures strategies are not designed to be a panacea for one-day market shocks but they will adapt as evidence builds for a new medium-term market trend, which they are explicitly designed to identify and exploit. Crisis alpha is most frequently discussed in the context of equity market crises, but managed futures are also able to provide diversification and positive performance during crisis periods in other asset classes such as fixed income or commodities.

In the following chart we show the performance of both Aspect's flagship managed futures strategy, the Aspect Diversified Program, and the MSCI World, with equity crisis periods highlighted in red. Equity crisis periods are the sustained peak to trough drawdowns of the MSCI World using monthly data.

One of the key features of managed futures strategies is diversification across many sectors and markets. Managed futures performance during equity market crisis periods has come from many different sectors: all asset classes have the ability to contribute to returns during equity crises. This feature is particularly noteworthy in emphasizing the diversified drivers of managed futures crisis alpha.

A well-known result of modern portfolio theory is that a more efficient investment portfolio can be created by combining diversifying assets. The lower the correlation among assets, the more efficient the resulting portfolio will be. One of the main benefits of adding managed futures to a broader portfolio of traditional stocks and bonds is its potential to decrease the overall portfolio volatility. Although managed futures strategies typically operate at relatively high levels of volatility, consistent with that of equity markets, their low correlations to traditional investments mean that overall portfolio volatility tends to be reduced by the addition of managed futures.

Trend-following managed futures strategies provide exposure to a broadly diversified set of liquid markets. Responding systematically and dynamically to trends in global markets, they are able to profit from the persistent trends in market prices that often accompany market crisis events, providing crisis alpha to investors' portfolios.

The risk mitigating benefits of managed futures within a portfolio include:

• the potential to lower overall portfolio risk;


• the ability to enhance overall returns;
• providing access to broad diversification opportunities;


• the ability to perform well in a variety of economic environments; and


• additionally, improved drawdown profiles.

Equity, bond and commodity market crises have historically been recurrent but unpredictable, and have wrought havoc on many investors' portfolios. It is uncertain when or in what sector the next market crisis will strike, but an understanding of the risk-mitigating properties of managed futures, and the ability of managed futures to capture crisis alpha, should provide investors with confidence that the strategy will continue to provide these favorable features, whenever the next crisis occurs.

Stephen Wood is senior product manager, Aspect Capital Ltd., London. This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.