There are plenty of reasons to not like risk these days: the condition of the global economy, for instance, and Europe’s sovereign saga.
While European investors, according to a survey conducted by Fitch Ratings, have reaffirmed their belief in the eurozone (33% of respondents expect some sort of a fiscal union will occur and 31% expect Europe to muddle through), the jury is nevertheless still out on that situation, hoping policymakers will continue to make a concerted effort to put in place lasting reforms that address deeper fiscal, financial and political union.
Then there’s the 2008 financial crisis, still fresh in many minds. The memory of the losses they suffered is painful four years later, exacerbated by the disappointment from investment strategies that promised to deliver and didn’t.
It’s normal, therefore, for investors to look for strategies that minimize risk and protect on the downside. With government bonds yielding next to nothing, they’re hoping, of course, to make something on the upside without risking any major loss.
The managers profiled in this story are the first to admit that their low risk/low volatility approaches to investing may not have the same appeal in a better world that they have now. After all, memories are short when the going gets good. But, they maintain, even if things go back to the way they were, innovative investment strategies that minimize downside damage while capturing something on the upside should always be part of an overall investment portfolio.
Managed Futures, Part One: A Focus on Risk Management
“When it comes to managed futures, you don’t just have to have a strategy for why you’re getting in—why you’re getting out is even more important.”
—David Kavanagh, Grant Park Funds
For most investors, the words “managed futures” conjure up images of a volatile asset class subject to suffering huge losses. Either they stay away from managed futures totally, said David Kavanagh, president of Chicago-based Grant Park Funds, or they go by the old non-correlation adage and buy them when the broader markets are in turmoil.
While it’s true that these instruments do work well in rocky markets, having exposure to managed futures in any market cycle is the way to go for investors who always want a “seat belt” around their investment portfolios, he said.
Consider that since 1990, the Barclay BTOP50 Index of managed futures has had a correlation of monthly returns of 111% with the S&P 500. During the same period, the average return of the S&P 500 for its worst 15 quarters of performance was -11.7%, compared to 5.1% for the BTOP50.
“Although the diversification benefits of managed futures become even greater in times of poorly performing equity markets, it makes sense to include them in a portfolio under any market conditions,” Kavanagh said.
Because of the 23 years he spent on the Chicago Board of Trade, Kavanagh bases his entire approach to the managed futures market on the mantra “live to trade another day.”
“When it comes to managed futures, you don’t just have to have a strategy for why you’re getting in—why you’re getting out is even more important,” Kavanagh said.
That’s why the core of his approach to the asset class centers on risk management and selecting a team of best-of-breed managers who trade in a broad range of futures contracts and who are known for having a stringent and robust risk management mechanism in place to preserve capital and control downside risk with strict volatility limits.
“When we sit down and talk to the managers who come through our door, most of them will show us good track records of varying lengths, but one of the most important questions we have is, ‘How much have you lost and how do you handle drawdowns?’” Kavanagh said. “Once a manager comes out of a drawdown, how is he going to put his trades back on? That’s what we’re interested in.”
Kavanagh is only interested in managers who know how to manage risk holistically.
“I want to know whether a manager reduced from 10% to 8% because he got out of losing trades and wanted to live to trade another day,” he said. Similarly, “I’d be alarmed if he went from 12% to 13% without knowing why.”
Diversity is another important factor, since it allows investors to get exposure to areas they might not have in their overall portfolio through managed futures. At any given time, trading happens in 150 individual futures contracts in currencies, energy, equity indexes, domestic and global fixed income, grains, and precious and industrial metals, among others.
As such, “a traditional investor who owns equity and fixed income would be getting exposure to markets he would not usually get exposure to,” Kavanagh said. “We never really know where the next best trade is going to come from, so for the most part, we will diversify across all market sectors to take advantage of everything.”
Using Fixed Income for Downside Protection Against Equity Risk
“We’re constantly looking at changes in the direction of earnings streams, for example, and the multiples of changes in earnings streams.”
—Mark Mowrey, Innealta Capital
If investors have become increasingly conscious of risk, Innealta Capital has made risk—predicting and minimizing it—the central theme of its investment philosophy.
“The idea is to win by not losing,” said Mark Mowrey, senior vice president and portfolio manager at Innealta, which specializes in the active management of two mutual funds, the Innealta Capital Sector Rotation Fund (ICSNX) and the Innealta Capital Country Rotation Fund (ICCIX), both of which contain ETFs.
Risk, he said, should be as relevant to the construction of a portfolio as returns are, which is why the Innealta funds are constructed upon a solid fixed income base. Fixed income is Innealta’s bedrock, and it is the best way to protect on the downside, Mowrey said, because “fixed income gives an investor a significant portion of their returns in a definable income stream. Given the changes in risk that can impact fixed income markets, investors can also get capital gains in fixed income markets. Because fixed income classes are, in general, less volatile than the equity markets, we ensure that our portfolios have a base level of stability.”
However, there are times when, from a quantitative standpoint, the environment is more favorable for equity or industry sectors as well as geographies. Innealta seeks to determine those times by leveraging the strengths of a proprietary, quantitative framework that takes into account a range of fundamental and macro variables, and illustrates whether the equity markets present a return opportunity that validates the extra risk they might pose. In the firm’s view of the world, equities are not worth the while unless they can meet that expectation.
“If our review of the framework results in a favorable risk-relative return outlook for the equity market, we may choose to invest in that market at equal weights in each fund, meaning 10% slices in the sector portfolio and 5% slices in the country portfolio,” Mowrey said. “Otherwise, investments in these funds are allocated to a fixed income portfolio, which is identical across the two strategies, excepting for any proration to account for different equity holdings.”