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.”
Currently, the model’s risk metrics have highlighted Russia as a good equity opportunity, Mowrey said.
“We saw Russia getting attractive before the [2012 presidential] election, but we decided to hold off and see the results of the election,” he said. “We still saw risks in the market, but they were not so onerous, and more importantly, we saw the fundamentals of the market as very attractive. So balancing the risk environment with the fundamentals, we put Russia on.”
Mowrey will be constantly monitoring Russia, though, to make sure that it continues to present the characteristics deemed appropriate by Innealta’s quantitative model.
“We’re constantly looking at changes in the direction of earnings streams, for example, and the multiples of changes in earnings streams,” he said. “Usually when stock prices go up and the market gets choppy, the risk metrics go up, too. We will exit if the risk comes on too strong.”
Both the country and the sector strategy might be, at any given time, invested 100% in equity or 100% in fixed income. Regardless of which way the equity markets go, Innealta guarantees a stable investment base that is enhanced by tactical asset allocation, but never undermined.
Managed Futures, Part Two: Safety, Transparency Through an Index-Based Approach
“Because you know exactly what’s under the hood at all times, you know what positions you’re in at any given time.”
—Ed Egilinsky, Direxion Funds
Ed Egilinsky, managing director of alternative investments at Direxion Funds, has worked in the alternative investment space for 20 years. In February, he launched the Direxion Indexed Managed Futures Strategy Fund (DXMIX), a product that, since its inception, has elicited enough interest from a range of advisors and investors to raise $50 billion in commitments.
Managed futures perform great in bear markets, Egilinsky said, particularly when equities have underperformed, and that’s the premise of the Direxion fund. More and more investors are becoming familiar with this idea, he said. Egilinsky also firmly believes that an index-based approach to investing in the asset class is the best way to ensure that it works well in all kinds of markets.
“We feel an index-based approach is the most low-cost, transparent and effective way to get the best from the managed futures market at all times,” Egilinsky said. “Because you know exactly what’s under the hood at all times, you know what positions you’re in at any given time. Since we’re index-based, our institutional share price is also low enough for the retail investor to afford.”
Based on the Auspice Managed Futures Index from Canadian firm Auspice Capital Advisors, which aims to capture both upward and downward trends in the commodity and financial markets while carefully managing risk, the Direxion Indexed Managed Futures Strategy Fund is invested in 21 exchange-traded futures in the energy, metal, agricultural, interest rate and currency sectors. Metals are also a part of the package, Egilinsky said, but equity indexes are not because “we feel you can get exposure to those through other investments.”
The index upon which the fund is based incorporates dynamic risk management and contract-rolling methods, and it allocates risk and size positions based on the historical volatility of each of its components. These are also rebalanced monthly if their current risk exceeds a predetermined threshold.
“Our fund can go long or short depending on price trends,” Egilinsky said. “While a lot of managed futures funds look at long-term price trends, we look at short-term price trends so that we can be more dynamic, and we can be short or long in shorter windows of time.”
Blending a managed futures fund like the Direxion fund into an overall investment portfolio can help to enhance its returns and mitigate risk. The greatest advantage the asset class offers is its historical low correlation to stocks and bonds. In an approach like Direxion’s, which uses short-term price trends as its guide and aims to be quick and nimble, that is true in any kind of market, bull or bear.
A Multi-Asset-Class Strategy For All Markets
“We have a real willingness to shift the mix according to our view of the world.”
—Bill McQuaker, Henderson Global Investors
The last decade has been extremely disappointing for investors who bought into the idea that good things come to those who wait.
Contrary to conventional wisdom that a buy-and-hold strategy with respect to equities would ultimately pay off, many people have come to realize that equities do not always outperform in the long run, said Bill McQuaker, head of multi-asset products at Henderson Global Investors. Add to that today’s challenging markets and it’s clear that investors are looking for something that can give them equity-like returns without enduring the volatility of the equity markets.
“Many investors want to invest in products whose managers are sensitive to the idea of minimizing downside risk,” McQuaker said.
Henderson’s answer is a multi-asset-class fund, the Henderson All Asset Fund (HGAIX). Launched at the end of the first quarter of 2012, the fund relies on both qualitative and systematic measures to blend asset classes to produce a robust, all-weather portfolio. McQuaker and co-manager Chris Paine use a flexible approach to scout out investment opportunities across the globe, shifting nimbly between these as opportunities present themselves.
“Our product rests on the notion that benefit comes with diversification. However, that isn’t the whole story, because we have seen that correlation does head toward one and the benefits of diversification do disappear,” McQuaker said. “That’s why giving fund managers the freedom to shift the mix of assets allows for more dynamic asset allocation.”
The fund, which invests in a swath of asset classes including equity, inflation-linked bonds, emerging market debt, gold, oil and government bonds, is managed actively and underpinned by stringent quantitative analysis.
“We have a real willingness to shift the mix according to our view of the world,” McQuaker said.
The portfolio is founded upon a core scenario, but McQuaker and Paine believe in forecasting for all situations, so portfolio selection is also based on different risk scenarios.
“The core portfolio is now exposed to risk assets, based on the view that people want yield. Alongside that we have a very consciously chosen hedge portfolio, which reflects a scenario in which the world economy may not pull through and that there may be a recession,” McQuaker said. “That section of the portfolio contains U.S. government bonds and is quite a bit in cash in order to protect on the downside.”
The All Asset Fund was launched with $25 million and now has around $36 million in assets under management.