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Managed Futures and Managing Expectations

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Don’t invest in managed futures because you think you are guaranteed to make money if there’s a sell-off in the stock market. You might be disappointed. In my opinion, invest in managed futures because the strategy has shown itself to be a valuable portfolio diversifier over the past 30 years.

Managed futures have earned a reputation for zigging when the stock market zags, and historically that’s been true. Pick a financial crisis over the past 30 years — the 1987 crash, the Russian ruble devaluation, the tech wreck, the 2008 meltdown — and it’s understandable why the strategy often gets referred to as “crisis alpha.”

(Related: What is Alpha and Why Do We Care?)

But there are two challenges with that label. First, it does managed futures a disservice because the name undervalues the strategy’s record in good times as well as in bad times. During the massive bull market from 2003 to 2007, a non-crisis period, managed futures posted gains every year, according to the SG CTA Index.

More recently, in 2014, managed futures had double-digit returns as trend-following managers (who run about 70% of the managed futures funds) rode the wave of falling oil prices, rising European stocks, an upward-trending U.S. dollar and rising U.S. bond values. The S&P 500 Total Return Index, meanwhile, gained 13%. It was another powerful demonstration that, despite what many people think, managed futures are typically non-correlated to the stock market and not negatively correlated. Non-correlated returns mean just that — the strategy goes its own way.

Second, while “crisis alpha” has contributed to managed futures’ returns over the years, the crisis typically must last long enough for a strong, sustainable downtrend to develop. The first alarms of the 2008 financial crisis sounded a year earlier with the June 2007 collapse of the two Bear Stearns funds that had speculated in subprime mortgages. The bull market momentum faded in late 2007 and the ensuing crisis unfolded slowly enough to give trend followers time to put on short positions. The bear market was not only deep, but also lasted long enough for managed futures managers to achieve results on those shorts.

Catching Uptrends

Importantly, it is not just successfully capturing downtrends in stocks that have contributed to the crisis alpha label. In 2007-08, there were significant trends in other assets such as crude oil, fixed income, the Japanese yen and other currencies that contributed to returns for managed futures.

Meanwhile, the current bull market in stocks has been a sustained uptrend, and many trend followers are currently positioned long in global equity indexes. Therefore, they are likely to show losses in the early stages of a market correction that begins suddenly. How they fare over the long term depends on how the correction starts and how long it lasts.

What scenario would allow trend followers to potentially benefit from a correction? The answer will vary depending on whether the trend follower is a short-term or long-term trend watcher. For example, the former may regard a reversal of the 50-day moving average as a sell signal, while the latter will wait for a signal from the 200-day moving average before concluding that the uptrend is over and a new downtrend has begun. If there is an ensuing correction, the longer it lasts, the better these trend followers could potentially perform. Past performance, of course, is no guarantee that history will repeat itself.

Given widespread expectations of a market correction and the likelihood of more hikes in interest rates, investors have been turning to managed futures as a hedge, despite uneven returns in the post-crisis environment. Though assets under management are still below their 2011 peak level, net inflows have increased each year since 2015, according to eVestment. Though growth has been modest this year, there was a net inflow of $4.19 billion through the first quarter, the data analysis firm reports.

As investors consider an allocation to managed futures, it’s important that they manage their expectations. They should be firmly focused on the potential long-term benefits of managed futures instead of expecting a short-term hedge.

While managed futures have provided crisis alpha, the devil is in the details. In a sharp correction, managers may not have enough time to reverse course to prevent a short-term loss. Investors with a short-term mindset could be disappointed. But patient investors with a long-term strategic allocation to managed futures may be rewarded.

— Read Putnam Investments to Launch 3 Alternative Strategies: Portfolio Products on ThinkAdvisor.