Managed futures have had a tough 10 years, but gained much of their glory during the financial crisis when the category was up double digits while stocks were down 30%. Such performance enticed many to invest and use it as a “hedge” for their portfolio. It wasn’t until 2018 that this “hedging” strategy was tested, and aside from dispersion, the category returned -6.04%. Not much of a hedge at all.
While many investors may think of managed futures as a hedge, this is not the objective of the strategy; rather it’s meant to be a source of uncorrelated returns. To be fair, managed futures historically have performed well in tough markets. However, this isn’t always the case, nor is it the goal of the approach.
We often hear investors use the words “hedge” and “uncorrelated” synonymously. But the belief that managed futures are a hedge suggests there’s something being lost in translation.
Investors using a modern portfolio theory approach seek to build a portfolio of assets that generate an expected return for a given level of risk. Most importantly, each individual asset’s risk/return profile is less important than the combination of the assets’ risk, return and correlation characteristics.
Advisors are therefore tasked with constructing a portfolio of uncorrelated assets, regularly rebalancing and keeping clients invested to garner the benefit.
Besides stocks and bonds, real estate, gold and cash can be used to round out a portfolio of uncorrelated assets. But investors should also consider another investible asset — managed futures. Versus virtually any asset class, managed futures exhibit little to no correlation and have positive expected returns over time.
After 2008, many investors didn’t view the asset class this way. Nervous investors sought protection for their portfolio, and based on the strong performance of managed futures, investors assumed its role was as a downside hedge. Of course, there are times when it has protected with explainable reasons as to why; but there are also times when it didn’t and that’s precisely what uncorrelated means — it isn’t negatively correlated.
Not a Hedge
Some advisors say they want a managed futures fund for exposure to different asset classes to “hedge” those things out. We understand the sentiment, however, it doesn’t make sense. How many clients have wheat in their portfolio? The reason futures funds trade different contracts is not for a hedge on those assets; it’s because the momentum anomaly exists in all kinds of markets, thus it serves to diversify momentum exposure not as a hedge to a nonexistent overweight to wheat, for example.
Diversifying across contracts and asset classes isn’t the only path to diversification for futures. For example, using different timeframes as inputs to models and using a variety of types of models will change return paths whether investing across equity indices or being more commodity focused.
Instead of the number of contracts or asset classes traded, better questions to ask when evaluating an uncorrelated return stream include whether the strategy is getting the expected return for the level of risk. How are the peak to trough drawdowns? What about expenses, or correlation to other asset classes? In what environments do they do well or struggle?
If hedging is your goal, consider cash, long volatility, or long/short strategies; just don’t include managed futures in that list. Managed futures seek to provide a unique uncorrelated return stream within the MPT framework.
And if you choose to incorporate these strategies, resist limiting from where that uncorrelated return comes as it narrows the range of strategies from which to choose — and potentially your return. Keep an open mind and recognize the aim is uncorrelated, not hedged, because it is definitely not the same thing.
Andrea Coleman, CAIA, is 361 Capital’s director of the northeast. She is located in the Denver, Colorado headquarters.