Monday, September 30, 2013

Managed Futures: How bad is it?

The main CTA indices are all at 3.5 year lows and sitting on their worst drawdown levels in the past 15 years – at 28 months and -12% from their past all time highs.  And with the year to date numbers negative through August (albeit a small amount),  there’s the very real possibility of managed futures postings its 4th losing year out of the past 5 in 2013.
What’s more - a comparison of the 10 years prior to 2009 and the March 2009 til now period shows the asset class at levels not seen decades, in terms of the amount and duration of the losses, reminding us of the ‘generational low’ terminology used by the stock folks circa 2009).

            A Generational Low?
Managed Futures Indices Drawdown
(Disclaimer: Past performance is not necessarily indicative of future results)

Average of Managed Futures Indices Drawdown

(Disclaimer: Past performance is not necessarily indicative of future results)
Is it just something weird going on with the indices?  Nope. Check out the performance of 10 of the largest managed futures programs at the end of 2008. Since then, you can see the problem is widespread, with these big programs averaging a current drawdown of -16.95% and 24 months, on average, since their last equity high. 
CTA Drawdown
(Disclaimer: Past performance is not necessarily indicative of future results)
Is Trend Following Dead? (again)
So what’s going on? Is trend following dead?  The short answer is no. The more involved answer can be found in this newsletter, and in a follow up blog post here,  and in a review of 100 years of trend following here.  Both sides of the coin were also argued at length in this LinkedIn Group.
Everyone seems to have a different unscientific explanation for the so called death of trend following, with the following the main arguments supporting why trend following is dead: 
  1. There is too much money in trend following now, distorting the trends in the markets.
  2. Continuous government intervention in the markets has stymied the development (expansion) of significant trends.
  3. Risk on/risk off trading has brought all correlations to one- there is no diversification anymore.
  4. Interest rates at 0% have made it too difficult to make money.
  5. High frequency trading has destabilized the natural progression of the market cycles.
To tackle these – we’ve seen AQR answer the question of too much money being in trend following with their research showing trend following is at most 0.2% of the size of the underlying equity markets, 3% of the underlying bond markets, 5% of the underlying commodity markets, and 0.2% of the underlying currency markets.  We know from tracking such movements that Risk On/Risk Off is essentially dead.  We’ve seen significant trends in markets like Grains caused by weather, showing the government interventions don’t cap every opportunity, and even seen trends like the move down in the Japanese Yen caused by government intervention.  We’ve covered how the zero bound doesn’t necessarily mean no opportunity in bonds for managed futures.
That leaves HFT and its possible negative effects, which we really don’t know how to gauge or measure. But it seems to us a stretch to think that algorithms getting into and out of the market in milliseconds affect the performance of trend followers holding weeks to months.  HFT could have an effect on execution, but we’re not seeing poor managed futures performance because of slippage – losses are due to trends reversing or failing to emerge all together.
When it comes down to it, trend following at its core is a long volatility strategy which suffers frequent but small losses in exchange for infrequent but large gains.  The strategy attempts to keep its head above water until some market movement provides a large outlier move in which the strategy can profit. To say the periods between these large outlier moves equates to the strategy not working is akin to saying your car isn’t working when going slow in traffic, or that the market will not have outlier moves moving forward (very hard to believe).
But wait…Managed Futures Worst isn’t that Bad
So if trend following (and by extension managed futures) isn’t exactly dead, we can probably agree it’s at least in the hospital getting treatment for being in the worst period it’s ever seen.
Which leads us to the question of how bad is managed futures worst?
if  this is a ‘generational low’ in managed futures; if this is our “2008 crisis”, our 2007 real estate crash, our 1980s -16% loss in bonds? How does it compare with those disastrous periods? We’re glad you asked… because as bad as things are for managed futures right now in their ‘as bad as it’s ever been’ period, the comparison to other assets worst periods is as night and day as it can get.
     Asset Worst Drawdown
    (Disclaimer: Past performance is not necessarily indicative of future results)

    Drawdown Duration
    (Disclaimer: Past performance is not necessarily indicative of future results)
    Source: Gold data from; S&P Depression data from MorningStar;
    S&P 500 (post depr.) data from Yahoo Finance; Real Estate Data from Case Shiller U.S. National Price Home Index;
    Managed Futures data from NewedgeBarclayhedge CTA Index, and Dow Jones Credit Suisse;
    Bonds data from Fidelity Invesment Grade Bond 
    More of a real world example person? If these were car crashes – the “cars” in the worst periods for stocks and real estate would be totaled after the crash, requiring a full rebuild of the car or off to the scrap yard.  Meanwhile, the “cars” in the worst period for managed futures are seeing a bit of a dent on the bumper, which is unsightly, and a bit of an annoyance – but which is easily repaired.

    Other Asset Classes “Crash                                                       Managed Futures “Crash”

    Other Asset Class CrashManaged Futures Drawdown

    Where do managed futures go from here?
    We’re starting to see is a shift in attitude from those interested in managed futures exposure  – from invest in managed futures because of the crisis period performance and diversification value, etc. – to… this is a generational buy in managed futures akin to US stocks in 2009. 
    The new attitude is buy into managed futures not just because it will help your portfolio when the s^&% hits the fan, but because it isn’t likely to get much worse from here (although it could). It’s now a contrarian, dogs of the Dow, buy the beaten down asset class play.
    And here’s the best part – whether you buy managed futures at equity highs or at a ‘generational low’ like we’re in now, the asset class will still provide the crisis period performance and diversification value you’re looking for when the crash comes(assuming you access it via a long volatility crisis period performer, not an option seller or absolute return profile program).
    The flows into managed futures do not affect the performance of the asset class like they do in stocks, hedge funds, real estate, and more; meaning the underperformance of managed futures recently has done nothing to injure its ability to perform in the next market crisis (or for that matter – to perform between now and the next crisis).
    How do managed futures do it? How do they make sure they are in the next crisis? It isn’t magic, they do it by getting into all the false breakouts which don’t turn into outlier moves. They capture the outliers by exposing themselves to all the normal moves. And that is why there can be losses in between such outliers – they’ve been paying their insurance premium, so to speak, without any events which bring a payout.
    So where do we go from here? Well - we’ve been disbelievers in this stock market rally for a while now, so take whatever we say with a grain of salt. But if we ignore the stock market and all the other noise and just focus in on what managed futures itself has been doing, and how people have been feeling about its performance – it seems to us we’re either at, or quickly approaching, the point on the market emotions cycle which represents the ‘Point of Maximum Financial Opportunity’. 

    Market Emotions Cycle
    Chart Courtesy: Starlettis of Stock Twits
    In the words of Wilson Philips (yes, it is embarrassing to write that line) -  I know there is pain, but Just Hold On, just one more day (week/month/year), things will go your way. 

    No comments:

    Lunch is for wimps

    Lunch is for wimps
    It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.