Thursday, January 23, 2014



Well now what?  We were all ready to report on how managed futures eked out an annual gain or fell just the wrong side of the profit line – but the various managed futures indices went and screwed everything up: we saw a spread of +0.73% to -2.56% in 2013.

Do we say managed futures broke the two year losing streak (Newedge) and break out the confetti? Or should we start handing out black balloons and ‘life is over’ 40th birthday gag gifts, after managed futures had its third losing year and fourth out of the past five (BarclayHedge)?
Whether we ended the year slightly up or down, one thing is for sure: 2013 wasn’t the definitive “managed futures are back!” year those of us in the business were looking for. We want double-digit gains, not haggling over which side of even the asset class landed on.. 
Managed Futures 2013 Index
(Disclaimer: past performance is not necessarily indicative of future results)

One silver lining this past year was managed futures relative performance against other asset classes. Sure, we broke around even and were nowhere close to US stocks’ big rally, but nobody really was; and managed futures did outperform other stock market diversifiers such as commodities and bonds.  Yes, bonds. That’s an easy bet to win in the bar with some financial advisors, given all the negative press about managed futures this year: who did better in 2013 – bonds or managed futures?
2013 Asset Class Scoreboard(Disclaimer: past performance is not necessarily indicative of future results)
Sources: Managed Futures = BarclayHedge BTOP 50 Index, Cash = 13 week T-Bill rate,
Bonds = Vanguard Total Bond Market ETF (BND), Hedge Funds= DJCS Broad Hedge Fund Index;
Commodities = iShares GSCI ETF (GSG); Real Estate = iShares DJ Real Estate ETF (IYR);
World Stocks = iShares MSCI ACWI ex US Index Fund ETF (ACWX); US Stocks = S&P 500

But enough of what happened… how about what’s next.
Well, it's pure folly to pretend we can say with any accuracy where managed futures will end up over the next 12 months. We're not interested in playing that game.  But we are interested in analyzing the conditions which caused managed futures as an asset class to perform the way it did in 2013, and discussing whether those conditions will persist in the new year, reverse course, or yield to different conditions.
The only place to start when discussing managed futures conditions is a look at volatility in the global markets the asset class tracks – and specifically, whether volatility is expanding or contracting. Managed futures are often referred to as a “long volatility investment” in our materials, simply meaning that they are expected to do well when volatility is on the rise.
Turns out volatility was decidedly not on the rise again in 2013, no doubt contributing mightily to the woes of many a managed futures investment.
2014 Volatility(Disclaimer: past performance is not necessarily indicative of future results)
Using the average true range instead of a measure such as the VIX, we can see across the 47 markets we track, that more than 2/3rd of markets saw volatility contract, with an average contraction of about 5% {Disclaimer: past performance is not necessarily indicative of future results}. Now, those numbers aren’t all that impressive in and of themselves – but coming on the heels of a massive contraction in volatility last year, and two of the three years prior to that; these markets are becoming more and more compressed. 
Volatility by the years
(Disclaimer: past performance is not necessarily indicative of future results)
Managed futures putting in a slightly down year in this contracting volatility environment should be expected by investors. Indeed, they should count on that relationship to protect their portfolio, and consider that their long volatility portfolio component underperforming the rest of the portfolio in a volatility reducing up market for risky assets is sort of… as designed. No diversifiers (managed futures included), were called in to perform in 2012. That should be just fine for most investors. We don’t often blame the seat belt, life jacket, or the emergency exit doors on the plane when we didn’t need them, and the same could be said to some extent, for managed futures in 2013.
But the reality about contracting volatility is that it can be like a spring being coiled up, with only one evitiable way out, a fast, swift decompression. Will 2014 be the year things stop compressing and spring back into activity? Nobody knows for sure, but the odds have to be increased given the multiyear compression.
Is Trend Following Dead?
If the markets don’t spring back out of their compressed state in 2014, will we hear the “trend following’s dead” drums beat again? No doubt. Four out of five years of volatility contraction has led to a growing chorus of people claiming that trend following is dead. Their main arguments are as follows:
  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 we even saw 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 is well reported that HFT is on the wane and it seems a stretch to think that algorithms getting into and out of the market in milliseconds affect the performance of trend followers holding positions that last weeks to months. 
When it comes down to it, trend following, at its core, is a long volatility strategy that 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, which is very hard to believe.
The problem is the when part, and whether investors can live through those flat to down periods to see the outlier captures on the other side. And that problem will be at the forefront in 2014 as billions of dollars which came into managed futures in 2009 (following the great 2008 performance) will be looking at 5 years of flat to down performance and rightfully asking themselves if they really want to wait around for these outliers anymore.  Expect to see some major outflows from managed futures in 2014 if strategies continue keeping their head above water instead of walking on it.
It’s Not All Trend Following
Even if you think Trend Following is dead, that’s no reason to give up on the alternative investments collectively called managed futures - considering there are many different types of strategies within the category.
Barclayhedge CTA performance(Disclaimer: past performance is not necessarily indicative of future results)
Source: Barclayhedge CTA Sub-Index 
We spent a good amount of time over the past year discussing the Ag markets, and for good reason as you can see – with Ag Traders beating out the rest of the Barclayhedge CTA sub Indices for the 2ndyear in a row. They also managed to beat out those looking for commodity exposure via “long and wrong” commodity ETF’s for the third straight year.
Which got us to thinking… just what is the longer term performance between these three and what makes them different from each other?  Good question. Here’s the race between managed futures overall, the Ag Trader sub index, and the Dow Jones–UBS Commodity Index over the past 10 years. You’ll see Managed Futures as an asset class trailing the Ag Traders, and the commodity index itself well below (and actually below where it was 10 years ago! So much for the commodity supercycle). 
Vami of Commodity Indices(Disclaimer: past performance is not necessarily indicative of future results)
Source: Barclayhedge CTA Sub-Index  
10 yr returns(Disclaimer: past performance is not necessarily indicative of future results)
Source: Barclayhedge CTA Sub-Index  
So if the Ag Traders have been the best in managed futures two years running, and have been able to beat out the long and wrong commodity ETF’s for three years running – do they deserve more attention from managed futures investors and commodity allocations alike? Are they better than the systematic, multi-sector trend following programs managing billions of dollars in the managed futures space?
Well, to the first question; they are definitely worth your attention. A decade’s worth of outperformance should be ignored at your own risk {Disclaimer:past performance is not necessarily indicative of future results}.  Something is definitely going on there – from a sort of small manager premium (most have asset caps in the $100s of millions, keeping institutional investors out and the managers flexible) to a non-systematic premium (if everyone becomes a systematic program – is there value in being able to sit on the sidelines or switch your spots from a momentum player to a counter-trend, and so on).
As for the second question, of whether they are better than the billion dollar managers – better is probably too strong of a word to use… and doesn’t quite apply. The best term in our opinion would be ‘different’.
Will they outperform again in 2014? Over the next 10 years?  Part of us wants to say they will – just so traditional trend following managed futures prove us wrong and trounce the Ag Traders, benefitting the bulk of managed futures investors.
But all joking aside, there is definitely a tailwind for these types of traders right now. We’re in the continued unwinding of the Risk In/Risk Off trade (actually – we declared it dead, not just unwinding) and resulting return to fundamentals based price movement in the classic Agriculture markets. 
Just one important thing to note: Ag Traders do not have that classic managed futures crisis period performance profile. They may do well in another 2008-type market, or they may not. It will depend on how the Ag markets react to macro events.  So be careful switching allocations around from those with that profile (systematic, trend following types) to these without it. It would be tragic to endure 5 years of flat returns waiting for the crisis period performance, only to switch out right before it comes.
2014 Outlook
We said last year that “we’ll count on some support from the weak, non scientific logic that the asset class is due for some good returns after the past 4 years”, and that statement bears repeating after a flat 2013.
But here's the thing… it's likely to get worse before it gets better.  You see, any volatility expansion needed for managed futures to really put in a big year of 15% or higher will likely have to come from an end to the current uptrend in the stock index markets and eventual start of a new down trend… which will come with a price, as those managers currently long the existing up trend will suffer losses as those trends end.
The best scenario would be for a flattening out of the stock market up trend, triggering exits or pulling stops up closer to current prices – before a big down turn.  Absent that, a quick, massive reversal will likely be a case of 2 steps back before hopefully making 3 steps forward.
Which brings us to the bond and currency markets… historically one of the main growth engines for managed futures portfolios, and these days practically the only growth engine for those billion dollar plus managers who deal mainly in these markets (plus stock indices).
We dug into our volatility readings a little bit more and found the following data showing the change in volatility over the past 10 years in US Treasury futures, the EuroDollar (it’s not a currency), and the US Dollar (measured by the average true range) to be quite interesting…
10 Year Volatility Change

US 2yr Note
US 5yr Note
US 10yr Note
US 30yr Bond
Euro Dollars
Dollar Index
Average:                       -42.57%
We mentioned earlier about the overall compression across 47 different commodity and financial futures markets – but here we have some of the most heavily traded futures markets in managed futures portfolios among the most heavily compressed markets, averaging a volatility contraction of over 40% since 2003.
That’s one mean, mean reversion waiting to happen, calling to mind all sorts of metaphors: a caged tiger, volcano getting ready to erupt, Hooke’s Law (the force with which the spring pushes back is linearly proportional to the distance from its equilibrium length). Whatever, you get the point. There is a lot of potential “fuel” there to power managed futures returns. 
Of course, everyone has been saying interest rates will rise and tapering will begin and QE will end and it will be nasty… for quite some time now, without much effect. And there is the little problem managed futures folk have of a falling bond market (rising rates) not being a mirror image of the rising bond market (falling rates) which got us to this point – because of the negative roll yield
But rates moving, from say, 2.8% to 4.0% on the 10 year, are just the sort of outlier move which managed futures programs would love to sink their teeth into, not to mention the resulting volatility that would put into currency markets and the US Dollar (and in return everything priced in US Dollars – like Crude Oil, Gold, Soybeans).
All in all, we’ve got a funny feeling this might just be the year those managed futures seat belts, life jackets, and exit doors are needed, whether due to a long overdue correction in the US stock markets or a real move in interest rates, or both! 
Here’s to more volatility, more trends, and a better year for managed futures in 2014. 

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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.