Recent volatility has highlighted the need to diversify outside correlated assets in order to strengthen portfolios. Managed futures provide such diversification although they come with risks, writes Cherry Reynard.
Managed futures have not historically been an obvious choice for family office portfolios. They have a reputation for volatility and funds have usually been based offshore, creating tax difficulties. Across Europe, this is changing with the advent of UCITS III (undertakings for collective investments in transferable securities), which has enabled managed futures funds to become more widely available within a regulated structure. Equally, the US market is seeing innovation in this area with the launch of products such as the multi-manager Equinox MutualHedge Frontier Legends fund in May, which gives US investors access a basket of managed futures strategies for the first time.
There are two main types of managed futures funds – systematic funds and discretionary portfolios. The first are the most common and include behemoths such as AHL Diversified from Man Investments. The manager will create a computer programme that picks up on market trends in asset classes from pork bellies to equity indices.
These may be very short-term – intra-day in some cases – or longer-term, and usually this programme will also execute the trade automatically to minimise execution anomalies. However, the models used in these portfolios are not entirely "black box" and will be constantly updated. The second type of fund is discretionary with greater individual manager control, using a combination of fundamental and technical inputs.
To what extent are they a suitable choice for family office portfolios?
Managed futures funds are "trading" portfolios rather than "directional" strategies and their great advantage is their low correlation to equity markets. Marc Fisher, managing director at fund of hedge fund group Financial Risk Management (FRM) says: "There is a perception that this type of fund has higher volatility. However, when they are used in combination with a balanced portfolio, it can drop overall portfolio volatility. The portfolio will have a higher Sharpe ratio because of the diversification they offer."
He says that the type of return offered by managed futures funds is not available elsewhere. The credit crunch showed how a liquidity squeeze could increase correlation between markets, but managed futures funds remained uncorrelated to equity and bond markets. He adds: "These funds make money out of market momentum, which is rarely seen in other hedge fund strategies."
Alexei Chekhlov, partner and portfolio manager of Systematic Alpha Management, highlights how managed futures strategies work in practice. He focuses on 27 types of futures market in his fund – predominantly these are the equity indices of developed counties and currencies, plus a small number of commodity markets. Their approach is as a "mean reversion contrarian trader" and their time frame will often be hours rather than days or weeks.
Chekhlov says: "We aim to achieve positive absolute returns in any 12 month period in a fully de-correlated way. Our returns will be related to the amount of volatility and irrational behaviour in the market. Our model is constantly evolving and at any point we will have estimates of the risk of it being inaccurate and also the impact of 'outliers'."
Despite the bad press for financial modelling, Dan Kemp, fund manager at discretionary fund manager Saltus, says that most models used by managed futures managers stood up to the tests posed by the credit crunch and ensuing volatility in markets. 2008, in particular, was a very strong year, with 2009 proving more difficult.
However, clearly there are risks. Tony Gannon, CEO of Abbey Capital, says: "If investors just use trend-following funds they can be very volatile and there can be significant draw-downs. Traders tend to take a big run-up and then when the market turns they will give back some of those profits. In those cases it is worth looking at other managed futures strategies." It also means that it is more dangerous to simply follow last year's winners - this can often be the point at which a large draw-down is about to happen.
That said, while the volatility can be high, the draw-downs should not be over-stated. According to Credit Suisse/Tremont hedge fund research, the overall draw-downs for managed futures strategies are far less than those of the S&P 500 or the Goldman Sachs Commodities index. The Credit Suisse/Tremont index shows that managed futures strategies have delivered a cumulative three year return of 25.6%, compared to just 7.75% across all hedge fund strategies and a fall of 4.2% in the S&P 500. Over the longer term, the strategy is almost exactly in line with the wider hedge fund index.
Until recently, markets have suited managed futures. Kemp says: "Where these funds really add value is during a period of high volatility. They are designed to be very liquid and should be able to change positions and react very quickly. There is a place for this type of fund at all points in the cycle. Unlike corporate bonds, which will have times when they are not worth holding, managed futures funds always have a place as a diversifier."
Trend following funds will struggle when there are no strong trends to follow. Gannon says: "When markets are choppy and just moving 5% up or 5% down and don't know whether they are bullish or bearish, then these managers may struggle." This is why 2009 was a far weaker year for the trend following strategy than 2008.
Some remain unconvinced of the value in this type of strategy. Chris Keen of fund of hedge fund managers Culross, says: "We operate within a broad macro picture of the prospects for investors. This means that we need to have a good idea what the managers we select are going to do. Our experience of the managed futures group is that it is rarely easy to know exactly where they are likely to take risk in a given scenario."
He adds: "We do not have the expertise to tell a good systematic process from a bad one ex ante. In many cases, the process is not transparent, so even if we had the skills required, access is not available, and it is easy to see why not."
Among discretionary managed futures funds, Keen says that he has not found sufficient evidence that managers are using a repeatable process. Neither has he found convincing risk management disciplines among the members of this group, believing there is a tendency for managers in this category to carry risk levels that are not tailored to the overall environment.
If managed futures still appeal, how can investors diminish risk? Fisher suggests that bigger is often better in the managed futures market as long as the manager has not reached capacity. He adds: "There is an intellectual arms race in this area and often it comes down to who has the budget to hire the brightest minds. Research is vital when developing models looking for trends."
He believes the larger funds also tend to have longer track records and therefore a history of investing in both bull and bear markets. They will also have a stronger infrastructure in place, which is important in ensuring that trades are executed quickly and efficiently. Gannon says a big risk for investors is those managers who are not trading what they say they are trading. Most fund of managed futures funds, such as those of Abbey Capital or FRM, are run as a series of managed accounts and therefore have full visibility of the trading strategies of the underlying managers. If a manager is not trading as he has suggested, or has seen "style drift", then they will know about it immediately.
More generally, Kemp says: "All managers will use back tests as a justification for their approach and you never see a bad back test. As a result, we have to be very sceptical and be clear about what we want the fund to do for our portfolios." He admits assessing systemic traders can be difficult because their programmes are being constantly refined and updated.
Managed futures undoubtedly bring a new option to family office portfolios and the credit crunch has amply demonstrated the need for inclusion of non-correlated asset classes. But the inclusion of this type of fund – particularly the selection of single strategy hedge funds – is not without risk. Like most fund types, there are good and bad practitioners, but the sector can lack transparency and therefore the weaker practitioners can be harder to isolate. Managed futures should be handled with care.
In brief: managed futures
Managed futures have long been one of the most popular quantitative trading strategies. Futures are derivatives and their value is based on a view of the future value of an underlying asset. This can be anything from gold to pork bellies to interest rates.
Funds that employ this approach will go long and short of a range of liquid futures contracts according to their view on market trends.
Edward Cartwright, head of wealth management distribution at LGT CP, says: "All managers in this area go long and short futures, but within that there are sub-styles. Some are short-term and may look at things such as volatility; others will aim for longer-term pattern recognition over periods of one to three months.
"Some are completely systematic, whereas others have a discretionary overlay. Some funds are eclectic and will invest across a range of asset classes, while others will specialise in, for example, foreign exchange."