Managed Futures

The top performance of Managed Futures in 2008 led many investors to flood into managed futures throughout last year and into the start of 2009 chasing those positive returns. But while the stock market has continued its slide into oblivion thus far in 2009, managed futures haven’t exactly started out 2009 where they left off last year.
Past Performance is Not Necessarily Indicative of Future Results

Asset Class YTD Performance
Hedge Funds 1.09%
Cash 0.28%
Managed Futures -0.73%
Bonds -3.21%
Commodities -3.42%
US Stocks -18.62%
World Stocks -18.82%
Real Estate -36.58%

Key: YTD performance numbers are estimates as of 2/27/09 (1/31/09 for Hedge Funds) Managed Futures = Credit Suisse/Tremont Managed Futures Index, Cash = 3 mo T-Bill rate, Bonds = Vanguard Total Bond Market ETF, Hedge Funds = Credit Suisse/Tremont Hedge Index, Commodities – Reuters/CRB Commodity Index, Real Estate = Dow Jones Wilshire Real Estate Securities Index, World Stocks = MCSI World Index (ex USA), US Stocks = S&P 500 Index

As you can see in the table above, managed futures as an asset class have merely been treading water thus far in 2009.
Now, this still puts MF at the top of the table above in terms of performance relative to the more mainstream investments in stocks, bonds, and real estate; but some of the investors who have heeded the advice of Attain and others to diversify into managed futures are starting to ask where their returns went? Their asking why managed futures are seeing flat performance if volatility remains high and stocks and commodities continue their death march to zero.
Many of those early adopters who got into managed futures just as the credit crisis started worsening (early to mid 2008) saw very nice returns the 3rd and 4th quarters of 2008 with managed futures. Many of them were used to seeing week after week of profitable movement in their accounts, and after getting used to that pattern for 20 weeks or so, don’t know what to think of this new pattern of one week up, two down, one up, etc.
Others were more of late adopters – having gotten in near the market lows (until today) over the past few months. These folks find themselves in a similar mental state, having put money into managed futures as a play to try and make some money during this bear market, but seeing nothing but flat to down performance so far.
And finally, there are those who haven’t pulled the trigger yet. There are those who are waiting in cash (hopefully), or still trying to catch the falling knife of the stock market despite many gashes in their hands (and pocketbooks) and finally seeing the futility of that game. These investors may be thinking they are too late to the managed futures party.
The question on each of these groups’ minds is what is going on? And more specifically, where are the high returns we saw in 2008? Where are the gains amid the stock market losses? What will 2009 look like for managed futures?
Managed Futures are just fine, thank you.
The short answer is that nothing is going on. Managed Futures are not broken. They are not taking a break. They have not lost their status as a great crisis period investment. They are doing just fine.
What is really going on is a bit of a perception problem, in our opinion. People were used to profits week after week with their managed futures programs as moves normally seen happening over the course of a year were happening in mere days and weeks. These people now have to adjust to a more normal environment where such moves take several weeks to materialize, and that is admittedly tough to do psychologically.
The mental problem is that we just came through one of the best periods of all time for managed futures, and with that fresh in investors’ minds it is only natural to want that period of greatness to continue along indefinitely.
It’s like your team winning the Super Bowl or World Cup one year, and then just having a winning season the next year. The winning season is nice, but you constantly lament how and why they can’t return to the big game and bring home the championship. For many of us, we aren’t content to just have a winning season – we want the championship.
Unfortunately, we can’t have the championship every year. In investing terms, this means we shouldn’t expect any investment to simply go straight up and make money month after month, quarter after quarter. One of our favorite metaphors for this is ‘trees don’t grow to the sky’, and we’ve seen with the Madoff and Stanford cases that anything which does show those types of returns is probably a scam.
Risk/Reward Mismatch
It may not be all in our heads, however; as there could be a more technical reason for the flat performance over the past three months.
Many managed futures programs use some form of market volatility to size their trades and determine how many contracts of each market to trade for an account they manage. In a simple example, if a market has a range of 10 points normally, and you wish to risk 30 points per trade, you could do three contracts in that market (30/10 = 3: risk/volatility = contracts). Now, if the range of that market, which many managers equate to the possible loss or risk of that market, shoots up to 30 points, the manager may only be doing 1 contract (30/30 = 1).
This all works fine and well most of the time, when the market movement is roughly equal to the amount the market is moving on average over the past x number of days. But something unique has happened since about mid December through the end of February. That something is a risk/reward mismatch of sorts, where the potential positive return many CTAs are planning on has decreased because the average move of the markets they track has roughly been cut in half since the volatility peaks in Oct/Nov, while the average range which includes that Oct/Nov period has remained high.
In this scenario, trades are being placed right now with risk based off the highly volatile period, but profit potential is only based off the now lower market moves, which are much smaller than they were back at the peak of the crisis.
For example, each of the following markets has a 15 day average range only about ½ of what it was in late October, early November. Crude was moving about $6.75 per day, and is now averaging just $2.96. Corn was at an unbelievable 26.12 down to 12.98 now, and the Euro was at 348 a day versus 190 now.
So, while managed futures programs would usually love an environment where Crude is moving $3 a day and Corn 12 cents – when those levels are less than half what they were just two months ago, there is the potential for a risk/reward mismatch, where the risk is based off $6 moves in Crude, but the profit is linked to $3 moves.
This mismatch will work itself out in the normal course of business for systematic programs like APA and Clarke as the algorithms they use to measure volatility will put more and more weight on the market conditions we're in now, and less and less on those of a few months ago. Meanwhile, this may be part of the reason discretionary managers have scaled back their trading a bit; where a return to normally matched risk and reward might allow them to get back to business.
Where do we go from here?
So what is the outlook for managed futures in 2009? Most observers agree that we’re not out of the woods in terms of volatility by a long shot. And that should be a good thing for managed futures programs once the risk/reward mismatch outlined above works itself out. But no one knows for sure what the future holds. Volatility could rocket back up to the ’08 highs, or plummet from here down to the ’05 lows.
The reality is that any and all investments return to their mean. Managed Futures were due for a slowdown after coming through one of their best periods of all time. Perhaps more accurately, the economic crisis fueled market sell-off was bound to slow down (if it hadn’t, most assets would now be worth nothing), and with it slowing down so did the opportunity for profit for many managed futures programs (while risk remained high).
The reality and more normal pattern for managed futures is the positive gamma/option buying profile of frequent small losses interspersed with rare but more significant gains. The return stream will at best look like steps on a staircase, with moves up followed by relatively flat periods before another leg up, and at worst will resemble hilly landscapes with steep peaks and deep valleys. It will not look like a straight line at a 45 degree angle.
Unrealistic expectations are more often than not why investors lose money with managed futures. They may enter into managed futures during periods like the one we just came through, and expect an immediate return similar to the ones they just witnessed happen. But more often than not, the market may be going through an adjustment or consolidation after a large move which drove those returns, leading to a flat to down period just as the investor gets involved. This sort of negative feedback can lead to unhappiness and getting out of managed future just as the consolidation period is about to end and new moves may drive new profits. Don’t fall into the trap of getting in at the top and out at the bottom.
To ground oneself, investors should not equate managed futures with oversized positive returns every month, month after month. Even in this once in a century market crisis, that just isn’t realistic; and expecting such will only lead to the negative feedback loop outlined above. As the saying goes, Rome wasn’t built in a day, and investors need to let managers go through at least a few market cycles to see how they do. It is best to expect months of boredom and small losses with exciting spikes higher every now and then.
This isn’t the buy and hold myth perpetrated by your stock broker (a myth which seems to be showing its faults now that we are back to 1997 levels in the stock market), but it also isn’t a get rich quick scheme. It’s best to give a CTA program at least a full year to prove their worth in your portfolio, if not much longer. Generally speaking, the longer time frame your managed futures program operates on, the more time you need to give it to perform. Some CTAs may not even have all of their positions on for a few months after you start with them. Rome wasn’t built in a day, and managed futures managers can’t simply will their programs to make money. They need the proper set ups and market environment, and normally those take some time to set up.
Of course, unlike the buy, hold, and hope method – you should also have a worst case scenario “line in the sand” to get out of any CTA program in your portfolio if it breaches 1.5 times its past Max DD (or whatever level you are comfortable with). That is your protection from one program causing undue stress on the whole portfolio.
In conclusion, remember that the reason you probably got into managed futures was not just for the positive returns, but for the possibility of positive returns when general markets and economies are heading lower – for the non correlated performance.
But non correlated performance doesn’t mean opposite performance, it just means different performance. So there may be times when both go down together but at different intervals, or when both are up for the year but with one making the move early in the year and one later in the year. And there may be times like the last two months, when stock markets are reeling and managed futures are just surviving, trying not to lose too much while awaiting the next breakout moves which will fuel profits.
So don’t necessarily expect another round of fireworks in 2009. It may be a different year. You may just have to live with average managed futures performance. Of course, that’s the proverbial “ace in the hole”. Managed futures average performance is light years better than anything else going on right now, with a compound rate of return since 1980 of 13.5%, a worst losing period [max DD] of -15.6% (compare that with the current -55% peak to valley drawdown in US stock markets), and the last losing year back in 1999. [All numbers based on the BarclayHedge CTA Index. Past performance is not necessarily indicative of future results].

An average year….we should be so lucky!

Managed Futures end 2008 as top performing asset class

While the final 2008 numbers are stil l a few weeks away from being tallied on some asset class indices, we couldn’t wait that long, and have compiled the following estimates of 2008 performance across the various asset classes followed by most investors. Most people only know stocks and bonds, actually; not alternative investments in commodities, hedge funds, and managed futures; so perhaps we should say the asset classes followed by readers of this newsletter.
Past Performance is Not Necessarily Indicative of Future Results.


Asset Class 2008 Performance
Managed Futures 17.59%
Bonds 2.93%
Cash 0.08%
Hedge Funds -20.72%
Commodities -23.74%
US Stocks -38.41%
World Stocks -42.08%
Real Estate -43.12%

Key: All results estimates as of 12/31/08 - Managed Futures = Credit Suisse/Tremont Managed Futures Index, Cash = 3 mo T-Bill rate, Bonds = Vanguard Total Bond Market ETF, Hedge Funds = Credit Suisse/Tremont Hedge Index, Commodities – Reuters/CRB Commodity Index, Real Estate = Dow Jones Wilshire Real Estate Securities Index, World Stocks = MCSI World Index, US Stocks = S&P 500 Index

As you can see in the table above, managed futures finished the year on a strong note, not just surviving the financial crisis which hit markets in 2008, but thriving in it with double digit gains close to +20%. When comparing that with assets like cash and bonds which just barely survived at 0% and +3%, or supposed absolute return vehicles like hedge funds at -20%, or stocks and real estate which lost nearly one half of their value in a single year – the power of diversifying into managed futures has never been more apparent. (Again, the obligatory disclaimer that past performance is not necessarily indicative of future results)
Just how powerful is this diversification? Imagine a US stock portfolio in 2008 which had 20% of its value in managed futures. The portfolio containing managed futures would have lost just -27%, versus the stock alone portfolio losing -38%. That may seem like cutting hairs as they were both still down significantly, but the portfolio including managed futures would have lost about $110,000 less on a million dollar portfolio, for example. I don’t care who you are, that is still a significant amount of money, and that is still enough for a year of college, or perhaps not having to postpone retirement another year, and so on.