Asset Alliance understanding managed futures


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In a time of historically low bond returns and high realized and potential equity market
volatility, two strategies that investors are turning to are commodity trading advisors (CTAs)
and global macro hedge funds. In adopting these strategies, it is important for investors to
distinguish the similarities and differences between these strategies. CTAs in a hedge fund
portfolio can be both a complement to and a substitute for a global macro allocation.

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Asset Alliance understanding managed futures

  1. 1. Hedgeharbor Navigator June 2012Understanding Managed FuturesIn a time of historically low bond returns and high realized and potential equity marketvolatility, two strategies that investors are turning to are commodity trading advisors (CTAs)and global macro hedge funds. In adopting these strategies, it is important for investors todistinguish the similarities and differences between these strategies. CTAs in a hedge fundportfolio can be both a complement to and a substitute for a global macro allocation.Overview of Managed Futures Evolution of the Futures MarketsManaged futures strategies are the general category of The futures markets were originally a way for producersinvestment strategies into which CTAs fall. These and consumers of commodities to hedge price risk in anmanagers implement a wide variety of trading economy weighted more heavily toward agriculturestrategies, but the common element of each is that they than it is today. As the United States and globalapply these systems primarily to futures contracts, over- economies have shifted away from an agriculturalthe-counter spot and forward contracts (in the case of focus, so has the composition of the futures markets.currencies) and less often, options on futures contracts. Chart 1 illustrates this change. As late as 30 years ago, the futures markets were heavily weighted towardsChart 1: Futures Market Volumes by Contract Type (percent) 1980 Interest 2011 Metals Rate Metals 16% 14% Lumber & Currencies 2.9% Energy 7.6% Currencies 1% Agriculture Interest 5% Rate 8.7% 41.8% Energy Agriculture 12.2% Equities 64% 26.8%A key feature of these contracts is that they are very agricultural products. By 1980, trading in financialliquid. The futures contracts are traded on global products besides currencies was limited primarily to USfutures exchanges where large numbers of buyers and Treasury Bill and Bond futures.1 With the advent ofsellers transact every day. The liquidity provides easy trading Eurodollar futures in 1981 and stock indexentry and exit of positions as well as lower transactioncosts because of narrower bid-ask spreads. Lower 1 Interestingly, the first financial futures contract to trade wastransaction costs can improve the performance of the one on Government National Mortgage Association (Ginniestrategy. Mae) certificates—suggesting the longstanding importance mortgages have had in the US.
  2. 2. Table 1: Examples of Contracts that CTAs trade Currencies Equity Indexes Interest Rates Government Bonds (vs. US Dollar)  S&P 500  Eurodollar  30-Year US Treasury Bond  Canadian Dollar  CAC-40  Fed Funds Rate  German Bunds  British Pound  DAX  Short Sterling  Japanese Government Bonds  Euro  NASDAQ Grains & Energy Metals Soft Commodities Livestock  Crude Oil  Gold  Corn  Live Cattle  Natural Gas  Silver  Soybeans  Lean Hogs  Unleaded- Gasoline  Copper  Coffee  Pork Bellies  Electricity  Tin  Wheat  Feeder Cattle  Aluminum  Sugarfutures in 1982, the futures industry took a decided turn variety of underlying asset classes with a diversetoward financial instruments trading. These contracts geographic focus. Although global macro managers mayalong with the Treasury Bill and Bond contracts also trade individual equities, as well as ETFs and cashpermitted financial market participants to hedge and bonds, futures are an important way they express aspeculate on a variety of financial risks. view in the markets they trade. As Table 1 illustrates, futures contracts can cover the government bondThe development of these new futures contracts- markets as well as the equity markets in a variety ofcombined with the agricultural and industrial contracts countries. In addition, the physical commodities—suchalready in existence opened vast new opportunities for as oil, gold or wheat—that managers in both strategiestraders in these instruments. Government regulation of use are traded on global markets. As such, the pricethe futures markets—part of which created the CTA movements of these commodities reflect overall globaldesignation for an asset manager—also played a role in economic strength or weakness, as well as the relativethe growth of the managed futures industry. economic conditions of one versus others.Prior to the development of futures markets in In addition to trading similar instruments, the strategiesextensive and diverse underlying assets, futures traders of CTAs and global macro managers can be assigned tocould still implement trading systems in the markets similar categories. Both types of managers can take longthat did exist. Likewise, global macro managers could and short positions in the markets that they trade. Bothimplement their views in cash markets for government can trade systematic strategies, discretionary strategiesbonds and equities, but while using already existing or a combination of the two. Systematic strategiesfutures markets for instruments such as precious utilize quantitative models to identify trademetals. The development of the futures markets, opportunities and to make decisions about entry andhowever, made taking positions in these markets easier exit points for trades. Discretionary strategies rely onand more capital efficient because margin requirements the managers’ judgment to make trading decisions.2on the futures exchanges enable managers to gain thedesired exposures to the markets with less upfront In order to identify the differences between CTAs andcommitment. The liquidity of the futures markets also global macro managers, it is necessary to make somepermitted manages to put on and take off positions generalizations. CTA managers often focus on the pricewith relative ease. movements and trading volumes that individual commodities display. If they utilize technical analysis asHow CTA and global macro strategies arealike and different 2Both CTAs and global macro hedge funds often trade For a fuller discussion of the strategies and styles that CTAsthe same instruments, namely futures contracts on a employ, see the Asset Alliance presentation, The Benefits of Managed Futures, 2012
  3. 3. part of their trading strategy, price and volume data macro managers might not look at technicalmay be the only data they look at. Even if CTAs view indicators—but they both observe and respond to thecommodity prices within a more fundamental, supply- same set of prices. Those prices in turn are influenceddemand framework, it will often be the case that they by the factors that the managers are responding to.look at price movements most heavily in the trades that One implication of the above observation is that CTAsthey make. can be considered a subset of a larger trading strategyGlobal macro managers in contrast, will often make that includes both CTAs and global macro manager. Fortrading decisions with the context of an array of this reason, many investors include both CTAs andmacroeconomic data. The will base their view on “pure” global macro manages in their allocations to awhether to take long or short positions in government global macro portfolio.debt or equities in a particular country based on overall CTA performance in different marketchanges in such economic data. This is not to say that environmentsglobal macro managers ignore asset prices; clearly they We shift our focus now to the performance of CTAsdo not. It is simply generally true that they base their during different market environments. As any financialtrades on more than just prices. market observer over the last two decades can attest,Both types of managers can adopt relative value the market environment has varied greatly. Thestrategies in their trading, meaning that they will take a environment in each market period has presentedlong position in one instrument or market and a short different challenges to each asset class and strategy ofposition in another. In such a case, each strategy will be investing.basing their trade on the expectation that the spread Although the division of the last twenty years intobetween the instruments will tighten or widen, different sub-periods is somewhat arbitrary, we havedepending on the type of position they have taken. chosen to delineate the different environment intoEven in this case, however, the focus of their analysis periods marked by crises. For that reason we chose thewill be different. CTAs generally will be focused on following periods to examine the performance of CTAs:historical relationships between the two instrumentsthemselves, while global macro traders will base their  1990-1998—the run-up to the Russian/Asian debtjudgments on spread widening or tightening on crisesmacroeconomic relationships.  1998-2007—the period between the above crisisDespite these differences in approach, however, for and the global financial crisisboth types of managers, the prices that both types of  2007-2012—the global financial crisis and itsmanagers observe and at which they trade are aftermath.influenced by the same set of factors. Some CTAs might Chart 2 depicts the performance of CTAs with respect tonot look at macroeconomic data, and some global other asset classes and to hedge funds generally in eachChart 2: 1990-1998 1998-2007 2007-2012 20% 20% 16% S&P 18% HFRI 18% 14% 500 TR 16% Index 16% 14% GSCI 12% 14% HFRI 12% Total 10% BondCompound ROR Compound ROR 10% 12% Index Return Barclay Barclay Compound ROR 8% Index 8% 10% Bond CTA CTA GSCI 6% Bond Index 8% Index 6% Index Total Barclay S&P 500 4% Index 6% 4% S&P Return TR GSCI 2% 4% CTA 500 TR 2% Total 0% Index HFRI 2% Return -2% 0% Index -4% 0% -2% 0% 10% 20% 30% -6% -2% 0% 10% 20% 30% -4% -4% 0% 5% 10% 15% 20% -6% -6% Standard Deviation Standard Deviation Standard Deviation
  4. 4. of these two periods. In the first two periods, CTAs alpha that CTAs produce—that is the uncorrelatedproduced a comparable compound returns to bonds, return relative to the benchmark under comparison—isbut with somewhat higher volatility. In all three periods, significant across the board. These data are monthlyCTAs produced lower volatility than either equities or numbers, so for example, from 2007-2012, CTAscommodities. In the third period, CTAs have produced a monthly uncorrelated return of 0.4 percentoutperformed equities, commodities and hedge funds relative to the S&P 500.overall. It is interesting to note that the risk and return Table 2: Diversification benefits of CTAsperformance of CTAs has been much more stable during Barclays GSCI HFRI Fundthese periods than have equities, commodities or S&P Aggregate Total Weightedoverall hedge funds. These charts demonstrate that 500 TR Bond Index Return Composite Indexwhile it is true that CTAs do not always outperform 1990-1998 Correlation -8.9% 14.0% 13.1% -10.8%standard asset classes or hedge funds, the performance Alpha 0.8% 0.4% 0.7% 0.9%of the strategy overall is much more similar to the 1998-2007performance of bonds than are other strategies. Correlation -22.6% 27.9% 27.9% -3.7%Diversification benefits of CTAs Alpha 0.5% 0.1% 0.4% 0.5% 2007-2012A number of analyses have focused on the Correlation -6.0% 0.8% 19.3% 18.9%diversification benefits of CTAs in an overall portfolio. Alpha 0.4% 0.4% 0.4% 0.4%We focus here on two indicators of this diversificationbenefit—correlation and alpha. Final thoughtsTable 2 presents these two statistics for the same threetime periods as in the risk-return comparison above. As In this article we have shown how CTAs compare as anthe table shows, CTAs have exhibited a low or negative investment strategy to global macro hedge fundcorrelation to equities in all three periods that we strategies. In general, CTAs can be considered either aexamine. CTAs are also negatively correlated to a broad substitute or a complement to global macrohedge fund index in two of the three periods—the strategies—despite the differences in the approaches—aftermath of the global financial crisis being the because the instruments they trade are responding toexception. CTAs also show a low correlation to both the same conditions in the global economy. We havebonds and commodities in all three periods. Recent also seen how the performance and diversificationmonths represent examples of the lack of correlation. In characteristics of CTAs can add value in an overall assetMay, when the S&P 500 Index was down 6.1 percent, allocation. We have also seen that over the period sincethe Barclay CTA Index rose 2.7%; In contrast, for June 1990, the performance of CTAs contrasts with thethe CTA Index fell 1.62% whereas the S&P rose 4.1 performance of commodities in having lower volatility.percent. The staff of Hedgeharbor will be glad to discuss furtherAs more evidence that CTAs provide diversification, the how one or more CTA managers can add benefit analpha that they produce relative to other investments is existing portfolio—whether or not it already contains asignificant in each of the time periods we consider. The hedge fund allocation. We look forward to discussing this issue further.