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Managed Futures To Smooth Out Market Bumps

This article first appeared in the March issue of WealthManagement magazine and online at WealthMangement.com . Skeptics were easy to find in the bull market, but these funds are now working as advertised. If there was ever a time when a countertrend strategy was needed, it would be now. By countertrend, of course, I mean a tactic that gains while the stock market swoons. There are bear market funds aplenty but those aren’t suitable as permanent portfolio allocations. There are bond funds of various stripes, too, which boast of low correlations to equities, but those are typically low volatility products whose gains are often swamped by equity losses. Enter the 361 Capital Global Counter-Trend Fund (MUTF: AGFQX ) , a managed futures strategy of a different sort. Employing a suite of systematic trading models, AGFQX takes long and short positions in equity index futures contracts – and equity futures only – in U.S., European and Asian markets. At times, the fund also goes to cash. Over the past 12 months, the $18.9 million fund gained more than five percent while the S&P 500 lost nearly nine. Countertrend indeed. It didn’t score its gains by simply shorting equity futures. That would be trend following, just in an opposite direction. No, AGFQX thrives where there’s short-term up-and-down movement in its target equity indices. The fund aims to sell overbought contracts and buy futures at oversold levels to harvest market “noise,” or the frequency of directional changes. The greater the number of price swings, the more opportunities to buy on down days and sell on up ones. The fund’s managers, expecting that the size of trading losses and gains will be roughly equal over time, rely upon a high “hit ratio” (percentage of winning trades) to garner profits. The fund runs into trouble when its target markets trend violently in one direction. That’s what happened late last summer when a market drop sent the fund skidding into a sharp drawdown (see Chart 1). The fund subsequently recovered, ultimately reaching new highs as the broad stock market found fresh lows. More Strategies The equity countertrend fund wasn’t the only managed futures strategy that found purchase this year. In fact, 96 percent of public managed futures funds – exchange-traded and ’40 Act alike – have booked year-to-date gains. Some capitalized on the downtrend in the petroleum complex. Some picked up bullish gold positions. Others bought bond futures. For most, though, the gains haven’t been enough to overcome a year’s worth of setbacks. Of 34 portfolios extant (31 mutual funds and 3 ETFs), 21 are still under water on a 12-month basis. A handful, AGFQX included, stand out because their year-to-date gains built on positive results earned over the preceding 12 months. They’re tallied in Table 1. Like most managed futures strategies, these five mutual funds exhibit little correlation to the equity and bond markets. Notice the low r-squared (r 2 ) coefficients versus the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) and the iShares Core U.S. Aggregate Bond ETF (NYSEARCA: AGG ) . Think of these values representing the degree (in percentage points) that movements in the index ETFs explain the managed futures products’ price variance. Most are quite low, though AGFQX, not surprisingly, shows a modest link to SPY because of the summer selloff. Notable, too, is volatility or, rather, the relative dearth of it. Maximum drawdowns for four of the five funds are fractions of SPY’s. These drawdowns represent the greatest peak-to-trough loss for each portfolio before a new high is attained. Maximum drawdown is used to compute a managed futures or hedge fund’s risk-adjusted return. You can think of the Calmar ratio as the alternative investment world’s Sharpe ratio. The higher it is, the better an investment performed over a specified time period; the lower the ratio, the worse it behaved. Under the Hood We’ve already looked inside the 361 Capital countertrend portfolio, so let’s peek under the hoods of the others: The $555.4 million LoCorr Managed Futures Strategy Fund (MUTF: LFMAX ) manages the futures side of its portfolio through an investment in a wholly-owned Cayman subsidiary. This controlled foreign corporation (“CFC”) is not subject to all of the investor protections of the ’40 Act, a fact that might be worrisome for some investors. At the very least, the arrangement makes the fund opaque. We can see fairly well how the fund’s collateral – the fixed income portfolio used to meet margin requirements – is managed, but insight into the fund’s futures strategy is extremely limited. The fund engages a triad of trend-following commodity trading advisors (“CTAs”) on the futures side. At last look, the fund had a sizable short exposure in the energy sector. LFMAX is the most expensive product in the table with an annual expense ratio at 2.11 percent. The Abbey Capital Futures Strategy Fund (MUTF: ABYIX ) is another multi-manager product which allocates, through its own CFC, to a roster of nine global investment advisors, each pursuing diverse trading strategies. Like the LoCorr fund, ABYIX actively manages its fixed income collateral. And, like the LoCorr fund, Abbey’s $353 million futures fund most recently has been short the energy sector. Shorts in agricultural commodities also added to the fund’s gains. You’ll pay 1.99 percent a year to invest in ABYIX. Trend momentum drives the Goldman Sachs Managed Futures Strategy Fund (MUTF: GMSAX ) which has profited through short positions in the commodities, currency and equity sectors as well as positions designed to capitalize on flattening in the fixed income sector’s yield curve. GMSAX’s fund runners don’t use a CFC and manage the fund in-house, keeping the cost structure relatively low. Annual expenses run 1.51 percent currently for the $153.3 million portfolio. With assets of just $16.9 million, the TFS Hedged Futures Fund (MUTF: TFSHX ) is the table’s smallest – and best performing – portfolio. The fund relies upon a Cayman-based CFC to obtain its futures exposure which is managed internally based on proprietary models. The TFS models don’t look for trends. Instead, they plumb the futures market term structure looking for value plays – buying underpriced contracts and selling those deemed rich which, by combination, reduces exposure to the underlying asset. Ergo the “hedge” in the fund’s title. Hedging comes at a price, namely a 1.80 percent expense ratio. A Diverse Variety of Strategies Managed futures – at least those funds showcased here – represent a diverse variety of strategies. That makes them difficult to classify as a true asset class. It behooves investors, and their advisors, to look closely at a fund’s return pattern to get a sense of its ability to mesh with existing allocations. Sometimes, a fund with a high return takes a backseat to one that is the better yin to an investor’s yang. A lookback over the past 12 months (see Table 2) illustrates the impact each of our five managed futures funds might have had on classically allocated stock and bond portfolio. Here, a 20-percent exposure to managed futures is obtained with a carve-out from the equity allotment, transforming a 60/40 (by percentage, SPY and AGG respectively) portfolio into a 40/40/20 mix. Adding any of the managed futures products to the basic portfolio improves returns. Though a 20 percent allocation isn’t enough to overcome the entirety of the equity market’s damage, it comes darn close. Portfolio volatility, too, is appreciably dampened. Is it likely these funds will continue their (mostly) winning ways? Keep the words of Finnish Formula 1 racer Kimi Raikkonen in mind: “You always want to have a winning car, but there is no guarantee that it will be.”

What If Everyone Indexed?

People generally think that more indexing will make the markets function less efficiently. I don’t think this is true at all. The fact that most index funds and ETFs are more tax- and fee-efficient than mutual funds does not mean they are necessarily less “active”. Most passive investing means there will be greater demand for active managers in the form of market makers and arbitrageurs. If everyone indexed, then that much more active market making would be required. I see this question more and more as indexing grows in popularity. People generally think that more indexing will make the markets function less efficiently. I don’t think this is true at all. Unfortunately, the question and its answers are usually shrouded in misunderstandings about how assets are priced and myths about what it means to invest “passively”. So, let’s think about this from an operational perspective. An index fund is not really an “index”. They are portfolios managed every day trying to track an index. These funds are managed actively, and involve hundreds, if not thousands, of decisions every year. The simplest example is the modern-day ETF, which is essentially a real-time version of what most people think of as an index fund. When you buy shares in an ETF, there is someone who is actively managing the allocation of funds (the same is true for an index mutual fund, though it’s less apparent in real-time, since the fund is not traded on an exchange). For instance, if the market price of an ETF were to deviate from the intraday indicative value, then the market makers would either buy/sell the ETF or buy/sell the underlying securities. So, while there doesn’t appear to be much activity on the surface, the very act of buying an index fund could actually force some active management in the underlying securities markets. In other words, your “passive” investment is the other side of the active management of the market maker or fund administrator.¹ It’s not a coincidence that high-frequency trading firms and big banks are making huge gobs of money during the rise of passive indexing. After all, passive indexing means that there is a greater need for those alternative forms of what is nothing more than “active” management. Unfortunately, the studies blasting active management usually include mutual fund managers and not the most active managers of them all – market makers and HFT firms. And make no mistake – these “active” operations are hugely profitable because they are essentially making “passive” portfolios available.² The kicker here is that index funds really aren’t passive at all. When you look at the underlying components of how the funds are actually managed, you realize that there’s a lot of activity in all of this. The fact that most index funds and ETFs are more tax- and fee-efficient than mutual funds does not mean they are necessarily less “active”, though. People misuse the term “passive indexing” on a near-daily basis now. And it’s the result of this desire to create a black-and-white view of the world, which is usually nothing more than a marketing pitch (something along the lines of – “We’re passive, so invest with us, because the misleading academic studies show that ‘active’ managers are dopes.”). The reality, however, is that there is really only active management and its varying degrees. Literally no one replicates a pre-fee and pre-tax index. Not a single investor. And your purchase and maintenance of a “passive” strategy will require a good deal of active upkeep. The bottom line is, most passive investing means there will be greater demand for active managers in the form of market makers and arbitrageurs. The ease of passive investing is made possible thanks to these active underlying elements. And that’s great, because it’s a win-win. Indexers get a low-fee and easy way to access markets. But they also bear the cost of their laziness (in numerous unseen ways), which is why making markets in index funds is hugely profitable. So, if everyone indexed, then that much more active market making would be required. End of story. ¹ – Read this fun paper on how ETFs work. ² – E.g., ever wonder how a big bank like Bank of America (NYSE: BAC ) can be profitable on 100% of its trading days in a quarter ? It’s thanks, in part, to passive indexers like me! “During the three months ended March 31, 2013, positive trading-related revenue was recorded for 100 percent, or 60 trading days, of which 97 percent (58 days) were daily trading gains of over $25 million.” (click to enlarge) Related: The Myth of Passive Investing

Low Volatility & Momentum: Doubling The Market Return

Summary This series offers an expansive look at the Low Volatility Anomaly, or why lower risk stocks have historically produced stronger risk-adjusted returns than higher risk stocks or the broader market. While low volatility strategies are often an appropriate long-term buy-and-hold strategy, this article offers a strategy that uses a momentum signal to tilt towards higher beta securities selectively. The alpha-generative strategy combines two market anomalies – Low Volatility and Momentum – to produce outsized returns. In recent articles, I have been authoring a fairly extensive examination of the Low Volatility Anomaly, the tendency for low volatility assets to outpeform high beta assets over long-time intervals. A Low Volatility strategy was one of five buy-and-hold factor tilts that I described in a previous series of articles. I believe that these buy-and-hold strategies to capture structural alpha are appropriate for many in the Seeking Alpha audience, but understand that some readers are looking for strategies that can generate even higher absolute returns. This article depicts one such strategy. Long-time readers know that two of favorite topics on which to author have been Low Volatility and Momentum strategies. This article combines these two strategies to produce a return profile that as the title of the article suggests has more than doubled the return of the S&P 500 over the past quarter-century. Before we delve into this strategy, we should first discuss the two components that drive this tremendous performance. Low Volatility Anomaly Regular readers know that I am currently authoring a multi-part series on the Low Volatility Anomaly. These articles include an introduction to the concept, a theoretical underpinning for the anomaly , cognitive and market structure factors that contribute to its long-run performance, and empirical evidence that demonstrates the outperformance of low volatility strategies across markets, geographies and long-time intervals. In past articles, I have depicted the relative outperformance of Low Volatility strategies using the graph below which shows the cumulative total return profile (including reinvested dividends) of the S&P 500 (NYSEARCA: SPY ), the S&P 500 Low Volatility Index (NYSEARCA: SPLV ), and the S&P 500 High Beta Index (NYSEARCA: SPHB ) over the past twenty-five years. The volatility-tilted indices are comprised of the one-hundred lowest (highest) volatility constituents of the S&P 500 based on daily price variability over the trailing one year, rebalanced quarterly, and weighted by inverse (direct) volatility. Source: Standard and Poor’s; Bloomberg The Low Volatility strategy contributes an important base component to this strategy that would have doubled the return of the market over the past twenty-five years, but we also need an element that pushes the strategy into riskier parts of the market when we can get paid for this tilt in the form of higher returns. Momentum Like the low volatility strategy, momentum strategies have been alpha-generative over long-time intervals and across markets. Consistent with Jegadeesh and Titman (1993), which documented momentum in stock prices that have outperformed in the recent past over short forward intervals, the efficacy of momentum strategies have been widely documented. Academic literature has described excess returns generated by momentum strategies in foreign stocks ( Fama and French 2011 ), multiple asset classes ( Schleifer and Summers 1990 ), commodities ( Gorton, Hayashi and Rouwenhorst 2008 ), and my own studies on momentum in fixed income strategies and more recently the oil market . Academic literature offers competing theories on why momentum has generated alpha over long-time intervals across markets and geographies. Proponents of market efficiency suggest that momentum is a unique risk premium, and the long-run profitability of these strategies is compensation for this unique systematic risk factor ( Carhart 1997 ). Behaviorists offer multiple competing explanations. In my previous series, I referenced both Lottery Preferences and Overconfidence as potential justifications. Studies contend that markets under-react to new information ( Hong and Stein 1999 ), which allows for the autocorrelations found in return series. Other behavioral economists contend that the disposition effect, or the tendency for investors to pocket gains and avoid losses, makes investors prone to sell winners early and hold onto losers too long ( Frazzini 2006 ), which could be further amplified by a “bandwagon effect” that leads investors to favor stocks with recent outperformance. Blitz, Falkenstein and Van Vliet (2013) offer an expansive summary of these explanations. The Strategy I am of the opinion that low volatility stocks should be a part of investors’ longer-term strategic asset allocation given that class of stocks’ historical higher average returns and lower variability of returns. In ” Making Buffett’s Alpha Your Own ,” I described academic research ( Frazzini, Kabiller, Pederson 2013 ) that broke down the Oracle of Omaha’s tremendous track record at Berkshire Hathaway ( BRK.A , BRK.B ) into two components – capturing the Low Volatility Anomaly and the application of leverage. If an allocation to low volatility stocks should be part of your long-term strategic asset allocation, then an allocation to high beta stocks must be done tactically with a short-term focus given that class of stocks’ lower long run average returns and higher variability of returns. This view is borne out of the data underpinning the chart above. However, a temporary allocation to the High Beta Index in sharply rising markets can further boost performance. The High Beta stock index has typically outperformed in post-recession recoveries. How do we combine Low Volatility and Momentum? A quarterly switching strategy between the Low Volatility Index and the High Beta Index, which buys the leg that has outperformed over the trailing quarter and holds that leg forward for the subsequent quarter, would have produced the return profile seen below since 1990, easily besting the S&P 500 with lower return volatility. For a pictorial demonstration of the leg that would be chosen by the Momentum strategy, please see the exhibit at the end of the article. It is a very simple heuristic. The Momentum strategy buys either Low Vol or High Beta stocks based on the index that outperformed in the trailing quarter and holds that index for the subsequent quarter before re-examining the allocation once again. The results are striking. (click to enlarge) From the cumulative return graph above, one can see that $1 invested in the S&P 500 would have produced $9.04 at the end of the period (including reinvested dividends) whereas $1 invested in the Momentum portfolio would have produced $19.90. These are gross index returns and do not consider taxes. Readers envisioning employing momentum strategies should utilize tax-deferred accounts. Summary statistics of the trade are captured below: (click to enlarge) The simple quarterly switching momentum strategy would have produced a 13% return per annum over the long sample period. This 3.6% outperformance relative to the S&P 500 led to the cumulative doubling of the market returns over time. Note that while the Momentum strategy is riskier than the broad market as measured by the variability of quarterly returns, practitioners of this strategy would have been rewarded with correspondingly higher returns for this incremental risk. While I contend that a long-run, buy-and-hold tilt towards lower volatility equity is probably appropriate for many Seeking Alpha readers, this article demonstrates a momentum-based switching strategy that can help inform investors when to pivot towards higher beta stocks when they offer returns commensurate with their higher risk. Disclaimer My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon. Exhibit: Returns of Low Vol, High Beta, Momentum, & Market (click to enlarge) Disclosure: I am/we are long SPLV, SPHB. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.