DR.CHENJIAZI ZHONG

Hedge funds utilizing a global macro strategy take positions in equity, fixed income, or currency markets in anticipation of global macroeconomic events to generate risk-adjusted returns. Global macro fund managers rely on the “big picture” or trends to identify investment opportunities and profit from anticipated price movements. There are sub-strategies within global macro strategies, including managed futures that are employed by Commodity Trading Advisors (CTAs).

“The essence of investment management is the management of risks, not the management of returns.” — Benjamin Graham

Alternative assets are not designed to outperform the stock market on a quarterly basis; private equity, natural resources, foreign markets, and many hedging strategies work over time because a portfolio with these investments can deliver more diverse return streams with fewer and smaller losses, than do traditional investments.

Although the cost of active risk management with hedging strategies is relatively high, most of which include quantitative comparison, idiosyncratic behavior monitoring, and due diligence review, sophisticated investors choose to make an allocation to these alternative assets because the potential benefits outweigh the inherent costs.

Futures do not provide an immediate ownership interest in an underlying asset; instead, one transacting party agrees to buy, and the other agrees to sell at a future date. The “managed” part refers to the investment professionals who actively manage the investors’ assets using futures and other derivatives as financial instruments. In the U.S., managed futures managers are also known as commodities trading advisors (CTAs) or commodity pool operators (CPOs). BarclayHedge estimates that the CTA industry has grown to managing approximately $320 billion as of 2012.

Managed futures, taking both long and short positions in commodity, equity, fixed income securities, and currency futures and forward contracts, offer risk and return patterns that are not easily accessible through traditional asset classes. The vast majority of CTAs and CPOs use complex computer programs to identify and trade price trends with long, short, spread, and volatility strategies. The algorithms that dictate these trades are at the heart of the managed futures industry.

Managed futures have historically provided risk-return profiles comparable to those of many traditional asset classes but superior to those offered by long-only investments in commodities. The historical Sharpe ratio of a diversified managed futures portfolio could be four times higher than that of a long-only portfolio of commodities.

CTA strategies can be broken into three groups: trend following, relative value, and discretionary strategies.

Trend-following is similar to the market-timing strategy used in the equity markets. The investment manager takes long or short positions in the futures contracts that are trending up or down. The subtle differences are:

• A trend follower’s actions are predominantly based on technical analysis, using data on past price and volume to determine whether recent price changes constitute a trend in futures prices.
• A trend follower determines if the most recent changes in futures prices represent a trend, and if so, whether that trend is strong enough to warrant an allocation to futures contracts.

Relative value strategies consider the relative values of two related futures price, and the positions that are taken to profit from anticipated relative changes in those futures prices. A relative value trader may use historical price of these two products to determine their respective long-run equilibrium relative price. The return from this type of trade is essentially independent of the trend in the two prices, but the relative changes in the two prices.

Discretionary strategies may use signals from a technical trading system along with fundamental analysis of commodities, i.e. the demand for and supply analysis of commodities, to form an opinion about expected changes in futures price. These signals and analyses are not employed in a systematic manner to generate trading models; rather, it is up to the trader in terms of how he uses all the available information to implement each trading strategy.

Benefits of Investing in Managed Futures

In addition to the characteristics of “low-correlation with many other asset classes” that mentioned earlier, the benefits of allocating a portion of the portfolio assets to managed futures strategies also include its upside potential during periods of financial market dislocation. Another benefit is that managed futures allow investors to economize on the use of cash. Furthermore, using futures to take market positions comes with a built-in currency hedge, because futures contracts have no net liquidating value. For CTAs, the only foreign currency risk associated with using futures to trade from the value of cash or collateral balances are the result of either posting margin collateral or accumulating gains or losses in currencies in which the contracts are denominated.

For endowments and foundations, one of the unique advantages that managed futures can offer is the ability to notionally fund investments, allowing their portfolios to efficiently deploy cash to gain increased exposure or for allocation elsewhere in the portfolio. Beyond that, since the margin requirements for most futures contracts are low, only a small fraction of the cash deposited at the manager’s futures commission merchant is deployed as margin for trading. The remainder sits in cash equivalents, earning interest and serving as a reverse in the event of trading losses.

Final Thoughts

The determinants of investment success of managed futures include many factors, such as CTA selection, trading skills, model construction, use of leverage, risk control systems, and behavior.

Investors should keep in mind that since managed futures strategies trade primarily in the futures markets, this type of investing is eventually a zero-sum game, and therefore, the total return to the entire managed futures industry should be less than the risk-free rate, or even negative taking fees and transaction costs into account. Given this fact, it is fair to conclude that only the most skilled CTAs could possibly generate positive returns consistently.

The key difference between an average CTA and an excellent CTA lies in how they can handle the complexities of collateral, segregated funds, single currency margining, as well as the costs involved in managing foreign exchange balances. In reality, the major difficulties in evaluating CTAs and hedge fund strategies share a lot in common. First, they both lack a central database of individual fund performance. The second major difficulty is related to the “look-back bias,” which results from the voluntary nature of performance reporting. A third issue is survivorship bias, when the performance data of the managed futures fund is removed from the database as a result of the fund close. Lastly, backfill bias, also called instant history bias, occurs when only new and successful funds report performance while unsuccessful funds close and the poor performance of these funds are not factored into the CTA’s overall track record.

References:

1. The Alternative Answer by Bob Rice 2013
2. A Quantitative Analysis of Managed Futures by CME Group May 2012