Monday, January 16, 2017
Bond-stock correlation should be driver of managed futures decision
Why should I hold managed futures? This was a much harder question to answer when bonds had such a negative correlation with stocks. Bond provided safety, yield, and return. Allocations to bonds provided diversification and return during the post Great Financial Crisis period. It protected portfolios when volatility spiked, it generated return during the falling inflation, and it did this through the simple allocation scheme of just holding two assets.
Managed futures is supposed to be a great diversifier and provide crisis alpha during strong negative economic events, but if bonds have a negative correlation much lower than managed futures and they do especially well during a crisis as a "flight to safety" asset, CTA's are less valuable for a portfolio. However, times are changing as evidenced by the recent correlation data.
If the stock bond correlation is rising and moving closer to 0, then managed futures will have similar diversification attributes. If bonds are underperforming because of low or negative yields and rising interest rates, managed futures programs are more likely to outperform on a total return basis. This makes holding managed futures more valuable.
The stock-bond correlation is increasing for a number of reasons, but the rise is primarily because of increasing inflation expectations. With inflation rising closer to 2% and the economy as measured by unemployment below 5%, inflation expectations has increased across most maturities. The negative correlation was associated with a "flight to quality" effect based on uncertainty, but with no current crisis, inflation expectations are the dominant driver. The low current volatility in equities as measured by the VIX index reduces any risk-off safety flows.
If you believe that inflation should be rising, a consistent allocation approach would be to increase managed futures exposure.