Thursday, September 5, 2019

Big managed futures returns - There is crises alpha just not associated with equities


Based on the continued bond rally, August posted another good return month for managed futures (trend-followers). The major trend-following indices are now well into double-digit returns. There are classic trend-followers who are returning well above 20 percent, but there has not really been a "crisis" for this alpha generation as defined by the "crisis alpha" crowd. The whole crisis alpha story is based on large trend-following gains during periods of high equity stress. This crisis story is an ex post analysis. Investors don't know there is a crisis period until after the fact. The crisis is based on a measured decline (down 20 percent) in equity index returns. All large equity declines see strong trend-following gains, but that does not mean that all trend-following gains are only associated equity declines. Some major market "crises" have occurred in 2019. They just have not been in equities. 

We like to use the language of market divergence explaining trend-following gains. Market divergences or dislocations away from equilibrium or existing price ranges lead to trend-following gains. The return gains are a function of the size of move and fund exposure. There have been significant market divergences in fixed income, energy, and currency markets over the last. These have been more significant than what we have seen in the last three years. US Treasury bond futures have gained over 15 percent this year, oil has fallen 25 percent in the last year, gold is up over 25 percent in 2019, and selected currencies have moved close to 10 percent in the last few months. These examples are not even accounting for more localized markets distortions. All these markets have signaled divergences. Still, their impact have not yet fully spilled-over to equity markets. Equities seem to be discounting a different set of facts or a very different time line for risk events. 

There is a key feature of trend-following that make it attractive, yet it seems there is trend-following strategy fear inconsistent with simple utility maximization. Managed futures trend-followers have return distributions that show positive skew. There is a higher likelihood of extreme positive returns which is a characteristic that should be desired by investors. Investors like lottery bets and they should especially like lottery bets that pay-off during bad times. Managed futures gives positive skew for two simple reasons, holding trends and cutting loses. 

A trend-follower will hold trades that move away from some past equilibrium price. There is no attempt at finding a price target or valuation. It does not matter if there is a price increase or decrease. Trend-followers exploit dislocations and do better as market prices move to extremes. Trend-followers are described as holding long straddles and are long convexity. Regardless of the description, they will have more losing trades under stable prices with large winners when prices move to extremes. Given that trend-followers are non-predictive, it cannot be said when these large return events will come or when they may reverse. High returns cannot last forever, but given the ability to go both long and short means that a trend-following can make money in any direction but not during price trend transitions. 

Systematic trend followers often use stop-losses which create synthetic option pay-offs. There is a willingness to create small loses in exchange for holding onto potentially large winners. This behavior will create a positive skew pay-off.

Diverges are more likely when there is a crisis or some large market dislocations which means that the positive skew events are most likely to occur when traditional long-only risky assets are in decline. This makes a skewed lottery ticket that actually adds value. 

This "non-crisis alpha" performance has caught investors off-guard and has created confusion on whether this is a good time to invest. In fact, an equity crisis is not needed for managed futures to do well. There just needs to be an extended divergence or dislocation from existing price equilibrium for a broad set of markets.  

Managed futures are generating expected returns for the strategy, yet investor flows have not been as strong as might be expected. Some have the view that managed futures, a long/short strategy, is like a long-only investment that will mean revert and loss money for new investors. There is no reason to expect mean reversion with fund performance because any reversal in price can also be exploited. The risk is during transition periods not during periods of divergence. 

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