Predicting managed futures returns - Follow the mean reversion

Managed futures have been in a significant drawdown with poor Sharpe ratios over the last two years albeit October has been a good performance month. Many investors have talked about throwing in the towel and getting out of this hedge fund strategy. New investors have focused on other strategies and not waste their time with CTA’s. A simple approach of looking at recent performance would not be compelling, yet a closer examination shows that this may be one of the best times to invest with managed futures. Forget the recent performance or more specifically, do the opposite of momentum investors and buy on the dips in risk-adjusted performance.

The investment people at Steben and Company have published a good piece of research on market-timing of managed futures called, "Can you Time Managed Futures?". Their results suggest that there is mean reversion or negative autocorrelation with 12-month Sharpe ratios. Periods of very low Sharpe ratios are followed by strong risk-adjusted returns. 

Simply put, buy the dips if you are interested in increasing your allocation or investing for the first time. This mean reversion is present in every decade for the Barclays CTA index.

This does not address the question of what manager should you buy if you want to increase your allocation, but it is a good start at looking at timing this hedge fund strategy space. We are currently conducting some research on how to choose which manager using a similar methodology of timing risk-adjusted returns.

The decision for investing in any one manager is more complex, but the general timing decision may be easier to address. When the investment committee likes management futures the least may be the period when you should love it the most. If you are holding managed futures and ready to divest, think again, it may be worth waiting for the reversal. 

How many biases dragged down your performance last month?

The behavioral finance revolution has been well noted by both academics and practitioners. Multiple Nobel Prizes have gone to economists who have studied in this area, yet investment decision-makers still make the same behavioral mistakes. We have noted our biases but often we have not changed our behavior. Perhaps it is too ingrained, but good has to be reinforced. 

The following info graph does a nice job of listing the possible mistakes (screw-ups) that can be made. Only 20? Without a review or inventory of your mistakes, there is little chance for decision improvement. If there is a performance review for a portfolio, it seems as though a performance review of decisions should also be made. 

How many decisions were made in the last month? How many were good ones? A good decision does not have to be profitable. It does have to be rational. In many ways the decision-making review for a quant system is so much easier because the behavior is hard-coded in the action. Nevertheless, discretionary decisions can still be made more rational and address a unique set of problems. A decision review system will help.

Trend continuation in currencies, energy, and equities will be good for managed futures

You could call it the second reflation trade. Based on economic data trends which suggest stronger global growth coupled with tax reform/cut talk, we are seeing major sectors show increasing trends and opportunities. The good October trends seem to be carrying over to November. The reflation trades has driven stock indices, energy, and base metals prices higher. The differential between monetary policy in the US and the rest of the world also suggests dollar strengthening. The rate differential is in favor of the the dollar. This dollar strength places downward pressure on precious metals. Bond price behavior has been a little surprising with some recent gains in spite of the the strong growth story.

Our general view is that October trends will continue given current price action relative to different trend timeframes and break-out models. 

October hedge fund performance led by CTA's - all hedge fund strategies positive for the year

CTA's showed their strongest performance of the year in October. Only the fundamental growth strategy came close to generating the returns seen in managed futures for the month. Some strategies actually posted losses for October even with the continued increase in equity returns. 

Managed futures will do best when there are trends outside the normal equity bond mix. With increases in the dollar, energy complex, and selected commodities, CTA's were able to find profitable opportunities.

All hedge fund strategies are now posting positive returns for the year. The best returning strategies are fundamental growth, special situations, and emerging markets. Most strategies have some combination of beta and alpha generation; consequently, the strong absolute gains in equities help hedge funds with performance.