Is it time to take the air bag out of the steering wheel? Managed Futures, an update.

  • Written by David
  • November 1, 2012 at 12:25 am
  • 0
  • When an asset class under performs, it is always tempting to sell that asset class and remove it from one’s portfolio.

    Enter Managed Futures.

    Managed Futures have significantly underperformed broad markets over the past few years with the exception of stock market declines in Q3 2011 and May 2012. As a sage money manager once said to me, ‘Dave, in bull markets we all look smarter than we are, and in bear markets we all look dumber than we are‘. So at times like this, it is back to basics, The four P’s of money management; people, philosophy, process and performance. Periodic reviews of markets, asset classes and managers are ongoing functions at Gratke Wealth. (If the reader does not have a working knowledge of managed futures, please refer to the related reading at the end of this article.)

    The chart below shows a managed futures index, The Altegris 40 (in red), against the S & P 500 stock market index (in blue) for the past twenty-two years. The data reflects 36-month rolling time periods. The takeaway is this, over the past twenty plus years, there have been four distinct time periods where managed futures have greatly underperformed against the broad stock market indices, 1995, 2000, 2006 and now 2012. We are in one of those periods right now. Historically, after some period of significant under-performance by managed futures, they have risen sharply, often against the backdrop of a declining stock market. One will also observe the rolling returns for stocks has been as sharp as -40%  while managed futures have a only exhibited a 36-moth ‘worst case’ return of just nearly zero.

     

    Hence the title of this article, ‘Is it time to take the air bag out of the steering wheel?‘ Managed futures (the air bag) have historically provided significant cushion to portfolios when traditional equity assets are in decline and headed for a ‘crash’. This is not to say we only own managed futures for protection during major stock market declines, even though they have done well during such events. Managed futures have generated solid long-term returns as compared to stocks which we will explore later on.  So is this the time to remove managed futures from one’s portfolio due to the current under-performance?

    Answer: No, in fact, if anything, this might be an appropriate time to direct more funds into this asset class.

    Are we making a prediction that stocks will collapses managed futures will sharply rally? No. But if history is going to be any guide, we are at a significant spread between managed futures performance and stock index performance. History would suggest this probably is not the time to be exiting from managed futures as an asset class.

    What have been some of the near term challenges for managed futures?

    Although we have experienced tremendous price fluctuations in the markets, and for various reasons, the longer-term, underlying trends for many of the managed futures asset classes (stock and bond indices, commodities and currencies) have, well, been trendless. Let’s review several charts to understand why near-term under-performance due to trend-less markets.

    Interest Rates:

    The chart above on the 10-year US Treasury bond reflects a yield of 1.6% in July 2012. Although the yield moved lower to 1.4% and then higher to 1.85%, it moved back near 1.6%. So in this three month window, although there was much volatility, (price fluctuations) the net, overall trend was nearly flat.

    Oil:

    The chart on oil is of a similar pattern, a lot of short-term price movement, but the overall trend for the period has been flat.

    Although oil has been as high as $110 per barrel and down to nearly $75 per barrel, the nine month trend has been flat thus making it difficult for intermediate to long-term trend following managers to make money.

    Central Bank Intervention: (aka money printing-and all that goes with that!)

    In the past five years, central banks around the world have printed in excess of $9 trillion dollars (yes that is correct, with a T) to ‘jump start’ or otherwise stimulate the global economy. My metaphor has been this; the global economy is a lump of wet briquets on your barbeque smoldering at best. In an attempt to ignite them to a robust flame, you squirt lighter fluid onto the briquets. You step back, and toss in a match. Sure, there is a sudden burst of flame, but after a short while, the briquets are just still smoldering. The $9 trillion dollars of money printing, known as ‘quantitative easing’ or ‘QE’ for short, has still not successfully ignited the global economy. But those short bursts of money printing have certainly led to unusual market movements known, and referred to, as ‘risk on’ (when central banks are printing money) and ‘risk off’ (when central banks stop printing money)

    The chart below clearly illustrates the ‘lighter fluid’ effect the Central Bank (our Fed, Federal Reserve Bank, and all Central Banks) has had on asset prices. This is just a chart of the S & P 500 stock index. Similar results have occurred in interest rates, commodities and currencies. All four being the major markets managed futures managers work in.

    Trends verses Price Fluctuations

    Many of the managed futures managers we work with are ‘trend following’ managers. This is to say, the portfolio manager is looking for a trend and invest accordingly. Many managed futures managers look for trends that persist for months, not just days and weeks. Other managed futures managers, however, do look for very short-term trends as measured in days and weeks, not months and invest accordingly. When longer term trends are ‘trendless’, flat with no direction, but experience much price movement in the interim, the intermediate to long-term manager often gets ‘whipsawed’ until a stronger, more dominant, trends persists. This is what many of the managed futures managers are experiencing today. One way to combat this is to hire more short-term trend following managers.

    Inflection Points/Tipping Points; What can change the trend, What can create a new trend?

    The table below illustrates four key ‘macro global events’ that could move markets, potentially change market direction over the next few years.

    A few of the significant events are:

    1. US Election
    2. US Fiscal Cliff
    3. European Debt Crisis
    4. China Economic/Political Environment

    Any one of these events, or any combination, can significantly create new trends within our global economy presenting risk (for those unprepared) and opportunities (for those prepared) going forward. Any one of these themes can be found in managed futures portfolio manager thinking right now.

    In the long-run, we will all get there:

    Yes all roads lead to Rome, but how does one want to arrive en route? The first chart in this blog displays the ’36-Month Rolling Returns’ noting that stocks lost as much as -40% while managed futures have a only exhibited a 36-moth ‘worst case’ scenario of just zero percent. Which is the better road to travel? As the chart below illustrates, over the past 15 years managed futures (red line) has arrived at nearly the same cumulative return (slightly better actually) than US stocks (blue line) but with much less trauma; reference time periods 2000-2002 and 2007-2009.

     

    Summary/Conclusions:

    Lack of significant trends in two or more sectors at any given time has resulted in difficult environment for intermediate to long-term trend following managers.

    Current under-performance of managed futures managers is within their historical pattern of returns of the past twenty years.

    We have increased exposure to short-term trend following managers, reduce exposure to intermediate to long-term trend following managers.

    Underlying economic fundamentals have frequently been interrupted by government intervention in USA and Europe.

    Currencies have been the most difficult strategy for 2012.

    What might be future opportunities given the list of potential ‘macro global’ events?

    Is it time to remove the ‘air bag’ (managed futures) out of the steering wheel (investment portfolio) at this point in the global economic/political cycle? We think not.

    We welcome your input, comments, questions and concerns.

    Thanks for reading.

    Source of Data: Altegris Q3  2012 Alternative Investment Market Review

    For more information on articles written by Gratke Wealth on Managed Futures, click here please.

 

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