The Death of Managed Futures?
By Chris Maxey, Ryan Davis
December 11, 2012
JOBS REPORT SURPRISES TO UPSIDE
It proved to be a busy week on the economic front, but there was relatively little movement in equity markets. The S&P 500 Index gained 0.1% and the Dow Jones Industrial Average finished higher by 1%.
Economic data ranged from news on manufacturing to the eagerly anticipated nonfarm payroll report. November turned out to be better than expected for job growth, but all the wrangling over the fiscal cliff led to a sharp drop in consumer sentiment.
Although it was one of the last releases of the week, the November nonfarm payroll report was undisputedly the most important. According to the Bureau of Labor Statistics, payrolls rose 146,000 in November and the unemployment rate ticked down by 0.2% to 7.7%.
The top-line number pleasantly surprised economists, but there continues to be questions about the strength of the underlying trends.
In particular, gains from the previous two months were revised lower by 49,000, the labor force participation rate declined 0.2%, and the overall size of the labor force fell by 350,000. On the positive side, average hourly earnings increased 0.2% and the average private sector workweek held steady at 34.4 hours.
Using a longer lens, concerns remain prevalent. Within the ranks of 12 million unemployed, 40.1% have been in search of employment for 27 weeks or more. In addition, young people are enduring the job losses. Nearly one in four 16 to 19 year olds is unemployed and 12.7% of 20 to 24 year olds are without work. That contrasts with a 5.8% unemployment rate for those over age 55.
Source: Pragmatic Capitalism
It is also important to consider where job growth is occurring. Over the past 12 months, it turns out that low wage jobs accounted for 51% of private sector job growth. That includes sectors such as leisure & hospitality, retail, and temporary hires. Those trends continued in November as retail added 53,000 jobs and leisure & hospitality added 23,000.
Source: The Big Picture
Despite the slight improvement in labor conditions, consumers are not feeling particularly optimistic about the macroeconomic backdrop. The University of Michigan Index of Consumer Sentiment fell from 82.7 in November to 74.5 in the latest reading. The decline was primarily the result of the expectations component, which experienced a 13-point drop. This is not a positive development during the important holiday shopping season and could hamper consumers’ willingness to spend.
Offsetting some of that pessimism, however, is an ongoing decline in retail gas prices. Since late summer, when the average price for a gallon of gas hit $3.86, prices have fallen roughly 50 cents per gallon. Prices are near their 2012 lows and will make consumers’ pockets feel a little fuller heading into year-end.
Data on the manufacturing and service sectors showed divergent trends in the latest month. The ISM Manufacturing PMI fell 2.2 percentage points to 49.5%. Following two months of expansionary readings, the index returned to contractionary territory for the fourth month this year. Respondents cited concerns about the fiscal cliff as well as delays in shipments due to the hurricane as cause for the disappointing performance.
In the service sector, the news remains positive, as the ISM NMI rose 0.5 percentage points to 54.7%. Strength was apparent across new orders and business activity, which rose to 61.2% and 58.1%, respectively. Certain respondents cited the hurricane as one reason behind the uptick in activity, as “emergency equipment” was requested.
THE DEATH OF MANAGED FUTURES?
Managed futures strategies, or systematic trend followers, have long been an important component of diversified high net worth portfolios. Because of their ability to go both long and short in more than 100 global futures markets – spanning equities, currencies, commodities, rates, and bonds – managed futures have historically generated very uncorrelated performance to traditional investments.
Steep bear market declines in 2008 opened many investors’ eyes to this asset class, with the average managed futures manager returning 17.2% that year, as measured by the HFRI Systematic Diversified Index. Meanwhile, the S&P 500 lost 37% and global indices fell by even greater magnitudes. Between 2008 and 2011, managed futures assets under management grew by 52%, while the broader hedge fund industry only grew 5%.
In recent years, however, many investors have been disillusioned with their managed futures investments. In the volatile risk on, risk off market environment that has characterized much of the economic recovery, the category has struggled to find its footing. Since the end of 2008, the HFRI Systematic Diversified Index has posted an annualized return of 0.1%, while the S&P 500 has compounded at 14.7%. This includes declines in 2009 and 2011, and the benchmark again appears headed for a contraction in 2012. Through November, the benchmark is down 3.5%, while many traditional hedge fund strategies are up mid to high single digits and equity indices have posted double digit performance.
What is behind these struggles? Many attribute the lack of performance to an unprecedented level of central bank intervention. In 2012 alone, central banks changed interest rate policy 146 times. These figures don’t even account for other nonconventional measures enacted this year, including asset purchasing programs and direct currency interventions.
Such intervention has disrupted the natural trajectory of many markets. In instances where trends develop – and where managed futures’ quantitative models start to initiate positions – central banks intervene and the markets reverse. This phenomenon was clearly illustrated in June, when managed futures strategies experienced big losses following key announcements in Europe.
Through June 5, managed futures strategies were up 3.6% in the second quarter, while the S&P 500 had lost approximately 8.4%. The next day, however, ECB President Mario Draghi announced at a press conference that the central bank was “ready to act” in response to deteriorating market conditions. This sparked a big rally in financial markets, working against many positions held by managed futures strategies. The group (as measured by the daily HFRX Macro: Systematic Diversified Index) lost 1.7% as a result.
A similar, but even bigger, event played out on the final day of the second quarter. Systematic trend followers slowly crawled back to a positive 2.1% quarter-to-date return through June 28. On June 29, though, an EU summit yielded provisions that directly recapitalized banks in Spain and Ireland and expanded the powers of the bailout fund known as the European Stability Mechanism (ESM). This catalyzed a sharp reversal in risk markets, once again destroying market trends. The category lost 2.8% on June 29, and many long-tenured managed futures managers experienced their worst one-day loss ever.
Despite the recent performance of managed futures, investors may be surprised to find that maintaining their positions over the past four years were still beneficial to the overall investor experience.
A naïve 80/20 portfolio of the S&P 500 and HFRI Macro: Systematic Diversified Index, respectively, since the beginning of 2009 has posted similar risk-adjusted performance to the pure equity index. While annualized return for the portfolio relative to the S&P 500 was reduced by 2.8%, volatility was decreased by 3.2% and maximum investor drawdown was decreased by 3.4%. The portfolio’s Sharpe Ratio was virtually identical to that of the equity index, at 0.84 vs. 0.85.
For what is arguably the worst stretch of performance in managed futures’ history, this simple exercise suggests the opportunity cost of maintaining exposure to this uncorrelated asset class was not extremely high. Indeed, in a time when correlations have converged among most asset classes, the HFRI Macro: Systematic Diversified Index maintains a correlation to the S&P 500 of 0.11 since the beginning of 2009.
In the meantime, managed futures strategies are adapting to their performance struggles. While the universe has long been dominated by intermediate term trend followers, more and more alternative strategies are coming to market. This includes trend following strategies that evaluate different time windows, particularly short-term, as well as fundamentally based systematic and pattern recognition methodologies. Funds that focus on mean reversion in markets – known as counter trend – are also proliferating. Many of these types of approaches are seeing more success in the recent market environment than the traditional approaches, although the broader indices fail to reflect their benefits.
Over the longer term, managed futures strategies have been a very consistent asset class. Despite encountering pockets of underperformance, the category as a whole has failed to post a negative three-year rolling return based on quarterly data since 1990.The index came close in early 2003, but surged back over the following four years.
While past performance is not a guide to future returns, the asset class does have a powerful long-term track record. Even if one were to assume performance never reached previous levels, however, managed futures’ diversification benefits remain intact. When considered in a broader portfolio context, managed futures can still play an important role in dampening volatility and providing a source of uncorrelated return. And this is in addition to the practical benefits contributed by one of the most liquid investment strategies in the industry.
While time will be the only true test, reports of managed futures’ death may be greatly exaggerated.
THE WEEK AHEAD
Although this week will be quieter, there is still a plethora of news to digest. Negotiations around the fiscal cliff will dominate headlines, but trends on consumer inflation will be released towards the end of the week, as will data on retail sales for November.
In the world of central banking, the FOMC meeting is scheduled to take place on Wednesday. Current expectations are for the Fed to extend quantitative easing efforts with an additional $45 billion per month of asset purchases. Other central bank meetings to watch include Russia, Chile, South Korea, and Indonesia.
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