The holy grail of investing is finding assets that are imperfectly correlated with each other. Adding assets that behave differently together in a portfolio improves the expected outcome. A reduction in volatility has obvious behavioural benefits, but it can also increase long-term wealth creation by smoothing returns.
There is little question that stocks and bonds belong in a portfolio. There is also substantial credible research demonstrating that adding exposure to certain factors – quantitative characteristics of stocks and bonds – increases portfolio diversification and expected returns. While many factors such as size, value, and profitability are relatively well-known, there are others that are discussed less frequently: trend following is one of those factors.
Trend following strategies are implemented with managed futures. Managed futures attempt to capture a factor known as time-series momentum, or trend momentum. This factor consists of long exposure to assets with recent positive returns and short exposure to assets with recent negative returns. The strategy is agnostic to the type of assets, meaning that it can be implemented with equities, fixed income, commodities and currencies.
Managed futures have historically proven to have strong returns, low correlation with stocks and bonds, and low volatility in general. Notably, the Credit Suisse Managed Futures Liquid Index returned 23.05% in USD in calendar year 2008 while the Russell 3000 – an index of US stocks – returned negative 37.31%.
This was not the first time that managed futures offered strong returns in bad markets. In a 2017 paper from AQR titled A Century of Evidence on Trend-Following Investing, the authors found that the performance of this strategy has been very consistent, including through the Great Depression and other substantially negative market events. Beyond the returns being strong, the asset class has maintained nearly no correlation with stocks or bonds, providing a substantial diversification benefit over time.
We do not consider implementing an investment product unless it is backed by great research. To meet that criteria, the research must show that a strategy is persistent, pervasive, robust, sensible, and investable. The research on managed futures does check many of these boxes – it is persistent, pervasive, and robust. The biggest questions are whether or not there is a sensible explanation for managed futures to outperform going forward, and is it investable?
Small cap and value stocks are riskier assets and therefore it is sensible that they would have persistent higher expected returns. The explanation for managed futures’ outperformance is harder to grasp. From the AQR paper:
The most likely candidates to explain why markets have tended to trend more often than not include investors’ behavioral biases, market frictions, hedging demands, and market interventions by central banks and governments. Such market interventions and hedging programs are still prevalent, and investors are likely to continue to suffer from the same behavioral biases that have influenced price behavior over the past century, setting the stage for trend-following investing going forward.
This is a bit of a stretch as far as expectations for the future go. Betting on persistent risk premiums makes sense. Betting on persistent behavioural biases and market interventions is not something that I am comfortable with. Is it reasonable to bet on behaviour persisting? Human behaviour can change, especially when we have knowledge about our past behaviour. Behavioural errors are notably different than risk premiums.
To be investable a strategy has to be cost effective and tax efficient to implement. We can look to a real-world example to examine how investable the managed futures strategy is.
In Canada, Horizons launched the Auspice Managed Futures Index ETF (HMF) in 2012. It closed in 2018 due to a lack of assets. A managed futures index is quite different from a typical low-turnover total market cap weighted index; managed futures indexes use a pre-defined quantitative methodology to follow the managed futures strategy. Similar to any momentum-based strategy, managed futures have an inherently high turnover.
HMF had a management expense ratio of a little over 1%, but it also had a substantial trading expense ratio in each year of operation due to the high turnover of the strategy. The TER is a real cost that reduces returns and must be considered.
Horizons Auspice Managed Futures Index ETF TER
Data Source: Horizons' HMF MRFP
As a point of reference, the Dimensional Fund Advisors US Vector Equity fund, which is a US total market fund with a heavy tilt toward small cap and value stocks, typically has a TER of 0.01%. This is not an apples to apples comparison as the two strategies are vastly different, but you see the difference in implementation costs between a small cap value strategy and a managed futures strategy.
The total costs of implementing this strategy are high, exceeding 2% in some years. These costs could be justified with a sensible reason to continue expecting substantial outperformance, but I believe that aspect of this strategy is too uncertain to bank on.
High turnover leads to tax inefficiency. Much like expenses, taxes lower investor returns. A managed futures fund could be held in a tax-preferred account to mitigate this issue, but the tax inefficiency is another drawback to contend with.
Does It Belong in a Portfolio?
I cannot argue with the fact that managed futures look excellent in a back test, and there are a lot of people much smarter than me selling managed futures products based on these back tests. Without a sensible risk-based explanation, the high costs and tax inefficiency of this strategy will keep me away for now.
Original post at pwlcapital.com