Managed futures, which are often referred to as CTAs are quantitative, evidence-based hedge fund strategies that seek to generate returns by investing in trends across a broad range of asset classes including rates, currencies, equities, bonds and commodities using futures. They are also often referred to as trend following strategies, with many funds having been around since the early 1980’s, some as early as the 1940s.
The trend is your friend
Human beings suffer from many behavioural flaws and biases that can cause us to act irrationally at times e.g. loss aversion, overconfidence, trend-chasing bias and anchoring to name a few, which now form part of the behavioural finance literature. The great news is, money can be made from these biases!
One such bias that results in trends being formed is called ‘conservatism bias’, which highlights that investors tend to under-react to news, and only progressively include the available information into asset class prices. This inertia leads to trends being formed. Trends are also formed because investors’ expectations are directly influenced by past trends: e.g. positive trends make them optimistic about future prices and vice versa. Trend following, together with “herding” is one the mental shortcuts (“heuristics”) that investors use to make their investment decisions when the volume of information is just too great to analyse. This is a direct contradiction to the idea that investors are always rational and can process infinite amounts of information almost instantaneously.
Currently, we are witnessing a very strong trend in the ever-increasing price of Bitcoins, which JPMorgan’s CEO Jamie Dimon, referred to as a “fraud”, threatening to sack any of his staff that invested in them. One of the most famous price trends (and subsequent collapses) was witnessed in the 17th Century during the Dutch Golden Age when the price of tulips reached astronomical heights before spectacularly collapsing, ruining many ‘investors / speculators’ in the process. This episode is referred to as Tulip Mania, which is now featuring in the Justin Chadwick directed movie Tulip Fever, featuring Judi Dench.
Sir Isaac Newton, who lost $3m in today’s dollars in the South Sea Company collapse in the 1720’s (another example of herding and trend-chasing), famously said, ‘I could calculate the motions of the heavily bodies but not the madness of people’.
How do managed futures make money from these trends?
To summarise, when assets are going up in value, investors tend to drive those asset prices ever higher, creating very strong trends in the process (Sydney property anyone?). Conversely, when asset prices are going down in value, they often continue to go down, as investors attempt to cut their losses, in both cases acting on mass like a giant buffalo herd.
Essentially, managed futures make money from these powerful trends by buying asset classes that are going up in value, whilst short selling asset classes that are going down in value. They do it across multiple asset classes, offering a very high level of diversification. Of course, trends can, and do, change – and when they do, managed futures strategies change their exposures in an unemotional and unbiased manner.
Liquidity is critical
Whilst trends do occur in individual stocks etc, managed futures funds, as the name suggests, typically invest in the underlying asset classes e.g. Cocoa, Sugar, US Rates, AUD, Gold etc by using futures to access the asset class that is experiencing a strong price move. ‘Futures are financial contracts obligating the buyer to purchase an asset or the seller to sell an asset, such as a physical commodity or a financial instrument, at a predetermined future date and price. They are standardized to facilitate trading on a futures exchange (Investopedia).’
Using futures is more cost-effective than physically trying to buy grain, or gold, or sugar etc with the holding costs that go with that. Further, investors want to be able to access their funds quickly if needed, and the managed futures managers want to be able to trade quickly with minimal costs, which is what investing in futures allows.
The GFC (and other market sell-offs) highlight their value
During the GFC we all experienced what happened to equities, but as we know, equities tend to crash down (it’s what we call ‘negatively skewed’) – it is one of the reasons why we demand a decent reward for holding them, to compensate, in large part, for these occasional large losses. But unlike equities, managed futures strategies crash up (e.g. ‘positively skewed’). That is, when they crash, they go up in value, which is exactly what happened during the GFC with many funds producing 20%+ returns. It is because of this ‘crash up’ feature that they are used by many financial advisers as a diversifying strategy. Using more technical language, managed futures are lowly correlated to traditional assets (i.e. they often zig, when equities zag), which means when added to a portfolio of equities and bonds, the overall Sharpe ratio (risk-adjusted returns) improves – the one free lunch in financial markets i.e. ‘diversification’.
When don’t they work and other criticisms?
Managed futures or trend following strategies as the name suggests, rely on powerful trends across multiple asset classes for them to deliver positive results for investors. As such, in any sideways trading markets, they can produce negative or flat returns.
Another valid criticism for many (but not all) of the strategies offered to Australian financial advisers is the very high, alpha-like fees charged for what is classified as a well known ‘alternative beta’ strategy. It is expected that lower fee funds will be offered in time.
How do I access these strategies?
In Australia today, there are several retail managed futures products available to investors that include Aspect Capital, Man AHL, Winton, AQR* and more recently CFM* – each of these firms have very strong links to academia, given their scientific foundations and have invested 100’s of millions of dollars in risk management, computational power and governance systems. The differences between each fund manager relates to the models they use to assess the trends, the average holding period per investment, the number of markets they trade in, the fees charged, the level of fund volatility and how they go about managing risk.
But at the core of each strategy, is the ability to make money from the trends created by the madness of crowds!
*Andrew Fairweather is a Founding Partner in Winston Capital Partners, which specialises in absolute returns funds. Andrew holds investments in both AQR and CFM, and has a commercial relationship with CFM.