Managed Futures Funds
Hedge funds come in a variety of shapes and sizes. There is a vast range of strategies or objectives, and these can be constructed and implemented differently. Some strategies may seek to enhance return, while others may target diversification.
Understanding the specific goals of varying hedge fund strategies can be helpful in recognizing and identifying which strategies may be suitable for a specific goal or situation.
In this piece, we are going to discuss the managed futures strategy.
Managed futures funds gained prominence when former Harvard professor John Lintner in 1983, wrote a classic paper discussing the strategy. In general, managed futures strategies utilize a top-down investment approach, focused primarily on capitalizing on the trends in global financial markets.
Some of the most common financial markets traded within managed futures funds are:
Amongst these global markets, managers typically allocate assets to areas that are well-established and have deeply liquid markets. In doing so, a manager can be very nimble when allocating capital. Liquidity is crucial as managed futures funds are generally recognized as a trend-following strategy, which requires the ability to quickly move money from one financial market to another as trends are established and/or broken.
Liquid financial markets also help alleviate the market impact. When a large asset manager executes trades, they risk impacting the price of the securities for which they are trading. If a manager has significantly impacted the market price, there is a chance that the manager may be unable to complete the entire trade.
Managed futures is a strategy whereby managers trade futures contracts. These managers are known in the U.S. as Commodity Trading Advisors (CTAs). Traditional money managers generally trade in stocks and bonds, whereas CTAs primarily go long and short futures contracts.
A futures contract is an agreement to buy or sell a particular position at a future date. The price and notional value of the futures contract are fixed at the time of the agreement, with most contracts liquidated prior to the contract’s expiration date.
Futures positions don’t own assets. Instead, they are exposures based on the notional value of the futures contracts held. This exposure stems from the contract being a commitment to buy the underlying asset in the ‘future.’
The futures markets where these contracts are traded are generally viewed as very liquid because they trade on regulated exchanges. The minimal collateral requirements also make it easier to implement leverage, often a notable characteristic associated with the strategy.
When thinking about the types of futures contracts held, it’s important to begin with the main strategy buckets: equities, fixed-income, commodities, and currencies.
Within equities, managers could go long or short index level contracts such as E-Mini S&P 500 futures. Within commodities, there are natural gas contracts, lumber contracts, or copper contracts, to name a few.
These examples are provided to illustrate the breadth of markets for which managed futures funds can allocate capital.
Managed futures funds can employ either a systematic or discretionary process.
A systematic CTA utilizes models or computer programs to make trades. These models seek to uncover patterns in financial assets and exploit these patterns by making predictions and executing portfolio decisions based on these predictions. Patterns can be identified based on technical analysis such as momentum indicators or fundamental factors such as GDP growth.
The overarching goal is to implement a model that performs well in a future “out of sample” period. Like most things, patterns don’t last forever and thus require continuous revision to locate new patterns or recognize when an existing pattern is broken.
A discretionary CTA differs from its counterpart as investment decisions are made at the discretion of the manager. Discretionary managers trading futures contracts and managing risk remains highly technical, but trading decisions are subject to the judgment and fundamental and technical analysis of a human.
Those who allocate to managed futures funds generally seek to supplement traditional portfolios with this globally diversified, liquid, and non-correlated strategy.
The uncorrelated nature of this strategy with traditional assets makes for an attractive diversification opportunity. And historically, the return distribution generally exhibits a greater level of positive skew relative to other hedge fund strategies when faced with market stress, meaning they often do well in down markets.
Conversely, this strategy has shown to underperform and be a drag on a portfolio in periods where the market grinds slowly higher. Markets environments with lower levels of volatility generally also lead to underperformance because these managers are unable to take advantage of market dislocation.
Moreover, with systematic CTA’s, significant model risk is present as market stress is by no means guaranteed to yield positive alpha. The models designed by managers must still be able to correctly identify and correctly predict the movements of the global financial markets.
Managed futures funds trade in markets that are outside of the purview of the general population. As such, they can often be viewed as an esoteric strategy. Managed futures funds, however, can be implemented and executed differently, meaning the opportunity set, investment horizon, and use of leverage can vary from one manager to the next. Many managed futures funds tend to implement a top-down approach in highly liquid markets.
Some CTAs implement a systematic approach, while others implement a discretionary approach. Overall, the strategy seeks to generate a positive return in any economic environment, but the ability of this strategy to short can lead to positive returns during times of market stress.
As such, the strategy may warrant consideration for investor portfolios.