Tuesday, April 1, 2014

Managed futures: Time to get back in

By Spalding Hall & Paul Rieger

The case for an investment in Managed futures has arguably never been stronger. While portfolio diversification is always imperative, many are currently concerned that traditional asset classes like equities and fixed income are priced to offer little in the way of solid returns over the coming decade. In addition, and perhaps somewhat counterintuitively, many hedge funds fail to help clients hedge their investments, with many programs actually showing positive correlations with equity markets. In contrast, Managed futures programs are aimed at offering investors uncorrelated returns that not only genuinely diversify a portfolio but have the potential to increase overall portfolio returns while also lowering overall portfolio volatility.

John Hussman, President, Hussman Investment Trust, does solid research on equity market returns. His models, which have shown tight correlation with future equity market returns (almost 90%), are estimating nominal total returns in the range of 0 to 3% annually for the coming decade in the equity markets, while showing negative returns on all time horizons shorter than around seven years.

Equity markets are extremely overvalued with the median stock even richer now on a price/revenue basis than at the 2000 peak. Stocks are not only overvalued, but they are trading here on record profit margins. Corporate profits/GDP are 80% above their historical norm. This is a mean reverting series. What happens to earnings when margins revert to a more normal level? As Kyle Bass says about the P/E ratio: “The E is wrong!”

Bond yields also low

When it comes to the 10-year Treasury yield, around 2.7% is what Hussman thinks stocks will yield over the next decade. One can look for higher yields in some spreads, but bond spreads are historically tight here as well. The Bank of America Merrill Lynch High Yield Master Option Adjusted II Index is currently priced at 3.85%. That is not a lot of return for the commensurate risk, especially when one considers the absolute low level of yields. In “The Policy Portfolio and the Next Equity Bear Market,” Bill Hester explores the real value of bonds in a diversified portfolio. Bonds’ true contribution to a diversified portfolio is that they often increase in value when equities enter a bear market. However, bonds don’t always go up the same amount that equities lose. In fact, Mr. Hester shows that bonds perform best when yield levels begin at average to above average yields, and when yields begin with an average to above average rate of inflation (which is set to decline in a recession-induced bear market).

While space does not permit a discussion of all the scenarios considered by Hester, he concludes: “Notice that unless interest rates were to fall to negative levels, investors cannot expect bonds to provide the same portfolio benefit as they have during bear markets in recent memory. From this analysis, those investors who are relying on a policy portfolio framework to protect their capital during the next bear market are left with a limited range of favorable outcomes.” And finally: “If a larger decline in stock prices were to occur, and for bonds to still defend against losses to the extent they have during the last two bear markets, yields on U.S. Treasury notes would need to go negative. In data reaching back all the way to 1871, this has never happened. That would likely result from an expectation for deep deflation. With stocks at currently high multiples on normalized earnings, that type of scenario would probably increase the odds off a deep recession and induce a much larger decline in stock prices.”

With equities, fixed income and other traditional investment solutions showing significant limitations, what other asset class is well positioned to offer true portfolio diversification? Consider Managed futures. For one, many managed futures programs have produced solid returns in the face of declining equity markets. This key characteristic is often referred to as ‘crisis alpha’ and its importance is difficult to overstate: Managed futures performed well during the quarter of Black Monday 1987, the Persian Gulf War of 1990, the Long Term Capital Management episode and Russian Crisis of 1998, the recession of 2000 -2002 following the Tech Bubble, as well as the credit crunch of 2008. During all of these time periods equities suffered and managed futures thrived, offering investors a haven and buffer from declining equity prices.

Investors may believe that hedge funds are most optimally positioned to achieve the important function of portfolio diversification. However, as alluded to above, this is not necessarily the case. Many hedge funds are positively correlated with equity markets. The HFRI Weighted Index shows a strong correlation to the S&P 500 Total Return of 0.74. Also, some hedge funds trade in illiquid markets that lack transparency and readily available mark-to-market pricing. In addition, many hedge funds and private equity funds regularly ‘lock up’ investors for a year or more, rendering the hedge fund investment illiquid.

With the taper under way, and the long-term effects of Fed intervention on the equity and bond markets still largely unknown, it is time for genuine portfolio diversification with the non-correlation benefits of managed futures. Managed futures programs also equip investors with ‘crisis alpha’.  And unlike many alternative investments, including hedge funds, it offers more favorable liquidity terms. Futures and options on futures, the underlying markets used by managed futures programs, are exchange-traded and marked to market daily, offering investors and managers both liquidity and a level of transparency.

Diversifying a traditional portfolio with a 10% to 20% allocation to managed futures (see chart below) has the potential to increase overall returns and decrease volatility. Should the current rally in equities extend through the spring, it is set to become the fourth longest rally recorded over the last 113 years. When is a better time to consider the important diversification benefits offered by managed futuro?

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