The Alternative Investment Management Association and Societe Generale Prime Services have together put out a white paper about managed futures funds and the commodity trading advisers who manage them.
A key themes of the paper is that managed futures strategies aren’t as risky as are typical investments in equity markets. Managed futures do require patience, though, due to lumpy returns and long (though comparatively shallow) periods of drawdown.
Also, the market is highly algorithmic, which the authors of this paper treat as a good thing. As they write, “[T]rades are predominantly automated and decisions are made by following rules and signals Adhering to such a system of trading is a useful method of avoiding a number of the common behavioral biases that can affect discretionary traders.”
Riding the Wave(s)
Another of the benefits of algorithmic trading, mentioned late in the paper, is that it can reduce the trading footprint of a particular CTA in its execution of its strategy. Some investors are wary of managed futures funds in the belief that they have gotten too large in size, meaning that they become the market everyone else is playing. The paper contradicts this view, crediting the “development of execution alghorithms that seek to break large orders into smaller pieces” and in general the “sophistication and efficiency with which a trading order is processed.”
The authors note that trend following is the most common strategy in the managed futures space. In fact, that is the inspiration of the title of the paper, “Managed Futures: Riding the Wave.” Expounding on the metaphor a bit, the authors of the paper observe that there exists “no one and openly perfect way to catch and surf a wave.” Some surfers will wait a long time for a really gnarly wave. Others “will look to coast in and out on a number of shorter rides.”
In a foreword Jack Inglis, the CEO of AIMA, and Tom Wrobel, director of Alternatives Investment Consulting at SGPS, say that CTAs are “not for everybody.” But they add their hope that with the help of this paper “investors will be able to make better informed choices about the sector.”
Not a Black Box
The paper contradicts the common impression that such a fund is a “black box,” that is, a vessel into which the investor pours money on faith, without any opportunity to understand what is going on inside.
To this the authors respond first that on the broad level of strategy, there was never anything “black” about the box. The market inefficiencies and resulting market trends have been discussed and expounded in a number of papers; models have been generated and tested, all in the light of day.
At the more specific advisory level, CTA’s “have long been renowned for providing transparency” including where demanded segregated individual managed accounts and funds. For investors and institutional allocators who want help asking the right questions, the report references the AIMA Due Diligence Questionnaire, as a tool to elucidating how a manager’s strategy will develop, what are the primary sources of returns, what are the products and markets involved, as well as “the investment terms, structure, governance, and the effectiveness of the firm’s operations.”
Though market realities and thus the issue of performance may make some opacity necessary, this is no more so for managed futures than for a range of other investments.
As noted above, trend following is the most common strategy in the area. At the beginning of this millennium it represented roughly 85% of the assets under management in the field. But that percentage fell slowly through the next 4 years, and then fell more sharply in the three years after that, so that figure was down to below 50% before the Global Financial Crisis got underway. It has recovered some of that ground since, though not much.
Quantitative macro, commodities, and currencies strategies gained ground while that movement away from trend following was underway.
Still, the great importance of the trend-following strategy helps explain the “lumpy” nature of the returns in this space, and the need for patience. After all, trend followers need markets with a distinctive trend they can follow! As a consequence, range-bound trendless markets will often produce underperformance or losses, because in those contexts the market can “zig” just when the trend followers have set their course to “zag.”