A new paper from Aquila Capital Group looks at managed futures, and makes the case that they offer investments tools with which one can achieve a “robust and diversifying risk/return profile.”
The paper begins with the concerns many investors have at present. Record long bull markets, high asset prices, and correlations among asset classes are all spooky.
But ‘be not afraid,’ as the angels say. There are good strategies out there. A good strategy in this environment has to be highly liquid “in order to allow for dynamic exposure management.” And a managed futures strategy can be liquid as well as adaptive.
The authors are: Urs Schubiger, Egon Ruetsche – Fabian Dori. Each is a quantitative strategist and portfolio manager in Aquila’s Systematic Trading Group. Ruetsche holds a Ph.D. in arithmetic geometry from the ETH, Zurich, Switzerland. Schubiger holds a master’s in mathematics, also from ETH, and a law degree from the University of Basel. Dori has a master’s in Quantitative Economics and Finance from the University of St Gallen.
King in Stress Scenarios
Schubiger et al speak of the prospect of attractive returns in turbulent times as the “King in Stress Scenarios,” or KISS. [Presumably this is a play on another and ‘simpler’ use of the acronym KISS, though that is not mentioned in the paper.]
The authors match managed futures scenarios against those of both a traditional benchmark and a diversified benchmark. The traditional benchmark is a hypothetical portfolio invested 60% in bonds and 40% in equity. The diversified benchmark is 50% in bonds, 40% in equities, 10% in commodities. Both are rebalanced monthly.
The hypothetical managed futures position matched against them “combines momentum and carries with a risk budgeting engine, and allows for both long and short positions.” The short positions are taken on if the PM gets negative momentum and carry signals. The risk budgeting engine “adjusts the positions by examining both the volatility of and co-movements between the individual assets.” Risk balancing is daily, and transaction costs are factored in.
Interest Rate Scenarios
The three portfolios under consideration are tested against a range of scenarios as to average interest rate change, from -1.8% to +1.5%, in a fixed 12 month window.
The returns from bonds are inversely correlated to the changes in interest rates. Equities, likewise, benefit from falling yields but on average equities maintain gains even during periods of strong interest rate increases.
“We attribute this,” the authors say, “to the fact that interest rates are usually positively correlated with the business cycle and, therefore, corporate profitability.”
As for the third element in the diversified benchmark: commodities work as an inflation hedge and interest rates can serve as a proxy of inflation, so commodities gain the most then.
The traditional and diversified benchmark (TB and DB) are very close to each other in performance assuming a 1.8% fall in interest rates. They are also both very close to the managed futures portfolio in that situation: each of the three receives close to a 12% return.
As these authors’ simulations assume lesser falls, the DB is hurt most, returning roughly 3% given a fall of only 0.6%. The TB returns 3% in that situation and managed futures returns 7%.
But for even smaller changes than that, the three lines converge. Given interest rate stability (0% change) all three portfolios return 4%. Assuming interest rate increases, the returns of the managed futures portfolio steadily increase, up to 7% for the maximum rise envisioned, +1.5%.
Both the TB and the DB show poorer performance in a hypothetical time of increasing interest rates, falling into the negatives at the 1.5% level.
Although the DB in that last mentioned situation “enjoys diversification effects from its commodities exposure when interest rates advance … given its limitations to long-only positions and a restricted investment universe:” the other assets cannot fully make up for the losses in the bond portion of its portfolio. The MF portfolio is the clear KISS-er in that situation.
Breaking down the MF portfolio, these authors suggest that it is the dynamic adjustment of gold and foreign exchange that do the heavy lifting. Those are the assets that “stabilize the strategy when interest rates jump.”
The paper concludes with the observation that there exists a “wide variety of different managed futures strategies” and that the question of “which trend is your friend should … always be answered by a holistic portfolio setup.”