Following the devastating losses in equity markets during the 2008 financial crisis, many investors found that their portfolios were not as diversified as they had expected. During this period, managed futures, or commodity trading advisors (CTAs), posted some of their best returns in the last two decades. This scenario has cast light onto the diversification benefits of including managed futures in equity-heavy portfolios. Although the benefits of futures seem to be more widely understood, the key to understanding their performance lies in understanding why they are able to deliver "crisis alpha" during moments of stress in markets and should be expected to do so in the future.
Periods of market crisis represent times when, for both institutional and behavioral reasons, market players are more likely to be driven or forced into action. When this happens, in collection, financial markets behave drastically differently and this collective behavior can create predictable opportunities across all types of markets. It is precisely the select few players that can adapt to this new market environment who are able to take advantage of the crisis alpha opportunities.
During an equity crisis, most market players cannot take advantage of these opportunities for several reasons. First, almost all market participants, both active and passive, are long-biased toward equities (and this includes most types of hedge funds including long/short). Times when equities take large losses represent times when the vast majority of investors are losing money. Passive investors will be more likely to become active, and losses will be more likely to cause investors to be driven by more predictable behavioral and emotional based decision-making.
Second, market frictions and investment constraints are widespread across the financial industry. In many cases, these constraints are imposed by federal regulation as a way to monitor the risk-taking of certain sub-classes of market participants. In less regulated industries, such as hedge funds, these rules are often self-imposed to signal to potential investors that a firm has limits on their risk-taking. Common examples of these are de-gearing limits, risk-limits, stop-loss limits, drawdown limits and, of course, margin and collateral requirements. These rules are set up to force investors to react when they take losses. When equity markets take large losses, in an investment universe that is long-biased on equity markets, the large majority of investors will be forced into action as a result of these institutional and self-imposed investment constraints.
It also is well documented that volatility and correlations rise when equity markets takes losses. Whether this is caused by institutional regulation or not is difficult to say, but it is clear that the vast majority of investors will be affected by investment constraints during moments with equity losses, increased volatility and high correlations, and thus be forced into action. When large groups of investors are forced into action, fundamental valuation becomes less relevant and markets can move in directions that may be more predictable than they normally would be. When the balance of competition in markets is offset, liquidity disappears and volatility increases, making it even more difficult for market participants to follow the actions they are driven or forced into following. This situation will not only affect equity markets, but as large groups of market participants attempt to dump certain assets or fly to others, this will create predictable trends in auxiliary markets. A commonly cited example is a classic flight to quality in which traditional institutional investors will move from equities to Treasuries.
In ordinary market scenarios, financial markets are highly competitive and relatively efficient. Yet, in times of stress, because of both behavioral and institutional reasons as explained above, the market environment can change drastically and market efficiency can become stressed (see "Crisis mode," above). During this new stressed financial environment, commodity trading advisors (CTAs) are some of the few players able to adapt and deliver crisis alpha (see "A port in the storm," below).