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).
Delivering crisis alpha
Managed futures strategies are subject to often self-imposed portfolio constraints, such as drawdown limits, risk limits and de-gearing. Several important characteristics differentiate them from hedge funds. They only trade in futures markets, they generally follow systematic trading strategies and they do not have a long bias to equities. Futures markets are some of the most liquid, transparent and credit-protected markets. This means that even in a time of crisis, they will still be more efficient than most markets. The absence of a long bias to equities and that they generally follow systematic trading models also will mean that these strategies may be less susceptible to the behavioral reactions the general market will experience. Systematic managed futures programs react to price and often will be in position or will get in position to take advantage of price dislocations in various sectors following the onset of a crisis. The result is that managed futures are affected initially by institutional limits during an equity market crisis (sometimes positively), but unlike other market players, they are able to change their positions quicker, be less susceptible to behavioral biases and position themselves to take advantage of opportunities, while other investors still are dealing with portfolio losses, illiquidity and lack of credit solvency (see "Performing under stress").
Given that managed futures can deliver crisis alpha, understanding CTA performance becomes straightforward. In standard market environments, because they trade in highly competitive and efficient markets, even with a particular edge or skill, they can deliver only modest returns in relation to traditional investments. During market crisis, however, their systematic nature and access to liquidity allow them to adapt to take advantage of an environment where most investors are unable to compete. These opportunities do not come primarily from short equity positions, but crisis alpha opportunities occur across a wide set of asset classes (see "The power of diversification").
We can break down performance into the risk-free rate and the following two pieces: 1) Using RPM Risk & Portfolio Management’s technical composite, an actual asset-weighted performance of all U.S.-dollar-denominated trading accounts in systematic technical managers that have been held in RPM’s managed futures portfolios, and 2) Equity crisis performance as defined by prolonged periods of negative monthly returns.
Given that RPM’s technical composite represents physically held portfolios of managers, crisis alpha performance also can be examined by sector. Profit opportunities occur across almost all asset classes during market crisis while the size of these opportunities and the ability of managed futures to take advantage of them will depend on market conditions pre- and post-crisis.
The flash crash is an example of a rather short-lived crisis period where managed futures seemed to find some opportunities in short rates and bonds while their inability to properly time equities and energy resulted in net losses. In this case, the crisis was not substantial enough to create sufficient alpha opportunities for a managed futures strategy. This example demonstrates how managed futures strategies are systematically different from insurance strategies (like those based on volatility or options) and in particular why crisis alpha is a much better description of what managed futures strategies deliver. "Crisis alpha and CTA indexes" (right) shows that outside of crisis alpha, managed futures’ average return is roughly the risk-free rate. This demonstrates that skill in managed futures is linked both to managers’ ability to provide crisis alpha and to deliver a risk premium when markets are more efficient.
The future of managed futures
Equity market crises are times when investors become polarized in their actions and markets experience brief periods of reduced efficiency. During these moments, managed futures can deliver crisis alpha by taking advantage of this predictability. Globalization and the increased integration of financial markets, coupled with a post-credit-crisis push for regulation, should create a market environment that is even more susceptible to these effects. Given this view, managed futures should be expected to deliver crisis alpha going forward as well. An understanding of crisis alpha provides a new and perhaps simpler interpretation of what managed futures deliver as a strategy and what they should be expected to deliver going forward.
Kathryn M. Kaminski holds a PhD from the MIT Sloan School of Management as well as visiting lecturer positions at the Stockholm School of Economics and MIT Sloan School of Management. Her research interests are in portfolio management, behavioral finance and alternative investments. She is an investment researcher at RPM Risk & Portfolio Management. Contact her at katy.kaminski@rpm.se.
