Managed futures: Time to get back in

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.”

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