Managed Futures and the Emergence of Core Trend-Following October 2014

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1 Dr Toby Goodworth, Director in the Hedge Fund and Liquid Alternatives team at, investigates strategies, assessing the recent development of Core benefits they could bring to institutional investors portfolios

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3 3 Table of Contents 04 The Evolution of Systematic Trading Strategies 05 What do CTAs Trade? 06 Why Allocate to? 08 The

4 4 Introduction strategies, also known as CTAs, are one of the oldest hedge fund strategies with a history stretching back to the late 1940s. The term CTA stands for Commodities Trading Advisor a term which accurately reflects the strategy s asset class origins. Although the CTA moniker has persisted through to today, modern Managed Futures strategies have benefited from the evolution of global futures markets and now trade a full range of markets across all major asset classes, and are no longer restricted to just trading commodities. As well as a focus on trading some of the most liquid instruments in the capital markets, another common trait of managers is their investment approach; strategies employ systematic (rules-based) quantitative models or algorithms to determine positions as opposed to a more discretionary investment process typical of many other hedge fund strategies. According to latest estimates (sourced from BarclayHedge), assets in the space total around $320bn, or roughly 13% of overall hedge fund and liquid alternatives industry assets, and by manager number they total around 1000, although this number varies quite significantly depending on the database used. As such, they represent an important part of the hedge fund and liquid alternatives landscape. The Evolution of Systematic Trading Strategies Compared to today, early trading strategies were comparatively simple, and focused predominantly on identifying trends in markets based purely on the evolution of their price data. As these algorithms were essentially agnostic to the direction of the trend, they were capable of making money when markets fell, as well as when they rose. Such an investment approach is commonly known as a Momentum or strategy and, despite being one of the oldest model types, it remains a very important tool in the toolbox of investing. Figure 1 below illustrates a simple variant of a momentum strategy, benefits it can bring in periods of both positive and negative market trends. As research in the area developed, so did the number of tools in the toolbox. Today, as well as the classic Momentum / strategies, which seek to identify market trends over periods of a week to several months (known as medium term models), there are also shorter-term trend models that can operate anywhere from tick-by-tick to several days investment horizon, as well long term models (typically 6 12 months plus) which can be more econometric in nature through the incorporation of non-price data sources such as GDP or inflation measures. Contrarian or reversion strategies are a type of model that seek to profit not from trends, but rather the breakdown of trends subsequent reversal of market directions. Finally, there are Cross-Asset models; algorithms that attempt to identify a tradable signal in one market using data from one or more other markets.

5 5 Index Level MODEL GOES SHORT FTSE 100 FTSE 100 (100 Day Moving Avg.) MODEL GOES LONG 3000 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Momentum Indicator Figure 1: Example of a simple trend following model using a 100 day moving average of the FTSE 100-index.The model is always in the market, taking a long position when the index level exceeds the moving average signal, and vice versa for a short position as shown by the momentum indicator signal in the lower chart. In this example, the model profits through the falling markets from mid-08 to early 09, as well as profiting from the subsequent rising markets from Q onwards. The terms and CTA are synonymous with one another, and are used somewhat interchangeably throughout the industry. More formally, however, the term is an umbrella term describing a range of strategies which include CTAs. At we have found it helpful to broadly classify the universe of managers as either Momentum (managers that have a clear bias towards trend-following strategies), or CTA (managers that employ a broader range of different trading strategies). However, there is always an exception to the rule, and that exception in this instance is the Systematic Macro manager. Systematic Macro managers may appear CTA-like, but a subtle distinction is made through the significant use of leading indicator and non-price models by systematic macro managers over the use of reactive, and more price-based data for CTAs. What do CTAs Trade? The range of instruments traded by managers is typically determined by the size and liquidity of the individual market. The majority of funds restrict themselves to trading anywhere between 50 to 80 of the most liquid markets across equity, fixed income, currency and commodities markets, and this is sufficient to provide full exposure across asset classes and, where appropriate, by geographic region too. An example set of commonly traded markets is shown below in table 1. In addition to the more common markets listed in table 1, some managers delve into esoteric, more thinly traded, markets albeit in smaller position sizes such as emerging market currencies, electricity, coal or even iron ore through to non-traditional markets such as credit markets (e.g. ITRAXX) or volatility markets. Here the belief is that the addition of more markets brings with it greater diversification, refore improved risk adjusted returns for the overall portfolio, but we would note this is at the expense of additional complexity and less liquidity. Another consideration for managers when determining which markets to trade is the speed of their models. Short term algorithms will inherently drive greater turnover in positions than

6 6 longer term models, application of sensible liquidity constraints by a manager (e.g. their position as a percentage of open interest in that market) will inevitably further restrict the range of eligible markets. Equity Fixed Income Currency Commodities S&P 500 US 10 Yr USD WTI Crude Oil Russell 2000 US 5 Yr CAD Brent Crude Oil DJ Ind. Avg. US 2 Yr GBP Natural Gas NASDAQ Can. Gov. Bond EUR Gold Euro STOXX Short Sterling CHF Silver DAX Long Gilt NOK Zinc CAC Euro Bund SEK Copper FTSE 100 Euro Bobl AUD Aluminium OMX Eurodollar NZD Wheat NIKKEI JGB JPY Soybean TOPIX Australia 3 Yr Corn Hang Seng Australia 10 Yr Sugar Coffee Cocoa Cotton Live Cattle Table 1: Common markets traded by strategies split by asset class. Why Allocate to? As well as being an integral component of many broad one-stop hedge fund allocations, e.g. through a well diversified multi-strategy fund of hedge funds, institutional investors may also chose specifically to allocate directly to strategies, and here the principal reason for doing so is one of diversification, as well as the proven persistence of positive return attributable to momentum in the long term. In addition to providing exposures to a range of markets not typically covered by a traditional portfolio, strategies are also equally as capable of posting positive performance in falling markets as well as rising markets. It is not the intention of this article to advocate an allocation for all to CTAs however, as shown below in figure 2, incorporating into a typical 60/40 equity-bond portfolio does improve its risk-return profile, and importantly CTAs were one of just a handful of hedge fund strategies to deliver very strong performance throughout the global financial crisis of 2008, arguably when it was needed most. However, as a counterpoint to the above, recent performance has generally been more muted, with representative indices, e.g. Newedge CTA index, posting small negative annual returns for 2011 and 2012, as well as having a negative 3 year trailing return. That said, year to date in 2014, CTAs returns have generally been stronger with August 2014 being one of, if not the strongest month for many in the post-crisis era. Alongside the dominant argument that strategies just simply haven t performed for a long time, other reasons that are commonly cited for not allocating to these strategies are ones of cost, with the funds being perceived as expensive. They are also considered by some to be too volatile. Whilst clearly not so against equity markets, when compared to the broader hedge fund universe (e.g. HFRI Fund Weighted index), Managed Futures funds have on average delivered their returns with 33% more volatility. Finally, there is also a concern that CTAs could simply be the wrong side of the next big equity market sell-off or bond market crack, and add to risk rather than diversify.

7 7 120% 100% 80% Traditional Portfolio Traditional Portfolio with 60% 40% 20% 0% -20% -40% Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Cumulative Return Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Managed Futures Traditional Portfolio Trad. Portfolio with Managed Futures Annualised Return 4.9% 3.3% 3.7% Annualised Volatility 8.6% 9.3% 7.5% Sharpe Ratio Period Returns Last 12m 6.3% 13.8% 12.3% Last 3 Years -0.3% 9.5% 7.6% Trad. Portfolio Peak to Trough (Oct 07 Feb 09) 17.5% -33.7% -25.3% Figure and Table 2: performance as represented by the Newedge CTA index in USD since inception (Jan 2000 to Aug 2014). Also shown is a traditional 60/40 equity-bond portfolio (MSCI World and JPM Global Govt. Bonds both in USD) with and without a 20% allocation (sized so as to illustrate the effect) to. Sharpe ratios have been calculated using the prevailing 1m USD risk free rates.

8 8 The Over the last year or so a new breed of funds have begun to emerge. Best classified as Core Trend, these are funds that focus either exclusively, or in the majority, on trend-following momentum strategies across a subset of the highest capacity markets, typically employing slower trading models that operate on a medium to longer term investment horizon. Empirically, we have also noted that these products are offered at a lower target volatility level (10 to 12% p.a.) than corresponding fully fledged CTAs which usually trade toward a 15% volatility target as standard. In exchange for these compromises Core Trend funds have been offered to investors at significantly lower fees, often with a flat fee option as well as the more traditional management and performance fee structure. The main Core Trend and CTA characteristics are compared in figure 3 below. Core Trend CTAs Eligible Markets Most Liquid Markets Liquid Markets Model Type Mainly Numerous Inv. Horizon Medium Longer Term Short Longer Term Target Volatility 10 12% p.a % p.a. Fees Lower Cost Higher Cost Figure 3: Main differences between Core Trend and CTA strategies Undoubtedly such strategies go some way to alleviating any potential capacity constraints managers may incur by trading less aggressively, at lower volatility (lower volatility equates to less notional capital, therefore fewer contracts traded), and only then in the very deepest of markets. Such strategies are therefore clearly advantageous to managers with existing products that have reached a size where they are near creating an unacceptable level market impact when they trade, either as a result of the speed of their trading or the markets they have chosen to trade in, as it allows them to continue asset raising as well as diversifying their revenue streams. However, there are also advantages to investors in that Core Trend funds might permit more cost conscious investors to access investment styles that were previously beyond their reach, or they might be more suitable for investors that only ever really wanted Core Trend type exposures without all the bells and whistles, but could not previously get it. Whilst there are only a handful of Core Trend funds that have been launched to date, we recognise that there is significant capability and willingness by managers to deliver such product if investors demand it. Given that Core Trend is an emergent strategy, it is pertinent to ask what the future holds for such investment approaches. The obvious questions to ask are Can Core Trend live alongside established fully-fledged CTAs within the same firm? but equally Can they survive without them? In terms of attracting a broader audience of investors, having a range of products with different objectives can be considered a positive, but only time will tell if existing investors elect to move their original investment into new lower cost offerings, thus potentially reducing firm revenues if new assets fail to materialise. In terms of Core Trend surviving without established CTAs, we would not expect a single asset manager to say that they haven t leveraged off their existing systems and expertise in developing Core Trend

9 9 products. However these teams and systems have historically been built off the revenues from more traditional 2 & 20 type fees (or more precisely 1.68% annual management fee and 20.49% performance fee according to the latest data from the 2014 Prequin Global Hedge Fund Report) as opposed to revenues from less expensive Core Trend products. If revenues shrink so, eventually, will the size of investment teams infrastructure spend required to sustain the levels of research and development they have historically enjoyed. We would also question whether price discovery in terms of the fee levels is still occurring, refore we wonder how cheap will Core Trend go? There is also anecdotal evidence that the presence of Core Trend products in the market is putting downward pressure on the fully fledged funds, so as they remain at least ballpark competitive on fees alone. Finally, there also has to be a back of the mind concern from managers over what happens if the lower cost fund consistently outperforms the unfettered, unrestricted flagship fund? Now, one swallow a summer doth not make, but going on year-to-date 2014 performance it seems those fears might be moving to the fore somewhat given Core Trend funds, in general, appear to be outperforming many fully fledged peers on a risk-adjusted basis, and in some cases an absolute basis too. Over the longer term however, many asset managers with both products would argue that expected Sharpe ratios for their Core Trend funds are slightly lower than those for their fully fledged funds given the constraints already highlighted. Conclusion In conclusion, we believe Core Trend strategies can prove themselves to be a useful addition to the range of strategies, and could benefit investors who are looking specifically to access trend-following strategies in a cost conscious manner. We expect the number of Core Trend products offered to rise as demand for the strategy grows. Whilst we feel that Core Trend strategies could happily coexist alongside other CTA strategies, it will be essential for investors in the strategy to keep track of relative performance and asset flows going forwards to ensure this really is the case. We would also hope that the arrival of Core Trend prompts investors in fully fledged CTAs to evaluate what they are paying extra for, and to ensure that these additional components are both desired and worth it.

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