Planning matters

“Once in a Lifetime”1

Note from the author:

Since this article first appeared in the July 17, 2015 issue of the Portland Business Journal, U.S. stocks have incurred two periods of heightened volatility, dropping 11% and 10% respectively. Given two stressful periods in equities over a short eight-month time period, it made sense to update this article and summarize how a managed futures strategy2 performed as stocks declined.

During the August 2015 stock market selloff, the S&P 500 dropped 11% while a managed futures strategy gained 3.50%. And, during the most recent year-to-date drop in stocks, the S&P 500 declined by over 10% while managed futures rose by 7%. Strategies that are uncorrelated to stocks, such as managed futures, provide enhanced diversification benefits to a typical stock/bond asset allocation. Therefore, it’s critical that individual investors view such strategies within the context of an overall portfolio as opposed to a stand-alone asset. Keep this in mind, and enjoy the update!

This once catchy lyric could surely be a metaphor for the Federal Reserve’s policy of easy money and near zero interest rates. Or perhaps, even the conundrum of negative interest rates in greater parts of Western Europe and Asia where, for example, investors are paying the governments of Germany, Switzerland, and Japan to hold their investment monies. But most likely, this lyric could sum up an era of free money driving up the prices of bonds, art, and housing. So, how does an investor navigate in an environment where most assets appear to be trading above their intrinsic value?

To start, we believe that compressed interest rates and elevated stock valuations indicate that a traditional 60/40 (stock/bond) portfolio will not perform as well moving forward as it has over the past five years.3 Therefore, it makes sense to consider repositioning such portfolios to include strategies that exhibit low or negative correlations to stocks, and also have the ability to perform well during periods of rising interest rates. Managed futures, also known as trend-following investing, is an alternative investment strategy that involves buying markets that are rising, and selling markets that are declining. Such markets include equity indices, various commodities, currencies, and/or government bonds.

Managed futures strategies have a long history of strong positive returns in both up and down markets. They also exhibit low correlation to traditional asset classes (Exhibit 1), and have the potential to produce positive returns in a rising interest rate environment. However, as with any investment, there are risks. Managed futures tend to perform poorly when markets stay range-bound with no defined trend, or when established trends sharply reverse. Furthermore, because the return profile is atypical of traditional asset classes and can experience drawdowns when stocks and bonds don’t, investors often lose sight of the uncorrelated return pattern, become frustrated and sell before allowing the investment to perform.

Exhibit 1: Simulated Correlations: Managed Futures Strategy to broad US Equity and Bond Markets

Asset Class

20 Year

10 Year

5 Year

3 Year

1 Year

US Stocks

-0.10

-0.14

0.01

-0.19

-0.39

US Aggregate Bonds

0.14

-0.18

0.09

0.20

0.21

Data: AQR Capital Management. Each time period ending in 3/2015. Note: a value of +1 is a perfect positive correlation, -1 is a perfect negative correlation, and 0 is no correlation or completely random. US Stocks represented by the S&P 500 Index. US Aggregate Bonds represented by the Barclays US Aggregate Bond Index.

Exhibit 2 shows the unconventional return pattern of managed futures, as represented by the Barclay CTA Index, and compared to US Stocks and US Aggregate Bonds from 2000-2015. The results show significant diversification benefits, as evidenced by both better relative performance and positive absolute returns when stocks have declined. Moreover, during periods of market stress, such as in 2008 when stocks dropped by 37%, managed futures performed well and produced a positive return of 14.09%.

Exhibit 2: Atypical Return Pattern of Managed Futures versus US Stocks and US Aggregate Bonds

Year

US Aggregate Bonds

US Stocks

Managed Futures

2015

0.55%

1.38%

-1.50%

2014

5.97%

13.69%

7.61%

2013

-2.02%

32.39%

-1.42%

2012

4.22%

16.00%

-1.70%

2011

7.84%

2.11%

-3.09%

2010

6.54%

15.06%

7.05%

2009

5.93%

26.46%

-0.10%

2008

5.24%

-37.00%

14.09%

2007

6.97%

5.49%

7.64%

2006

4.33%

15.79%

3.54%

2005

2.43%

4.91%

1.71%

2004

4.34%

10.88%

3.30%

2003

4.10%

28.68%

8.69%

2002

10.26%

-22.10%

12.36%

2001

8.43%

-11.89%

0.84%

2000

11.63%

-9.10%

7.86%

Data: Barclays, YCharts, BarclayHedge. Note: US Stocks represented by the S&P 500 Index. US Aggregate Bonds represented by the Barclays US Aggregate Bond Index. Managed Futures represented by the Barclay CTA Index.

Overall, because of the aforementioned characteristics, to include a modest allocation in a basic managed futures strategy may provide significant diversification benefits to a 60/40 portfolio. Exhibit 3 shows estimated return, risk-adjusted return (ratio), and volatility metrics for a standard 60/40 portfolio and a portfolio with 10% allocated to a managed futures strategy (55/35/10).

Exhibit 3: Diversifying a 60/40 Portfolio with a 10% Allocation to a Managed Futures Strategy

Portfolio

(Stocks / Bonds / Managed Futures)

Estimated Return

Volatility

(Standard Deviation)

Risk-Adjusted Return

(Sharpe Ratio)

60/40

7.12%

10.77

0.66

55/35/10

6.79%

9.60

0.71

Data: Morningstar, JP Morgan Asset Management. Performance is hypothetical as described above. Estimated returns are calculated using long-term arithmetic mean, and assumes reinvestment into the same strategy/portfolio over an indefinite time period and no rebalancing. 60/40 Portfolio is 36% US Stocks, 24% International Stocks and 40% US Aggregate Bonds. 55/35/10 Portfolio is 31% US Stocks, 24% International Stocks, 35% US Aggregate Bonds and 10% Managed Futures.

Hence, we believe that a modest allocation taken from both stocks and bonds and reallocated to a managed futures strategy has the potential to fortify an investor’s portfolio by enhancing diversification, improving risk-adjusted return, and reducing potential drawdowns when markets fall.

Footnotes:
1.Written by David Byrne, Brian Eno, Chris Frantz, Jerry Harrison, and Tina Weymouth. From the album ‘Remain in Light’, by the Talking Heads, February 1981

2.Managed Futures strategy represented by the AQR Managed Futures Strategy
3.Five-year average annual return (to 3/31/2016) of a Balanced Composite Index comprising 60% Broad US Stocks & 40% US Aggregate Bonds: 8.48%. Source: Vanguard

Disclosures:
The information presented herein has been obtained or derived by sources believed to be accurate and reliable. This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to purchases any securities or other financial instruments, and may not be construed as such.
The investment strategy, views, and themes described herein may not be suitable for all investors.
All opinions expressed are those of the author and are current only as of the date appearing on this material.
There is risk of substantial loss associated with trading equity, currency, interest rate and commodity-related futures, options, derivatives and other financial instruments. Before trading, investors should carefully consider their whole financial position and tolerance for risk, and determine if the proposed trading style and investment strategy is appropriate.
The performance results contained herein do not reflect the deduction of transaction costs and other fees that may be associated with investing, such as brokerage or advisory fees. Past performance is not an indication of future results, and should not be construed as such.