Swedroe: Trend Following & Managed Futures

A commodity trading advisor (CTA), also known as a managed futures fund, is a hedge fund that uses commodity futures contracts. They use a variety of trading strategies, including systematic trading and trend following—the vast majority of CTAs use strategies based on trends (time-series momentum)—which take long positions on securities that are trending upward and/or short positions on securities that are trending downward. CTAs tout the benefits of diversification and the generation of alpha. Assets under management in this strategy have risen to more than $340 billion.

The intuition behind the existence of price trends is behavioral biases exhibited by investors, such as anchoring and herding, the disposition effect and confirmation bias, as well as the trading activity of nonprofit-seeking participants, such as central banks and corporate hedging programs. For instance, when central banks intervene to reduce currency and interest-rate volatility, they slow down the rate at which information is incorporated into prices, creating trends.

CTA Performance Research

Martin Florea, Stefan Florea, Iliya Kutsarov, Thomas Maier and Marcus Storr contribute to the literature on the performance of CTAs with their study “CTAs: Superior Performance or Diversification Only?”, which was published in the Spring 2018 issue of the Journal of Wealth Management. Their data set, which is free of the survivorship bias that plagues many studies, covered 1,558 CTAs and the period 1971 through 2016. The authors examined two issues related to the performance of CTAs:

1) Does allocation to CTAs improve risk-adjusted returns of traditional portfolios (stocks, bonds and commodities)?

2) Do they deliver above-average risk-adjusted returns on a stand-alone basis?

If the study were a boxing match, the outcome would be a split decision.

On the first question, the authors found that, while on a stand-alone basis, the risk-adjusted returns delivered by CTAs have been lower than those of traditional asset classes, the addition of CTAs improves a portfolio’s overall Sharpe ratio due to their diversification benefits—CTAs have exhibited virtually no average correlation with traditional asset classes. The diversification benefit allowed them to conclude that traditional portfolios would benefit from a significant (up to 20%) allocation to managed futures.

They also found that CTAs performed better during both extremely good and extremely bad periods in equity, bond and commodity markets—their strong performance during extremely bad periods provides a hedging benefit for traditional portfolios.

Another finding of interest was that CTAs do not exhibit fewer drawdowns compared with traditional asset classes. However, they typically have shorter drawdown periods, and ultimately manage to reduce average drawdown depth and maximum drawdown compared with equities and commodities.

Trend-Following Strategies & Alpha

On the second question, they found that most CTAs employing trend-following strategies do not deliver significant alpha—the average CTA does not generate statistically significant excess returns relative to benchmarks—indicating that investors are better served using cheaper methods to obtain similar diversification benefits. They also noted wide dispersions in returns.

This makes the choice of the vehicle chosen to gain exposure to managed futures important. Fortunately, today investors do not have to pay hedge-fundlike fees to access managed futures. Instead, lower-cost ETFs and mutual funds are available. (Full disclosure: My firm recommends AQR Capital Management’s funds in constructing client portfolios. These funds provide exposure to time-series momentum strategies, including their Alternative Risk Premia Fund and their managed futures funds.)

The above findings were consistent with those of Geetesh Bhardwaj, Gary Gorton and K. Geert Rouwenhorst, authors of the study “Fooling Some of the People All of the Time: The Inefficient Performance and Persistence of Commodity Trading Advisors,” which appeared in the November 2014 issue of The Review of Financial Studies. They found that from 1994 to 2012, CTA excess returns to investors (i.e., net of fees) were insignificantly different from zero, while gross excess returns (i.e., before fees) were 6.1%, which implies that managers captured the performance in fees. They also found that CTAs display no alpha relative to simple futures strategies in the public domain.

For those interested in a detailed review of the literature on time-series momentum, see my August 20, 2017, article “Diversification Benefits of Time Series Momentum.”

Summary

As an investment style, trend-following has existed for a long time. The data from the aforementioned studies provide out-of-sample evidence beyond the substantial evidence that already existed in the literature. The body of research also provides consistent, long-term evidence that trends have been pervasive features of global stock, bond, commodity and currency markets.

The bottom line is that, given the diversification benefits and the downside (tail-risk) hedging properties, a moderate portfolio allocation to trend-following strategies merits consideration. Note, however, that the generally high turnover of trend-following strategies renders them relatively tax inefficient. Thus, there should be a strong preference to hold them in tax-advantaged accounts.

One final note: As is the case with investments in all risky assets, patience and discipline are the keys to success. This is especially true in the case of managed futures/time-series momentum, because its largest benefits come in the rare, but very damaging, extensive bear markets in equities, such as the ones we experienced in 1973–74, 2000–02 and 2008. Thus, investors are best served to think of investments in this strategy as a form of insurance, hoping it is not needed.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.