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Managed Futures Outlook - 2013
January 15, 2013
Add 2012 to the list of poor managed futures years. It wasn’t supposed to be this way. 2012 was supposed to the bounce back year for managed futures after a negative 2011. Managed futures as an asset class had never had back to back losing years, so it surely wasn’t going to happen this time… right?
Wrong. As the disclaimer says – past performance is not necessarily indicative of future results. Managed futures did indeed put in back to back losing years, with the main managed futures indices finishing down between –1.65% and –3.21%. And the bigger problem – that’s three out of four losing years for the poster child for portfolio diversification after 2008. What’s worse, it’s not like managed futures losses came in the context of larger losses for stocks or bonds or real estate. Nope, they performed poorly on a relative scale too, coming in last among the asset classes we track:
The question is – what’s next? What does 2013 hold? Do we give up? Is trend following really dead? Has high frequency trading (HFT) really changed the game for non trend followers?
Well, it's pure folly to pretend we can say with any accuracy where managed futures will end up over the next 12 months. We're not interested in playing that game. No, we’re interested in analyzing the conditions which caused managed futures as an asset class to perform the way it did in 2012, and discussing whether those conditions will persist in the new year, reverse course, or yield to different conditions.
The Volatility Puzzle
Managed futures are often referred to as a long volatility investment in our materials and elsewhere, meaning they are expected to do well when the volatility expands in the markets they track (essentially every global market). Historically, they have done well when there is more volatility (think 2008), and not as well when volatility is contracting (2005).
But then came 2010, with managed futures seeing gains in spite of a declining volatility environment (not something many people were complaining about). And then 2011, with managed futures posting losses even with an increase on volatility across most markets. The head scratching was in full force. Had managed futures lost their compass, so to speak? Their raison d'être? If we couldn't count on their performing when volatility expands, what could we count on?
The above chart compares the 264 day Avg True Range (ATR) in dollar terms as of the last day of each year with the same measure from the previous year to determine the annual percentage increase/decrease in each market’s volatilty.
Well, a quick glance at the chart above tells us these worries are premature, with the main reason for managed futures losses in 2012 being a massive contraction in volatility - reversing the confusing pattern of the past two years when volatility expansion/contraction wasn’t a driver of managed futures performance.
That is a silver lining to be sure, as investors count on that relationship to protect their portfolio, and usually aren’t as worried about their long volatility portfolio component underperforming in a volatility reducing up market for risky assets. The impressive performance of stocks and real estate in the asset class table above tells us managed futures wasn't really called in to perform in 2012. While you wouldn't believe it from watching the news day in and day out, there wasn’t a true market crisis in 2012 that would have shone a spotlight on managed futures.
This is especially true when looking across a broad swath or markets. As the table below shows, across the 47 markets we track, and using the average true daily range instead of a measure such as the VIX (which plummeted in 2012), volatility was way down, with a higher percentage of markets seeing falling volatility as well as a higher level of decline than even 2009.
We were somewhat worried about his coming into the year, saying the following in our 2011 outlook:
With the threat of the EuroZone coming undone, a possible hard landing for China, war games with Iran, and further fireworks in the US as our debt mounts higher and higher, it seems an easy choice to say volatility will likely rise across the 44 stock, bond, and commodity markets we track. But the contrarian in us wants to think that the more likely course is a volatility contraction to counter the expansion we just lived through
But we didn’t think we would be looking at an environment so bad it would be near 2009 levels of decreasing volatility. That contraction made sense in the context of coming after the massive volatility expansion of 2008; but 2011 was no 2008. How could we see such a big drop in volatility off such a small increase in volatility in 2011?
Which got us to thinking… what if we’re still working off the volatility expansion we saw in 2006, 2007, and 2008? Much like the real economy is still trying to work off the excesses of the credit bubble by deleveraging, what if it takes years for volatility to return to pre-crisis levels?
That’s a scary thought for those who rely on volatility for a living. For example, several markets such as Corn, Gold, the German Dax, Hong Kong’s Hang Seng, and Wheat saw 300% or greater increases in their 100 day average true range between 2006 and 2008, yet have only “given back” -26% of those volatility gains in the 4 years since the crisis. Are we at a "new normal" in terms of volatility, where these markets remain permanently above their pre-crisis levels, or do we have many more years of volatility contraction to go until things return to normal? Food for thought.
Trending Markets… Calling All Trending Markets…
Why do we care so much about expansions in volatility? Because they usually result in the type of directional volatility (although not always) which leads to trending markets. And trending markets are the engine that makes managed futures go.
Unfortunately, 2012 was about as good in terms of trending markets as it was for expanding volatility... meaning terrible. We saw the lowest reading in 13 years for our average percentage of trending days indicator on a sampling of 6 markets meant to act as a crude proxy for a managed futures portfolio. (S&P 500, Crude Oil, Soybeans, US Dollar, 30yr Bonds, and Copper - when we have a free week, we’ll run it on a full sampling of markets and share the data on our blog). We define trending via the ADX indicator, considering a day trending when its ADX reading is greater than the previous day.
The asset class built on trend following has trouble when there are no trends, plain and simple. And the silver lining here, again, is that this relationship between performance and trending days reasserted itself, even if it was on the downside; giving us hope that it will remain in place when the percent of trending days cycles back to the upside.
But that all begs the question – where have the trending days gone? Is it a normal down phase like we see in the chart above, with the markets cycling between trendiness and non-trendiness – or is something more sinister at work which has resulted in two of the past four years seeing the worst trendiness readings of the past 13 years?
Is trend following dead?
We touched on this concept of something more sinister at work (that this time is different) in managed futures poor performance in three of the past four years in our newsletter titled: Is Trend Following Dead? And the resulting discussion around that newsletter centered around 5 main themes on why this is such a poor environment for trend following and, by extension, managed futures as a whole.
In no particular order, the main "problems" people put forth arguing this time is different are:
- There is too much money in trend following now, distorting the trends in the markets.
- Continuous government intervention in the markets has stymied the development (expansion) of significant trends by creating false backstops.
- Risk on/risk off trading has brought all correlations to one- there is no diversification anymore.
- Interest rates at 0% have made it too difficult to make money.
- High frequency trading has destabilized the natural progression of the market cycles.
Roland Austrup of Integrated Managed Futures Corporation weighed in on the subject, saying:
There is little information to support that “this time is different” and that trends will not emerge… an environment of lower inter-market correlations (and lower volatility) mathematically results in a greater probability that some markets will trend (&/or increase in volatility) regardless of what is going on elsewhere. Thus the removal of fear in markets in 2012 is sufficient to support a higher probability of a normal degree of trending markets going forward, and industry-average performance versus underperformance [in 2013].
We agree with the sentiment, Roland – but also want to expand on it by tackling each of the doubters’ claims above to see whether they have legs or not. And an annual outlook on the managed futures environment in 2013 seems like as good of a place as any to get that down on digital paper.
1. There is too much money
We don’t see this as a problem for managed futures as a whole, nor something which is hurting the trendiness of markets, and have never heard of a manager complain of too much slippage or trouble getting the trades they want because of too much completion.
For one, futures trading volume hasn’t mirrored this supposed growth problem. More and more money into managed futures should mean more and more volume, but the CME saw volume fall -15% last year and has averaged volume growth of just 0.25% per year since 2009 – hardly an explosion of volume which would skew markets.
Also, the validity of the managed futures assets under management (AUM) number is in question, in our opinion. We spoke on our blog a while back about the AUM being inflated by about 56% due to BarclayHedge’s inclusion of hedge fund Bridgewater in the number, and can back out some Bridgewater growth in AUM numbers to see that, of the reported growth of $124 billion in managed futures AUM since 2009, about $100 billion of that is due to Bridgewater alone.
So is $20 billion of real managed futures money added to the asset class since 2007/2008 really enough to skew markets and distort trends, all without proof of it happening via volume numbers? We don’t think so.
2. Government Intervention
We’ll pass on some comments from Tom Rollinger of Sunrise Capital to sum up the fears here:
Why have [managed futures] seen sub-optimal performance since ? Mainly due to the lack of sustained trends. Why has there been a lack of sustained trends? No one can say for sure, but it appears government intervention and the human emotions of doubt and concern are playing a part.
During the Great Financial Crisis the U.S. Government took a very active approach – in fact they appeared to have “co-signed” for the entire U.S. real estate mortgage market …They allowed major changes to important accounting laws, and “free markets” were no longer free. The Fed is doing everything it can to keep interest rates artificially low – this is very likely having an effect on the global futures markets that most trend following CTAs trade. Artificially manipulated and back-stopped markets behave differently than markets that are allowed to move based on more typical factors.
Scott Foster of short term trader Dominion Capital echoed these thoughts:
Markets move not for normal economic reasons (supply/demand, trade/money flow), but almost exclusively on the words and whims of politicians and central bankers. The same political hacks that have sent the entire western world into staggering debts and deficits—routinely appear on television sending markets into a tizzy with their unsustainable, ridiculous “solutions” to the problems they have created and incentivized. Artificial interest rates, currency manipulation, and banning of short selling are just a few of the “manipulations” in the marketplace that keep prices from performing their market functions. This has created a tremendous amount of “noise” in most markets relative to absolute price movement—which I believe is the primary cause of the under-performance over the last several years in managed futures. Short-term trading is impacted to a greater degree by this noise, as their signals tend to be closer to the current market price…
It is easy to see the connection here – where backstopped markets are not markets free to move where they want and find their own equilibrium, and we won’t argue that government intervention has been a problem for managed futures and their reactive (not predictive) models.
But what does this government intervention look like in 2013 and beyond? Two graphics below tell a story of the intervention slowing down. In the first (lifted from Bill Gross Jan ’13 outlook) , we see that the central bank balance sheets expanded by about 8% from May ‘11 to May ‘12, as compared to growth of about 24% from May ’10 to May ’11, clearly a slow down.
And in the second, we see that the US Fed balance sheet expansion flattened out in 2012 after a run up in 2011.
In short, it appears to us that most of the intervention work/damage has been done, and that there isn’t the physical ammunition or political/public willingness to do as much intervention as we’ve already seen.
Could there be more intervention? Sure. Will it be on the same scale as what we’ve lived through over the past four years and affect markets in the same way? Very doubtful. The bigger story here moving forward is likely the market effect of unwinding these balance sheets. Will that be seen as artificial activity which hurts markets, or will it cause beneficial market moves for managed futures? Only time will tell.
3. Risk On/Risk Off Environment
The Risk On/Risk Off-environment-is-hurting-managed-futures argument goes like this: managed futures portfolios rely on diversification as a risk tool, with losses in one market hopefully offset by gains in another non correlated market seeing trends while the other is seeing a false breakout. A higher than normal correlation between markets causes all of the “risk on” markets to all breakout and reverse trends at, or close to, the same time – robbing managed futures of this diversification risk tool.
We created the following chart looking at the percent of days seeing risk on/risk off behavior since 2000 to get a handle on just where we are in the risk on/risk off cycle, if you will. The results surprised us a bit, with risk on/risk off days coming back to 2006 levels, and down sharply since their highs in 2008 and 2009.
How did we come up with this chart? We looked at the daily price moves for 20 "risk" markets, and then calculated an average daily gain across those markets. If the change is a gain of greater than 1%, that day is considered "risk on." If the change is a loss of greater than -1%, that day is considered "risk off." Otherwise, it is considered "normal." The 20 markets are: British Pound, Euro, Yen, Nasdaq, S&P 500, Sugar, Cotton, Coffee, Cocoa, Soybeans, Wheat, Corn, Heating Oil, Crude Oil, RBOB Gas, Copper, Palladium, Platinum, Silver, and Gold.
We’re hopeful this is the start of a pattern in this direction, as a further weakening of the Risk On/Risk Off environment should further improve managed futures performance through strengthening multi-market programs' market diversification risk tools and allowing fundamental traders to do what they do best – which is specific market analysis, not macro level bets on the world economy.
4. Interest Rates at Zero
We’ve highlighted on our blog how bonds at the zero bound aren’t necessarily a bad thing for managed futures, but we’re coming around to the idea that while not necessarily hurtful, interest rates at zero aren’t really providing a beneficial environment for managed futures, either. For example, losses in other markets may not be able to be offset by gains in bonds as they could have been in years past.
So we’ll agree that interest rates remaining at zero isn’t the best case scenario for managed futures, and that they are more likely to do well in 2013 if the world can somehow figure out a way to let interest rates rise (like they have since the end of November).
Managed futures love bonds for many reasons: their lower risk per contract entry levels, liquidity, volume, and use as a flight to safety investment by investors the world over, and we can’t say this enough: When and if the long awaited bond bull unwinds, managed futures will have a front row seat and likely be screaming in joy all the way down (rates up).
5. High Frequency Trading
We put the question of how and if High Frequency Trading in futures markets is affecting managed futures performance to a few managers to get a sense of what the mood toward HFT is out there, and whether it is being used as an excuse for poor performance in managed futures.
The answers we got back, such as the following from Nigol Koulajian of Quest Partners, LLC told us most managers are not viewing HFT as a problem:
I don’t think HFT is affecting or breaking systems other than time frames with less than 2 days per trade. Volatility breakout strategies might be affected a little but most HFT is directly competing with market makers and mean reversion traders, not the typical CTA. Volatility breakout has stopped working in the past 3-4 years but it is not clear if this is due to the low volatility environment or to some longer term factor such as HFT. My sense is that it is 75% due to the environment and 25% due to HFT.
But that’s not to say it is not a concern or something managers are dealing with. Take Mesirow Financial Commodities manager Tom Willis’ comments, for example:
There’s no question that high frequency trading has altered the information coming across the trading screen on a tick by tick basis- it doesn’t have the same meaning anymore....[as] the ability to manage that information on a short term basis has been compromised- [with information becoming] random, less meaningful than it used to be.…
The way we see it is that you can try to play their game, but you won’t beat them... until regulation comes in, and we’re not going to wait around for that. It probably should- jamming in quotes is manipulation, but I’m not here to fight that battle.
If your ideas are still good, what you have to do is elevate your time horizon to a level where they [HFT] have a much smaller impact on your profitability. Once you have that, you can stand on the strength of your ideas.
It makes sense that HFT would affect short term information, and absent an arms race for ever faster co located servers, that a move to a bit longer time frame is needed to retain an edge in the short term time space. As for the longer term trend following space, we can’t find any managers who believe that HFT tactics in the futures markets are affecting long term trendiness of markets, and we can’t think of an argument as to how they could affect trades with weeks to months-long hold times (anyone have one?).
In the end, HFT is not going away anytime soon, and will be something managers have to contend with and adapt to. Dominion’s Scott Foster may have put it best:
What is the key for successfully navigating the short-term space? The answer is what it has always been—research. Futures managers have been adapting to structural and secular changes in the markets for over 40 years—and the successful will continue to do so. This is proving to be a bigger challenge, then say, adapting from the inflationary markets of the 70's to the deflationary 80's, but it is a challenge that will be met and overcome.
We see all of the factors above coming together in one way or another to support a bounce back year of positive performance for managed futures as a whole in 2013. We’ll also count on some support from the weak, non scientific logic that the asset class is due for some good returns after the past 4 years.
How can we get there? For starters, with an expansion of volatility driven by a simple reversion to the volatility mean of the past few years, or if that fails – by any one of the 10 sarcastic reasons Michael Belkin put forward on why you should be bullish on US stocks listed here.
And coming off its lowest reading since we started tracking it, we see market trendiness cycling back towards its long term average of about 45% of days (up from 27%), again to the benefit of managed futures. This expansion of volatility across global markets may result in an increase in intermarket correlation, resulting in a bump up in the percent of days seeing risk on/risk off behaviour, but that isn’t necessarily a bad thing if the risk on or risk off moves are bunched together – as we saw in 2008.
Where can some of this volatility expansion and better trendiness come from in 2013?
Bonds, Bonds, Bonds, Bonds
We continue to see bonds as a big wildcard which could dwarf the results from other sectors should we start to move off of the zero line in US fed funds (as we have the past month or so) and see more volatility expansion in the bond market as traders try and guess exactly where rates will end up. This trade will happen eventually – the question is just whether there will be any managed futures investors left around to benefit when it does.
Debt Ceiling/US debt debate
What could move bonds finally? How about failure to solve the debt ceiling in the next month. We watched Congress flail on the subject in 2011, but by the looks of it, the 113th Congress will be just as dysfunctional (if not more so) than the 112th. While the failure to raise the debt ceiling in time looks likely, the impact of that failure is far less clear. The short term affect would likely be a negative event for managed futures with risk on/risk off spiking and trendiness taking a hit with a “surprise” failure likely to result in trend reversals; but the longer term effect could be disillusionment with the US government’s ability to handle its own affairs. And that sort of disrespect in the bond world means higher rates, which means lower prices.
The Euro Crisis
It seems like yesterday that the Euro Crisis was unfolding, but it actually subsided in 2012, as evidenced by the European stock index and bond futures markets we track seeing an average volatility contraction of -34% (about 1.3 times more of a contraction than in the rest of the markets). Even Christine Lagarde of the IMF is on board, saying recently: “We forecast the eurozone to be delivering growth in 2013, which is better than the recession that it has experienced in 2012. There is an improvement, and there is the beginning of recovery.”
But the contrarian in us thinks it highly unlikely we’ve seen the worst of the Euro Crisis - just look at the recent streak of violence in Greece. If the same scene plays out, with medium term sell offs interrupted by sharp rallies based on “solutions” put forth by Euro area big wigs, that could expand volatility – but in such a way where it is not directional volatility – resulting in lower trendiness. But if a “they tried and failed” sentiment takes hold, it could expand volatility and provide meaningful trends in the Euro currency and Euro area bonds.
You can’t go very far in any analysis of commodity markets without bumping into China and their insatiable demand for hard commodities, but writing concisely about the potential impact of China in the coming year is a little bit like trying to provide a one paragraph summary of a set of encyclopaedias.
The China story all boils down to growth and whether its eventual slow down occurs via a hard landing or soft landing. A hard landing would likely be a better scenario for managed futures as it would be sure to create some massive volatility expansion in nearly everything – starting first and foremost with hard commodities like Copper and Crude Oil, then by association the so called commodity currencies of the Aussie and Canadian dollars, which in turn affects the US dollar, which in turn affects everything priced in dollars, and so on.. you get the point. A soft landing could, in theory, provide a nice smooth down trend; but we feel it would be more likely to provide mixed signals and a choppier environment with fewer trending days for the aforementioned markets.
Our last wildcard looking ahead will be the same wildcard which popped up in 2010 and 2012 – weather and climate issues. As has been widely reported, 2012 clocked in as the hottest year on record, with the Midwestern drought driving big moves in grain markets this summer and gains for agriculture-focused CTAs. Before that, it was the Russian drought of 2010. Whether it is lingering problems from those droughts, or a storm like Katrina or the more recent Sandy causing damage to the oil industry in the gulf or economies in the East, weather-related market moves seem to be becoming more and more common – and indeed two of the most expensive years for disasters in the US have been recently. That’s bad for those in nature’s path, but good for markets in terms of moving on their own fundamentals instead of as one in a risk on/risk off environment. That’s good news for the market diversification used by the bulk of managed futures programs as a risk tool.
The Bottom Line
Some of these market environment improvements might already be under way; with many managed futures programs having caught on to trends in the Japanese Yen, Nikkei, and Euro Currency to name a few, posting gains in December and thus far in January.
The Yen move has been of particular interest, as it all but ignored the movements of US markets during the fiscal cliff drama (when the S&P sold off about -4% then rallied about 6% upon a deal) and carried along on its own trend.
That is just the sort of non-correlated move managed futures want (and need) to see more of, and whether such moves are brought on by geo-political reasons, weather, or other reasons, we really don’t care. Just bring them on, already.
2012 was unfortunate for managed futures, but we remain optimistic (half joking disclaimer: there is a heavy bias and feeling of ‘what else are we supposed to do’ embedded in that optimism). There are a variety of catalysts in the mix for 2013, and each of them presents unique opportunities for volatility to expand and for trends to emerge- regardless of the outcome. This opinion has been echoed by people across the industry in conversation.
We’ll leave you with the opinion of Roland Austrup of Integrated, which we couldn’t agree with more:
Looking forward, [all the QE money] either has to work or it won’t work… and either outcome results in market trends.
Here’s to more volatility, more trends, and a better year for managed futures in 2013.
Jeff Malec, CAIA
IMPORTANT RISK DISCLOSURE
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IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.
Past performance is not necessarily indicative of future results. The performance data for the various Commodity Trading Advisor ("CTA") and Managed Forex programs listed above are compiled from various sources, including Barclay Hedge, Attain Capital Management, LLC's ("Attain") own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.
The dollar based performance data for the various trading systems listed above represent the actual profits and losses achieved on a single contract basis in client accounts, and are inclusive of a $50 per round turn commission ($30 per e-mini contracts). Except where noted, the gains/losses are for closed out trades. The actual percentage gains/losses experienced by investors will vary depending on many factors, including, but not limited to: starting account balances, market behavior, the duration and extent of investor's participation (whether or not all signals are taken) in the specified system and money management techniques. Because of this, actual percentage gains/losses experienced by investors may be materially different than the percentage gains/losses as presented on this website.
Please read carefully the CFTC required disclaimer regarding hypothetical results below.
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.