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Will a Negative Roll Yield Shut Down Managed Futures Bond Tailwind?

August 27, 2013

 

This past April legendary bond trader Bill Gross penned a timely, introspective article titled after the famous Michael Jackson song - “A Man in the Mirror.” In summary, Mr. Gross ponders if many of the world’s greatest investors from Peter Lynch, to Ray Dalio, to Warren Buffet, as well as himself should thank thirty years of nothing but falling interest rates for their overall success. The discussion questioned whether these sold called “Kings” would have been able to replicate their returns in an interest rate environment other than what we have seen the past thirty years. Mr. Gross didn't answer the question, leaving us with an open ended outlook that essentially says investors should be prepared for "change" or in Michael Jackson's words "chaaaaaaange."

We immediately saw parallels with our little corner of the universe – managed futures, where those very same falling interest rates have similarly been a boon to many a manager and the asset class as a whole, providing what some have called a falling rate tailwind.  

How good has the bond tailwind been?

Quite Good! Earlier this year, We highlighted Quest Partners research, which points out that fixed income has been nothing but a boon to trend followers, contributing close to 100% of the returns for the Btop50 index per their factor analysis testing. They had this to say:

“The drop in global sovereign bond yields over the last 30 years resulted in price trends that were an ideal environment for trend following. Capital gains and positive carry jointly contributed to strong efficient trends with few reversals… Also, since 1987, the established uptrends in Fixed Income further accelerated during equity corrections, which provided CTAs with outsized returns. These returns during equity corrections came without the typical delay and losses experienced by TF models as trends reverse at such a critical time in a portfolio.”

We’ve  also looked at Welton Investment Corp.’s research showing fixed income accounting for about 45% of the [hypothetical] return for trend following during falling interest rate periods, despite their trend following model only allocating 25% of the risk to fixed income. [disclaimer: their research was intended for educational purposes only, and does not represent trading in actual accounts. See full hypothetical disclaimer below]

And back in 2011, we did our own research showing 52% of returns due to fixed income during the past six market crisis periods.  

Is the bond tailwind gone?

Well, change might be upon us faster than we thought.  Take the following chart courtesy SocGen via Barry RItholtz showing US 10-Year Note Yields up nearly 70% over the past 16 weeks, the highest such percentage change in 15 years!  

Increase in Bonds
Chart Courtesy: SoGen
Disclaimer: (Past performance is not necassirly indicative to future results)

This recent spike is a little hard to ignore, and the root appears to be that wonderful phrase that has been plastered all over the financial press and twitter of late – Fed Tapering. Just what is ‘tapering?’ We found a nice explanation on about.com of all places:

“Tapering” is a term that exploded into the financial lexicon on May 22, when U.S. Federal Reserve Chairman Ben Bernanke stated in testimony before Congress that that Fed may taper the bond-buying program known as quantitative easing (QE) in the coming months. Currently, expectations are the at the Fed will bring its current pace of $85 billion per month in bond purchases to $60 or $65 billion within its next three meetings, which take place on September 17-18, October 31, and December 17-18.

If you would prefer a metaphor – think of tapering like a kid just out of college having his parent’s tell him it’s time to trade in the $100 sushi dinners for $2 cans of Tuna – as they will no longer be paying the credit card bill.

But enough of the what and why; the fact is, rates have risen, and most forecast them to keep rising. The reason might be because of tapering, the US running out of money, or because the economy is doing so well it can afford to have higher rates.

So how did managed futures do during this sort of rising rates dress rehearsal?

Managed Futures and 10 Yr Yields
Disclaimer: (Past performance is not necassirly indicative to future results)

Not so great. We charted out the Newedge CTA index’s daily returns over the past 16 weeks (80days), and it’s down about 5% as yields have rallied over 70% in 10 YR notes. It is worth noting that the 10-yr moves are somewhat inflated numbers, because relatively small moves in rates coming from close to zero make for larger percentage moves.

We also know there has been a whole lot of other things going on dragging managed futures down recently, such as reversals in equities, grains, and the US Dollar in late June/July.  So we can’t pin all the blame on rising interest rates (bond prices down).

Does the Bond tailwind work in reverse?

But let us assume for a second that recent managed futures losses are due to the rise in interest rates. If that is the case, why is that so?  It is a down trend. And isn’t a trend a trend – no matter whether it goes up or down? Well, yes, the beauty of managed futures does lie in their ability to capture market trends, both long and short, up or down. That, in theory, means trend followers should be able to profit from an extended downturn in bonds (rates up) just like they have been able to from the extended up move outlined earlier.

But…. there are a few problems with that theory:

Niederhoffer points out roll yield:

In his April update to investors the infamous short-term volatility trader, Mr. Roy Niederhoffer, argues that managed futures investors should not expect trend following investors to benefit from a sustained downward trend in bond prices. The crux of Mr. Niederhoffer’s argument is that barring an inverted yield curve where investors can earn carry (roll yield) for holding short bonds, trend followers should expect to have to pay (the cost to roll from one month to the next) for the right to be short in the market. 

-  Sell-and-hold is not the inverse of buy-and-hold -

“The chart at right summarizes our findings. A buy-and-hold strategy in 10-year Note futures returned about +110% since 1990, an annualized return of +4.7%. However, if interest rates were to rise for the next 23 years in exactly the opposite fashion, the yield from sell-and-hold is a shocking -24%, about -1% per year. The huge discrepancy is caused by the negative carry of being short futures while the yield curve is positively sloping. The massive 5.8% per year difference in return will pose a tremendous challenge for CTAs and Hedge Funds, and most certainly calls into question the idea that a rise in interest rates will not pose a problem for long duration strategies because it is just as easy to be short futures as it is to be long.”  


Short Not inverse of long
Disclaimer: (Past Performance is not nessacrrily indicative to future results)

With most trend followers holding bonds for a period of three months or longer (depending on the trend), this is a valid argument.  For example, at the close of business today, it would cost a trader who is holding a short September 10 year note future just over $1000 to roll that position from the September contract to December contract (of course, if they knew they wanted to hold for a longer period, they could simply enter the further out contract).  Multiply this by four potential rolls per year (-$4000) and suddenly holding short fixed income does not look as attractive as it did at first glance. Plus, we also need to consider that not only are trend followers now paying for the right to be short the market, they are also giving up the $1000 in additional roll yield they would have taken in when holding long.  So you are looking at a combined $8,000 per contract difference. Yuck.

Mr. Niederhoffer further supports his position via three assumptions:

1. Inverted Yield Curve:

Inverted Yield Curve
2. CTAs have made the majority of their gains from holding the long end of the curve (10 year notes and 30 year bonds).

3. The path of rates will rise in the same manner they fell – a slow upward climb.

Whether these three assumptions hold true is anyone’s guess; although we would agree that an inverted curve for a lengthy period of time is unlikely.  However, if the next 12 to 36 months are as interesting as everyone expects them to be, it isn’t hard to fathom that the curve might flip back and forth more often than it has in the past.

As for assumption #2, we think there is quite a bit more trend following on the short end of the curve than Niederhoffer assumes. That is based on our tracking the positions of quite a few trend following CTA’s on a daily basis and seeing positions on both ends of the curve (fed funds, Eurodollars, 2’s, and 5’s in addition to 10’s, 30’s, and the new ultras), as well as both short and long ends of a variety of fixed income markets from around the world including Australia, Europe, and Asia.

As for the assumption that rates will fall in the same manner that they went up, that seems very unlikely to us just based on the fact that life rarely repeats (or mirror images) itself.

What’s the fixed income pro think?

We’ll be the first to tell you we’re not necessarily fixed income experts, and we don’t have Bill Gross’ number on speed dial. But we do know a bond guru in his own right, Mr. Jay Feurstein of 2100 Xenon. Jay has spent his entire career studying and trading fixed income. He even shared a desk early in his career with Richard Sandour and John Harding, who are credited (according to Jay) with creating and drafting the first financial (bond) futures contact. If anyone could speak intelligently on what a bond market selloff might look like, it’s likely to be Jay. Here is what he had to say:

“Global bond markets behave differently when they go down. They are more volatile and the downward trend is anything but smooth. Traditional trend-following models have difficulty capturing “bearish” bond markets because trend following is too slow and too static. Rather, fundamental factor models are much better at capturing “bearish” bond behavior. The factors often coincide with the sudden downward trajectory in global bonds. Also, such models are more persistent. They are “sticky” so that the short positions remain through the inevitable sharp reversals that happen so often during bearish bond markets. In fact, some of the biggest one-day bond rallies have happened in the midst of sharply trending bear markets. Fundamental models are able to weather those moves while trend-following models most often “stop “ out so that they miss the subsequent selloff that typically follows the short-term bullishness.”

                     -  Jay Feuerstein, CEO 2100 Xenon 

Hmmmm… Based on Mr. Feuerstein’s comments, we think it safe to toss out assumption #3 that the fixed income markets will behave the same on the way down as they did on the way up. But unfortunately, it sounds like Mr. Feurstein agrees with Niederhoffer that trend followers might struggle with falling bond prices (higher rates), albeit for a different reason.   

What do we do now?

So what do we do now? Give up? Do we throw managed futures out of the portfolio because trend following might have problems with falling bond prices and the negative roll yield?

In the words of college football’s Lee Corso – “Not so fast my friends” (we’re ready for some football).

For starters, we saw in Welton’s aforementioned piece a month or so ago that a [hypothetical] trend following model performed head and shoulders above stocks and bonds during periods of rising interest rates, seeing average gains of 12% while the S&P 500 was flat and 10-yr treasuries down about 1.5%. So getting rid of managed futures because of a weakness in one area may be throwing the proverbial baby out with the bath water. [disclaimer: this is intended for educational purposes only, and does not represent trading in actual accounts. See full hypothetical disclaimer below].

The bigger point, however, is that trend following doesn’t have to be all about fixed income. It can (and in our opinion, SHOULD) be about commodities, too. Managed futures managers do have to register as Commodity Trading Advisors after all; and the ‘commodity’ moniker might be more accurate for managed futures in a rising rate environment than ever before.

The change is coming, whether we like it or not. And trend following programs that rely too heavily on fixed income probably may have a hard time justifying the large fixed income allocations if they fail to keep up with the competition that has a larger allocation to commodity markets. This is where the small to mid-size CTAs that still have ability to trade lower volume commodity markets might separate themselves from the “big boys” who have been forced out of trading commodities with any effective size in favor of the more liquid currency, equity index, and fixed income asset classes.

So what will managed futures managers and investors find when they look in the mirror over the next 3, 5, or 10 years? More than likely it will not be a mirror image of the past with the portfolios making the same money being short bonds. The rest of the portfolio, namely commodities and currencies will need to pick up the slack. 

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.