June 2023 - Flirting with Models

In Return Stacking^TM: Strategies for Overcoming a Low Return Environment, we advocated for the addition of managed futures to traditionally allocated portfolios. We argued that managed futures’ low empirical correlation to both equities and bonds and its historically positive average returns makes it an attractive diversifier. More specifically, we recommended implementing managed futures as an overlay to a portfolio to avoid sacrificing exposure to core stocks and bonds.

The luxury of writing research is that we work in a “clean slate” environment. In the real world, however, investors and allocators must contemplate changes in the context of their existing portfolios. Investors rarely just hold pure beta exposure, and we must consider, therefore, not only how a managed futures overlay might interact with stocks and bonds, but also how it might interact with existing active tilts.

The most common portfolio tilt we see is towards value stocks (and, often, quality-screened value). With this in mind, we want to briefly explore whether stacking managed futures remains attractive in the presence of an existing value tilt.

Diversifying Value

If we are already allocated to value, one of our first concerns might be whether an allocation to managed futures actually provides a diversifying return stream. One of our primary arguments for including managed futures into a traditional stock/bond portfolio is its potential to hedge against inflationary pressures. However, there are arguments that value stocks do much of the same, acting as “low duration” stocks compared to their growth peers. For example, in 2022, the Russell 1000 Value outperformed the broader Russell 1000 by 1,145 basis points, offering a significant buoy during the throes of the largest bout of inflation volatility in recent history.

However, broader empirical evidence does not actually support the narrative that value hedges inflation (see, e.g., Baltussen, et al. (2022), Investing in Deflation, Inflation, and Stagflation Regimes) and we can see in Figure 1 that the long-term empirical correlations between managed futures and value is near-zero.

(Note that when we measure value in this piece, we will look at the returns of long-only value strategies minus the returns of broad equities to isolate the impact of the value tilt. As we recently wrote, a long-only value tilt can be effectively thought as long exposure to the market plus a portfolio that is long the over-weight positions and short the under-weight positions¹. By subtracting the market return from long-only value, we isolate the returns of the active bets the tilt is actually taking.)

Figure 1: Excess Return Correlation

Source: Kenneth French Data Library, BarclayHedge. Calculations by Newfound Research. Performance is backtested and hypothetical. Performance is gross of all costs (including, but not limited to, advisor fees, manager fees, taxes, and transaction costs) unless explicitly stated otherwise. Performance assumes the reinvestment of all dividends. Past performance is not indicative of future results. See Appendix A for index definitions.

Correlations, however, do not tell us about the tails. Therefore, we might also ask, “how have managed futures performed historically conditional upon value being in a drawdown?” As the past decade has shown, underperformance of value-oriented strategies relative to the broad market can make sticking to the strategy equally difficult.

Figure 2 shows the performance of the various value tilts as well as managed futures during periods when the value tilts realized a 10% or greater drawdown².

Figure 2: Value Relative Drawdowns Greater than 10%

We can see that while managed futures may not have explicitly hedged the drawdown in value, its performance remained largely independent and accretive to the portfolio as a whole.

To drive the point of independence home, we can calculate the univariate regression coefficients between value implementations and managed futures. We find that the relationship between the strategies is statistically insignificant in almost all cases. Figure 3 shows the results of such a regression.

Figure 3: Univariate Regression Coefficients

Source: Kenneth French Data Library, BarclayHedge. Calculations by Newfound Research. *, **, and *** indicate statistical significance at the 0.05, 0.01, and 0.001 level. Performance is backtested and hypothetical. Performance is gross of all costs (including, but not limited to, advisor fees, manager fees, taxes, and transaction costs) unless explicitly stated otherwise. Performance assumes the reinvestment of all dividends. Past performance is not indicative of future results. See Appendix A for index definitions.

But How Much?

As our previous figures demonstrate, managed futures has historically provided a positively diversifying benefit in relation to value; but how can we thoughtfully integrate an overlay into an portfolio that wants to retain an existing value tilt?

To find a robust solution to this question, we can employ simulation techniques. Specifically, we block bootstrap 100,000 ten-year simulated returns from three-month blocks to find the robust information ratios and MAR ratios (CAGR divided by maximum drawdown) of the value-tilt strategies when paired with managed futures.

Figure 4 shows the information ratio frontier of these portfolios, and Figure 5 shows the MAR ratio frontiers.

Figure 4: Information Ratio Frontier

Figure 5: MAR Ratio Frontier

Under both metrics it becomes clear that a 100% tilt to either value or managed futures is not prudent. In fact, the optimal mix, as measured by either the Information Ratio or MAR Ratio, appears to be consistently around the 40/60 mark. Figure 6 shows the blends of value and managed futures that maximizes both metrics.

Figure 6: Max Information and MAR Ratios

In Figure 7 we plot the backtest of a 40% value / 60% managed futures portfolio for the different value implementations.

Figure 7: 40/60 Portfolios of Long/Short Value and Managed Futures

These numbers suggest that an investor who currently tilts their equity exposure towards value may be better off by only tilting a portion of their equity towards value and introducing a managed futures overlay onto their portfolio. For example, if an investor has a 60% stock and 40% bond portfolio and the 60% stock exposure is currently all value, they might consider moving 36% of it into passive equity exposure and introducing a 36% managed futures overlay.

Depending on how averse a client is to tracking error, we can plot how the tracking error changes depending on the degree of portfolio tilt. Figure 8 shows the estimated tracking error when introducing varying allocations to the 40/60 value/managed futures overlay.

Figure 8: Relationship between Value/Managed Futures Tilt and Tracking Error

For example, if we wanted to implement a tilt to a quality value strategy, but wanted a maximum tracking error of 3%, the portfolio might add an approximate allocation of 46% to the 40/60 value/managed futures overlay. In other words, 18% of their equity should be put into quality-value stocks and a 28% overlay to managed futures should be introduced.

Using the same example of a 60% equity / 40% bond portfolio as before, the 3% tracking error portfolio would hold 42% in passive equities, 18% in quality-value, 40% in bonds, and 28% in a managed futures overlay.

What About Other Factors?

At this point, it should be of no surprise that these results extend to the other popular equity factors. Figures 8 and 9 show the efficient information ratio and MAR ratio frontiers when we view portfolios tilted towards the Profitability, Momentum, Size, and Investment factors.

Figure 9: Information Ratio Frontier for Profitability, Momentum, Size, and Investment Tilts

Figure 10: MAR Ratio Frontier for Profitability, Momentum, Size, and Investment Tilts

Figure 11: Max Information and MAR Ratios for Profitability, Momentum, Size, and Investment Tilts

Once again, a 40/60 split emerges as a surprisingly robust solution, suggesting that managed futures has historically offered a unique, diversifying return to all equity factors.

Conclusion

Our analysis highlights the considerations surrounding the use of managed futures as a complement to a traditional portfolio with a value tilt. While value investing remains justifiably popular in real-world portfolios, our findings indicate that managed futures can offer a diversifying return stream that complements such strategies. The potential for managed futures to act as a hedge against inflationary pressures, while also offering a diversifying exposure during relative value drawdowns, strengthens our advocacy for their inclusion through a return stacking^TM framework.

Our examination of the correlation between managed futures and value reveals a near-zero relationship, suggesting that managed futures can provide distinct benefits beyond those offered by a value-oriented approach alone. Moreover, our analysis demonstrates that a more conservative tilt to value, coupled with managed futures, may be a prudent choice for inverse to tracking error. This combination offers the potential to navigate unfavorable market environments and potentially holds more of a portfolio benefit than a singular focus on value.

Appendix A: Index Definitions

Book to Market – Equal-Weighted HiBM Returns for U.S. Equities (Kenneth French Data Library)

Profitability – Equal-Weighted HiOP Returns for U.S. Equities (Kenneth French Data Library)

Momentum – Equal-Weighted Hi PRIOR Returns for U.S. Equities (Kenneth French Data Library)

Size – Equal-Weighted SIZE Lo 30 Returns for U.S. Equities (Kenneth French Data Library)

Investment – Equal-Weighted INV Lo 30 Returns for U.S. Equities (Kenneth French Data Library)

Earnings Yield – Equal-Weighted E/P Hi 10 Returns for U.S. Equities (Kenneth French Data Library)

Cash Flow Yield – Equal-Weighted CF/P Hi 10 Returns for U.S. Equities (Kenneth French Data Library)

Dividend Yield – Equal-Weighted D/P Hi 10 Returns for U.S. Equities (Kenneth French Data Library)

Quality Value – Equal-Weighted blend of BIG HiBM HiOP, ME2 BM4 OP3, ME2 BM3 OP3, and ME2 BM3 OP4 Returns for U.S. Equities (Kenneth French Data Library)

Value Blend – An equal-weighted Returns of Book to Market, Earnings Yield, Cash Flow Yield, and Dividend Yield returns for U.S. Equities (Kenneth French Data Library)

Passive Equities (Market, Mkt) – U.S. total equity market return data from Kenneth French Library.

Managed Futures – BTOP50 Index (BarclayHedge). The BTOP50 Index seeks to replicate the overall composition of the managed futures industry with regard to trading style and overall market exposure. The BTOP50 employs a top-down approach in selecting its constituents. The largest investable trading advisor programs, as measured by assets under management, are selected for inclusion in the BTOP50. In each calendar year the selected trading advisors represent, in aggregate, no less than 50% of the investable assets of the Barclay CTA Universe.

The Research Library of Newfound Research

Month: June 2023

Is Managed Futures Value-able?