This post is available as a PDF download here.
Summary
- Managed futures strategies have historically provided meaningful positive returns during left-tail equity events. Yet as a trading strategy, this outcome is by no means guaranteed.
- While trend following is “mechanically convex,” the diverse nature of managed futures programs may actually prevent the strategy from offsetting equity market losses.
- We generate a large number of random managed futures strategies by varying the asset classes included. We find that more diverse strategies have, historically, provided a larger offset to negative equity events.
- This curious outcome appears to be caused by two effects: (1) diversification allows for increased total notional exposure; and (2) past crises saw coincidental trends across multiple markets simultaneously.
- Therefore, for investors trying to offset equity market losses, an allocation to managed futures requires believing that future crises will be marked by a large number of simultaneous trends across multiple assets.
- Less diversified strategies – such as just trading S&P 500 futures contracts – appear to work if the volatility target is removed.
Shortly after the 2008 crisis, the appetite for risk management strategies exploded. At the forefront of this trend was managed futures, which had already proven itself in the dot-com fallout. With the Societe Generale Trend Index1 returning 20.9% in 2008, the evidence for CTAs to provide “crisis alpha”2 seemed un-debatable. AUM in these strategies sky-rocketed, growing from $200 billion in 2007 to approximately $325 billion by 2012.
Source: http://managedfuturesinvesting.com
Subsequent performance has, unfortunately, been lack-luster. Since 12/31/2011, the SG Trend Index has returned just 14.2% compared to the S&P 500’s 200.8% total return. While this is an unfair, apples-to-oranges comparison, it does capture the dispersion the strategy has exhibited to the benchmark most investors measure performance against during a bull market.
Furthermore, the allocation to managed futures had to come from somewhere. If investors reduced exposure to equities to introduce managed futures, the spread in performance captures the opportunity cost of that decision. There is hope yet: if the S&P 500 fell 50% over the next year, managed futures would have to return just 32% for their full-period performance (2011-2020) to equalize.
Yet how certain are we that managed futures would necessarily generate a positive return in an S&P 500 left-tail environment? Hurst, Ooi, and Pedersen (2017)3 find that managed futures have generated anything from flat to meaningfully positive results during the top 10 largest drawdowns of a 60/40 portfolio since the late 1800s. This evidence makes a strong empirical case, but we should acknowledge the N=10 nature of the data.
Perhaps we can lean into the mechanically convex nature of trend following. Trend following is a close cousin to the trading strategy that delta-hedges a strangle, generating the pay-off profile of a straddle (long an at-the-money put and call). Even without an anomalous premium generated by autocorrelation in the underlying security, the trading strategy itself should – barring trading frictions – generate a convex payoff.
Yet while mechanical convexity may be true on a contract-by-contract basis, it is entirely possible that the convexity we want to see emerge is diluted by trades across other contracts. Consider the scenario where the S&P 500 enters a prolonged and significant drawdown and our managed futures strategy goes short S&P 500 futures contract. While this trade may generate the hedge we were looking for, it’s possible that it is diluted by trades on other contracts such as wheat, the Japanese Yen, or the German Bund.
When we consider that many investors have portfolios dominated by equity risk (recall that equities have historically contributed 90% of the realized volatility for a 60/40 portfolio), it is possible that too much breadth within a managed futures portfolio could actually prevent it from providing negative beta during left-tail equity events.
Replicating Managed Futures
We begin our study by first replicating a generic trend-following CTA index. We adopt an ensemble approach, which is effectively equivalent to holding a basket of managers who each implement a trend-following strategy with a different model and parameterization.
Specifically, we assume each manager implements using the same 47 contracts that represent a diversified basket of equities, rates, commodities, and currencies.4
We implement with three different models (total return, price-minus-moving-average, and dual-moving-average-cross) and five potential lookback specifications (21, 42, 84, 168, and 336 days) for a total of 15 different implementations.
Each implementation begins by calculating an equal-risk contribution (“risk parity”) portfolio. Weights for each contract are then multiplied by their trend signal (which is simply either +1 or -1).
The weights for all 15 implementations are then averaged together to generate our index weights. Notional exposure of the aggregate weights is then scaled to target a 10% annualized volatility level. We assume that the index is fully collateralized using the S&P U.S. Treasury Bill Index.
Below we plot our index versus the SG Trend Index. The correlation of monthly returns between these two indices is 75% suggesting that our simple implementation does a reasonable job approximating the broad trend-following style of CTAs. We can also see that it captures the salient features of the SG Trend Index, including strong performance from 2001-2003, Q4 2008 and Q1 2009, and the 2014-2015 period. We can also see it closely tracks the shape the SG Trend Index equity curve from 2015 onward in all its meandering glory.
Source: Stevens Analytics. Calculations by Newfound Research. Past performance is not an indicator of future results. Performance is backtested and hypothetical. Performance figures are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Performance assumes the reinvestment of all distributions. These results do not reflect the returns of any strategy managed by Newfound Research.
Convexity versus Diversification
To explore the impact of diversification in managed futures versus convexity exhibited against the S&P 500, we will create a number of managed futures strategies and vary the number of contracts included. As we are attempting to create a convex payoff against the S&P 500, the S&P 500 futures contract will always be selected.
For example, a 2-contract strategy will always include S&P 500 futures, but the second contract could be 10-year U.S. Treasuries, the Nikkei, the Australian Dollar, Oil, or any of the other 42 futures contracts. Once selected, however, that pair defines the strategy.
For 2-, 4-, 8-, 16-, and 32- contract systems, we generate the performance of 25 randomly selected strategies. We then generate scatter plots with non-overlapping 6-month returns for the S&P 500 on the x-axis and non-overlapping 6-month returns for the managed futures strategies on the y-axis.5 We then fit a 2nd-degree polynomial line to visualize the realized convexity.
(Note that for the single contract case – i.e. just the S&P 500 futures contract – we plot overlapping 6-month returns.)
Source: Stevens Analytics and Sharadar. Calculations by Newfound Research. Past performance is not an indicator of future results. Performance is backtested and hypothetical. Performance figures are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Performance assumes the reinvestment of all distributions. These results do not reflect the returns of any strategy managed by Newfound Research.
There are two particularly interesting artifacts to note.
First, as the number of contracts goes up, the best-fit model turns from a “smile” to a “smirk,” suggesting that diversification dilutes positive convexity relationships with the S&P 500. This outcome should have been expected, as we generally know how managed futures has done over the 20-year period we’re examining. Namely, managed futures did quite well offsetting losses in 2000-2003 and 2008-2009, but has failed to participate in the 2010s.
Perhaps more interestingly, however, is the increase in left-tail performance of managed futures, climbing from 20% when just trading the S&P 500 futures contract to 150% in the 32-contract case. The subtle reason here is diversification’s impact on total notional exposure.
Consider this trivial example: Asset A and Asset B have constant 10% volatility and are uncorrelated with one another. As they are uncorrelated, any combination of these assets will have a volatility that is less than 10%. Therefore, if we want to achieve 10%, we need to apply leverage. In fact, a 50-50 mix of these assets requires us to apply 1.41x leverage to achieve our volatility target, resulting in 70.7% exposure to each asset.
As a more concrete example, when trading just the S&P 500 futures contract, achieving 10% volatility position in 2008 requires diluting gross notional exposure to just 16%. For the full, 47-contract model, gross notional exposure during 2008 dipped to 90% at its lowest point.
Now consider that trend following tends to transform the underlying distributions of assets to generate positive skewness. Increasing leverage can help push those positive trades even further out in the tails.
But here’s the trade-off: the actual exposure to S&P 500 futures contracts, specifically, still remains much, much higher in the case where we’re trading it alone. In practice, the reason the diversified approach was able to generate increased returns during left-tail equity events – such as 2008 – is due to the fact correlations crashed to extremes (both positive and negative) between global equity indices, rates, commodities, and currencies. This allowed the total notional exposure of directionally similar trades (e.g. short equities, long bonds, and short commodities in 2008) to far exceed the total notional exposure achieved if we were just trading the S&P 500 futures contract alone.
Source: Stevens Analytics. Calculations by Newfound Research.
Our confidence in achieving negative convexity versus equity left-tail events, therefore, is inherently tied to our belief that we will see simultaneously trends across a large number of assets during such environments.
Another interpretation of this data is that because negative trends in the S&P 500 have historically coincided with higher volatility, a strategy that seeks to trade just the S&P 500 futures with constant volatility will lose convexity in those tail events. An alternative choice is to vary the volatility of the system to target the volatility of the S&P 500, whose convexity profile we plot below.
Source: Stevens Analytics and Sharadar. Calculations by Newfound Research. Past performance is not an indicator of future results. Performance is backtested and hypothetical. Performance figures are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Performance assumes the reinvestment of all distributions. These results do not reflect the returns of any strategy managed by Newfound Research.
This analysis highlights a variety of trade-offs to consider:
- What, specifically, are we trying to create convexity against?
- Can diversification allow us to increase our notional exposure?
- Will diversification be dilutive to our potential convexity?
Perhaps, then, we should consider approaching the problem from another angle: given exposure to managed futures, what would be a better core portfolio to hold? Given that most managed futures portfolios start from a risk parity core, the simplest answer is likely risk parity.
As an example, we construct a 10% target volatility risk parity index using equity, rate, and commodity contracts. Below we plot the convexity profile of our managed futures strategy against this risk parity index and see the traditional “smile” emerge. We also plot the equity curves for the risk parity index, the managed futures index, and a 50/50 blend. Both the risk parity and managed futures indices have a realized volatility of level of 10.8%; the blended combination drops this volatility to just 7.6%, achieving a maximum drawdown of just -10.1%.
Source: Stevens Analytics and Sharadar. Calculations by Newfound Research. Past performance is not an indicator of future results. Performance is backtested and hypothetical. Performance figures are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Performance assumes the reinvestment of all distributions. These results do not reflect the returns of any strategy managed by Newfound Research.
Conclusion
Managed futures have historically generated significant gains during left-tail equity events. These returns, however, are by no means guaranteed. While trend following is a mechanically convex strategy, the diversified nature of most managed futures programs can potentially dilute equity-crisis-specific returns.
In this research note, we sought to explore this concept by generating a large number of managed futures strategies that varied in the number of contracts traded. We found that increasing the number of contracts had two primary effects: (1) it reduced realized convexity from a “smile” to a “smirk” (i.e. exhibited less up-side participation with equity markets); and (2) meaningfully increased returns during negative equity markets.
The latter is particularly curious but ultimately the byproduct of two facts. First, increasing diversification allows for increased notional exposure in the portfolio to achieve the same target volatility level. Second, during past crises we witnessed a large number of assets trending simultaneously. Therefore, while increasing the number of contracts reduced notional exposure to S&P 500 futures specifically, the total notional exposure to trades generating positive gains during past crisis events was materially higher.
While the first fact is evergreen, the second may not always be the case. Therefore, employing managed futures specifically as a strategy to provide offsetting returns during an equity market crisis requires the belief that a sufficient number of other exposures (i.e. equity indices, rates, commodities, and currencies) will be exhibiting meaningful trends at the same time.
Given its diversified nature, it should come as no surprise that managed futures appear to be a natural complement to a risk parity portfolio.
Investors acutely sensitive to significant equity losses – e.g. those in more traditional strategic allocation portfolios – might therefore consider strategies designed more specifically with such environments in mind. At Newfound, we believe that trend equity strategies are one such solution, as they overlay trend-following techniques directly on equity exposure, seeking to generate the convexity mechanically and not through correlated assets. When overlaid with U.S. Treasury futures – which have historically provided a “flight-to-safety” premium during equity crises – we believe it is a particularly strong solution.
Diversification with Portable Beta
By Nathan Faber
On February 18, 2020
In Craftsmanship, Portfolio Construction, Risk & Style Premia, Risk Management, Weekly Commentary
This post is available as a PDF download here.
Summary
Portable beta strategies seek to enhance returns by overlaying an existing portfolio strategy with complementary exposure to diversifying asset classes and strategies. In overlaying exposure on an existing portfolio strategy, portable beta strategies seek to make every invested dollar work harder. This idea can create “capital efficiency” for investors, freeing up dollars in an investor’s portfolio to invest in other asset classes or investment opportunities.
At Newfound, we focus on managing risk. Trend following – or absolute momentum – is a key approach we employ do this, especially in equities. Trend equity strategies are a class of strategies that aim to harvest the long-term benefits of the equity risk premium while managing downside risk through the application of trend following.
We wrote previously how a trend equity strategy can be decomposed into passive and active components in order to isolate different contributors to performance. There is more than one way to do this, but in the most symmetric formulation, a “long/flat” trend equity strategy (one that that either holds equities or cash; i.e. does not short equities) can be thought of as a 100% passive allocation to a 50/50 portfolio of stocks and cash plus a 50% overlay allocation to a long/short trend equity strategy that can move between fully short and fully long equities. This overlay component is portable beta.
We have also written previously about how a portable beta overlay of bonds can be beneficial to trend equity strategies – or even passive equity investments, for that matter. For example, 95% of a portfolio could be invested in a trend equity strategy, and the remaining 5% could be set aside as collateral to initiate a 60% overlay to 10-year U.S. Treasury futures. This approximates a 60/40 portfolio that is leveraged by 50%
Source: Newfound. Allocations are hypothetical and for illustrative purposes only.
Since this bond investment introduces interest rate risk, we have proposed ways to manage risk in this specific sleeve using factors such as value, carry, and momentum. By treating these factors as fully tactical long/short portfolios themselves, if we hold them in equal weight, we can also break down the tactical U.S. Treasury futures overlay into active and passive components, with a 30% passive position in U.S. Treasury futures and 10% in each of the factor-based strategies.
Source: Newfound. Allocations are hypothetical and for illustrative purposes only.
When each overlay is fully invested, the portfolio will hold 95% stocks, 5% cash, and 60% U.S. Treasury futures. When all the overlays are fully short, the strategy will be fully invested in cash with no bond overlay position.
While the strategy has not changed at all with this slicing and dicing, we now have a framework to explore the historical contributions of the active and passive components and the potential diversification benefits that they offer.
Diversification Among Components
For the passive portfolio 50/50 stock/cash, we will use a blend of the Vanguard Total U.S. stock market ETF (VTI) and the iShares Short-term Treasury Bond ETF (SHV) with Kenneth French data for market returns and the risk-free rate prior to ETF inception.
For the active L/S Trend Equity portfolio, we will use a long/short version of the Newfound U.S. Trend Equity Index.
The passive 10-year U.S. Treasury futures is the continuous futures contract with a proxy of the 10-year constant maturity Treasury index minus the cash index used before inception (January 2000). The active long/short bond factors can be found on the U.S. Treasuries section of our quantitative signals dashboard, which is updated frequently.
All data starts at the common inception point in May 1957.
As a technical side note, we must acknowledge that a constant maturity 10-year U.S. Treasury index minus a cash index will not precisely match the returns of 10-year U.S. Treasury futures. The specification of the futures contracts state that the seller of such a contract has the right to deliver any U.S. Treasury bond with maturity between 6.5 and 10 years. In other words, buyers of this contract are implicitly selling an option, knowing that the seller of the contract will likely choose the cheapest bond to deliver upon maturity (referred to as the “cheapest to deliver”). Based upon the specification and current interest rate levels, that current cheapest to deliver bond tends to have a maturity of 6.5 years.
This has a few implications. First, when you buy U.S. Treasury futures, you are selling optionality. Finance 101 will teach you that optionality has value, and therefore you would expect to earn some premium for selling it. Second, the duration profile between our proxy index and 10-year U.S. Treasury futures has meaningfully diverged in the recent decade. Finally, the roll yield harvested by the index and the futures will also diverge, which can have a non-trivial impact upon returns.
Nevertheless, we believe that for the purposes of this study, the proxy index is sufficient for broad, directional attribution and understanding.
Source: Kenneth French Data Library, Federal Reserve Bank of St. Louis, Tiingo, Stevens Futures. Calculations by Newfound Research. Data is from May 1957 to January 2020. Returns are hypothetical and assume the reinvestment of all distributions. Returns are gross of all fees, including, but not limited to, management fees, transaction fees, and taxes. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is not indicative of future results.
The 50/50 Stock/Cash portfolio is the only long-only holding. While the returns are lower for all the other strategies, we must keep in mind that they are all overlays that can add to the 50/50 portfolio rather than simply de-risk and cannibalize its return.
This is especially true since these overlay strategies have exhibited low correlation to the 50/50 portfolio.
The table below shows the full period correlation of monthly returns for all the portfolio components. The equity and bond sub-correlation matrices are outlined to highlight the internal diversification.
Source: Kenneth French Data Library, Federal Reserve Bank of St. Louis, Tiingo, Stevens Futures. Calculations by Newfound Research. Data is from May 1957 to January 2020. Returns are hypothetical and assume the reinvestment of all distributions. Returns are gross of all fees, including, but not limited to, management fees, transaction fees, and taxes. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is not indicative of future results.
Not only do all of the overlays have low correlation to the 50/50 portfolio, but they generally exhibit low cross-correlations. Of the overlays, the L/S bond carry and L/S bond momentum strategies have the highest correlation (0.57), and the L/S bond carry and passive bond overlay have the next highest correlation (0.47).
The bond strategies have also exhibited low correlation to the equity strategies. This results in good performance, both absolute and risk-adjusted, relative to a benchmark 60/40 portfolio and a benchmark passive 90/60 portfolio.
Source: Kenneth French Data Library, Federal Reserve Bank of St. Louis, Tiingo, Stevens Futures. Calculations by Newfound Research. Data is from May 1957 to January 2020. Returns are hypothetical and assume the reinvestment of all distributions. Returns are gross of all fees, including, but not limited to, management fees, transaction fees, and taxes. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is not indicative of future results.
Finding the Optimal Blend
Up to this point, we have only considered the fixed allocations to each of the active and passive strategies outlined at the beginning. But these may not be the optimal holdings.
Using a block-bootstrap method to simulate returns, we can utilize mean-variance optimization to determine the optimal portfolios for given volatility levels.1 This yields a resampled historical realized efficient frontier.
Source: Kenneth French Data Library, Federal Reserve Bank of St. Louis, Tiingo, Stevens Futures. Calculations by Newfound Research. Data is from May 1957 to January 2020. Returns are hypothetical and assume the reinvestment of all distributions. Returns are gross of all fees, including, but not limited to, management fees, transaction fees, and taxes. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is not indicative of future results.
Plotting the benchmark 60/40, benchmark 90/60, and the tactical 90/60 on this efficient frontier, we see that the tactical 90/60 lies very close to the frontier at about 11.5% volatility. The allocations for the frontier are shown below.
Source: Kenneth French Data Library, Federal Reserve Bank of St. Louis, Tiingo, Stevens Futures. Calculations by Newfound Research. Data is from May 1957 to January 2020. Returns are hypothetical and assume the reinvestment of all distributions. Returns are gross of all fees, including, but not limited to, management fees, transaction fees, and taxes. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is not indicative of future results.
As expected, the lower volatility portfolios hold more cash and the high volatility portfolios hold more equity. For the 9% volatility level, these two allocations match, leading to the full allocation to a 50/50 stock/cash blend as in the tactical 90/60.
The passive allocation to the Treasury futures peaks at about 60%, while the L/S bond factor allocations are generally between 5% and 20% with more emphasis on Value and typically equal emphasis on Carry and Momentum.
The allocations in the point along the efficient frontier that matches the tactical 90/60 portfolio’s volatility are shown below.
Source: Kenneth French Data Library, Federal Reserve Bank of St. Louis, Tiingo, Stevens Futures. Calculations by Newfound Research. Data is from May 1957 to January 2020. Returns are hypothetical and assume the reinvestment of all distributions. Returns are gross of all fees, including, but not limited to, management fees, transaction fees, and taxes. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is not indicative of future results.
In this portfolio, we see a higher allocation to passive equities, a smaller position in the tactical equity L/S, and a larger position in passive Treasury futures. However, given the resampled nature of the process, these allocations are not wildly far away from the tactical 90/60.
The differences in the allocations are borne out in the Ulcer Index risk metric, which quantifies the severity and duration of drawdowns.
Source: Kenneth French Data Library, Federal Reserve Bank of St. Louis, Tiingo, Stevens Futures. Calculations by Newfound Research. Data is from May 1957 to January 2020. Returns are hypothetical and assume the reinvestment of all distributions. Returns are gross of all fees, including, but not limited to, management fees, transaction fees, and taxes. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is not indicative of future results.
The efficient frontier portfolio has a lower Ulcer Index than that of the tactical 90/60 even though their returns and volatility are similar. However, the Ulcer index of the tactical 90/60 is very close to that of the benchmark 60/40.
These differences are likely due to the larger allocation to the tactical equity long/short which can experience whipsaws (e.g. in October 1987), the lower allocation to passive U.S. equities, and the lower allocation to the Treasury overlay.
In an uncertain future, there can be significant risk in relying too much on the past, but having this framework can be useful for gaining a deeper understanding of which market environments benefit or hurt each component within the portfolio and how they diversify each other when held together.
Conclusion
In this research note, we explored diversification in a long/flat tactical equity strategy with a portable beta bond overlay. By decomposing the strategy into its passive holdings (50/50 stock/bond portfolio and U.S. Treasury futures) and active long/short overlays (trend equity, bond carry, bond momentum, and bond value), we found that each of the overlays has historically exhibited low correlation to the passive portfolios and low cross-correlations to each other. Combining all of these strategies using a tactical 90/60 portfolio has led to strong performance on both an absolute and risk-adjusted basis.
Using these strategy components, we constructed an efficient frontier of portfolios and also found that the “intuitive” tactical 90/60 portfolio that we have used in much of our portable beta research is close to the optimal portfolio for its volatility level. While this does not guarantee that this portfolio will be optimal over any given time period, it does provide evidence for the robustness of the multi-factor risk-managed approach.
Utilizing portable beta strategies can be an effective way for investors to pursue capital efficiency and maximize portfolio returns while simultaneously managing risk. While leverage can introduce risks of its own, relying on diversification and robust risk-management methods (e.g. trend following) can mitigate the risk of large losses.
The fear of using leverage and derivatives may be an uphill battle for investors, and there are a few operational burdens to overcome, but when used appropriately, these tools can make portfolios work harder and lead to more flexibility for allocating to additional opportunities.
If you are interested in learning how Newfound applies the concepts of tactical portable beta to its mandates, please reach out (info@thinknewfound.com).