Managed Futures & Trend Following - Inside the Black Box
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"While the correlations certainly vary over time, it can be seen clearly that trend-following has structurally low correlation with the other assets. At -.0302 the correlation with equities is statistically indistinguishable from zero. Equities are often the largest source of risk in diversified portfolios, and it is often desirable to hedge this risk with assets that perform well when stocks struggle. Over the past 20+ years, Treasuries have filled this role and, up until 2022, have generally done a good job. However, 2022 has revealed significant gaps in portfolios that rely solely on bonds for downside protection. In today’s environment of high inflation, sagging growth and high volatility trend-followers have excelled. When it comes to diversification, managed futures do exceedingly well."
Here I have sorted the returns into deciles based on the performance of the MSCI World. The idea is to show how managed futures performed when the MSCI World did particularly well/poorly. The third panel shows the average 12-month return for the 10th (i.e., best) decile. The interpretation is as follows: during periods of “good” returns for the MSCI, what is the average “good” return for each index? The average top decile return for the MSCI World is ~34%; so very good. On the other hand, the average return for managed futures in the top decile is only about 7%. So, when equity markets really run you want to own stocks (this probably comes as no surprise!).
The second panel shows the average 12-month return for the 1st (i.e., worst) decile. The interpretation is: during periods of “bad” returns for MSCI, what is the average “bad”? As can be seen, the average bottom decile return for the MSCI is approximately -24% while the average return for managed futures is positive 12%. This is the critical point: managed futures have a positive expectation in both up & down markets, but it is in down markets where their hedging benefits are felt most strongly; just when you need it most.
One final iteration on this theme, let us consider the extreme cases in addition to the simple averages elucidated above. The following chart depicts the maximum & minimum return for the top and bottom deciles of the MSCI World and the corresponding performance of the BTOP50.
Panel 2 shows the maximum return for decile 10 (i.e., 100th percentile). Essentially, this panel displays the best 12-month return for the MSCI since 1990 and how the BTOP50 performed over the same period. We can see the MSCI returned about 55% while the BTOP put up 24%. In a ripping bull market managed futures can produce solid returns, but ultimately won’t keep pace with stocks (recall that the BTOP50 has much lower volatility so this observation is not necessarily surprising).
Let’s shift our attention to Panels 1 & 3; the “bad times” for stocks. Panel 1 is the maximum return for decile 1 (i.e., the 10th percentile) of the MSCI. The least amount that the MSCI has lost over a 12-month period is approximately -13.5%. In contrast, when the MSCI was down 13.5% the BTOP50 was up 30%. Likewise, in Panel 3 we observe that the worst (i.e., 1st percentile) 12-month return for the MSCI was a merciless -47%. Over this period the BTOP50 did lose money, but it was a very manageable -2.6%.
Bringing it all together we can make two important observations. 1) trend-following has a long-run positive expected return and, moreover, a positive expected return in both Bull and Bear markets (this is the lesson of the means chart). 2) managed futures have an asymmetric return profile. While generally failing to keep pace with stocks in a Bull market the strategy is still capable of producing solid returns. However, in Bear markets, managed futures strategies have significantly outperformed stocks, producing positive returns or, at minimum, offering substantially less downside.