Managed Futures Strategies: Inside the “Black Box”
What are quantitative strategies?
Quantitative, or “quant,” strategies select securities based onprespecified sets of rules. These rules are based on quantifiable evidence,informed by a combination of proprietary analysis and academic research.Quant strategies are then executed based on where current prices aretrading relative to the rules of the quantitative framework. For example, asimple quantitative value strategy may rely entirely on a quantifiablemeasure of value (e.g., price-to-book ratio), rather than on the manager’sforecast of the future price to instruct buy or sell decisions. In thisway, quant strategies differ from discretionary strategies, whichconsistently rely on the skill of the investment manager to make investmentdecisions at every step of the way.
Are all quant strategies “black boxes”?
While it’s true that some quant managers consider specific details of theirimplementation strategy proprietary and are not willing to disclose their“secret sauce,” not all strategies rely on top-secret algorithms to makemoney. In fact, the majority of quant strategies are based on widelyunderstood principles and well-researched pricing anomalies, such asmomentum, value and carry, which are difficult to time and are bestaccessed through a rules-based approach. Managed futures strategies focuson momentum through a rules-based approach, rather than an opaque “blackbox.” Though managers typically don’t publish all details of their rules,they are generally relatively transparent regarding the substance of themodels, making these strategies more like “glass boxes” than “black boxes.”Additionally, managed futures is often offered in liquid and relativelytransparent structures.
What is managed futures?
A type of quant strategy, managed futures employs trend-following acrossasset classes. Trend-following is also referred to as “momentum” investing.Momentum investing contrasts with the more familiar “value” investing thatseeks to buy low and sell high. In contrast, momentum investors seekpositions in securities that have moved in one direction for a period oftime – either up or down. They join the trend, taking long positions inassets that are going up in price, and short positions in assets whoseprices are declining.
Momentum investors use quantitative signals to define when securities aretrending. Often, these signals compare the current (spot) price of an assetto the trailing (historical) moving average of the price. If the spot priceis above the moving averages, then the security is in an uptrend, and viceversa.
While most managed futures strategies focus on time series momentum, thereare different types of momentum strategies:
- Time-series momentum strategies use trailing signals of past prices to construct portfolios of trending securities that can be directional based on the nature of the trend signals (e.g., short equities as equities trend lower);
- Cross-sectional momentum strategies look at a set of securities relative to each other and take long positions in those with relatively positive momentum and short positions in securities with relatively negative momentum. This type of strategy is most commonly executed on single stocks in equity markets.
Why does trend-following work?
A well-studied anomaly in academic literature, beginning with Jegadeesh andTitman, 1993,1 momentum is a recognized phenomenon across globalasset classes. And in practice, it has worked remarkably well over longperiods of time, generating positive returns with low correlations tostocks and bonds, and especially strong positive returns during equity bearmarkets. But if everyone knows about it, why does it work?
There are some interesting behavioral reasons that are thought to causemomentum to persist over time and across asset classes:
- New information takes time to be fully reflected in security prices, which leads to price trends as global investors adjust their positions.
- The over-reaction or “bandwagon” effect can push winners to trend higher and losers to trend lower for a period of time.
- There’s also the “disposition effect” in which investors tend to hold on to losers and sell winners. In other words, investors tend to gamble with losses to try to earn back their money, but tend to become risk-averse with winners to take profits while they can. Both effects can drive trends by increasing the time it takes for prices to reflect fundamental information.
- Investors tend to behave the same way in response to significant regime shifts, especially in risk-off markets. For example, when equity markets have large sell-offs, many investors tend to reduce risk across their portfolios, which can lead to trending prices across global asset classes.
What’s in the managed futures “box”?
While all managed futures strategies focus on quantitative trend-following,not all trend-following strategies are designed the same. Managed futuresstrategies commonly vary along the following dimensions:
- The universe of securities: How many securities does the manager access and what is the tradeoff between diversification and liquidity?
- Asset classes often included in managed futures strategies are equities, fixed income, currencies, and commodities.
- Defining trend signals: How long are the “look back windows” used to determine whether a security is trending?
- Shorter windows lead to higher turnover and potentially stronger performance in risk-off markets since they adapt to new trends quickly;
- Longer windows lead to lower frequency strategies with lower turnover.
The choices that managers make for which securities to include and whichtrend signals to follow can cause performance to vary quite a bit amongmanaged futures managers. It’s important that investors understand eachmanager’s relative advantage when investing in trend-following strategiesto make sure that a particular managed futures strategy will align withtheir investment objectives.
Why do investors allocate to managed futures?
Managed futures strategies have a unique profile relative to otherpotential investments, including:
- Long-term positive historical returns of a similar magnitude to equities;
- Very low correlations to equities and other global asset classes;
- Strong historical performance during equity bear markets.
As a result, an allocation to managed futures can have a powerful impact onbroader portfolios by potentially increasing returns, reducing risk andmitigating drawdowns.
That said, it is important to keep in mind that managed futures strategiesare relatively volatile. While this volatility is likely to reduce risk ina broader portfolio context, it can be significant on a standalone basis.Most managers target levels of volatility between 10–20%, with somevariation in those targets over shorter periods.
Another important consideration is that managed futures strategies may notprovide a buffer against sudden, short-lived market moves or “flashcrashes.” Although these strategies have the potential to be highlydiversifying and tend to perform best over periods of prolonged marketsell-offs, they cannot be relied on to hedge against sudden market moves.Essentially, if the strategy doesn’t have enough time to identify thetrend, then it may not be positioned to profit from it, and may in facthave losses if a sharp move is in the opposite direction of previoustrends.
For most investors, a 5–15% allocation to managed futures may offer a goodbalance of diversification and volatility. Over the long term, thevolatility of most managed futures strategies will be closer to that ofequities than that ofcore bonds, and this size of allocation generally maybe enough to “move the needle” positively in most portfolio allocations.
Past performance is not a guarantee or a reliable indicator of future results.
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Derivatives and commodity-linked derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Commodity-linked derivative instruments may involve additional costs and risks such as changes in commodity index volatility or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Investing in derivatives could lose more than the amount invested. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. The use of models to evaluate securities or securities markets based on certain assumptions concerning the interplay of market factors, may not adequately take into account certain factors, may not perform as intended, and may result in a decline in the value of an investment, which could be substantial.
There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown.
This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2017, PIMCO.