Alternatives: Can managed futures offer diversification?

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Over the past few decades, alternative investments have been one of the fastest growing asset classes among institutional investors. The global financial crisis in 2007/08 merely served to reinforce this desire to look beyond traditional asset classes in the search for genuine diversification and new sources of alpha.

As often happens, this trend is beginning to make the leap from institutional investors to the retail market, where a similar desire exists for sources of return with low correlations to traditional asset classes. In particular, retail investors are looking for liquid forms of alternative investments, with Investment Association data from September showing interest in these strategies growing by approximately 40 per cent in the last year.

A form of liquid alternative that has enjoyed substantial success in the US and is now beginning to attract UK interest is managed futures funds. This type of strategy enjoyed a brief spike in interest in 2010 after the Ucits III directive enabled them to be brought to the wider market, having produced attractive levels of alpha during the financial crisis.

However, this was followed by a period of general underperformance and it is only now that they are beginning to take off as volatile market conditions and renewed positive performance make them increasingly attractive.

Managed futures strategies follow systematic investment approaches based on trend-following strategies, focusing on identifying price momentum across a broad range of markets including equities, fixed income, currencies and commodities.

Crucially these strategies typically have the flexibility to buy long or sell short, creating the potential to profit whether the assets in which they invest are rising or falling. For example, a managed futures portfolio may be positively correlated with stock markets when they are rising, but that correlation can reverse when equities are in decline.

This has made them very attractive as a portfolio diversifier to increasingly downside-focused UK retail investors, who want to know that while they are able to make returns during the good times, some of their capital may be protected in the event of negative market returns.

BTOPgraph

Managed futures funds’ ability to be ‘conditionally’ correlated with equity markets, particularly during a crisis, is a key reason for their growing interest among UK investors – not only can they provide some downside protection, but they can also offer the possibility of low-risk sources of return. To illustrate this, the chart below shows a comparison of returns for the S&P 500 and the BTOP50 managed futures index during periods when the market was in decline by more than 5 per cent.

Yet overall, between 1987 and 2014, the average correlation between the S&P 500 index in the US and the BTOP50 managed futures index was -0.04, which is practically no correlation at all, highlighting the attractiveness of managed futures as a portfolio diversifier.

It is worth noting, however, that trend-following strategies require trends to follow, and the directionless nature of the markets in the years post-crisis was not helpful to these types of strategy. But as markets have normalised managed futures funds have begun to recover and turn in strong performance once again.

The other major criticism levelled at managed futures funds is that they have perceived low levels of transparency. Investors considering employing the funds as a component of their portfolio should do their homework carefully and make sure to choose managers who are clear and transparent about their portfolio holdings, exposures, and approach.

Overall, employed in the right way, managed futures funds can be a highly useful addition to a diversified portfolio, offering both the potential for uncorrelated or low correlation returns that may provide some protection in falling markets.

Chris Jackson is deputy CEO of international distribution at Natixis Global Asset Management.