Managed Futures: An Underappreciated Diversifier

“Managed futures are well-suited given the global uncertainty that exists in current equity markets, especially when considering the high correlation that stocks and bonds have shown over the last several years. Having a truly ‘liquid’ managed futures solution for clients can provide much needed diversification with historical low correlation.” – Kevin Kinzie, founder and CEO of Octavus Group, LLC , the parent company of LoCorr Funds .

When I asked why he considered this moment “an extraordinarily risky time for investors,” legendary investor and Graham Capital Management, L.P. founder Ken Tropin pointed to multiple factors:

• We’re currently experiencing concentration risk in technology stocks, with approximately 30% of the S&P 500’s market value held in only seven names.
• U.S. equity market valuations, by most measures, are expensive.
• Duration risk in the fixed income market, Tropin argues, is mispriced – you’re getting paid very little to invest in longer bonds.
• The accumulated federal deficit is unlike anything we’ve seen since World War II and continues to grow.

Tropin believes these risks could result in a buyers’ strike, a bond selloff and a steepening of the yield curve. His conclusion? “If you’ve participated in rising equity markets, now would be a good time to consider lightening up, to take some risk off the table.”

Managed futures – one of the least understood investment strategies – could be an essential tool to investors looking to diversify their portfolios and hedge against downside risks in this “extraordinarily risky” environment. Let’s start with some basics.

According to Barclay Hedge, managed futures managers (also known as commodity trading advisors) manage approximately $350 billion of the $7 trillion hedge fund universe. These strategies seek to generate alpha by trading in highly liquid and transparent global markets comprising stock indices, interest rates, commodities and foreign currencies. Many of these managers adhere to a “trend-following” or momentum approach, where fundamental investing metrics (such as valuation, earnings and macro considerations) are replaced by things like momentum, price signals and breakouts, trailing stops and profit targets. They seek to identify big persistent price movements – in either direction – and capitalize on them, taking long positions in positively trending markets and short positions in negatively trending ones.

Trend-following strategies use algorithmic models that are systematic – i.e., removing as much human decision-making as possible – combined with rigorous risk controls. Rules are applied automatically, though those rules are constantly tweaked. Holding periods can be extremely short (intra-day) or intermediate term (6–12 months).

What’s especially interesting is that managed futures saw outsized performance during times of recent societal, political and economic unrest, including the pandemic shutdown (2020) and Russian invasion of Ukraine (2022).

An analysis of the performance of the 20 largest managed futures hedge funds between 2000 and April 2023 showed on average single-digit returns that fell in between equities and bonds – with far fewer maximum drawdowns as well as outsized returns during prolonged crises.

The most essential differentiating characteristic of managed futures’ returns is that they tend to be lowly correlated with those of either stocks or bonds. Which means that for any given portfolio, including an allocation to managed futures has the potential to increase that portfolio’s risk-adjusted returns.

Why Should Low Correlation Matter?

Correlation reflects the degree that two assets or strategies move in tandem with each other. Highly correlated investments in a portfolio can lead to wild swings up and down, while assets in a well-diversified portfolio with little or no correlation can lead to a smoother ride. There are multiple benefits to a low-correlation portfolio:

• Asset owners and investors usually need their portfolios to accomplish certain objectives, like fund the operations of hospitals or universities, pay pensions or cover personal lifestyle expenses over the balance of their lives. Choosing investments and strategies that have little correlation can mitigate the damage of a widespread market downturn later in life.
• Investors can be emotional, and sharp swings in portfolio value increase the risk they will act impulsively. (Just ask anyone whose 401(k) accounts dropped 50% during the Great Financial Crisis.) Smoother performance can make it easier for many investors to stay committed to their longer-term investment plans.

A third reason especially relevant today is the heightened uncertainty and elevated valuations of financial assets. I asked Michael Pomada , President and CEO of Crabel Capital Management, LLC , if the current environment poses particular challenges or opportunities for his managed futures strategies. He replied, “We do better in periods of volatility. There are several wars going on right now. The stock market was up over 20% two years in a row, the first time that’s happened since 1999. Frankly, it feels a little bubbly right now. All that presents an opportunity to be more defensively positioned.”?

So What’s the Downside?

Managed futures aren’t necessarily an effective tail-risk hedge against sharp market drops. They can be volatile as a standalone investment and go through choppy periods of underperformance, and trying to market time one’s exposure to managed futures strategies is a sure path to suboptimal returns. Investors considering this strategy may be better served by committing to a managed futures “sleeve” in their portfolio, sizing it appropriately and holding it for the intermediate to longer term.

Managed futures can be volatile over short periods, are not without risk and may not be suitable for every investor – before undertaking any investment strategy, you should have a conversation with your advisor about your risk tolerance and portfolio goals.

Baird has a minority ownership interest in Octavus Group, the parent company of LoCorr Funds.