Understanding Investing

Managed Futures Strategies: Inside the “Black Box”

Momentum, trend-following, managed futures - are terms that can seem intimidating and opaque for many investors. But, while these types of investment strategies may be less familiar than traditional strategies, they can be quite intuitive and offer attractive diversification and return potential that is worth getting to know.

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 toconstruct portfolios of trending securities that can be directional basedon the nature of the trend signals (e.g., short equities as equities trendlower);
  • Cross-sectional momentum strategies look at a set of securities relativeto each other and take long positions in those with relatively positivemomentum and short positions in securities with relatively negativemomentum. This type of strategy is most commonly executed on single stocksin 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 securityprices, which leads to price trends as global investors adjusttheir positions.
  • The over-reaction or “bandwagon” effect can push winners to trendhigher and losers to trend lower for a period of time.
  • There’s also the “disposition effect” in which investors tend tohold on to losers and sell winners. In other words, investors tendto gamble with losses to try to earn back their money, but tend tobecome risk-averse with winners to take profits while they can.Both effects can drive trends by increasing the time it takes forprices to reflect fundamental information.
  • Investors tend to behave the same way in response to significantregime shifts, especially in risk-off markets. For example, whenequity markets have large sell-offs, many investors tend to reducerisk across their portfolios, which can lead to trending pricesacross global asset classes.

The line chart follows S&P 500 levels mostly rising (a fall from 2008 to 2009) from 2007 to 2016. Long positions (mostly) and short positions are shown as either falling above or below the trend line.

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 manageraccess and what is the tradeoff between diversification andliquidity?
    • Asset classes often included in managed futures strategiesare equities, fixed income, currencies, and commodities.
  • Defining trend signals: How long are the “look back windows” usedto determine whether a security is trending?
    • Shorter windows lead to higher turnover and potentiallystronger performance in risk-off markets since they adaptto new trends quickly;
    • Longer windows lead to lower frequency strategies withlower 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 toequities;
  • 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.

This graph shows two pie charts and a table. One pie chart shows a traditional portfolio breakdown of 40% U.S. bonds and 60% U.S. stocks. The second pie chart included an allocation to managed futures (10%) along with U.S. bonds (36%) and U.S. stocks (54%). The table compares returns, volatility and maximum drawdowns and the potential for higher returns and lower volatility with managed futures. U.S. stocks are the S&P 500 Total Return, U.S. bonds are the Bloomberg Barclays U.S. Aggregate, and managed futures are SG Trend.

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 of core bonds, and this size of allocation generally maybe enough to “move the needle” positively in most portfolio allocations.

1 “Returns To Buying Winners and Selling Losers: Implications for StockMarket Efficiency,” Narasimhan Jegadeesh and Sheridan Titman, The Journal of Finance, March 1993.

Disclosures

Past performance is not a guarantee or a reliable indicator of futureresults.

All investmentscontain risk and may lose value. Investing in the bondmarket is subject to risks, including market, interest rate, issuer,credit, inflation risk, and liquidity risk. The value of most bonds andbond strategies are impacted by changes in interest rates. Bonds and bondstrategies with longer durations tend to be more sensitive and volatilethan those with shorter durations; bond prices generally fall as interestrates rise, and the current low interest rate environment increases thisrisk. Commodities contain heightened risk includingmarket, political, regulatory, and natural conditions, and may not besuitable for all investors. Derivatives andcommodity-linked derivatives may involve certain costs and risks such asliquidity, interest rate, market, credit, management and the risk that aposition could not be closed when most advantageous. Commodity-linked derivative instruments may involveadditional costs and risks such as changes in commodity index volatility orfactors affecting a particular industry or commodity, such as drought,floods, weather, livestock disease, embargoes, tariffs and internationaleconomic, political and regulatory developments. Investing in derivativescould lose more than the amount invested. Currency ratesmay fluctuate significantly over short periods of time and may reduce thereturns of a portfolio. Equities may decline in value dueto both real and perceived general market, economic and industryconditions. Investing in foreign denominated and/or domiciled securities mayinvolve heightened risk due to currency fluctuations, and economic andpolitical risks, which may be enhanced in emerging markets. The use ofmodels to evaluate securities or securities markets based on certainassumptions concerning the interplay of market factors, may not adequatelytake into account certain factors, may not perform as intended, and mayresult in a decline in the value of an investment, which could besubstantial.

There is no guarantee that these investment strategies will work under allmarket conditions or are suitable for all investors and each investorshould evaluate their ability to invest long-term, especially duringperiods of downturn in the market. No representation is being made that anyaccount, 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 andshould not be considered as investment advice or a recommendation of anyparticular security, strategy or investment product. Information containedherein has been obtained from sources believed to be reliable, but notguaranteed. No part of this material may be reproduced in any form, orreferred to in any other publication, without express written permission.PIMCO is a trademark of Allianz Asset Management of America L.P. in theUnited States and throughout the world. ©2017, PIMCO.

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