TL;DR
Broadly speaking there are two sources of investment returns available to investors – risk premia and alpha.
Many investors concentrate their asset class risk premia and alpha exposure within equities. Managed futures can provide exposure to alternative, diversifying risk premia, as well as to a class of alpha strategies distinct in approach and correlation from those in equities.
Investing in a Nutshell
Put simply, investing is about seeking opportunities to earn returns. Put in a slightly more sophisticated form, and this is core to experienced investor and allocator thinking, investing is also about earning the highest risk-adjusted returns. Common metrics for considering investments on a stand-alone basis – the information ratio (IR) and the Sharpe ratio (SR) – are literal arithmetic formulations of that statement.
So, what approaches should one take in order to increase or maximize risk-adjusted returns? The ratio formulation forms an initial guide (see Modern Portfolio Theory):
- For a given level of risk, seek out the highest returning investments, or
- For a given level of return, seek out the lowest risk investments
Within those two straightforward sets of instructions lay many paths that one may follow. The undoubtedly glamorous path of seeking out the highest returns is beyond the scope of this piece. That effort typically involves a combination of proprietary data, insights, and specialized analytic capabilities combined with access to a network of excellent managers. So, we’ll focus on the seemingly mundane question of risk and will endeavor to demonstrate that it possesses a glamor of its own.
The Only Free Lunch
The heading above refers to diversification, of course. Allocators seeking to increase their risk-adjusted returns look to identify sources of returns with low, zero, or perhaps negative correlation to each other and to existing sources of return. Diversification results from putting together return streams with low correlations. In technical terms, diversification can reduce the “specific risk” of an uncorrelated portfolio of strategies all the way to zero, all the while enjoying the mean return of these strategies.
Correlations are the obvious starting point for thinking about diversification. One way to enrich a basic correlation analysis and at the same time help focus and direct the search for diversifying return streams is to consider the aforementioned sources of those returns: Risk premia and alpha [1].
When investing in risk premia, the investor earns returns for being able to bear risk when others aren’t able to do the same. Commonly recommended implementations include index investing and exposure to factor risk premiums (aka smart beta). Investing horizons in these cases are typically long. We’ll come back to this point later.
When investing in alpha strategies, the investor earns returns from having, or identifying a manager who has, an analytical, behavioral, computational, or informational advantage over other investors. The hope is that this advantage will persist over time. (Alpha decay, of course, can occur and so innovation in trading and strategy development, finding and exploiting new market inefficiencies, is central.) Investing horizons in this case are generally shorter than those for risk premia strategies, ranging from milliseconds to months.
So, our mission seems clear – diversify among as many risk premia as possible, and access as many alpha streams as possible, in both cases keeping in mind historical correlations and/or forecast correlations [2]. In addition to diversifying across sources of returns, consider time horizon diversification, as well.
What’s For Lunch?
Sophisticated investors normally have access to a wide menu of risk premia investments across global public markets, and hopefully some access to persistent sources of alpha. A common step when diversifying beyond public market asset class beta and smart beta is to enter private markets, that is, private equity, real estate, infrastructure, private credit, and the like. Such investments provide both the underlying asset class exposure as well as alpha. The exposures and diversification, however, come at the cost of liquidity.
Going further down the menu, we come to the pure alpha choices. Managers offer a wide variety of alpha strategies in public markets, and they come in many flavors of horizons and styles. While that sounds good, and is good, at a high level there are a couple of hurdles that allocators may run into:
- Finding diversifying quantitative managers: Once an investor has access to a handful of managers, sourcing diversifying alpha may become increasingly difficult.
- Ensuring that the correlations of discretionary managers are consistent post-investment with the pre-investment correlations and, ideally, remain invariant to market regime. This is a monitoring issue rather than a sourcing issue.
So, what is an allocator to do? We recommend investigating an oft-overlooked menu option – managed futures.
I’ll Have the Managed Futures, Please
The descriptor “managed futures” refers to a diverse set of strategies that employ futures across myriad asset classes and commodities. Well-known among these is diversified trend following i.e. strategies that aim to identify and profit from price trends in instruments by either going long (in the case of an upward expected trend) or going short (in the case of a downward expected trend) and closing-out, ideally, when the trend ends (of course identifying a start and end to a price trend is no simple matter).
Futures represent an excellent asset class for these types of strategies for at least two reasons:
- Diversification: There are several low and/or uncorrelated futures available for trading, from agricultural commodity futures to precious metals to equity indices.
- Favorable leverage e.g. taking on a multitude of positions in futures, generally required for a successful trend following strategy, requires far less margin than in equities.
As a bonus, trend following strategies in futures tend to have crisis alpha [3], performing well when equity markets do not. In this way, managed futures can be an excellent diversifier to a typical equity portfolio.
Some additional points to consider regarding managed futures as a potential allocation:
- They are liquid. While illiquid strategies, e.g., private assets, certainly have a place in a diversified portfolio, managed futures may enable the allocator to diversify their sources of alpha while retaining the important characteristic of liquidity. Diversifying into illiquid assets is no longer the only choice when venturing away from equity and bond markets.
- The alpha from managed futures can be diversifying as compared to many well-employed equity alpha factors to which allocators likely already have exposure.
- Diversified managed futures trend following tends to be negatively correlated to equity markets [3]. This characteristic alone should warrant an examination of this class of strategies.
- The opportunity to use leverage judiciously is very favorable, especially as compared to equities. This characteristic of efficient leverage allows an investor to take on more positions without a large account size. Extending the thinking a little, we see there is an interplay between leverage and diversification that works in the investor’s favor with managed futures.
When considering the addition of managed futures strategies to a portfolio, the allocator will need to make an initial decision: Seek out and evaluate individual managers and bring on an appropriate aggregate that spans the desired styles, or seek out and evaluate multi-strategy funds. The latter option removes much of the heavy lifting from the allocator’s plate.
Citations
[1] There is a third source, namely deterministic/risk-free arbitrage. These opportunities, however, can be fleeting or are academic, so we don’t focus on this source of returns here.
[2] Astute readers will argue that we need to worry about tail dependencies also, i.e. dependencies beyond the second order of the joint probability distribution of returns. At QTS, with our emphasis on tail risk and risk management, we are particularly adept in taking advantage of the kurtosis of returns. See Protecting your Portfolio from Crisis – QTS Capital Management (qtscm.com).
[3] Clenow, A. F. (2023) Following the Trend (2nd ed.)
DISCLAIMER
- The information and opinions contained in this document are for background purposes only and do not purport to be full or complete. The information in this document is not personalized investment advice or an investment recommendation on the part of QTS Capital Management, LLC (“QTS”). No representation, warranty, or undertaking, express or implied, is given as to the accuracy or completeness of the information or opinions contained in this document, and no liability is accepted as to the accuracy or completeness of any such information or opinions.
- All investments involve the risk of a loss of capital. QTS believes that its proprietary investment program and research and risk-management techniques moderate this risk through the careful selection of portfolio investments. However, no guarantee or representation is made that QTS’ investment program will be successful, and investment results may vary substantially over time. Past performance is not necessarily indicative of future results.
- This material is not intended to provide, and should not be relied on for, tax, legal, investment, or accounting advice. You should consult your own tax, legal, investment, and accounting advisers before engaging in any investment transaction.
- This material does not constitute an offer or the solicitation of an offer to purchase any investment product.
- This material contains information obtained from third party sources which are believed to be reliable but which are presented without any warranty as to their accuracy or completeness.
- This material contains certain forward-looking statements and projections regarding asset class correlations, historical tendencies, and expectations of relative performance. These projections and guidelines are included for illustrative purposes only, are inherently predictive, speculative, and involve risk and uncertainty because they relate to events and depend on circumstances that will occur in the future. There are a number of factors that could cause actual events and developments to differ materially from those expressed or implied by these forward-looking statements, projections, and guidelines, and no assurances can be given that the forward-looking statements in this document will be realized or followed, as described. These forward-looking statements will not necessarily be updated in the future.
- Futures investing involves risk and is not suitable for everyone.
