Managed Futures for Microcap Investors
There is both academic and practitioner research literature that discusses the use case of managed futures as potential benefits when employed with large cap equity indices[i], such as the S&P 500 index (SPX) for portfolio allocation. However, there is very little, if any, literature discussing the comparison of microcap indices to managed futures. In researching these two investments, the results demonstrate how managed futures may be a beneficial allocation to a microcap portfolio.
Definitions
Microcap stocks are defined as firms with a low market capitalization between $50 million and $300 million. Managed futures are professional managers who trade futures contracts, options on futures contracts and forex markets. The managers are also known as Commodity Trading Advisors (CTAs). They are known for being systematic, trend-following strategies. However, some managers are discretionary and there are a variation of strategies and time horizons employed. Such as spread trading strategies and option strategies. Some managers may use intra-day strategies or hold positions for only a few days, while others will hold for several months or longer. Some managers trade only commodity futures, while others trade only financial futures, and some will trade a combination of commodity and financial futures.
Data
I compared the monthly returns of the BarclayHedge CTA index to the Wilshire U.S. Micro-Cap index. The Wilshire U.S. Micro-Cap Index is a cap-weighted index with constituents of all stocks in the Wilshire 5000 Index below the 2501st rank of the Wilshire 5000 Index. The BarclayHedge CTA index is an equal-weighted managed futures index and rebalanced annually. For 2018, there were 541 programs included in the managed futures index. Between 1992 and 2018 the index has an average of 396 programs.
The data is January 1992 to November 2018, nearly 27 years of monthly returns. This period includes economic expansions, contractions and various volatility regimes.
Methodology/ Results
This research was broken into multiple parts:
- Examining both static correlations and rolling correlations (Jan 1992 to Nov 2018). The static correlation is -0.08 between microcap stocks and CTAs, thus implying non-correlation between the two indices. The correlation of the microcap index to the S&P 500 index is 0.70, noting, over time a relatively strong positive correlation between the two indices.
- The rolling correlation chart (Figure 1) supports the above results of a positive correlation between microcap stocks and large cap stocks on a 12-month basis. And a non-correlation between microcap stocks and managed futures. This suggests when investing in microcap stocks, an allocation to large cap investments offers some diversification for microcap investments, but it may not offer a strong diversifier or vice versa.
- Figure 1 notes when investing in microcap stocks, allocating to managed futures may offer greater diversification than allocating to large cap stocks may offer, as the correlation tends to cycle between positive and negative, thus non-correlated.
- The correlation difference is more pronounced in the three-year rolling correlation chart (Figure 2) as it filters out some of the shorter-term noise of the one-year rolling correlation. Except for the downward correlation spike in 1999/ early 2000s, the correlation between micro and large cap remained relatively consistent over the last few decades and more so in roughly the last 15 years. The chart also supports evidence of the diversification of managed futures to microcap stocks.
Tail Risk
Figure 3 is often referred to as the “managed futures smile” or the “CTA smile”. The quarterly microcap returns are on the x axis (horizontal axis) and the managed futures quarterly returns are on the y axis (vertical axis). The right side of the chart demonstrates when stocks are positive, many times managed futures is also positive. But there are plenty of times when microcap stocks are positive and managed futures are not, often when microcap stocks have relatively smaller returns, as managed futures tend to be a diversifying investment for the portfolio, but it’s not a hedge.[i] However, the more imperative characteristic is found on the left (negative) side of the scatter plot.
When microcap stocks experience a negative quarter, there are several moments when managed futures will be positive, thus offering potential reduction in both tail risk and correlation risk. The black dotted trend line in Figure 3 offers evidence for potential non-correlation in periods of both positive and negative months. It also demonstrates the relationship between the two indices is non-linear.
The managed futures smile in Figure 4 with the S&P 500 index on the X axis and managed futures on the Y axis, demonstrates a similar relationship between large cap stocks and managed futures as the orange trendline is parabolic with a u-shaped curve at the extremes of the return distribution. The correlation results are also supported in evidence with a low R2 of 1.3% for microcap stocks to managed futures. R2 of 0.72% of SPX to managed futures. Lastly, an R2 of 55% for SPX to microcap stocks.
Figure 5 demonstrates the greater volatility of microcap stocks vs managed futures on a quarterly basis. Microcap stocks had the maximum and minimum quarterly returns of 48.65% and -39.02%. Whereas, the managed futures benchmark experienced a smaller dispersion between positive and negative tails with maximum and minimum quarterly returns of 12.39% and -8.70%, respectively.
Figure 6 exhibits the change of portfolio performance metrics as the allocation shifts from 100% microcap stocks to 100% managed futures (X axis). As the allocation shifts, the gap between the monthly maximum and minimum returns narrows. The monthly standard deviation and the monthly returns decline. This is due to the larger return tails of microcap stocks. However, the portfolio’s skewness (yellow line, based on the right axis) moves from -0.25 to 0.42, indicating as the standard deviation decreases, there is a potential for tail returns to be derived more from the positive returns than the negative returns, thus potentially reducing the portfolio’s tail risk. As I’ve often stated, volatility is like cholesterol, there is good and bad volatility. Volatility derived from positive returns is the “good’ volatility. While the bad volatility is derived from the negative returns and is what investors would like to control or reduce.[i]
Conclusion
In summary, the results show, managed futures may offer diversification for a microcap investment as noted in the rolling correlations, the managed futures smile and the change of portfolio metrics as the allocations shift from microcap stocks to managed futures.
[1]10 compelling reasons to consider adding managed futures … (n.d.). Retrieved from https://www.cmegroup.com/education/files/10-reasons-to-consider-managed-futures.pdf.
Shore, M. (2005). Skewing Your Diversification. Retrieved from https://www.cmegroup.com/education/alternative-investment-resource-center/research/skewing-your-diversification.html
Kat, H. M. (2002). Managed Futures and Hedge Funds: A Match Made in Heaven. SSRN Electronic Journal.
[1] https://www.sec.gov/reportspubs/investor-publications/investorpubsmicrocapstockhtm.html
[1] Shore, M. (2018). Managed Futures Lecture Notes
[1] https://wilshire.com/indexes/wilshire-us-style-indexes/wilshire-us-micro-cap-index
[1] https://www.barclayhedge.com/barclay-cta-indices/barclay-cta-index/
[1] Shore, M. (2015). Decoding the Myths of Managed Futures. Retrieved from https://www.cmegroup.com/education/files/decoding-the-myths.pdf
[1] Shore, M. (2005). Skewing Your Diversification. Retrieved from https://www.cmegroup.com/education/alternative-investment-resource-center/research/skewing-your-diversification.html
