DC Spotlight: Managed Futures — What’s in a Strategy?
Managed Futures — What’s in a Strategy?
When we talk about managed futures, some people simply assume you are talking about diversified systematic trend following. That is an easy assumption to make as the vast majority of managed futures strategies have traditionally been some form of trend following.
The problem is that trend following is just one strategy utilized by systematic managed futures traders — and the moniker trend following itself is an extremely broad description of a multitude of varied approaches to trading futures markets. Timeframes, markets traded, gearing, and the varied methods of defining momentum and trend create a wide disparity in the results of managers who broadly can be defined as trend followers.
These are important distinctions as the various strategies utilized to manage money with futures contracts have distinctive elements and their own unique risk profile. However, one should not definitively assign a risk profile to a specific strategy, as managed futures allows for different gearing —both by the manager and by the investor — based on a managed account approach and the ability to notionally fund it.
Long-term trend following often gets short shrift as it represents a sort of baseline for systematic managed futures. Since the likes of John Henry, William Dunn, Keith Campbell, and other pioneering long-term trend followers began managing money in the early 1980s, there has been a push to add diversity within the ranks of the commodity trading advisor (CTA) universe. While many have tried and some have been successful, the long-term trend following strategy has survived because it has been the most successful managed futures strategy over the longest period of time.
In any event, there are other successful approaches to investing with futures; and — as mentioned above — an investor must drill down to understand more precisely what a trend follower or any manager is actually doing.
Coquest Advisors, as part of its CTA Challenge, has worked hard at defining the various managed futures methods and strategies to help investors create a broad, clear, and sensible diversified portfolio. Investment strategy descriptions and definitions provide a method for classifying and aligning managers with industry standards, which fosters the growth of peer groups and an opportunity for analysis.
Coquest has created a matrix of attributes that breaks down managed futures programs by methodology, strategy, timeframe and market focus. Each manager, whether they can technically be labeled a trend follower, countertrend trader or something else will display unique attributes depending on where they fall within this matrix.
Coquest breaks down managed futures into two main methodologies: Systematic and discretionary. It defines the core systematic approach as “relying primarily on rules-based trading signals, typically generated by a computerized system. These signals are often technical in nature, but may also include fundamental and/or macro data. Once they are designed, systematic strategies require little to no human intervention with regard to day-to-day trading decisions.”
Coquest notes that discretionary strategies rely primarily on the judgment and expertise of traders. Discretionary strategies are often fundamental in nature, but may also include technical signals or inputs. Discretionary managers research and evaluate markets and often develop important sources within a particular industry that provide important non-public information that may affect price.
Coquest lists seven separate strategies: Fundamental/macro, technical (trend/momentum), technical (non-trend), options (volatility), options (premium capture), options (volatility arbitrage) and multi-strategy.
Below is a brief description of the different strategies:
- Fundamental/macro: These strategies utilize public and non-public information from broad sources to make trading decisions. These sources may be market-specific, such as supply and demand figures for a specific commodity, or global in nature, such as foreign exchange rates or interest-rate differentials.
- Technical (trend/momentum): Trend following and momentum strategies utilize technical price information to determine trends (based on each managers’ proprietary definition of trend), and place trades in anticipation that that trend or momentum will continue.
- Technical (non-trend): Non-trend technical strategies utilize price to anticipate changes in market prices. These strategies may utilize a wide variety of technical signals and methodologies, including mean reversion, pattern recognition, and various other approaches.
- Options (long volatility): Long-volatility option strategies utilize option contracts to structure trades that can profit from increases in volatility. These strategies typically have frequent but small losses due to the cost of purchasing options but may have significant upside potential if volatility increases.
- Options (premium capture): Premium capture option strategies (or option writing strategies) sell out-of-the-money options with the goal of collecting the premium once the option(s) expire worthless. These strategies often show frequent small gains due to the income generated from selling options but may have significant downside potential if volatility increases.
- Options (volatility arbitrage) Option volatility arbitrage strategies structure trades designed to take advantage of inefficiencies in the option and futures markets. These strategies should have minimal exposure to directional market movements.
- Multi-Strategy: Multi-strategy programs incorporate a combination of the strategies described above. These strategies should have diversified exposures, with no individual sub-strategy representing more than 50% of the underlying exposure.
Time Frame & Market Focus
Coquest’s matrix also involves breaking down strategies by timeframe and market focus. Coquest defines a long-term approach as being several months to years; medium-term as several weeks to months; short-term as several days to multiple weeks and ultra-short-term as intra-day to several days.
This is important to define as many managers, brokers, and traders define timeframe differently so it is important to know how a program is defining the length of its trades and have one common definition.
While one can split managed futures programs broadly into diversified and sector-specific strategies, it is important to drill down and understand the specifics. Within the broad group of diversified CTAs, managers allot allocations to the various sectors and sub-sectors differently and may exclude certain sectors.
For example, many CTAs choose not to trade stock indexes because they wish to provide non-correlation to equities. While managers who do allocate to stock indexes will still produce returns that are often non-correlated to equities, the point is that a diversified manager who trades stock indexes will look different from one that doesn’t.
Often the size if a program can dictate the amount the manager allocates to certain sectors. A manager with more than $1 billion of assets under management may have difficulty trading certain markets and market sectors such as the softs. Some managers will mandate specific allocations per sector. It is important to understand the nature of that allocation. A program that requires 50% of its risk to be dedicated to physical commodities will produce much different returns than one that concentrates most of its risk in financial futures.
Programs that trade specific sectors tend — more often than not — to be discretionary but can be systematic as well. This can create a much different profile.
Understanding which of the various buckets a manager falls in is extremely important in building a diversified portfolio.
Next: A vertical dive into a multitude of strategies and how to build a portfolio
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Disclosure: The risk of loss in trading futures and/or options is substantial. Past performance is not indicative of future results. The information in this message derived from third-party sources is believed to be accurate and reliable; Coquest does not guarantee the accuracy or completeness of the information. Opinions expressed in this material are subject to change without notice. This report should not be interpreted as a request to engage in any transaction of futures, options, and/or OTC derivatives. The information contained in this material is not to be relied upon in substitution for the exercise of your independent judgment. Seek independent financial, tax, legal, and accounting advice from your own professional advisers, based upon your particular circumstances.