Morningstar Advisor - August/September 2011 - 64

Gray Matters
Despite all of the seemingly different types of
managed-futures strategies out there, the
results are surprisingly homogenous. Morningstar
tracks managed-futures hedge fund
strategies in its global trend hedge fund
category, which was established in 2005 based
upon the relatively high average correlations
among its constituents (about 0.7). In 2008,
80% of the funds in the category made money.
From this result, it's pretty clear that managedfutures
and momentum strategies gain access
to some sort of market risk or style factor,
similar to small-capitalization and value-driven
equity strategies. But does this risk and
style factor deliver returns, and will it help
with diversification in the future?
The Case for Momentum
In 2009, Asness, Moskowitz, and Pedersen
published " Value and Momentum Everywhere. "
The paper argued that value and momentum
factors exist across all asset classes and
geographies, as far back as the authors tested
(1975, when the first financial futures were
introduced). Furthermore, these factors are
negatively correlated to each other. Finally, the
study said that, in and of itself, momentum
has provided attractive, long-term, positive
risk-adjusted returns. An equally weighted
(across asset classes), passive, long-short,
momentum strategy delivered a Sharpe ratio of
0.9 (through 2008). It's extremely difficult
to find two strategies that run opposite to each
other but that both make money over time.
Most people understand why value stocks
might be able to deliver outsized returns over
time-they are cheap to begin with, often
because of some sort of idiosyncratic risk.
Most people, including academics, don't
understand exactly why momentum works. The
explanation most likely lies in the unexplainable-human
behavior. For some reason,
people tend to anchor their views of the future
on the recent past and are slow to adjust to
news. Furthermore, investors of all sophistication
levels tend to move with the herd.
How to Gain Access to Managed Futures
Eyeing a new market, fund firms have launched
a slew of managed-futures funds since 2008
(Exhibit 1). There are at least 19 managedfutures
funds, including one ETF and one
exchange-traded note. The average prospectus
net expense ratio of the funds is 1.65%,
but the cheapest option, ELEMENTS S&P CTI
LSC, charges 75 basis points. The options range
from index-tracking funds to active singlemanager
strategies and funds of managedfutures
hedge funds.
Investors should be aware that the expense
ratios of funds of managed-futures hedge funds
do not account for the underlying management
fees and even performance fees (which can
exceed 2% and 20%, respectively). Also, the
Commodity Futures Trading Commission may
pass rules that require registered investment
companies (such as mutual funds and ETFs)
trading futures to register as commodity
pool operators. It's not likely that the commission
will do away with these funds, but
some of the terms may change (depending on
how the commission coordinates with the SEC).
For now, these funds are still viable investments.
To choose among the many options,
investors should consider how much they value
diversification. A commodities-only managedfutures
strategy may have more volatile
64 Morningstar Advisor August/September 2011
Regardless of the reason why these strategies
work, the proof is in the pudding. From the
January 2003 inception of the Morningstar
Global Trend Hedge Fund Index through March
2011, managed-futures strategies have
delivered a 6% annualized return, with an 11%
annualized standard deviation, for a Sharpe
ratio of about 0.4. The S&P 500 delivered a
similar return, with a higher standard deviation
(15%), resulting in a lower 0.4 Sharpe ratio. The
Russell 2000 Value Index returned 10%
annualized, with a 20% standard deviation,
resulting in a similar Sharpe ratio to that
of managed-futures strategies. The correlation
between the Russell 2000 Value Index and
the Morningstar Global Trend Hedge Fund Index
is not negative, but it is low, at about 0.12.
performance than a diversified, cross-assetclass
strategy. Furthermore, investors should
ask themselves how much they are willing
to pay for active management. Because
a large portion of these managed-futures funds'
returns can be attributed to some type of
momentum factor, even a passive strategy will
likely provide adequate diversification.
Making It Work in a Portfolio
Finally, the most important question is how to
allocate to managed-futures strategies.
Because managed-futures strategies aren't
correlated to stock or bond investments, it's
hard to figure out which sleeve of a portfolio
to pull assets from. A prudent and simple
strategy would be to allocate assets from the
portion of the portfolio that presents the most
risk. In a traditional 60%/40% stocks/bonds
portfolio, this means the equity allocation. To
illustrate, we created three hypothetical
portfolios (Exhibit 2). The first was weighted
60% in the S&P 500 Index and 40% allocation
in the Barclays US Aggregate Bond Index. We
replaced part of the stock allocation with a
5% and a 10% allocation to the S&P Diversified
Trends Indicator Index. (The index is the
oldest diversified trend-following index that is
publicly available.) From Jan. 1, 2003, through
May 31, 2011, which encompasses both
good and bad years for stocks and managed
futures, each of the three portfolios had very
similar returns (about 6.8% annualized),
but the standard deviation of the 60%/40%
portfolio was reduced by about 70 and 150
basis points for the 5% managed-futures
and 10% managed-futures portfolios, respectively,
resulting in better Sharpe ratios.
As with any hypothetical model, past results
may not predict the future, but the lesson
of diversification is timeless. Diversification
was not dead in 2008; it was simply misunderstood.
And an investment in managed futures
may help improve the future prospects of
your clients' portfolios. K
Nadia Papagiannis, CFA, is an alternative investments
strategist with Morningstar.
Morningstar Advisor - August/September 2011

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