Asset allocation models are built on long-term assumptions about the expected returns of both traditional and alternative asset classes. For traditional asset classes, like stocks and bonds, allocators generally extrapolate expected returns from the long-term historical performance of indices, like the S&P 500 – a sensible approach given that index products now provide access to those returns at de minimus fees.
For hedge funds and managed futures, the only “indices” consist of the reported performance of high cost hedge funds. In recent years, management fees, performance fees and trade churning has consumed well over half of gross performance and virtually all alpha (calculated versus the MSCI World index).
Today, however, investors can access managed futures at far lower fees. As a result, allocators should evaluate the performance of managed futures strategies based on the returns of the sector (before fees) – just as they would with traditional asset classes. This paper presents the results of such an analysis.
We use the SocGen CTA index as the benchmark for managed futures strategy returns. The index has been published daily since 2000 by Société Générale and is an equally-weighted composite of the 20 largest managed futures hedge funds open for new investment, determined annually. The index is reported net of management and performance fees.
In order to estimate pre-fee performance, we adjust historical data since 2000 using assumed management and performance fees of 2% and 20%, respectively. For simplicity, fees are adjusted for the index rather than for each of the constituents.
This fee/expense level likely is understated for three reasons: many funds in the pre-crisis period charged even higher fees; performance fees are paid on individual funds that rise but not recovered for funds that lose money, which can be significant when the annual dispersion of constituents can be 30% or more; and trading costs alone for many funds are estimated to be 200 bps or more. Consequently, we conclude that this is a conservative estimate.
Managed futures performance relative to traditional asset classes
Using adjusted figures, managed futures as a strategy returned 7.4% per annum since 2000 – higher than global equities with much lower volatility. The chart below shows annualized returns and standard deviation for multiple asset classes since 2000:
Most asset allocation models use a “building block” approach that looks at the expected returns of each asset class relative to cash over ten or twenty years. Over a shorter horizon, riskier asset classes often underperform cash, sometimes by a wide margin. What differentiates managed futures is the consistency of outperformance relative to cash. Using monthly data, the chart below shows the average, minimum and maximum returns over cash for every rolling five-year period since 2000.
In the worst such five-year period, managed futures still generated a positive return over cash of 1.20%, whereas the S&P 500 underperformed cash at one point by -10.2% per annum. The consistency of outperformance is similar to that of investment-grade fixed income markets.
Another compelling statistic is the consistency of risk-adjusted performance through various market cycles. The chart below shows the rolling five-year Sharpe ratio (excess returns over cash divided by standard deviation) compared to that of the S&P 500 index. Despite concerns that strategy returns have been compressed in recent years, the Sharpe ratio has been consistently around 0.5 for nearly two decades.
Managed futures as a diversifier
The value of a diversifier is measured both by expected performance and correlations to other asset classes, especially equities. While the active nature of the strategy means that it will go through periods of positive and negative beta, long term results consistently show a beta close to 0. Since 2000, the beta of managed futures to the MSCI World equity index has been around zero, and in 93% of the rolling five-year periods it was between -0.2 and +0.2.
The combination of high returns and low correlations makes managed futures a highly valuable diversifier, even relative to bonds and REITs, which benefited from declining rates over the past two decades. The charts below show the impact of a 20% addition of various asset classes to the MSCI World equity index since 2000:
An unusual characteristic of managed futures is that it has historically delivered strong positive returns during bear markets – when asset classes tend to trend strongly. Institutional investors call this “crisis alpha.” In 2008, for instance, managed futures returned nearly 20%, while other diversifiers like commodities and REITs declined over 40%:
Most asset allocators agree that hedge fund fees have been untenably high over the past decade or two. Fortunately, institutional investors today have a wide range of lower cost investment options available to “access” managed futures – separately managed accounts or bank-offered swap products, to name a few. Retail investors as well can invest through lower cost mutual funds and ETFs. In most cases, lower fees should translate into better net performance – and higher alpha for end investors.
The key for asset allocators is to re-examine capital markets assumptions to reflect the actual historical performance of the strategy – not how investors who arguably overpaid in the past have fared. This could pave the way for higher allocations that can smooth portfolio returns and, as importantly, help to protect capital during prolonged market drawdowns.
 Data in this article reflects performance through the end of the first quarter of 2019
Andrew Beer is the Founder and Managing Member of Dynamic Beta investments, a New York-based firm that specializes in liquid alternative investment strategies