The strategy remained uncorrelated, helping long-term investors diversify in a volatile year

Investors will likely be relieved to close the curtain on 2016—a year filled with uncertainty, unpredictability and upsets. Who among us could have foreseen the Brexit shockwaves, Donald Trump’s Republican sweep in November, or the Cubs winning the World Series?

Financial markets were equally unpredictable. The bulls were immediately put to the test with the worst start to the year on record for U.S. equities. The bears were no better off, with each market correction followed by powerful, and increasingly rapid rebounds. Similar degrees of volatility and reversals played out across global asset classes, creating challenges for investors of all stripes.

Managed futures stood out as a rare safe haven to start the year, with double-digit returns against free-falling equities and commodities prices through mid-February. It also delivered “crisis alpha” during the Brexit panic, as the previous downtrends in risk assets accelerated and safe haven assets soared in value.

Despite these bright spots of outperformance, trend reversals ultimately caused the managed futures category to underwhelm at the year’s end—generating a -5.90% return for 2016.

Some investors are understandably frustrated when viewing the recent performance of managed futures against a backdrop of new record highs in equities. However, when managed futures’ performance is viewed through the lens of its expected and historical performance, a different picture emerges.

Managed futures played its role well in 2016

While absolute performance was negative in the short-term, the managed futures strategy delivered on its intended role: it took a different kind of risk to produce uncorrelated returns.

As it is designed to do, managed futures took a unique path compared to traditional investments like the S&P 500. By taking this path less traveled, managed futures helped investors offset downside risk and volatility throughout the year.

Specifically this included short exposure to commodities deflation and falling equities early in the year, and then long exposure to currency trends and safe haven assets leading up to the Brexit. As market conditions shifted from deflation to inflation midway through the year, opportunities developed for uptrends in commodities and global equities. A series of trend reversals later in the year, including the failed uptrends in global fixed income markets, offset some of these positive returns going into year’s end.

Managed futures
Source: Morningstar

For an analysis of how Longboard’s own managed futures strategy performed in 2016, visit our fund site.

By taking on a different kind of risk in sourcing trends, managed futures delivered non-correlation against equities that helped investors guard their overall portfolios against downside risk and volatility.

The fact remains that the category’s returns were underwhelming in 2016. However, the real value that this asset class can deliver—uncorrelated returns—becomes more evident as investors view its performance over the long-term.

Let’s go back over a decade.

How managed futures can benefit a diversified portfolio over time

The real value from managed futures lies in its ability to provide true diversification[link] against traditional asset classes such as equities.

The long term non-correlation between equities and managed futures causes one strategy to outperform/underperform the other about half of the time. So, even though they each generate similar long term returns, random chance dictates which strategy comes out on top during any short term interval (including multi-year stretches).

The unavoidable cost of a truly diversified portfolio is the need to weather periods of performance dispersions among the portfolio components. While the value of holding the underperforming assets can be hard to ascertain in the present, the data shows that over the long term, these assets add value by significantly reducing risk and preserving returns:

Managed futures
Source: Morningstar

Further, history provides a guide to how quickly and unexpectedly relative performance can change.

Downside protection delivers when it matters most

The U.S. is fresh off of 7 years of economic expansion. Political power is shifting from Democrat to Republican. Stocks are making new record highs. Managed futures is underperforming equities by double-digits.

Sound familiar? It should. This isn’t just 2016—I’m describing the year 2000.

Managed futures
Source: Morningstar

Why do I bring this up? It’s probably just as tempting today as it was in 2000 for investors to view the relative performance of managed futures with frustration, and stock market returns with excitement.

Of course, as often happens, market regimes rapidly changed after 2000. New trends fueled managed futures upward while stocks began to underperform.

Managed futures
Source: Morningstar

We cannot predict the future, but heading into 2017 investors may find it helpful to step back from the market noise and remember that the goal of managed futures is not to outperform stocks on any given short time interval. In fact, we expect these uncorrelated, independent strategies to underperform/outperform one another about half the time.

Benchmarking the success of managed futures against the S&P 500 is akin to using a compass to measure the wind speed. We believe investors will find success in developing a balanced mix of independent strategies to maintain for the long term.

If anything, investors can take the time to rebalance more cost-effectively during this period of short term relative performance.


 

Article by Longboard Funds