Managed futures CTA have enjoyed a “cozy relationship with declining interest rates,” and in a rising rate environment “evolution will become mandatory,” according to an investor letter from R. G. Niederhoffer.
Is the party over?
In a letter titled “CTAs and Rising Interest Rates: Is the Party Over?” authors Roy Niederhoffer and Coen Weddepohl note that “a large fraction of their profits came from being long fixed income futures during a 32-year period of falling rates.” As a result, the letter said “the years ahead may present significant challenges for CTAs as trend following strategies are likely to have a more difficult time in a rising interest rate environment.”
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CTA model performance during rising rate environment didn’t fare well
To model potential CTA returns in a rising rate environment, the managed futures players designed a CTA proxy that simulated performance from 1980 to 2013. The study found that CTAs delivered a significant portion of their returns from long positions in fixed income. If interest rates were to rise, “CTAs will struggle to make money due to a lack of clear price trends in fixed income futures and the negative carry from being short fixed income futures,” the letter said. “This problem will become worse if the yield curve steepens.” The model of CTA performance in a rising rate environment generated an average monthly return of +0.2% with a Sharpe Ratio of .2. By contrast, in a declining rate environment the model generated an average monthly return of +1.7% with a Sharpe Ratio of 1.4%.
Managed futures has always been advertised as an uncorrelated cushion in a portfolio to protect against a sharp drop in equity prices. The Niederhoffer report thinks the historic lack of CTA correlation with equities will “rise as fixed income will no longer provide an effective hedge against equities,” a stunning statement that changes the game.
To make this case, the letter points out the power of a buy and hold strategy in the ten year note futures from January 1990 to December 2013, up +109% (excluding transaction costs).
Then the report breaks the total return on a long position into two components: 36% of the return came from price appreciation, as rates fell, while 73% of the return came from roll yield, or positive carry, of the futures contract. “Clearly, the falling rates period presented CTAs with an enormous opportunity. But what will happen if rates experience a sustained rise?” the letter questioned. Considering periods of time when interest rates did rise, the results were not positive.
Difference in CTA results
Noting the differential in a futures contract between a buy and hold strategy with roll yield, which is very positive, versus a sell and hold strategy used in a rising rate environment, which is negative, CTA results look very different, the report noted. While the long position yielded a 109% return, projecting a rising rate environment the short position only delivered a 36% return. “An investor shorting fixed income futures in a rising rate environment will face a headwind of – 6% per year compared with an investor being long the same futures markets in a declining rate period, all else being equal,” the letter noted.
Niederhoffer: Sharpe Ratio yielded by Newedge CTA Index
The study also considers the Sharpe Ratio. As rates fell for during the previous 24 years, the report noted, “the long positions held by the trend following models yielded positive Sharpe Ratios (shown in blue). The combined portfolio of four trend following models produced a Sharpe Ratio of +0.8. To put these in perspective, the entire Newedge CTA Index yielded an actual Sharpe Ratio of +0.4 during this period.” Then the report compared its hypothetical model during rising rates, where the trend following portfolio achieved a Sharpe Ratio of 0 (shown in red). “All strategies did much worse in the rising rate period than in the falling rate period. This suggests that trend following will be very difficult in fixed income during a rising rate environment. In both the falling rate and rising rate environments, buy/sell-and-hold had better risk-adjusted returns than the trend following models.”
The Niederhoffer study, which stands in contrast to other studies from CTAs that suggest managed futures alpha can be generated during a rising rate environment, concludes that CTAs will “be forced to adapt to succeed in a more challenging potential rising rate period,” the letter said. The report did not indicate the potential volatility would have on trend following strategies during periods of rapidly rising rates, but said managers will be required to consider additional strategies in their mix. “Managers are likely to seek additional sources of return, such as long and long/short equity strategies or carry trades, all of which, because of their strong relationship to rising equity prices, will likely increase the correlation CTAs to equities over time. The record high 0.53 weekly correlation of CTAs to the S&P 500 in 2013 suggests that this is already occurring.”