We talked last week about AIMA’s research on what a Managed Futures can do for your portfolio. But the paper is full of other interesting data and charts that we didn’t get to cover our first time round, detailing unique aspects of Managed Futures as it relates to correlations.
We won’t blame you if correlation statistics are a little hard to wrap your head around. It’s easy to understand positive correlation (performance moves together) and negative correlation (performance moves in opposite directions), but non-correlation is a bit harder to grasp. Just what does a -0.06 correlation look like, anyway. How do we conceptualize a lack of correlation one way or the other? Most of us incorrectly conflate negative correlation with noncorrelation, but the reality is that non-correlations really just means sometimes positively correlated, sometimes negatively correlated. Here’s an explanation and graphic from the AIMA paper:
The shaded areas demonstrate times (throughout the 17-year period) where global equity returns over the past 12 months were negative. The relationship between CTAs and equities is not static, with the correlation varying from positive to negative through time. Further, CTA trend-followers have been negatively correlated to equity markets over the course of four equity market corrections since 2000. In other words, when equity markets have been falling in value, typically these trend following managed futures strategies have been behaving in an opposite fashion i.e. with the potential to produce positive returns.
There are two takeaways here: 1) Managed Futures was negatively correlated to world stocks (going up while they were going down) when world stocks were experiencing a crisis in performance. And 2) the correlation spans a range as low as -0.8 and as high as 0.8 – showing what a non-correlation really looks like. We would almost expect it to be oscillating around the zero line with the correlation over the whole period just -0.06, but you can see the rolling correlation line spends nearly no time around that level… instead venturing an order of magnitude above and below it.
Looking closely at the data above, but in a slightly different way, should surely make you smile. You see, when the correlations are the strongest, it also happened to be when performance in those markets was the most extreme (up and down). Said another way, Managed Futures performance in relation to world stocks is flat when world stocks are flat, and big on the ends… like a smile. AIMA has just the chart to show the heaviness of the performance tied to a stronger correlation, what some people call a performance smile. Here’s the AIMA:
To be precise, they have shown an increased ability to generate positive returns when a traditional financial market portfolio is either falling or rising, i.e. moving in a clear direction. Figure 6 indicates the historical positive correlation to a diversified portfolio of +0.2 when it is increasing and a negative correlation of -0.2 when it is decreasing. A trend line has been added to the graph to demonstrate the reason behind the name for the return profile of managed futures, which resembles a smile.
Correlation to All Investments
Chances are, World Stocks and Managed Futures aren’t the only asset classes that make up your portfolio. So what asset classes out there have the lowest correlation to each other? AIMA – again – has this chart – looking at the ten-year correlation of ten different asset classes, and Managed Futures is right in the sweet spot.
There you have it. All this is to say that the reason Managed Futures offers almost the same return with less risk, is because those return drivers are dynamic – at times aligning themselves with stocks, hedge funds, and the like; but other times zigging when they zag – to create a long-term noncorrelation out of short-term positive and negative correlations.