Portfolio Construction: Offensive or defensive?
Kathryn Kaminski argues that the adaptable, liquid, systematic profile of managed futures makes it a more efficient long-term approach to tail risk than insurance-style strategies
Tail risk insurance strategies have been all the rage in a post-credit-crisis world. Insurance strategies are, by nature, defensive. Given their exemplary performance during the credit crisis, managed futures have often been grouped in with tail risk insurance strategies. But while managed futures and tail risk insurance strategies tend to be highly correlated during crisis periods, they come from fundamentally different approaches.
Defensive tail-risk insurance strategies often couple upfront costs with protection during a crisis. Managed futures strategies are offensive, delivering modest returns during normal market conditions and ‘crisis alpha' opportunities around tail events that have a sustained impact on markets. Crisis alpha opportunities are profits gained by exploiting the persistent trends that occur across markets during a crisis. A better explanation of crisis alpha and a comparison with the performance of tail risk strategies can help communicate to investors what managed futures actually delivers and how it can function as part of a portfolio diversification strategy for tail risk events.
Times of market crisis, for both behavioral and institutional reasons, represent times when market participants become polarised in their actions and create short-term persistent trends in markets. It is only the select (few) most adaptable market players that are able to take advantage of these ‘crisis alpha' opportunities.
When equity markets go down, the vast majority of investors (including hedge funds) are long-biased to equity and realise losses. During loss periods investors are more likely to be governed by behavioural biases and emotions-based decision making. When this is coupled with the widespread use of institutionalised and often regulatory drawdown, leverage, and risk limits, which are all triggered by losses, increased volatility and correlation, large groups of investors will be forced and/or driven into action. Liquidity disappears, credit issues come to the fore, fundamental valuation becomes less relevant and persistent trends occur across all markets as investors fervently attempt to change their positions, desperately seeking liquidity.
Futures markets are extremely liquid and they remain more liquid than other markets, even in times of crisis. The clearinghouse mechanisms of futures markets coupled with the transparency and standardisation of contracts creates a market relatively void of both the counterparty risk and asymmetries between long and short positions common in traditional markets. Managed futures trades in all asset classes exclusively in futures, does not exhibit a long bias to equity, and generally follows systematic trading strategies.
Although managed futures are also subject to institutionalised drawdown, risk, and loss limits, trading primarily in futures guarantees it will be less affected by the reduced liquidity that accompanies a market crisis event. Given its lack of long bias to equity and systematic trading style, it will also be less susceptible to the behavioural effects that also accompany market crisis.
Following the onset of a market crisis, managed futures will be one of the few strategies able to adapt to take advantage of the persistent trends across the wide range of asset classes they trade. It is important also to note that managed futures are not about timing equity markets - it profits from a wide range of opportunities during market crises (this includes currencies, bonds, short rates, soft commodities, energies, metals, and equity indices).
When equity markets are not in crisis, markets are highly competitive and efficient - especially futures markets. Strategies like hedge funds often provide seductive returns, but many researchers have pointed out that these strategies often contain hidden risks related to liquidity and credit exposures.
Given their lack of exposure to liquidity and credit risk, managed futures will not produce the exemplary returns experienced by other hedge fund strategies. Consistent with this point, while good manager selection and skill might produce return premiums, managed futures indices tend to produce returns similar to the risk free rate outside of crisis periods. For this reason, other hedge fund strategies are not the proper peer group for managed futures performance comparison outside bear markets.
Managed futures should be seen as a modest return-generating investment that is poised to be offensive and profitable during a sustained market crisis event (managed futures adapts to market crises, so while it might adapt during sudden and short-lived crisis periods, such as the ‘flash crash' of May 2010, there may not be sufficient crisis alpha opportunities for the strategy to exploit).
Tail-risk insurance, similarly, delivers an offsetting payoff during tail events. Commonly cited examples of tail-risk insurance strategies are based on using positions in options and/or long-volatility.
The most basic example of an options-based strategy would be long-dated, out-of-the-money puts on equity indices, with the potential for immense payoffs in the event of a crisis. The key drawback of this strategy is that it is costly to implement over the long run, it provides little or no return in the absence of a tail event, and if options are purchased in the heat of a crisis they would be prohibitively expensive. As a result, if you can time a market crisis event or if you get lucky and happen already to have insurance for a market crisis event, options-based tail risk strategies can have a drastic impact on the performance of a portfolio - especially compared with other investments.
Long-volatility strategies can be implemented using vehicles that may avoid the upfront costs. A simple example would be replicated by a long position in a futures contract on a volatility index. But while a position in volatility similar to one using futures might have no upfront costs, it is a directional bet on volatility, so during periods when volatility is decreasing or during bull markets it can take large losses. As a result, if you can time a market crisis, anticipate spikes in volatility, or happen to be long-volatility when volatility surges, your portfolio will benefit tremendously.
As we can see, although tail-risk insurance strategies are not limited to simple options and long-volatility strategies, they do all have one common theme - successful performance is highly dependent on market timing. Since market timing is difficult, tail-risk strategies tend to lean towards the defensive - hence the references to their being ‘insurance' approaches.
Are you smarter than Buffett?
Timing market crises is difficult if not impossible. Tail-risk insurance strategies would be much simpler if market crises could be timed. In fact, a tail-risk strategy should be the most seductive after a market crisis when the profits of that type of strategy are obvious. The real problem for an investment manager is determining when this type of insurance might be useful again. On the contrary, managed futures is an offensive strategy that adapts favourably to a crisis and, depending on the extent of the crisis, should profit accordingly.
To parallel a popular example, Warren Buffett anticipated the crash of the credit crisis with well-documented statements about derivatives being "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal" as far back as 2002. Given his understanding of the potential dangers ahead, Buffett profited not by predicting it or insuring against it, but by following an adaptable strategy which kept him liquid. In the heat of the crisis, he was poised to take advantage of the reduced liquidity and immense set of ‘crisis alpha' opportunities that resulted. Buffet's approach was offensive, but even he could not predict the exact moment the credit crisis would hit.
In a post-credit crisis world, after all the pain of 2007-08, investors are keen to protect themselves from future crises. Tail-risk insurance strategies and managed futures are two types of strategies that have caught investors' attention. Tail-risk insurance strategies can provide exceptional profits if they are implemented with ample market timing ability. Without market timing ability, they can suffer consistent losses.
Managed futures is a highly adaptable, liquid strategy poised to take advantage of predictable trends during market-crisis events but able to provide modest returns over time. In the absence of market timing ability, an investment in managed futures is an offensive approach to dealing with tail events. It is up to all investors to decide how they want to position themselves for market-crisis events, but in order to know what to expect, it is important to understand what tail-risk insurance strategies and managed futures strategies can deliver during crisis and why.
Kathryn Kaminski is senior investment research analyst at RPM Risk & Portfolio Management, a managed futures and global macro specialist in Stockholm