Steeve Brument, Head of Quantitative Multi-Asset Strategies, and Johann Mauchand, Senior Systematic Fund Manager at Candriam, explain how CTAs or managed futures play a very useful role in diversifying portfolios.
After years of negative interest rates, runaway government debt, and barely any inflation, the tide turned in 2022: Deglobalization, the Covid crisis and the war of aggression on Ukraine created shortages of raw materials, goods and labor. As a result, consumer prices exploded. Only after many months, during which monetary authorities convinced themselves that the high inflation rates were only "temporary", did central banks return to their primary mandate of keeping inflation at an acceptable level. They raised interest rates steeply, triggering massive corrections across asset classes. Today, investors are asking: is this restrictive monetary policy going too far and ultimately bringing the economy to its knees?
In the short term, investors face uncertainty from several directions: When and at what level will interest rates peak? Are central banks showing enough flair for a mild recession – or will there be a hard landing? How will the energy crisis affect Europe this winter? What about next winter? And what other consequences might be in store with the war in Ukraine?
"While some of these uncertainties have definitely already been priced into the financial markets now. Nevertheless, 2023 is likely to be uncomfortable and put pressure on many allocations," write Brument and Mauchand. "Diversification" is the watchword of the day, they say. CTAs, or managed futures funds, have defied many crises and market reversals in the past. These instruments are typically based on trend-following strategies that aim to profit from the direction of the market, whether it moves up or down. The BarclayHedge CTA Index, for example, has exhibited a clear decorrelation to the authoritative asset classes for 40 years – across many market regimes. In the past, it provided an effective hedge against extreme risk events. This currently makes it a suitable tool for investors, as the coming year promises some uncertainties and surprises.
Performance despite recession
Candriam has analyzed the returns of several asset classes during U.S. recessions over four decades. The asset classes studied include global equities, global bonds, a traditional 60:40 portfolio, an alternative asset portfolio, and gold.
"Stagnant absolute performance during recessionary periods shows: Historically, CTAs generated positive returns during recessions and were able to keep pace with a bond allocation. They have been more consistent than gold."The precious metal surprisingly showed losses during several of these periods. In this respect, it may well be questioned whether its reputation as a "safe haven" is still justified. But this is only one result of this analysis. The goal was to examine the historical function of a CTA allocation in a diversified portfolio. Here is an interesting picture.
CTAs of advantage in most crises
To address the question of how CTAs have performed during market turmoil in recent years, Candriam analyzed the performance of the BarclayHedge CTA Index during the turmoil of the past forty years. In addition, 14 extremely unpredictable events over the past 35 years were specifically considered. These included geopolitical, health and financial market crises, including the attack on the World Trade Center, the Lehman crisis, the Brexit and the Covid-19 outbreak.
As a result, the CTA index generated positive returns during 12 of those 14 periods of market turmoil, in some cases exceptionally good returns. Government bonds and gold also rose in value in most cases, more precisely, during ten and. nine crises. In contrast, global stock prices plunged massively in all but one of these "risk-off" events (the 2016 election of President Trump in the U.S.). During some market disruptions, equities lost almost half their value. With the inclusion of a CTA allocation, investors would have improved the diversification and thus the performance of their portfolio in the vast majority of cases – this is shown by the comparison of two model portfolios with and without CTAs.
Since 2000, market participants have experienced several unexpected events with varying degrees of market dislocation. Guessing the timing of changes in the business cycle or predicting low-probability events is incredibly difficult. CTAs can play a very useful role in diversifying portfolios to be ready for unpredictable developments such as those that may be in store in the coming year.