Five years after the financial crisis, many advisors are still wondering how they might have averted the calamitous portfolio tumble their clients experienced in 2008 and early 2009. From its peak in 2007 to its March 2009 nadir, the S&P 500 fell 57%.
Was there a way to have shorted equities as volatility rose, for instance, going long on Treasuries and gold? And, perhaps more important: Were there signals suggesting that the time was right for these actions?
Managed futures are designed to have little correlation with other asset classes, hoping to provide a zig to the broader equity market's zag. In 2008, the Altegris 40 index, which tracks 40 programs using a managed futures strategy, rose 15%, while the S&P shed 38%.
"Most investment strategies are long biased," says Brian Hurst, a principal and one of the managers of the $4.6 billion AQR Managed Futures Strategy fund. "But in our fund, we are equally likely to go short as we are to go long."
In the aftermath of the financial crisis, investors were clamoring - albeit belatedly - for alternatives to the standard portfolio staples of stocks, bonds and cash. The managed futures fund category has grown from $814 million in August 2008, when there was only one such fund, to $10 billion and 52 funds as of the end of July, according to Morningstar.
As stocks have rebounded, there's been less attention on alternatives, but during periodic market routs, they can prove their mettle for jittery investors.
Managed futures are supposed to tamp down volatility during falling markets. But it doesn't always work that way. High fees and poor performance have put the brakes on the enthusiasm, but AQR, short for Applied Quantitative Research, has been a standout on both fronts. Launching in 2010, the Greenwich, Conn., firm rolled out three alternative funds that are targeted at advisors and based on the hedge fund strategies it was already using for institutional accounts.
In a category where the typical fund charges an astounding 2.97% expense ratio, the AQR Managed Futures Strategies fund levies just 1.5% (and just 1.25% in the institutional share class, which has a $5 million minimum). And while it wasn't around for the last big meltdown, its more recent performance looks good. For the three-year period ended Aug. 28, the fund is up an annualized 2.8%, placing it in the top 3% of similar funds followed by Morningstar. True, that's significantly less than the S&P's 17.9% gain over that period - but managed futures are aimed at declining markets, when they are supposed to provide some downward protection.
Running a managed futures fund, Hurst says, comes down to extensive data analysis and trend spotting. "We go long on things that have gone up and short things that have gone down, then bet that those trends will continue," he explains.
AQR Managed Futures' four managers try to identify which trends are prominent and how much risk it would entail to pursue them. They buy futures contracts in one of four asset classes: equities, fixed income, currencies and commodities. They are active in 120 markets worldwide, creating a portfolio with global and asset diversification. Position sizes vary by the strength of the trend; strong trends that are expected to persist command bigger positions.
"We think trend following works in every single market," Hurst says. For example, late last year, the fund shorted the Japanese yen, as monetary policy in Japan began to favor a weaker currency after years of strength. At the same time, they went long on U.S. equities, given how well American stocks were performing. (Both bets paid off.)
Commodities proved a bit trickier; that asset class had a number of sharp and frequent trend reversals last year. Despite losses there, the fund returned 2.7% for full-year 2012, in the category's top 7%. Even so, Hurst says, the fund can do better. "It was below our expectations in absolute performance," he says, adding that AQR targets returns of six to seven percentage points above the interest rate on cash investments.
In addition to following trends, AQR uses signals to help it spot those that have become overextended. "That tells us where the trend might have gone on too long or moved too quickly," Hurst says. "We try to identify if a reversal might occur and if it will be larger than normal."
Earlier this year, the firm's signals pointed to potential risk in the Japanese market. After years of stagnating, the Nikkei had finally perked up in mid-2012, due to the weaker yen. But several months into this reversal of fortune, AQR's managers thought that there wasn't as much upside to be had in Japan as there was at the beginning of the trend. "We were still betting on the trend to continue," Hurst says. "But we bet less, because we didn't view it as a good risk/reward signal."
Hurst doesn't discriminate against any of the asset classes, even though at any given time he expects one or another to outperform. He says that many asset classes can be similarly risky - and offer similar returns - over the long run, "but it varies a lot through time," he notes. Over five to 10 years, equities (via both long and short positions) should produce the same amount of risk and the same return as, say, commodities or currencies, he argues.
The team is equally active in the different asset classes. Other managed futures funds tend to concentrate on one or two asset classes where they have developed expertise.
Of course there are times when markets prefer one asset class to another. "Because it's a trend following strategy, [the fund is] positively correlated in up markets and negatively correlated in down markets," Hurst explains.
The fund has about 120 positions. "And not one of them dominates," Hurst insists. In the first quarter, the managers were long on Japanese and U.S. equities. That paid off well as those markets rallied. In the second quarter, AQR Managed Futures shorted gold and other commodities like copper and some agriculture. And a short of the Australian dollar vs. the New Zealand dollar helped that quarter's performance, as slumping commodity prices and worries over a weaker economy in China weakened the Australian dollar.
Not all the fund's calls proved right. A short of the euro earlier in the year failed when eurozone countries moved away from austerity measures toward more stimulus spending, leading the currency to rally. And a position in Canadian stocks didn't do well when the market there fell because of declining commodity prices. But at the same time, the fund successfully followed overextended signals to short fixed-income bets.
The best climate for the managed futures fund is "a market that is generally rising, but choppy along the way," Hurst says. "If you're more focused on the short term, you would lose, but if you're focused on the long term, you can take advantage of that trend."
To be sure, managed futures funds aren't for every advisor or client. But for those who cannot stomach severe losses, a well-managed fund with relatively low expenses is an option worth investigating. And even then, a managed futures fund should just be a small slice of an overall portfolio, helping to smooth out returns when markets turn dicey.
Ilana Polyak, a Financial Planning contributing writer in Northampton, Mass., has also written for The New York Times, Money and Kiplinger's.
Brian Hurst, AQR Managed Futures Strategy
Credentials: B.S. in economics, Wharton School at University of Pennsylvania
Experience: Co- portfolio manager, AQR Managed Futures Strategy fund (2010-present); principal, AQR Capital Management (1998-present); associate, Goldman Sachs (1994-1998)
Inception of fund: January 2010
Style: Managed futures
AUM: $4.6 billion
1- and 3-year performance as of Aug. 28: 6.91%, 2.78%
Expense ratio: 1.5%
Front load: None
Minimum investment: $1 million
Alpha: 3.29 vs. S&P 500
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