Investors that seek diversifiers outside of the traditional 60/40 portfolio may find that managed futures offer a source of alpha that is both resilient and liquid.
- Following years of successful returns, portable alpha strategies faced challenges during the Global Financial Crisis (GFC) due to correlation melt-ups and liquidity issues but have since evolved to reduce hidden equity market risks.
- Modern portable alpha strategies tend to exhibit more resilient properties in the face of market shocks.
- Managed futures can be a viable source of alpha to enhance traditional benchmarks due to their liquidity, cash efficiency, and both low cycle and negative tail correlations.
The recent market turbulence of 2022, when both stocks and bonds fell in the wake of an inflationary shock, highlighted a potential liquidity mismatch in portfolios that heavily relied on private markets as the alternative asset class. To avoid moving further away from long-term strategic allocations to traditional assets while still diversifying risks (like those seen in 2022) and maintaining liquidity, the idea of portable alpha has come back into the fold. If configured correctly, the approach has the potential to introduce excess returns on top of the investor’s preferred benchmark and provide a controlled amount of crisis risk mitigation – all without disrupting the investor’s overall strategic asset allocations.
Portable alpha’s troubled past gives some investors pause, but thoughtful choices of alpha sources forged from historical cautionary tales might suggest the advanced approach deserves another look.
Understanding Portable Alpha
Portable alpha is hardly a novel concept: the strategy has been a part of the investment lexicon since the late 1990s and early 2000s. At its core, portable alpha involves combining the beta (benchmark returns) of some markets with the alpha (an independent source of returns). The idea is to maintain full exposure to a benchmark such as the S&P 500 for its beta return while adding an independent return stream on top to achieve alpha. Assuming the alpha source is truly uncorrelated and has positive expected returns, this approach allows investors to potentially outperform their chosen benchmark.
In the past, portable alpha strategies relied on equity market-neutral strategies or fund of funds to attempt achieving alpha, which historically showed low correlations to equity benchmarks. However, the GFC of 2008 exposed certain vulnerabilities of this framework. The strategy used leverage and rather than tying up capital in a passive index fund to obtain the beta component, portable alpha strategies relied on derivatives to “copy” the market, but on margin – thus freeing up money for an all-out pursuit of alpha.
The approach worked, generating attractive returns for investors for many years. Shortly before the 2008 credit disaster, an industry estimate put the total capital invested in portable alpha by institutions around the world at roughly $75 billion. Sadly, during periods of severe market stress like the GFC, many allegedly independent strategies became closely correlated, leading to simultaneous declines in both the alpha and beta components. This resulted in steep losses, highlighting the risks of leverage and the importance of selecting truly uncorrelated alpha sources.
Lessons from the Past
The resurgence of portable alpha requires a careful consideration of past mistakes. Fund of funds strategies involve pooling capital to invest in a diversified portfolio of other investment funds – typically hedge funds. During the GFC, fund of funds strategies were used in portable alpha solutions but faced challenges due to hidden equity market risks. These strategies were often correlated with the broader markets during periods of stress, leading to simultaneous declines in both the alpha and beta components as liquidity dried up throughout the market. Fund of funds strategies can help mitigate risk when spread out across multiple underlying funds; but when those underlying funds also lose value along with the rest of the market – as was the case in the GFC – the strategy experiences significant losses. In more tepid market conditions, hedge funds or fund of funds strategies might lose value, but a historic pressure such as the credit crisis and collapse of the housing market was too much of a stressor and assets that were presumed to be uncorrelated began to lose money as well. As liquidity dried up nearly everywhere, fund of funds strategies faced redemption pressures and were forced to sell holdings quickly.
The challenge with portable alpha structures in the past predominantly stemmed from the wrong choice of alpha and its incompatibility with the selected beta during crises. Managed futures, by contrast, with their resilient and almost anti-fragile properties, may offer a compelling alternative. These strategies tend to perform well during times of market stress, and importantly, become increasingly cash rich the riskier markets get. Thus, investors deploying portable alpha strategies by combining equities with managed futures within an appropriately defined risk budget of course, should be able to withstand market crises without having to unwind the structure allowing for the diversification benefits to add useful returns over the long-term.
The Role of Managed Futures
Managed futures have emerged as a compelling solution in delivering portable alpha. The strategy relies primarily on the trading of futures contracts by Commodity Trading Advisors (CTAs), and most commonly seeks to benefit from the identification and capture of market trends by going long when an asset is doing well and selling short when an asset is doing poorly. The basic premise is that trends are a persistent feature of the fabric of markets, caused by the behavioral biases of the aggregate investor or by slow-moving structural, or fundamental changes to markets. These dynamics are driven by the ebb and flow of the interconnected global economy. Although persistent, trends are unpredictable, so the best way to identify and capture them when they occur is to systematically look for opportunities over as broad a set of markets and time horizons as possible. Managed futures strategies are typically implemented using liquid futures contracts, and the portfolio will hold the majority of its money in unencumbered cash, with a small proportion posted as margin (covering initial and variation margin). Typical markets for managed futures managers include futures on equities and bonds, as well as commodities and currencies. By participating in a broadly diversified set of markets, the return stream generated by these strategies has exhibited very low correlations to any of the underlying markets over time.
The vast majority of managed futures strategies typically include trend-following models in varying proportions. Trend strategies have delivered positive returns during market downturns in the past to investors who have long enough time horizons and remain invested in the strategy. Timing the strategy can be notoriously hard. Investors must be already allocated to the strategy in order to benefit from market divergence: if an investor were to enter a position as momentum in one direction or the other has already commenced, it may be too late. The ‘Tech Wreck’, which began in September 2000 and played out over 4 years, is one such example of when managed futures exhibited outperformance over equities for investors that were patient enough to remain faithful to the strategy1. In the 12 months preceding the Tech Wreck, US stocks gained over 16%, while managed futures lost -5%. In the decade or so that followed though, stocks were up 15% (after a precipitous fall of 57% from 2007-2009), while managed futures were up over 124% by June of 2012. CTAs had 4 years of back-to-back strong returns while the equity market was in a drawdown, but an investor might have missed the initial turning point if they were not already allocated. Trend following is a reactive strategy, not a predictive one, and having a CTA in a portfolio to react whenever downturns occur could allow investors to get more out of their beta.
For institutional investors, it can be hard to match appropriate assets and liabilities. Institutions whether foundations, endowments, pensions funds, insurance companies, or sovereign wealth funds all must align their asset allocations to generate return streams that are suitable for the nature of their liabilities. These liabilities may include philanthropic commitments, funding university operations, or paying pensions and insurance claims. Some investors lean too heavily on the asset side, focusing on generating returns and forget that what was perceived as a ‘smooth long-term liability’ can turn into a rather chunky liability at some discreet point in time, dependent on the nature of those exogenous shocks. One example of this was the recent inflation and interest rate spikes. Imagine an US endowment that has to pay CPI+3% in 2023 from an impaired stock and bond portfolio, or someone reaching retirement age and wanting to set up an annuity in Q4 2008 or Q1 2020.
Under such stressors, managed futures may provide resilience to a portfolio, historically generating strong returns during equity market crisis periods, making them a strategic fit for portfolios needing to withstand severe market conditions and while maintaining certain obligations. Managed futures as portable alpha allows an investor to structure the asset allocation side to meet their long-term liability needs with the potential for the timing and nature of the alpha returns to smooth out some of those rockier liability shocks. The goal is then to create a more resilient portfolio overall, without sacrificing long-term returns.
Behavioral Challenges and Adoption
Managed futures are able to respond rapidly to fluctuations in price, but the strategy requires a disciplined investor and a longer time horizon. By utilizing futures contracts which allow for both long and short positions, managed futures are able to profit from market movements in either direction. This flexibility is enhanced by their systematic and reactive trading strategies which are designed to capture trends and divergence across various asset classes. Strong returns might not be realized every year, as the strategy does best during times of market divergence. This can make it difficult to justify from a behavioral standpoint, says Razvan Remsing, director of investment solutions at London-based systematic investment manager, Aspect Capital. “Timing of our returns is contrary to what the market returns are, so it’s very difficult for some institutional investors to hold the line through a cycle. It takes an educated investor that has a long-term horizon and a patient investment board,” he adds.
This more modern interpretation of portable alpha does not disturb the underlying strategic allocation, which means in order for managed futures to successfully exploit price moves, institutional investors will need to keep their portfolios structurally stable once the allocations to the strategy are decided on. The trend strategy is funded via margin for its futures positions, which means a very (relatively) small cash investment is all that is needed to provide the alpha overlay on top of the beta.
While the strategy seems tempting enough for institutions seeking alpha, Remsing posits investors simply cannot pull themselves off current equity returns.
“I believe that investors have this fear of missing out and don’t want to allocate away from this current equity market as they reckon they’re going to somehow miss out on a lot of return. They’re struggling to sell anything down, and they want to keep all their equity exposure concentrated – yet they also want to be diversified,” he says.
The conundrum has been driving the comeback of strategies like portable alpha to diversify beyond the traditional mainstays. As yields across asset classes began to converge in 2023 (an unprecedented event at the time), investors began realizing bonds were not the reliable equities diversifier they once were.
As inflationary concerns persist, this will put added pressure on the need for true diversification. “I think we can argue that inflation risk is not extinguished, and if anything, the prospect of a tit-for-tat tariff war in the near-term may well add inflationary pressure. In that environment, how do you know how much longer to surf the beta wave? How do you have your cake and eat it too? I think the key is that you have to take part in the financial alchemy that is portable alpha – but the type of alpha you choose really matters,” says Remsing.
As market performance forces investors to reconsider their diversification strategies, they would be wise to rethink portable alpha using managed futures. The liquidity, resiliency, low equities correlation, negative equity correlation in the tails and potential for alpha make them a significant addition for investors seeking to actively diversify their benchmark risk without compromising the potential for future returns.
Note: Any opinions expressed are subject to change and should not be interpreted as investment advice or a recommendation.
1Altegris. (2012). Managed Futures: Staying the Course. Retrieved from [https://www.tradingwithrayner.com/wp-content/uploads/2014/11/ManagedFutures_StayingTheCourse.pdf].