It seems like clockwork that whenever an investment strategy goes through a soft period of lackluster returns, the investment community questions its validity. You can almost set your watch to it. This seems particularly true for strategies that are divergent in nature, the most common of which are managed futures/CTA strategies.
Divergent return streams are characterized by many small losses followed by an occasional large gain, often at times of crisis or correction. Unlike feel-good convergent return streams, which produce many small gains followed by an occasional devastating loss, divergent strategies often feel like taking many small paper cuts, waiting patiently for a possible large return. For this reason, investors often struggle with this type of strategy, as they do not provide constant gratification, but instead feel like waiting for a huge insurance payoff.
Seeing as most equity, fixed income and alternative strategies produce a convergent return stream, one solution to creating a better portfolio, for any investor, is to add divergent alternative return streams to the typical investments that dominate portfolios. Holdings that boast a negative or near-zero equity correlation but still produce positive returns over time are particularly valuable, as they're able to provide investors with moderate gains over the short-term, and really kick in once the markets decline.
To help understand the value of this return stream and managed futures in general, in 2014, we published a white paper on the CTA Value Added Index ("VAI™"). This research illustrated that managed futures/CTA strategies consistently add risk-adjusted value not only in times of financial crisis, but over the long term as well, and that timing plays a significant role in improving portfolio performance when increasing risk-adjusted exposure.
A perfect example of this is gleaned from the graph above, which shows the additive risk-adjusted value of using managed futures within a portfolio. Anything above zero denotes that investors experience risk-adjusted benefits.
As one can see, while the CTA VAI™ largely remained positive for the better part of two decades, in 2014, it briefly dipped into negative territory before fiercely rallying over a short period of time on the back of exceptional CTA performance despite the continued strength of the stock market. During this time, any investor who increased their CTA exposure was rewarded handsomely for their shrewd decision.
At the time the CTA VAI™ whitepaper was written, the CTA sector had softened for three years and the investment category found itself on the hot seat despite being valuable over most time periods. It didn't matter whether an investor added exposure in a time of financial crisis or when stocks were outperforming: over a rolling 60-month period, the index was mainly positive. As long as the benchmark's value stays above zero, whatever its current performance, there is still an additive long-term risk-adjusted benefit to including managed futures within a portfolio.
Make no mistake however, despite CTA portfolios offering investors long-term gains, timing still shapes performance. Historically, the most valuable time to add CTA exposure is when the CTA VAI has significantly dislocated from the S&P 500 (grey sections in Figure 1 above in 1998, 2000, 2007, and 2014). If investors are able to add CTA exposure just before the spread begins to tighten, they experience significant gains. This is why the benchmark is such a valuable tool when trying to time asset allocation perfectly and further improve your portfolio's performance.
In 2016, with the exception of Auspice's products and a few others, CTA strategies did not fare well while the equity market marched higher. This caused the spread between the index and the S&P to widen further, currently sitting on the low end of the historical range at 1.16.
While this index does not predict the future, we can learn from the past. At this time, the spread between CTA Value added Index and equities is starting to look stretched. Could it widen even further? Of course. However, it is at times like these that adding a divergent return stream seldom harms a portfolio materially, yet has the potential to help tremendously.