Managed Futures Today Magazine

Most investors are aware of the dangers of chasing a trend or a “hot” market: A big up move attracts lots of new buyers looking for more of the same, but at some point the market becomes saturated and when no more buyers are available, the market tanks.

True, it doesn’t always turn out this way, but by definition the longer any price move has been in effect, the closer it is to ending. This is the reason many trading models are designed to trade in the direction of the long-term trend when corrections occur. For example, the December 2010 issue of Active Trader magazine features an article (“Catching longer-term market swings”) that shows the results of buying the S&P 500 after the appearance of a pattern that includes a relatively sharp (5 percent or greater) sell-off over a brief time period.

The approach significantly outperformed the market over a two-month time horizon. However, the approach took big risks and experienced sizable drawdowns during severe bear-market moves (such as the one in 2008-2009), since it often bought while the market continued to fall precipitously. Despite their apparent edge, one of the primary problems with such investment approaches is the psychological challenge of buying something that’s dropping and holding on to it when it continues to drop.

Just as investors tend to be attracted to stocks that are rising rather than falling, they’re also likely to invest with managers on hot streaks rather than those experiencing drawdowns. This begs the question: Should you attempt to “time” a managed futures investment — that is, buy into a managed futures program that is currently in a down swing, with the expectation that better performance is in the wings?


Buying drawdowns
Two widely referenced studies from the 1990s, one originally published by noted author Jack Schwager in his book Managed Trading: Myths & Truth (John Wiley & Sons, 1996), and another from around the same time written by commodity trading advisor (CTA) Tom Basso, then of TrendStat Capital Management, argued that investing in managed futures programs during drawdowns was a profitable approach.

For example, Basso’s study, which simulated buying CTAs experiencing three-month drawdowns, found the odds were better than 2 to 1 for positive performance over the following 12 months. Brandon Langley and Jon Robinson of Robinson-Langley Capital Management (www.rlcap.com) revisited the approach earlier this year (using trend-following CTAs) and also found it to be successful. Using data from three CTA-ranking sites, the authors compiled a portfolio of 32 trend-following programs with at least three-year track records and a minimum of $5 million under management. Negative three-month periods were followed by profitable 12-month periods 1,393 times vs. unprofitable 12-month periods only 301 times for a ratio of 4.6:1. Also, both the Basso and Robinson-Langley studies found the opposite approach — selling after big equity run-ups — didn’t provide a similar benefit. (The article is available at: http://rlcap.com/downloads/RL%20Capital%20-%20Drawdown%20Study.pdf.)

Robinson and Langley conducted a similar test that replaced the three-month losing period with a six-month losing period and increased the forward-performance window from 12 to 18 months. The performance was even better: 1,091 profitable vs. 156 unprofitable 18-month periods, a 7:1 ratio.

One of the limitations these studies acknowledged is that they incorporate some measure of “survivorship bias.” Because they’re based on portfolios of CTAs that have survived over the length of the analysis period, the analysis by default is selecting “winners” and doesn’t reflect the performance of those funds that might have failed during that time.

Another recent study by Jeff Malec, CEO and founding partner of Chicago-based asset management firm Attain Capital Management (www.attaincapital.com), incorporated losing CTAs in its drawdown-buying analysis to combat survivorship bias. Malec analyzed the performance of five separate CTA portfolios using different start dates between January 2002 and January 2006, adding to the investment in a CTA when its drawdown reached half its maximum historical drawdown. This approach outperformed simply buying and holding all the CTAs, as well as an alternate approach that exited CTAs when they reached 1.5 times their maximum historical drawdowns, and then rolled the funds into another CTA.

A subsequent study (www.attaincapital.com/alternative-investment-education/managed-futures-n...) Malec’s firm conducted, which used drawdown duration rather than magnitude, showed that investing in a program at its 21-month low point resulted in performance over the following 12 months that was two times the historical average 12-month performance. (Conversely, investing in a program at a 21-month high resulted in performance over the next 12 months that was only .70 of the average.)

The challenge, of course, is being able to apply such an approach with real money, which is an understandably difficult task for many investors.

“The success of it centers around being a contrarian investor and not chasing returns,” Malec says. “Most [investors] do not wait for drawdowns; [they] invest in programs at equity highs — likely because their brains are hard wired to avoid something that causes pain. It’s a rare investor who can look at a program at a 21-month low and say, ‘That’s the one I want to get in, instead of the one that has been going up the past two years.’”

Malec’s study also notes the importance of having a “line in the sand” — a stop-trading point at which you will exit an unsuccessful program (see “Track record length” for more information).


Complications
Investing in the real world is always more difficult than in a simulated environment. It could be argued the benefit of buying CTAs experiencing drawdowns hinges upon the ability to proactively identify “quality” trading programs that are likely to survive and prosper in the long term — as much a challenge for an investor as knowing which individual stocks in a group are likely to go up or down over the next 12 months.

Using different drawdown definitions (time- or depth-based), altering the length of a time-based drawdown, deciding how often reinvestment will occur, and changing the subsequent review period (two years, five years), will change the outcome of any historical analysis. These are decisions investors have to work out beforehand.

And these aren’t the only variables.

BarclayHedge.com president Sol Waksman argues the issue of investing in fund drawdowns isn’t as straightforward as some make it. He points out that one CTA’s drawdown might be a natural function of the program’s trading style — say, the tendency of a trend-following fund to go into a drawdown when markets are wandering in trading ranges — while another CTA’s drawdown might be a case of a genuine breakdown in the trading program.

“The question it really comes down to is whether the [drawdown] means the wheels are coming off, or just that the system isn’t designed to deal with the current environment,” he says. “If you know the answer to that question, then yes, maybe [a drawdown] is a good time to add to your investment or to make an investment.”

But Waksman also points out investors must consider the other half of the “timing” equation.

“If you’re going to start timing, how do you determine when to get out?” he asks.

Waksman says research he conducted years ago indicated that from a true investment perspective, there was little benefit to timing.

“If you’re a long-term investor, it doesn’t really matter,” he says. “Say you get in at a little better time. After a few years, what difference does it make whether you had a little bit more or less volatility in the first few months? In the end you still need a diversified portfolio.”

Waksman stresses that managed futures investors must do their due diligence and outline their risk and trade goals in advance.

“I think there are two things you need to ask yourself,” he says. “Number
one — and this is before you put any money in — how much are you willing to lose? Where’s the exit? The only time you can have a rational opinion on that, in my mind, is before you’ve made the investment.”

More food for thought: Just as markets that have dropped significantly can sometimes drop even more — just ask all the people who bought stocks in July and August 2008 — a negative trend in a CTA can be difficult to buck. Waksman gives the example of a fund with a compound annual rate of return of more than 20 percent over more than two decades, but which for the past four to five years has suffered massive redemptions — on the order of 90 percent.

“A rate of return over 20 percent for more than 20 years is a remarkable, remarkable achievement,” he notes. “Does that argue the case that [the fund] is going through a rough spot and now is a good time to buy? Well, maybe, but more people are voting in the other direction. That’s telling you what investors are thinking.”

Ultimately, Waksman says, investing is hard work, and investors have to be honest with themselves about their goals as well as why they’re making decisions.

“The question is, why do you believe this manager is going to continue to provide returns like the ones you’ve seen in the past? How are you coming to that decision?” he says.