L9 - Managed Futures

Question 1

When did Managed Future Trading become popular?

Answer 1

CTAs (Commodity Trading Advisors) and hedge funds have pursued Managed Futures strategies at least since the 1970s when futures exchanges expanded the set of tradable contracts.

Question 2

in general, What do Commodity Trading Advisors and hedge funds trade when it comes to futures?

Answer 2

Invest using liquid exchange traded futures and futures related instruments to take views on the direction of global markets

–Commodity futures

–Currency forwards

–Equity futures

–Fixed-income futures

Question 3

What is Cross sectional momentum?

Answer 3

• • Cross-sectional momentum:
• –Typically what is used in equity market neutral as discussed in the earlier classes
• –Long securities that outperformed their peers regardless of whether they went up, and
• –Short securities that underperformed their peers regardless of whether they went down

Question 4

What is Time-series momentum?

Answer 4

Time-series momentum, i.e., trend-following investment:

• –Each security is seen in isolation and the trend is a time-series phenomenon:
• –Long securities that went up
• –Short securities that went down

This tends to work in some of the biggest financial crisis (the bad times)

Question 5

Why do trends start?

Answer 5

• A catalyst—a positive earnings release, a supply shock, or a demand shift—causes the value of equity, commodity, currency, or bond to change.
• The change in value is immediate
• Price under-reaction due to contrarian market participants

Question 6

Why do Prices under-react at the start of a trend?

Answer 6

1. Anchor. People tend to anchor their views to historical data and adjust their views insufficiently to new information e.g. 52-week high
2. The disposition effect. People tend to sell winners too early and ride losers too long.
   
   1. –They sell winners early because they like to realize their gains. This creates downward price pressure, which slows the upward price adjustment to new positive information.
   2. –On the other hand, people hang on to losers because realizing losses is painful. They try to “make back” what has been lost. Fewer willing sellers can keep prices from adjusting downward as fast as they should.
3. Non-profit-seeking activities.
   
   1. –E.g. Central banks operate in the currency and fixed-income markets to reduce exchange-rate and interest-rate volatility, potentially slowing the price adjustment to news.
   2. –E.g. investors who mechanically rebalance to strategic asset allocation weights trade against trends. For example, a 60/40 investor who seeks to own 60% stocks and 40% bonds will sell stocks (and buy bonds) whenever stocks have outperformed.
4. Frictions and slow moving capital. Frictions, delayed response by some market participants, and slow-moving arbitrage capital can also slow price discovery and lead to a drop and rebound of prices.
5. Rational Inattention.There are too much information in the market, it is impossible for average investor to keep track of all available information.

Question 7

What causes an Over-reaction during a trend pushing prices pas their fundamental value?

Answer 7

• Confirmation bias and representativeness.
  
  • –People tend to look for information that confirms what they already believe and to look at recent price moves as representative of the future.
  • –This attitude can lead investors to move capital into investments that have recently made money and conversely out of investments that have declined.
• Herding and feedback trading.
  
  • –When prices have moved in one direction for a while, some traders may jump on the bandwagon because of herding or feedback trading.
  • –Herding has been documented among equity analysts in their recommendations and earnings forecasts, in investment newsletters, and in institutional investment decisions.
• Fund flows and risk management.
  
  • –Fund flows often chase recent performance (perhaps because of confirmation bias and herding).
  • –As investors pull money from underperforming managers, these managers respond by reducing their positions (which have been underperforming), while outperforming managers receive inflows, adding buying pressure to their outperforming positions.
  • –Furthermore, some risk-management schemes imply selling in down markets and buying in up markets, in line with the trend

Question 8

What is one of the most simply managed futures strategies to trade the underreaction to a price change (trading on trends)?

Answer 8

• Problem with taking different X periods of months:
  
  • Too small –> signal is precise but you have a pretty high turnover as your position may chance month to month as returns may be volatile month to month
  • Too high –> turnover is smaller but potentially trading on stale information
• in pension funds almost all of the volatility comes from from equity as it is more risky than the bonds –> not a very efficient diversification
  
  • However basing it off its annualised volatility we can now make it so each instrument contributes equally to the riskiness of the portfolio –> risk weighted strategy (this is the 40% term in the formula)
• standard deviation in this case is the rolling standard deviation of s over the period
• Final term is the realised return of S
• Returns may be highly correlated across different X values but the underlying assets may not be correlated –> so while time-series momentum may not work for one asset class does not mean it won’t work for another
• Might even be benefical to diversify a portfolio across lots of different asset classes and time periods

Question 9

What are the diversification benefits of managed futures?

Answer 9

• Trend-following investing has performed especially well during periods of prolonged bear markets and in sustained bull markets, giving rise to a “smile” curve.
• To understand this smile effect, note that most of the worst equity bear markets have historically happened gradually.
  
  • –The market first goes from “normal” to “bad,” causing a TSMOM strategy to go short.
  • –Often, a deep bear market happens when the market goes from “bad” to “worse,” traders panic, and prices collapse.
  • –This leads to profits on the short positions, explaining why these strategies tend to be profitable during such extreme events.