Selecting the Optimal Investment Universe in Managed Futures
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- Stuart Chapman
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1 STRATEGY SPOTLIGHT May 2017 Selecting the Optimal Investment Universe in Managed Futures AUTHORS Matt Dorsten Senior Vice President Portfolio Manager Managed futures strategies use quantitative models to invest in price trends. These strategies seek to capitalize on the well-supported observation that security prices follow trends that stem from behavioral biases among investors. Put simply, trend-following strategies systematically buy securities that have been increasing in price and sell securities that have been falling in price. The ability of this approach, also known as momentum investing, to deliver returns for investors has been established over decades of academic research. Nicholas Johnson Managing Director Portfolio Manager Chris Santore Senior Vice President Derivatives Strategist However, for a strategy based on widely understood theory and public data, manager approaches can vary considerably, resulting in dissimilar outcomes depending on their choices in strategy design. This paper focuses on one of those choices: How many securities should a managed futures portfolio hold? As a managed futures investor, we seek to generate long-term positive returns, diversify investor portfolios through low correlations to traditional asset classes and deliver strong positive performance during long-term bear markets. One of the trade-offs we face is the potential marginal benefits of expanding our strategy to include more securities versus the potential marginal costs of using less-liquid securities. Indeed, the PIMCO TRENDS Managed Futures Strategy seeks to provide a diversified source of return to client portfolios. It uses a carefully controlled opportunity set that seeks to minimize transaction costs and maximize diversification potential.
2 2 May 2017 Strategy Spotlight Figure 1: Decreasing marginal benefits Return/Vol The benefits of adding similar assets fade quickly Number of assets Source: PIMCO Hypothetical example for illustrative purposes only. Figure 2: Decreasing marginal benefits Return/Vol Only uncorrelated assets move the needle Number of assets Source: PIMCO Hypothetical example for illustrative purposes only. INVESTMENT UNIVERSE The depth and breadth of the investment universe are critical elements in building a robust managed futures strategy. On this topic, we discuss a key question investors must answer: Does incremental diversification by trading an additional asset outweigh the incremental transaction costs? There are clear benefits to combining imperfectly correlated assets in a diversified portfolio. But those benefits do not extend equally to every new security. For example, if 25 similar investments with 0.75 correlations with one another (think 25 different equity markets) were pooled in a portfolio, the diversification benefit would quickly diminish as more securities were added beyond the first few assets (see Figure 1). The third asset matters much more than the 25th. If we extend this to 50 assets, where the next 25 also have 0.75 correlations with one another but a lower correlation 0.25 in this example with the first 25 (a proxy for adding an additional asset class), then again there is a clear initial benefit with declining marginal contribution (see Figure 2). This analysis illustrates two critical points: An investor should add assets to the portfolio that exhibit low correlations to existing assets, and, if the trading costs are
3 May 2017 Strategy Spotlight 3 relatively higher, the bar for diversification must be higher as well. To make these concepts more concrete, we look at two asset classes common to trendfollowing programs: commodities and equities. In commodities, global benchmark contracts trade with significantly higher volumes than more specialized contracts. For example, average volumes for West Texas Intermediate crude oil are about 30 to 40 times greater than for lean hogs (see Figure 3). The two contracts have very different fundamental drivers and low historical correlations, and thus there is diversification when trading both markets (see Figure 4). However, a trend-following investor trying to trade $100 million of lean hogs will pay a much higher transaction cost than one trading $100 million of oil. In practice, if a large fund tried to trade hogs in the same volume that it traded oil, transaction costs would swamp the diversification benefits. To control for this, most managers will put a cap on the size of a position they can have in smaller markets. This is a sensible way to manage the trade-off between diversification and transaction costs. Yet it means that looking only at the number of markets in which a manager trades is misleading without knowing how big a share of their portfolio these smaller markets can be. If the position of lean hogs can be only a fraction of the size of the oil position, then its portfolio impact will be small. In practice, the assets under management (AUM) of a manager s trend-following strategy can be a more important driver of risk-adjusted returns than the number of markets. Next, let s look at equities. S&P 500 futures trade with a daily dollar volume of roughly $150 billion. That is more than 10 times greater than the volume of Dow Jones Industrial Average (DJIA) futures contracts, which is roughly $10 billion (see Figure 5). The two contracts are highly correlated, at Figure 3: Commodity volumes: Big differences in liquidity (and cost) Crude oil futures trade with significantly more volume than lean hogs 1,600,000 Contracts traded (series aggregate) 1,400,000 1,200,000 1,000, , , , ,000 0 Mar 12 Mar 13 Mar 14 Mar 15 Mar 16 Mar 17 Crude oil futures volume (60-day average) Lean hog futures volume (60-day average)
4 4 May 2017 Strategy Spotlight Figure 4: Correlation: Low correlations can justify less-liquid assets Crude oil vs lean hogs correlation =.06 15% Lean hogs futures daily return -15% -10% -5% 10% 5% -5% -10% -15% 5% 10% 15% -20% -25% Crude oil futures daily return Figure 5: Equity volume: Big differences in liquidy (and cost) S&P 500 futures trade with significantly more volume than DJIA futures 2,500,000 Contracts traded (series aggregate) 2,000,000 1,500,000 1,000, ,000 0 Mar 12 Mar 13 Mar 14 Mar 15 Mar 16 Mar 17 S&P 500 futures volume (60-day average) DJIA futures volume (60-day average)
5 0.97 using daily returns (see Figure 6), indicating that the addition of DJIA futures to a trend-following program is unlikely to add any diversification value. It is likely to add cost, however, particularly during times of market turbulence and reduced liquidity. NUMBER OF TRADES MATTERS MORE THAN NUMBER OF MARKETS With the PIMCO TRENDS Managed Futures Strategy, we seek to strike the right balance between the number of markets, the maximum size of each market and the frequency with which we can trade in each of those markets. One way to quantify this approach is to look at the effective number of uncorrelated trades in the May 2017 Strategy Spotlight 5 portfolio. As an example, suppose you traded a certain number (N) of assets. If they were perfectly correlated, that portfolio would have 1 uncorrelated trade. And conversely, a portfolio of perfectly uncorrelated and equally sized trades would have N uncorrelated trades. The practical reality is that the number of trades in a portfolio is somewhere between 1 and N, depending upon the correlations and volatilities of the various markets and the relative position sizes in the portfolio.1 the effective number of uncorrelated trades is 1.7. In other words, even though there are 50 assets in the portfolio, from a risk and diversification perspective, it s equivalent to having 1.7 uncorrelated trades of similar size. For an intuitive understanding, imagine the assets within each group are pretty highly correlated, so each group of 25 assets is essentially just 1 trade. If the two groups were uncorrelated, we would expect effectively 2 trades. But given that the two different groups had a low correlation of 0.25, the number of effective uncorrelated trades is slightly lower. For the earlier example of 25 assets with 0.75 correlation, and then another 25 assets also with 0.75 correlation to one another and 0.25 correlation with the first 25 assets, Figure 6: Correlation: High correlations make it hard to justify less-liquid assets S&P 500 vs DJIA futures correlation = 0.97 DJIA futures daily return 4% 2% -6% -4% -2% 2% 4% -2% -4% -6% S&P 500 futures daily return The actual definition of the number of uncorrelated trades is technical and requires more space than we have here to explain fully, but can be understood by thinking of the principal components of the portfolio covariance matrix. This allows one to identify the truly independent parts of the portfolio and quantify their significance. For instance, when a small number of principal components have a large degree of explanatory power, the effective number of uncorrelated trades will be low. 1
6 6 May 2017 Strategy Spotlight Figure 7: Larger portfolios may take longer to adjust less-liquid positions AUM $1 billion AUM $5 billion AUM $25 billion Sector Contract Contract volatility Max target weight for 10% vol portfolio Fraction of open interest Days to close position, trading 10% of daily volume Fraction of open interest Days to close position, trading 10% of daily volume Fraction of open interest Days to close position, trading 10% of daily volume Interest rates US 10YR NOTE (CBT) 4% 25% 0% 0 0% 0 2% 0 Interest rates EURO-BUND FUTURE 5% 22% 0% 0 0% 0 2% 0 Interest rates LONG GILT FUTURE 5% 22% 0% 0 1% 0 6% 2 Interest rates Euro-BTP Future 5% 21% 1% 0 3% 1 13% 3 Interest rates CAN 10YR BOND FUT 4% 25% 1% 0 3% 1 14% 7 Interest rates JPN 10Y BOND(OSE) 1% 95% 1% 0 4% 1 22% 7 Equity S&P500 EMINI FUT 7% 16% 0% 0 0% 0 1% 0 Equity DAX INDEX FUTURE 10% 11% 0% 0 1% 0 6% 1 Equity H-SHARES IDX FUT 16% 7% 0% 0 1% 0 7% 2 Equity S&P/TSX 60 IX FUT 10% 11% 0% 0 2% 2 8% 9 Equity SPI 200 FUTURES 10% 11% 0% 0 2% 1 8% 5 Equity BOVESPA INDEX FUT 21% 5% 1% 0 4% 2 19% 8 Equity SWISS MKT IX FUTR 8% 14% 1% 0 4% 2 20% 9 Equity IBEX 35 INDX FUTR 11% 10% 1% 0 5% 2 23% 9 Equity FTSE/JSE TOP 40 13% 9% 1% 1 6% 3 28% 13 Equity KOSPI2 INX FUT 9% 12% 1% 0 7% 1 33% 4 Equity OMXS30 IND FUTURE 9% 12% 1% 0 7% 2 34% 11 Equity MSCI TAIWAN INDEX 8% 13% 2% 1 9% 3 43% 13 Equity MSCI SING IX ETS 10% 11% 3% 1 17% 7 83% 37 Equity Nifty 50 9% 13% 4% 1 19% 3 94% 17 Commodity WTI CRUDE FUTURE 24% 5% 0% 0 0% 0 1% 0 Commodity NATURAL GAS FUTR 43% 3% 0% 0 0% 0 2% 0 Commodity GOLD 100 OZ FUTR 11% 10% 0% 0 1% 0 4% 1 Commodity GASOLINE RBOB FUT 19% 6% 0% 0 1% 0 5% 1 Commodity SOYBEAN FUTURE 12% 9% 0% 0 1% 0 7% 2 Commodity SUGAR #11 (WORLD) 25% 4% 0% 0 1% 1 7% 5 Commodity COPPER FUTURE 18% 6% 0% 0 2% 1 10% 3 Commodity COFFEE 'C' FUTURE 21% 5% 1% 0 3% 1 13% 7 Commodity LIVE CATTLE FUTR 15% 7% 1% 0 3% 2 14% 8 Commodity WHEAT FUTURE(CBT) 20% 6% 1% 0 3% 1 15% 5 Commodity SOYBEAN OIL FUTR 23% 5% 1% 0 3% 1 15% 5 Commodity COCOA FUTURE - ICE 29% 4% 1% 1 3% 3 16% 14 Commodity LEAN HOGS FUTURE 21% 5% 1% 0 4% 2 20% 12 Commodity COTTON NO.2 FUTR 15% 7% 1% 1 4% 3 21% 17 Commodity PLATINUM FUTURE 18% 6% 2% 1 10% 4 48% 20 Commodity WHITE SUGAR (ICE) 21% 5% 2% 2 12% 10 58% 51 Commodity PALLADIUM FUTURE 21% 5% 3% 1 13% 6 64% 29 Hypothetical example for illustrative purposes only.
7 May 2017 Strategy Spotlight 7 SIZE MATTERS The pursuit of uncorrelated trades can lead managers to less-liquid securities. In fact, the discovery of positive expected returns from trend-following can be a tempting source of evidence of diversification potential in the marketing of trend-following strategies. But as portfolios grow in terms of assets, the potential contributions to expected returns and diversification from securities that are lightly traded diminish. Figure 7 shows an example of how size constraints can affect a portfolio of common listed global rates, equities and commodities futures. We have estimated the natural maximum position for three different sized portfolios trading a given security in a simple hypothetical trend-following model running at 10% volatility to be 1% standalone volatility contribution (maximum size = 1%/ volatility). Of course, lowervolatility assets would have larger maximum sizes, thus contributing portfolio risk similar to the highervolatility assets. Across each portfolio, we calculate the fraction of total open interest across the entire futures curve that the 1% position would represent. We then calculate the number of trading days required to exit a 1% position, assuming trades are limited to 10% of daily average volume. Reading the table from left to right, the portfolio is relatively unencumbered by size at $1 billion but could encounter significant challenges in some of the smaller securities as AUM grows. At one extreme, this analysis suggests that it would take 51 days for a $25 billion portfolio to unwind a 5% position in white sugar, assuming that the portfolio was active across the entire futures curve, and those trades would constitute 58% of open interest. This reality doesn t prohibit large managers from using smaller markets, but it implies that large portfolios are likely constrained in how they use them. OUR APPROACH Trend-following seeks to produce positive returns that are uncorrelated with equities and bonds by capitalizing on investors behavioral biases. Given we are taking advantage of small, systematic biases, the probability of being right on any one position is not that high. This means the potential key to success in such a strategy is having as many different positions as possible. However, certain positions are not very well captured by markets. A position in DJIA futures is not additive to a portfolio that already trades S&P futures. When we look at building our portfolio and adding new markets, we are seeking to maximize the number of uncorrelated positions as opposed to just the number of markets. As we implement this framework in the PIMCO TRENDS Managed Futures Strategy, we leverage the company s existing execution infrastructure. Our dozens of dedicated traders have access to both algorithmic and more direct execution options across developed and emerging markets rates, currencies, commodities, credit and equities.
8 Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. The strategy may utilize quantitative models as part of implementing its investment strategies. The models evaluate securities or securities markets based on certain assumptions concerning the interplay of market factors. Models used may not adequately take into account certain factors, may not perform as intended, and may result in a decline in the value of your investment, which could be substantial. Managed futures contain heightened risk, including wide price fluctuations and may not be suitable for all investors. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. The strategy will seek exposure to commodities through commodity-linked derivatives. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Derivatives and commodity-linked derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Commodity-linked derivative instruments may involve additional costs and risks such as changes in commodity index volatility or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Investing in derivatives could lose more than the amount invested. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Hypothetical examples are for illustrative purposes only. Hypothetical and simulated examples have many inherent limitations and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated results and the actual results. There are numerous factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. No guarantee is being made that the stated results will be achieved. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. This material contains the opinions of the manager but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. PIMCO provides services only to qualified institutions and investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA is regulated by the United States Securities and Exchange Commission. PIMCO Europe Ltd (Company No ) and PIMCO Europe Ltd - Italy (Company No ) are authorised and regulated by the Financial Conduct Authority (25 The North Colonnade, Canary Wharf, London E14 5HS) in the U.K. The Italy branch is additionally regulated by the CONSOB in accordance with Article 27 of the Italian Consolidated Financial Act. PIMCO Europe Ltd services and products are available only to professional clients as defined in the Financial Conduct Authority s Handbook and are not available to individual investors, who should not rely on this communication. PIMCO Deutschland GmbH (Company No , Seidlstr a, Munich, Germany) is authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie-Curie-Str , Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The services and products provided by PIMCO Deutschland GmbH are available only to professional clients as defined in Section 31a para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH ), Brandschenkestrasse 41, 8002 Zurich, Switzerland, Tel: The services and products provided by PIMCO (Schweiz) GmbH are not available to individual investors, who should not rely on this communication but contact their financial adviser. PIMCO Asia Pte Ltd (501 Orchard Road #09-03, Wheelock Place, Singapore , Registration No K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. PIMCO Asia Limited (Suite 2201, 22nd Floor, Two International Finance Centre, No. 8 Finance Street, Central, Hong Kong) is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. PIMCO Australia Pty Ltd ABN , AFSL (PIMCO Australia). This publication has been prepared without taking into account the objectives, financial situation or needs of investors. Before making an investment decision, investors should obtain professional advice and consider whether the information contained herein is appropriate having regard to their objectives, financial situation and needs. PIMCO Japan Ltd (Toranomon Towers Office 18F, , Toranomon, Minato-ku, Tokyo, Japan ) Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No PIMCO Japan Ltd is a member of Japan Investment Advisers Association and The Investment Trusts Association, Japan. Investment management products and services offered by PIMCO Japan Ltd are offered only to persons within its respective jurisdiction, and are not available to persons where provision of such products or services is unauthorized. Valuations of assets will fluctuate based upon prices of securities and values of derivative transactions in the portfolio, market conditions, interest rates and credit risk, among others. Investments in foreign currency denominated assets will be affected by foreign exchange rates. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein. PIMCO Canada Corp. (199 Bay Street, Suite 2050, Commerce Court Station, P.O. Box 363, Toronto, ON, M5L 1G2) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. 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