What are quantitative strategies?
Quantitative, or “quant,” strategies select securities based onprespecified sets of rules. These rules are based on quantifiable evidence,informed by a combination of proprietary analysis and academic research.Quant strategies are then executed based on where current prices aretrading relative to the rules of the quantitative framework. For example, asimple quantitative value strategy may rely entirely on a quantifiablemeasure of value (e.g., price-to-book ratio), rather than on the manager’sforecast of the future price to instruct buy or sell decisions. In thisway, quant strategies differ from discretionary strategies, whichconsistently rely on the skill of the investment manager to make investmentdecisions at every step of the way.
Are all quant strategies “black boxes”?
While it’s true that some quant managers consider specific details of theirimplementation strategy proprietary and are not willing to disclose their“secret sauce,” not all strategies rely on top-secret algorithms to makemoney. In fact, the majority of quant strategies are based on widelyunderstood principles and well-researched pricing anomalies, such asmomentum, value and carry, which are difficult to time and are bestaccessed through a rules-based approach. Managed futures strategies focuson momentum through a rules-based approach, rather than an opaque “blackbox.” Though managers typically don’t publish all details of their rules,they are generally relatively transparent regarding the substance of themodels, making these strategies more like “glass boxes” than “black boxes.”Additionally, managed futures is often offered in liquid and relativelytransparent structures.
What is managed futures?
A type of quant strategy, managed futures employs trend-following acrossasset classes. Trend-following is also referred to as “momentum” investing.Momentum investing contrasts with the more familiar “value” investing thatseeks to buy low and sell high. In contrast, momentum investors seekpositions in securities that have moved in one direction for a period oftime – either up or down. They join the trend, taking long positions inassets that are going up in price, and short positions in assets whoseprices are declining.
Momentum investors use quantitative signals to define when securities aretrending. Often, these signals compare the current (spot) price of an assetto the trailing (historical) moving average of the price. If the spot priceis above the moving averages, then the security is in an uptrend, and viceversa.
While most managed futures strategies focus on time series momentum, thereare different types of momentum strategies:
- Time-series momentum strategies use trailing signals of past prices toconstruct portfolios of trending securities that can be directional basedon the nature of the trend signals (e.g., short equities as equities trendlower);
- Cross-sectional momentum strategies look at a set of securities relativeto each other and take long positions in those with relatively positivemomentum and short positions in securities with relatively negativemomentum. This type of strategy is most commonly executed on single stocksin equity markets.
Why does trend-following work?
A well-studied anomaly in academic literature, beginning with Jegadeesh andTitman, 1993,1 momentum is a recognized phenomenon across globalasset classes. And in practice, it has worked remarkably well over longperiods of time, generating positive returns with low correlations tostocks and bonds, and especially strong positive returns during equity bearmarkets. But if everyone knows about it, why does it work?
There are some interesting behavioral reasons that are thought to causemomentum to persist over time and across asset classes:
- New information takes time to be fully reflected in securityprices, which leads to price trends as global investors adjusttheir positions.
- The over-reaction or “bandwagon” effect can push winners to trendhigher and losers to trend lower for a period of time.
- There’s also the “disposition effect” in which investors tend tohold on to losers and sell winners. In other words, investors tendto gamble with losses to try to earn back their money, but tend tobecome risk-averse with winners to take profits while they can.Both effects can drive trends by increasing the time it takes forprices to reflect fundamental information.
- Investors tend to behave the same way in response to significantregime shifts, especially in risk-off markets. For example, whenequity markets have large sell-offs, many investors tend to reducerisk across their portfolios, which can lead to trending pricesacross global asset classes.
What’s in the managed futures “box”?
While all managed futures strategies focus on quantitative trend-following,not all trend-following strategies are designed the same. Managed futuresstrategies commonly vary along the following dimensions:
- The universe of securities: How many securities does the manageraccess and what is the tradeoff between diversification andliquidity?
- Asset classes often included in managed futures strategiesare equities, fixed income, currencies, and commodities.
- Defining trend signals: How long are the “look back windows” usedto determine whether a security is trending?
- Shorter windows lead to higher turnover and potentiallystronger performance in risk-off markets since they adaptto new trends quickly;
- Longer windows lead to lower frequency strategies withlower turnover.
The choices that managers make for which securities to include and whichtrend signals to follow can cause performance to vary quite a bit amongmanaged futures managers. It’s important that investors understand eachmanager’s relative advantage when investing in trend-following strategiesto make sure that a particular managed futures strategy will align withtheir investment objectives.
Why do investors allocate to managed futures?
Managed futures strategies have a unique profile relative to otherpotential investments, including:
- Long-term positive historical returns of a similar magnitude toequities;
- Very low correlations to equities and other global asset classes;
- Strong historical performance during equity bear markets.
As a result, an allocation to managed futures can have a powerful impact onbroader portfolios by potentially increasing returns, reducing risk andmitigating drawdowns.
That said, it is important to keep in mind that managed futures strategiesare relatively volatile. While this volatility is likely to reduce risk ina broader portfolio context, it can be significant on a standalone basis.Most managers target levels of volatility between 10–20%, with somevariation in those targets over shorter periods.
Another important consideration is that managed futures strategies may notprovide a buffer against sudden, short-lived market moves or “flashcrashes.” Although these strategies have the potential to be highlydiversifying and tend to perform best over periods of prolonged marketsell-offs, they cannot be relied on to hedge against sudden market moves.Essentially, if the strategy doesn’t have enough time to identify thetrend, then it may not be positioned to profit from it, and may in facthave losses if a sharp move is in the opposite direction of previoustrends.
For most investors, a 5–15% allocation to managed futures may offer a goodbalance of diversification and volatility. Over the long term, thevolatility of most managed futures strategies will be closer to that ofequities than that of core bonds, and this size of allocation generally maybe enough to “move the needle” positively in most portfolio allocations.1 “Returns To Buying Winners and Selling Losers: Implications for StockMarket Efficiency,” Narasimhan Jegadeesh and Sheridan Titman, The Journal of Finance, March 1993.