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Opalesque Futures Intelligence

Decoupling "Convex" Relationships with Volatility Cycles:

In this second of a two-part series, managed futures researcher Kathryn Kaminski discusses managed futures and how it relates to market cycles. By first understanding where long volatility and convex classification derives, investors can understand how breakouts in volatility occur and why managed futures has weathered past equity market storms.

Monday, July 02, 2012

Decoupling "Convex" Relationships with Volatility Cycles

By Kathryn M. Kaminski, PhD.

Recap:
This is the second part of a two part series.  To read the first part in the May Opalesque Futures Intelligence newsletter, click here. [Link: http://www.go2managedfutures.com/OFI40FINAL.pdf]

2011 was a period fraught with turbulence in financial markets. Managed Futures strategies, despite their common association with long volatility, did not fare as well as some might have expected amidst this turbulence. A closer look at volatility, what it means to be long or short volatility, and Managed Futures performance across different regimes in volatility can provide insights into the strategy's complex or "convex" relationship with volatility. A closer look at the cycles of volatility demonstrates that Managed Futures is able to capture "crisis alpha" for investors over negative volatility cycles while in certain turbulent periods they also face some of the same "short volatility" risks that plague many hedge fund strategies.

What is Managed Futures?
Managed Futures strategies are futures based, highly liquid, regulated, low counterparty risk strategies. The Managed Futures (CTA Space) has generally been dominated by trend following strategies. They follow trends across the entire scope of futures investments including equities, fixed income, commodities, and currencies. Trend following is a technique of using past prices and data to determine positions based on a perceived trend in financial price data. A trend following approach will be most successful when there are trends in financial markets. Since equity is often the main focal point for trends all markets, it is no surprise that bigger moves for equities are better times for trend followers. Given that Managed Futures strategies trade in highly efficient markets, they earn their stripes in times when markets are least efficient. Crisis periods represent the moments when these strategies have a competitive advantage based on their liquid, adaptable, and opportunistic approach. Given this description, Managed Futures is one of the few strategies capable of accessing the ever coveted "crisis alpha" opportunities which occur during equity market crisis.1

Where does the "long volatility" or "convex" classification come from?
In 2001, Fung and Hsieh wrote a seminal paper on trend following where they demonstrated the convex or "straddle" like relationship between Managed Futures and equity markets. This straddle-like relationship showed that Managed Futures is similar, but not equal to a position in volatility. Fung and Hsieh also demonstrated how you could (in theory) attempt to replicate a trend following strategy with lookback straddles (a more complicated type of option contract which is not exchange traded). The fact that this type of replication is not used in practice can be a testament to the fact that trend following is not the same as a strategy of options despite having option-like characteristics.

The most important characteristic that Fung and Hsieh brought to attention was the "convex" option-like relationship between trend following and equity markets. To demonstrate this simply, equity market returns can be divided into 5 bins. These bins range from the worst equity months (or bottom 20% of returns for equity) to the best equity months (top 20% of returns for equity). When equity market returns are divided up and compared with the performance of Managed Futures it results in a convex function(A convex function is a curve that holds water – a bowl like shape). Figure 4 plots the conditional performance of Managed Futures versus equities in both conditional on performance of equities under 5 subgroups and a scatter plot. The bar graph on the left of Figure 4 shows positive performance for the worst months in equities and good performance during good periods in equity markets suggesting a convex relationship. It is important to remember that a convex relationship implies that the strategy has good performance in both tails of equity markets – both positive and negative extreme events. Given equities inverse relationship with long volatility, a natural extension which is often made is that Managed Futures is "long volatility".


Managed Futures (Barclay CTA Index) vs. Equity Markets (MSCI World Gross) Bar Chart and Scatterplot

Figure 4: Managed Futures (Barclay CTA Index) vs. Equity Markets (MSCI World Gross) Bar Chart and Scatterplot. Source: Pertrac and HFR

Despite being classified as "long volatility": Managed Futures is both "long volatility" and "short volatility"
By taking a closer look at the relationship between volatility and managed futures, Managed Futures is only slightly positively correlated with changes in volatility at 7%when compared with the -60% correlation between equity and volatility (See Figure 5 below). If Managed Futures was truly "long volatility" the correlation should be much larger and positive. This simple statistics shows that the effects of different types of volatility cycles needs to be decoupled from the overall impact of volatility on Managed Futures to better pinpoint under what type of volatility scenario Managed Futures will perform.

Return Profiles during Rising Volatility for Managed Futures

Figure 5: Correlations with Changes in Volatility: Managed Futures (Barclay CTA Index) and MSCI World Gross. Source: Pertrac and HFR
Figure 6: Return Profiles during Rising Volatility for Managed Futures Source: Pertrac and HFR

A closer look at times where a "breakout"2 in volatility occurs can help clarify the origins of Managed Futures' performance during periods of rising volatility. These breakouts can be classified as being initiated by positive events (similar to a "run-up" of positive volatility cycles) or negative events (similar to a "threat" of negative volatility cycles). Given the period of January 1990 until January 2012, there are 265 months during this period and there are 51 months (or 19.2%) which qualify as a rising volatility breakout movement upwards 23 of these are precipitated by positive equity returns and 28 are by negative equity returns. In Figure 6, the annualized performance of Managed Futures during rising volatility following negative events is very large and positive whereas Managed Futures performance rising volatility following positive events is negative. Figure 7 plots the performance of both equities and Managed Futures during positive volatility cycles, negative volatility cycles and both combined. A closer look at Figure 7suggests that Managed Futures may deliver "crisis alpha" during the "threat" or crisis phase of a negative volatility cycle while they seem to suffer during the reversals associated with positive volatility cycles (which sometimes may also be the beginning of a crisis event).3

This simple decoupling of volatility demonstrates that Managed Futures is "long volatility" collecting "crisis alpha" over negative volatility cycles and "short volatility" during positive volatility cycles where quick reversals hurt the strategy. Since the overall relative size of "crisis alpha" for managed futures is substantial, the strategy "on average" is net "long volatility."

Past Performance of Managed Futures (Barclay CTA Index), MSCI World Gross, and the VIX

Figure 7: Conditional Performance pre and post Breakout for Equity (MSCI World Gross) and Managed Futures (Barlcay CTA Index) Source: Pertrac and HFR

Equity Market Crisis, Negative Volatility Cycles, and Managed Futures
Given that investment community as a whole is holding equity, equity market crisis or smaller equity market crisis events (similar to the flash crash) represent a threat to investors. In a recent analysis of crises and hedge funds, it has been shown that most hedge fund strategies are holding latent common idiosyncratic risks in liquidity, credit and volatility.4 These risks stem from the fact that our investment universe is more interconnected and coordinated than it may seem (in times of normalcy) and the use of leverage in investment strategies may accelerate these effects. This means that when these hidden risks come out, most investors (including hedge funds) are holding some or all of these risks. Most investors experience losses which is both perceived as a "threat" as well as it causes a violation in risk control protocols and flocks of investors correspondingly attempt to dump many of these risks by decreasing credit exposures and taking leverage down. As a result, times of market crisis, for both behavioral and institutional reasons, represent times when market participants become synchronized in their actions creating trends in markets causing surges in volatility. Only a few select market players, those holding less of these hidden risks and adaptable enough to take advantage of these trends,  are able to profit from "crisis alpha" opportunities. 5

Market crisis is then followed by periods of uncertainty (or high volatility), the hidden risks have come out there are no new serious risks plaguing investors but investors change their risk appetite based on their previous negative experiences. A managed futures strategy will have difficulty finding real trends in an uncertain market environment. The selective advantage the strategy has during crisis will no longer be valid since other investors will also be less exposed to credit and liquidity. In fact, when equity markets surge back Managed futures strategies may or may not be able to catch trends since the positive trends tend to revert much quicker (similar to the shorter positive volatility cycles).

A Closer Look at Managed Futures Performance and Volatility Post Credit Crisis
The credit crisis was a major crisis event in the history of financial markets. The event shocked and traumatized investors who scrabbled desperately to make sense of the event and its implications on their portfolios. Since the event originated in the banking sector, the hidden issues relating to credit solvency, counterparty issues, and liquidity plagued almost all investors world-wide. When these risks came to the forefront, losses were immense and fear and uncertainty soared across financial markets. Lost in this scrabble, there were "crisis alpha" opportunities to be made. Managed Futures strategies, being one of the few that were resilient enough to take advantage of some of these opportunities, earned exemplary returns in 2007 and 2008. Post trauma, investors were still un-nerved by the past and volatility remained high as investors found more and more issues to be concerned and worried about. Risk appetite was drastically altered and investors, including hedge funds, had difficulty making money in uncertain markets. Managed Futures also struggled to make money in uncertain markets. In fact, the Flash Crash and the turbulent Summer/Fall of 2011 proved to be difficult times for Managed Futures to provide crisis alphadespite the losses in equity markets and increases in volatility. This performance is shown in Figure 7 below.

Examining Hidden Risks in Managed Futures Strategies and their Prevalence in Past Crisis Events

Figure 7: Past Performance of Managed Futures (Barclay CTA Index), MSCI World Gross, and the VIX Source: Pertrac and HFR

The inability of the strategy to deliver crisis alpha during these times could be attributed to the following points. First, risk preferences may still residually reflect 2007-2008. Second, most investors are not holding as many hidden risks as they might have prior to 2007-2008 decreasing the strategy's competitive advantage. Third, the subsequent drawdowns in equity markets in 2010 and 2011 pale in comparison to the drawdowns experienced during 2007-2008 limiting the quantity of crisis alpha to be captured. These events, in the long run, pale in comparison to the bear markets of 2007-2008. Fourth, each of the two subsequent drawdown periods where initiated by a positive volatility cycle with quick reversals which are on average difficult for Managed Futures strategies which may hold a "short volatility" bias based on their use of leverage. The role of hidden risks, common in hedge fund strategies, can also help explain why Managed Futures had such an advantage in 2007-2008 as opposed to Spring 2010 and Summer/Fall 2011. These risks in Managed Futures strategies as well as their prevalence during the past three crisis periods are detailed below in Table 1.

 

Liquidity Risk

Credit/Counterparty Risk

Volatility Risk

Performance

Managed Futures

Limited
futures markets are some of the most liquid markets

Limited
clearinghouse mechanisms limit counterparty risk (credit sensitive instruments will make big moves)

Moderate
Leverage increases exposures, higher chance of call on collateral due to marking to market, large potential drawdowns when trends change quickly

The strategy has an advantage over other illiquid strategies by not carrying liquidity and credit risks. Given the use of leverage, the strategy does carry short term "short volatility" risk

Recent Crisis Events

 

 

 

 

Credit Crisis/Lehman Bros.

Extreme, Inability for brokers to give lines of credit, collateral called, toxic assets

Extreme, credit spreads widened significantly, serious counterparty issues

Extreme, highest levels of volatility in history

Hedge funds bad, Managed Futures good

Flash Crash

Marginal

Moderate, sovereign credit issues

Moderate, Big price swings, run up and quick unwind and reversal

Hedge funds bad, Managed Futures ok

Turbulent Summer/Fall 2011

Marginal

Moderate, Renewed sovereign credit issues

Extreme, Large intraday price swings, tremendous volatility

Hedge funds bad, Managed Futures ok

Table 1: Examining Hidden Risks in Managed Futures Strategies and their Prevalence in Past Crisis Events

Conclusions
Managed futures is often said to have a convex relationship with equity markets. Managed Futures is also labeled as a "long volatility" strategy. Although these two descriptions are partially correct, they are statistical in nature. Instead if we think about markets as going through cycles in volatility where risk appetite depends on the past experiences of market participants, the performance of Managed Futures can be explained in the context volatility cycles. Managed Futures strategies earn their stripes by being one of the few strategies which are able to catch "crisis alpha" during negative volatility cycles yet the same characteristics which allow the strategy a chance to perform during crisis do not help during quick reversals similar to positive volatility cycles.

Investors who may have labeled Managed Futures as long volatility may have been disappointed in Spring of 2010 and Summer/ Fall 2011. Managed Futures is a strategy which makes money during breakdowns in market efficiency, these breakdowns usually are the most pronounced during financial crisis or periods of "threat". As a result, managed futures ability to capture these inefficiencies will be directly related to the level of inefficiency which occurs during crisis and the negative volatility cycle that follows crisis. A Managed Futures strategy is reliant on the calm before the storm or on markets going back to a state of normalcy where investors become comfortable in risk taking again. This allows investors to forget about past losses and pile on new hidden risks unknowingly leaving them unprepared for the next financial storm that may lay ahead.

BIOGRAPHY :

Kathryn M. Kaminski, PhD, is the CIO and Founder of Alpha K Capital LLC, a thematic fund of hedge funds focused on "pro-active strategies" for tail risk management. Prior to starting Alpha K Capital, Kathryn worked in investment management as a Senior Investment Analyst at RPM, a fund of hedge funds in Managed Futures. While at RPM, she coined the phrase "crisis alpha" to describe Managed Futures strategies with her work in Futures Magazine and for the CME Education Group as a market commentator. She also has quant experience in both emerging fixed income and credit markets. Kathryn earned her PhD at the MIT Sloan School of Management where she did research on financial heuristics in collaboration with Professor Andrew W. Lo as part of the MIT Laboratory for Financial Engineering. Her research interests are in the area of portfolio management, asset allocation, financial heuristics, behavioral finance, and alternative investments. She holds and has held academic lecturing positions in the areas of derivatives, hedge funds, and financial management at the Stockholm School of Economics, the Swedish Royal Institute of Technology (KTH), and the MIT Sloan School of Management.



 
This article was published in Opalesque Futures Intelligence.
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