Diversify Your Hedge
Managed-futures funds protected beautifully against the 2008 financial crash. Not that retail investors benefited. With one exception, the managed-futures funds that existed at the time were hedge funds, meaning that they weren’t available for the rank-and-file. Too bad. Between late 2007 and early 2009, from the stock market’s peak to trough, the average managed-futures hedge fund gained 12% while stocks dropped 41%.
The fund industry rapidly filled the gap; today, there are 43 managed-futures funds in the US – 124 counting all their share classes. To date, those funds haven’t helped their investors, not necessarily through mismanagement, but rather because there hasn’t been any point in cushioning stock-market exposure. The more equities, the better. Hedging against downturns has meant leaving money on the table.
Last Monday, that changed, with the S&P 500 dropping by 4.1%. At least for the one day, managed-futures funds had their opportunity. And they… declined by an average of 3.1%. This showing would have come as no surprise to careful Morningstar readers. Last week, Morningstar analyst Tayfun Icten published an article entitled, “Managed-Futures Funds Vulnerable to Market Turbulence,” because, he wrote, they currently have a long position in equities. Four days later, he was proven correct.
Managed-futures funds owe no apologies. Although they typically have not behaved much like the stock market, that was never a promise. Managed-futures funds invest mainly in the futures of stocks, bonds, the dollar, and commodities. At any given time, they could collectively favour, being trend followers, managed-futures funds tend to behave similarly to, long equities. That is what they did in January, along with owning energy, and they were spot on, the category had a great month.
The point instead is the danger of owning one flavour of alternatives fund. This time, market-neutral funds did their job, being almost flat on the day, long-short equity wasn’t bad, and managed-futures and options-based funds disappointed. Next time, the reverse might be true.
Except for bear-market funds, which are a terrible long-term holding, no alternatives fund will reliably rise if the market falls. Thus, best to own the whole group, through a multi-asset alternative fund that samples among the different strategies.
Be Careful While Picking Up Pennies
Shorting stocks or futures contracts is different than shorting out-of-the-money options. The first two strategies have symmetrical payoffs: If a stock or futures contract were to rise by $5, the loss to the portfolio manager who shorts would be match the gain, should that stock or futures contract rise by $5. The maths is different when shorting options that are out of the money. The returns are no longer symmetrical, and could possibly be disastrous.
In Wall Street parlance, the investor who writes out-of-the-money options picks up nickels, at the risk of being squashed by a steamroller. The profits that accrue from selling out-of-the-money options are frequent and small. The losses are infrequent, and sometimes huge. In fact, if the positions are not monitored carefully, a surprise market move can be ruinous.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. While Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.
