One of the biggest faux pas in investing is jumping from one supposed hot stock to the next. Motivated by greed, average investors are often jumping from one investment to the next looking for large and quick profits often without fully assessing the risks involved.
This phenomenon can be seen in many areas. For instance the end of a bull run can often be spotted by large retail buying and a peak in the growth of assets under management of equity mutual funds. At the same time as the buying in bullish assets occurs, we also see sustained selling pressures in lagging assets as investors sell the laggards and pile into the best performing markets.
Nothing that I have stated above is ground breaking or new knowledge. However, the recent herding of investors to the latest upward trending investment (i.e. the US equity market) has had a tremendous negative impact on the managed future industry of late.
Managed futures were the darling of the investment industry in the early to late 2000's. Many strategies offered large double digit returns thus giving the industry tremendous asset growth. However, most of this asset growth was from the classic greedy investor trying to invest in the latest hot thing.
What has happened since 2009 is that the US equity market has been on a tear which has led to a drop in volatility. This has made it very hard for a strategy that relies on high volatility, like managed futures, to outperform.
As the markets have started to become tougher for managed futures algorithms to trade, the managed futures industry has seen diminishing returns. These diminishing returns have led to an exodus of capital from managed futures to the new hot thing, the U.S. equity markets.
As the U.S. equity markets appear to be in a strong bull run and have garnered increased assets, the managed futures industry has seen a stagnation of asset growth.
The stagnation in asset growth is difficult for the young and upcoming managed futures managers to bear. Managed futures shops have staff and expenses that must be covered and they need assets to generate fees.
So the managed futures managers have followed the mantra, "if you can't beat them, join them". Consequently, they have changed their strategies to become less alpha and more beta in nature to follow the S&P 500.
These alterations to their strategies are not improvements on their algorithms. They are merely attempts to fit the market so they can grow their asset base and stay operational. This action to stray from the core strategy to mimic the latest hot market trend is known as "style drift".
Empirical evidence of this style drift can be seen in the increased correlation between managed futures programs and the S&P 500, especially over the last couple of years. The increased correlation can be seen in the chart below.
Modifications and enhancements are required to maintain any algorithm over a long period of time, however, these modifications should not be confused with style drift. If a managed future program experiences a large correlation move due to an algorithmic change, one should be cognizant of the fact that this correlation move is most likely the result of style drift and not a program enhancement.
Style drift moves the algorithm from it's original methodology to more closely resemble the performance of it's benchmark. For instance, in present markets, style drifts have managed futures managers changing their strategies to more closely resemble the returns of the U.S. equity markets.
One can argue that this change is good because the algorithm is adapting to be more profitable in the present market. This may be true in the interim, but when the market changes you have then lost all benefits from your initial algorithmic investment.
Managed futures gained popularity because they utilize systematic algorithms to provide a true form of diversification. As an algorithm experiences style drift to resemble the benchmark it loses the alpha component and starts to resemble beta. At this point the investor is left holding a beta asset for which they pay alpha level fees and lose the benefits of diversification.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by MA Capital Management, LLC unless a client service agreement is in place.Nothing in this presentation should be construed as a solicitation or offer, or recommendation, to buy or sell any security, or as an offer by MA Capital Management, LLC to provide advisory services. Investment management services are offered only pursuant to a written Customer Agreement, which investors are urged to read and carefully consider in determining whether such agreement is suitable for their individual facts and circumstances.