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The writer is chief investment officer of PGIM Wadhwani, a CTA manager, and a former member of the Bank of England Monetary Policy Committee
Last year, a traditional investor portfolio of 60 per cent in equities and 40 per cent in bonds registered a double-digit percentage loss.
Unexpectedly high inflation saw both equities and bonds fall together. We have seen such disappointing out-turns for a 60/40 portfolio before now during past periods of high inflation, such as 1973-74, and recessions, such as in 2008.
One hedge against such poor outcomes is to diversify and add exposure to so-called managed futures investment strategies, also known as CTAs from their origins as a product managed by commodity trading advisers. These typically take long or short positions in a wide array of futures markets spanning equities, bonds, currencies and commodities.
These generally seek to exploit the momentum of market moves but can also include positions taken with macroeconomic considerations. In 2022, such strategies, on average, registered double-digit gains after fees.
As a CTA manager, it is pleasing to note that last year’s performance was unlikely to be a flash in the pan. We looked at the dozen worst periods in over the last five decades for a 60/40 portfolio, in terms of its one-year losses, and how CTA funds performed in each episode (excluding our own funds). In 11 out of the 12 episodes, CTAs outperformed — and with an average gain of 19.9 per cent. So, last year’s episode appears typical: not a one-off.
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In several of these episodes, such as 1974 and 1990, the environment was one with key parallels to last year’s — with inflation high and commodities roaring. So it is clear that CTAs can help provide some protection — and, indeed, did rather better in 2022 than several of the frequently touted “inflation hedges” such as index-linked bonds and property.
One reason that property exposure has suffered in the recent period is that interest rates went up. By contrast, many CTAs have benefited from higher interest rates by betting against bonds.
It is important to not think of CTAs as akin to an insurance policy as they do not always pay off, such as in 2018, when they underperformed.
Equally, unlike an insurance policy, CTAs can and often do make money even when the sun is shining. When we look at the past 50 years of data, in periods when the 60/40 portfolio made money, so, generally, did CTAs — and at a healthy average annual rate of 8.6 per cent (using our index of CTA returns since 1973). This is because CTAs are often long equities during such periods.
In the recent period, we have seen again as to how difficult it is to predict a recession, with forecasts of such an eventuality continuing to get postponed. CTA strategies have the advantage in this situation of being agile — responding fast if the macroeconomic situation deteriorates and as policymakers respond.
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In the seven recessions identified by the US National Bureau of Economic Research since 1973, for example, CTAs have offered traditional investors much needed protection — with an average return of 11.6 per cent per annum, thus outperforming a 60/40 portfolio 8.3 percentage points.
Most investment strategies suffer from drawdowns. Thus, investors need to be patient. This is true as much for CTA strategies as it is for “long-only” investments. Indeed, if one looks at what turned out to be one of the best ever periods for trend-following — from 1973 to 1984 — it is striking that the strategy exhibited some significant drawdowns.
It should also be pointed out that, although the empirical work here is based on CTAs, other related strategies (such as investing to take advantage of macroeconomic trends) are likely to exhibit similar properties.
Notwithstanding the diversification benefits afforded by CTA strategies, the allocation to them in most portfolios we see is minimal. The low allocation is puzzling to us but, in our experience, often relates to the desire on the part of trustees to not deviate too much from what is conventional. Recall that, in the 1950s, it was equally conventional to have a low allocation to equities.
We believe it is worthwhile for investors to reconsider the case for CTA and related strategies when seeking to make their portfolios more resilient to high inflation and recessions. The possibility that we have entered a more turbulent macroeconomic regime makes this more important.