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Managed Futures, Hedge Fund and Mutual Fund Return Estimation: A Multi-Factor Approach Thomas Schneeweis* Richard Spurgin** *Professor of Finance, University of Massachusetts **Assistant Professor of Finance, Clark University The author(s) would like to thank the Managed Futures Association for their support in this research. The results of this study, however, represents the conclusions of the authors and do not necessarily reflect the opinions of various MFA members. Managed Futures, Hedge Fund and Mutual Fund Return Estimation: A Multi-Factor Approach Abstract The past five years have witnessed a dramatic increase in managed futures products whose managers (commodity trading advisors) trade primarily in futures and options markets and which are available to the retail public as well as in hedge funds whose managers invest in both cash and futures markets simultaneously and which are structured primarily for pool investment and not for public sale. Despite this growth, funds invested in managed futures and hedge fund products are estimated to be less than 1% of the over 3 trillion dollar mutual fund industry. One reason for the relatively small percentage invested in managed futures or hedge fund vehicles is that little published research exists on the determinants of managed futures and hedge fund expected performance. However, while extensive literature exists on theoretical and empirical models of return expectation for stock and bonds, little academic research has directly tested for the underlying factors which explain managed futures and hedge fund return. In this paper, various factors, chosen to capture managed futures and hedge fund trading styles and investment markets, are used to explain managed futures and hedge fund performance. Similar tests are run on portfolios of traditional stock and bond funds in order to evaluate the relative explanatory power of the multiple factor models. Results indicate that for the managed futures, hedge fund, and mutual fund portfolios, a set of factors exist which help to explain managed futures, hedge fund, and mutual fund returns. These factors are based on the characteristics of the trading style (e.g., discretionary, systematic . . .) and the unique asset markets traded (e.g., currency, financial) of managed futures, hedge funds, and mutual funds. Results indicate that technical trading rule and market momentum variables are shown to explain managed futures return. In contrast, technical trading rules are shown to be less helpful in explaining return movements in traditional stock and bond funds whose returns are consistent with long positions in underlying cash markets, and hedge funds whose trading style is often based on capturing undervalued stock or bond investments. Results provide evidence that to the degree that underlying stock and bond markets provide explanatory power for traditional stock and bond managers returns but fail to describe the return patterns of managed futures and hedge fund products, while certain trend following and volatility factors help describe managed futures but not hedge fund return patterns, managed futures and hedge funds provide reasonable diversification patterns to traditional stock and bond funds as well as to each other. 1 Managed Futures, Hedge Fund and Mutual Fund Return Estimation: A Multi-Factor Approach I. Introduction The past five years have witnessed a dramatic increase in managed futures products, which are available to the retail public, and hedge funds, which are structured primarily for pool investment and generally not for public sale.1 Despite this growth, total funds invested in managed futures and hedge fund products are estimated to be less than 1% of more than three trillion dollars invested in mutual funds. One reason for the relatively low level of investment in managed futures and hedge funds is that investors often require both a theoretical basis for investment as well as supporting empirical results before investing in a new investment vehicle. For traditional assets such as stocks and bonds, there are broadly accepted single factor and multi-factor theoretical models (e.g., CAPM, APT) as well as empirical tests that support the alternative theories. For instance, Sharpe [1992] used over fifteen global stock and bond indices to explain the return structure of U.S. equity funds. Elton, Gruber, and Blake [1995] also used fundamental economic variables to describe the cross sectional returns of U.S. bond funds. Theoretical models as well as empirical tests of stock and bond return formation, however, may neither fully explain the theoretical basis nor the empirical factors describing returns to managed 1 The past five years has also witnessed a dramatic increase in academic research conducted on the potential benefits of non-traditional asset forms. This is due not only to the recent growth in these vehicles but to the recent availability of researchable data bases which provide historical information on market performance. Within the past few years, research on return persistence in managed futures returns [Elton et al., 1989; Irwin et al., 1994; Schneeweis et al., 1997], survivor bias [Elton et al., 1992; Schneeweis et al., 1996], the potential benefits of managed futures in portfolio creation [Chance, 1994; McCarthy et al., 1996, Schneeweis et al., 1996; Schneeweis 1996] as well as comparisons of the risk and return properties of commonly used passive commodity and active and passive managed futures and hedge fund benchmarks [Schneeweis and Spurgin, 1996, 1997] has been published. 2 futures or hedge funds. Schneeweis [1996] and Fung and Hsieh [1996] point out that hedge fund traders and managed futures traders (commodity trading advisors (CTAs)) have different investment styles and opportunities than traditional stock and bond fund managers. These include the ability to trade in multiple markets, take long and short positions, and use varying degrees of leverage. As important, while futures and options markets are a zero sum game, that is, daily gains must equal daily losses for market participants, academic research [Schneeweis, 1996; Chan et al., 1996] has shown that the existence of arbitrage returns, convenience yields, and returns to providing liquidity as well as the existence of trending markets due to institutional and market trading characteristics may provide a source of positive return for CTA and hedge fund managers.2 Little research, however, exists on the actual market or trading factors that explain the performance of managed futures investments or hedge funds.3 Previous research has concentrated on either a simple benchmark consisting of the average return of all public funds [Irwin et al., 1994] or a more complex Bayesian risk-adjusted beta based CTA benchmark [Schneeweis et al., 1997]. However, little research exists on the sources, or factors, that underlie these CTA based benchmark returns or the individual public commodity funds/CTAs themselves. Mitev [1995] used traditional factor analysis to explain the differential factors explaining commodity trading advisor returns, however, no attempt was made to strictly identify explanatory variables consistent with those factors. Similarly, Fung and Hsieh [1996] also used factor analysis to explain the relative returns to mutual funds, hedge funds, and CTAs and to extract the trading styles and market factors common to all. Fung and Hsieh conclude that the number of possible CTA or hedge 2 The review of number of articles describing various arbitrage activities, the existence of convenience yield, and trending markets is beyond the scope of this article. The cited articles are only several among hundreds which explore their existence. 3 For general books on the structure of managed futures or hedge funds, see Lederman and Klein, 1995 and Chandler, 1994. 3 fund strategies make extension of the single factor CTA benchmarks [Irwin et al., 1994; Schneeweis et al., 1997] or the multi-factor mutual fund models [Sharpe, 1992] unsuitable for describing CTA or hedge fund returns. However, while individual CTA or hedge fund strategies may vary, the fact that they can be grouped into general explanatory factors by factor analysis and/or into common benchmarks by selection criteria used by firms such as Managed Account Reports, EACM, or Barclay, indicates that variables may exist which capture common CTA trading strategies or market-based CTA returns. In contrast to earlier single-index regression or factor analytic approaches, this research uses a multi-factor approach to explain the sources of return to a wide variety of actively managed investment vehicles, including managed futures, hedge funds, and stock and bond mutual funds. Analysis of measurable factors reflecting the return to CTA and hedge fund trading is important, since in previous research the actual factors proposed to explain CTA or hedge fund return are unspecified.4 Thus empirical factors (variables) must be specified which reflect the trading styles or markets described by the factor regression or the underlying strategies of the traders themselves. Tests are conducted on both commonly used benchmark indices for stock and bond funds (e.g., Morningstar), managed futures vehicles (e.g., Managed Accounts Reports, EACM, Barclay, TASS) and hedge funds (e.g., Hedge Fund Research, EACM) as well as portfolios of individual stock and bond funds, hedge funds, and CTAs grouped by trading style or market sectors. The study is designed to extend Sharpe’s style/market regressions by measuring the influence of CTA and hedge fund investment style or market selection on their return. As such, factors such as trading opportunities (e.g., arbitrage, value) and trading approach 4 Single-factor models use the average performance of CTAs as a benchmark, but a benchmark itself is not a factor determining return. Similarly, factor analysis identifies the number of common factors in return performance, but cannot identify what those factors are. 4 (technical trendfollowing or fundamental) as well as markets traded (e.g., stock, bond, currency, and commodity) are used to explain CTA, hedge fund, and mutual fund return performance. The factors underlying the return patterns of managed futures and hedge funds are shown to differ from those that explain stock and bond mutual funds as well as from each other. Section II of this paper reviews previous academic results on explanatory return models for managed futures and hedge funds. In Section III, the data and methodology are presented. Since managed futures and hedge funds are capable of profiting from increases and decreases in the price of underlying asset markets, we use both the nominal and absolute value of cash (e.g., S&P 500, Salomon Brothers Bond index, USDX exchange rate index) and futures-based commodity indices (e.g., GSCI) as determinants of managed futures returns. Similarly, since higher volatility may offer managed futures and hedge funds more trading opportunities, intramonth volatility measures (standard deviation and intramonth drawdowns and intramonth drawups) are also tested. In addition, since CTAs and hedge fund managers often base timing decisions on technical trading rules, another proposed explanatory variable, the Mount Lucas Management (MLM) passive futures markets trading index, a moving average index of commodity and financial futures contracts, is used.5 Results are discussed in Section IV. These results provide evidence that several factors contribute to the return of CTAs and that those factors are different from the factors that explain hedge fund and mutual fund stock and bond returns. Investment implications, conclusions and areas of future research are discussed in the final section. For instance, the results provide evidence that stock and bond markets provide explanatory power for traditional stock and bond managers returns but fail to describe the return patterns of 5 The MLM index is used primarily due to its industry acceptance and that it exists as a tradeable index. Other time series models may exist which provide a better fit to actual return structures of various technical trading CTAs. 5 managed futures and hedge fund products, while certain trend following and volatility factors help describe managed futures but not hedge fund return patterns. Thus, managed futures and hedge funds provide reasonable diversification patterns to traditional stock and bond funds as well as to each other. Future research should focus on higher frequency data and unique trading strategies, as the results presented here point to intramonth volatility and market pressure as important sources of managed futures and hedge fund returns.6 II. Managed Futures, Hedge Funds, and Mutual Funds Return Determinants Theoretical models, such as the single index capital asset pricing model and the multi-factor arbitrage pricing theory, have been used to describe the basis for returns to traditional stock and bond funds. For stocks and bonds, both single factor and multi-factor empirical tests of return formation have also been conducted. For instance, Sharpe [1992] used over fifteen global stock and bond indices to explain the return structure of U.S. equity funds. Elton, Gruber, and Blake [1995] also used fundamental economic variables to describe the cross sectional returns of U.S. bond funds. Theoretical models as well as empirical tests of stock and bond return formation, however, may neither fully explain the theoretical basis nor the empirical factors explaining returns to managed futures or hedge funds. First, the fact that the underlying futures and options markets operate in a zero sum game; that is, daily gains must equal losses for market participants, has led to questions as to the potential benefits of many non-traditional investment vehicles. However, recent academic research [Clardia and Taylor, 1993; Kapadia, 1995; Chan, Jegadeesh, Lakonishok, 1996] on the existence of convenience yields, market momentum, and institutional features which result in the existence of short-term arbitrage or 6 Since research [Schneeweis, 1996] has shown that CTA return is due to a relatively small number of actual trades, research is required as to the source of these unique return opportunities (e.g., squeezes). 6 positive potential risk/returns tradeoffs to those providing liquidity, has indicated that positive returns may accrue to non-traditional investment managers whose investment styles may capture returns due to arbitrage, convenience yield, or market momentum factors. Various academic studies [Chance, 1994; Schneeweis, 1996] point out that CTAs and hedge fund traders have different investment styles and market opportunities than traditional stock and bond fund managers. These alternative investment styles and market opportunities include the ability to trade in multiple markets, take long and short positions, and use varying degrees of leverage in varying market conditions which may thus permit them to capture returns consistent with arbitrage or market momentum. For instance, for stock and bond funds, in which investment managers are strictly regulated to hold primarily long positions in the underlying assets, theoretical and empirical models of return estimation may focus on the expected return of the underlying assets themselves. In contrast, for investment vehicles such as a hedge fund which focus on market-neutral arbitrage positions, the comparison benchmark may be the risk-free rate. However, if the hedge fund focuses on domestic or international equity/bond investments, then U.S. or international equity/fixed income benchmarks similar to those used for traditional mutual funds may be regarded as the standard. In managed futures investments, where traders in futures and options markets are operating in a zero sum game, the existence of a zero sum game does not restrict futures and options investors from holding positions which offer positive return/risk tradeoffs. Futures and options investors may simply hold positions that mimic the return of the underlying cash asset, which would yield a positive expected return if, as with stock index futures, the underlying asset had an expected return greater than the cost of financing. Moreover, given the lower transaction costs of trading in futures and options markets, managed futures returns may, in fact, offer superior returns to the underlying cash markets for 7 comparable long (short) positions. Furthermore, institutional characteristics and differential carry costs among investors may permit managed futures traders to take advantage of short-term pricing differences between theoretically identical futures, options and cash market positions as well as differential risk transfer needs. This differential hedging demand may create investment situations where hedgers are required to offer speculators a return for holding unhedged long or short positions. This return to speculative traders for offering liquidity to hedgers, who desiring to limit losses, may exist not only in futures markets but may exist in a wide range of derivative products such as options. For instance, option traders may be able to create positions which offer a risk premium in exchange for accepting exposure to certain portions of the return distribution of the underlying security. This return (e.g., convenience yield) can be earned simply by buying and holding a derivative portfolio and is, arguably, the basis for the positive long-term return seen in various futures-based commodity index products, such as the JPMorgan or the Goldman Sachs commodity index. The return to managed futures can also stem from the ability of managers to exploit imperfections in the markets for futures and options as well as the market for the underlying cash instrument. Research on traditional investment vehicles (e.g., stocks, bonds, and currencies) indicates that investors may underreact to information and, consequently, security prices may trend. Trading techniques based on capturing these trends may be profitable.7 In addition, research on traditional security markets has shown that market prices react to unexpected changes in micro or macro information [Ederington and Lee, 1995; Johnson and Schneeweis, 1993]. Unlike stock and bond 7 It is not the purpose of this paper to review the mound of research dedicated to the existence or non-existence of liquidity premia, market momentum, or the profitability of technical trading rules or call writing. For the purposes of this paper, the existence of extensive and costly proprietary trading operations at some of the largest financial houses is at least somewhat indicative of the potential for short-term trading profits from a wide variety of alternative trading techniques. For recent academic evidence, see Chan, Jagdeesh, and Lakonishok, [1996]. 8 funds, managed futures accounts often have few restrictions on short sales, either institutional (such as the uptick rule) or structural (poor liquidity when short selling small capitalization stocks). Because of the ability of futures traders to take unrestricted short positions, it is not necessary for markets to trend upward or gap upward to make money. In fact, some of the most impressive periods of return for trading advisors have been during periods of poor performance in the equity markets (e.g., October, 1987). While the existence of positive security returns from technical trading rules have been questioned, most studies rely on the high transactions costs of cash markets to rule out profit. Low transaction costs combined with the ability to sell short and utilize leverage may permit technical trading rules to obtain positive returns in markets which, for short time periods, may be mispriced.8 Access to options markets permits managed futures and hedge fund traders to create positions which offer potential returns due to changes in market volatility. While it is not possible at present to trade volatility directly on public exchanges, it is possible to construct positions (e.g., straddle positions) that derive some of their return from volatility or changes in expected volatility. Since managed futures can replicate many strategies available to a cash market investor at a lower cost, and allow strategies that are unavailable to cash investors, return models must be based not only on factors that explain traditional asset returns but also on factors unique to managed futures and hedge fund market trading opportunities.9 Managed futures and hedge funds may, thus, offer a positive risk-adjusted return that differs from underlying cash markets. Thus, to the degree that different factors 8 These factors could explain the explain some portion of the historical return to the MLM index, which incorporates a trend-following timing rule. 9 For a discussion of the basis of managed futures returns as a natural result of market forces or based primarily on trader skills, see T. Schneeweis and R. Spurgin, 'Managed Futures: Nature vs. Nurture' Barclays Newsletter [Fall, 1996]. 9