What You Need to Know About Bonds and Managed Futures before Interest Rates Rise

What makes the financial world go round?   Stock prices?  Not quite. Job numbers? Good try. James Bond?  No, but close and something we wish were true with the new movie due out tomorrow.

No, in our humble estimation – it’s the thing which made Greenspan, “The Bernank,” and now Yellen household names. We’re talking interest rates – and their market personification – bond prices. Just yesterday, Fed chairwoman Janet Yellen hinted at the “live possibility” of an interest rate hike in December, the Treasury Department auctioned $26 Billion in two year notes at a higher yield, and the CME Group is now giving the FOMC a 60% chance of raising rates in December – sending the financial twittersphere into a tizzy.

While the rest of the world is concerned about how bank deposits, mortgage rates, and mezzanine debt will shake out in a world where the Fed is raising rates for the first time since 2006; we’re looking at what types of investments are likely to benefit from the increased bond market volatility and potential price trends which could come from a rising rate environment.

And first up on our list – managed futures and their core investment strategy, trend following.

Bonds Dominate a Basic Trend Following Test

To show just how important a volatile and/or trending bond market is to managed futures, we enlisted some of the smartest people we know to run a simulation showing the portion of a trend following model’s performance comes from the bond sector. We called Toronto, the home of Integrated Managed Futures Corp. (IMFC) –  who’s the manager of the Attain Global Macro Fund,  to run a simulation back to 1990 using a basic trend following model. The model used a simple 60/120 moving average cross over to signal either a long, short, or flat position in each market in a portfolio of 49 markets across the bond, stock index, currency, grain, energy, meats, metals, and softs. They normalized the position sizing by using a fixed 0.25% risk allocation based on the 99% VaR for each market, starting the portfolio with a fictional $1 million and allowing fractional lot sizes for the sake of simplicity.

Finally, they applied sector limits so that no one market sector had a larger share of performance due solely to that sector containing more markets.

Please note: the numbers throughout this article are a simulation of the educational topic outlined herein, they do not represent trading in actual accounts nor the hypothetical track record of an investable model. It is intended for educational purposes only.
2 Pie Charts Return Drivers

Show Me the (Bond)jamins

The results of the test confirmed what we’ve experienced in real time over the past 20 years – with the amount of performance attributable to the bond market about double the amount of returns coming from any other market sector; as much as Grains, Energies, and Metals combined.

This simple trend following model saw a hypothetical return of 4,666% over the course of twenty five years, with about 1,400% coming from bond markets (meaning 1/8 of the portfolio was responsible for about 1/3 of the returns – making Bonds the Michael Jordan of Trend Following.  That’s a far cry from boring, and why CTAs usually get excited when they see a new bond position initiated. It is also worth noting that close to 60% of returns since 1990 for this model were from financials (bonds, stocks, and F/X or currency futures). Now you know how the Wintons of the world are able to manage 10s of Billions of dollars (hint – it’s not in Lean Hogs).

If you’re wondering if this was lumpy performance (ie. coming in just a few large spurts) or rather consistent, our friends at IMFC gave a look into that as well, plotting out the bond performance in each year going back 25 years.

Bond Sector Performance by Year 1990(Disclaimer: Past performance is not necessarily indicative of future results)
Data = The bond sector accounts for the total returns of YBA, TY, US, FV, CGB, EBL, FLG, JGB, FEI, FSS, YTC, EBM)

There’s a reason Managed Futures (and specifically Trend Following strategies) load up their portfolios with bond markets and love to see those bond markets move.   You can see above that the bond component of the portfolio has been a rather steady performer for this trend following model, seeing profits in about 70% of the years and averaging about 7.5% during those winning years (based on risking 0.25% per trade, on a non-compounded basis). The average loss during the losing periods was about -2.5%, and interestingly – 2015 is one of the 6 losing periods the past 25 years. (Disclaimer: These results are a simulation of the educational topic outlined herein, they do not represent trading in actual accounts nor the hypothetical track record of an investable model. It is intended for educational purposes only).

Is this all because rates have been moving lower the past 20 years. Maybe. But you’ll note that the bond sector had positive performance even in rising interest rate environments as well (shaded above). Remember, they aren’t betting on one direction or the other – they just want extended moves in one direction or the other.

The Kicker = Crisis Period Performance

Now, here’s where things get fun, and we look at the bond component of this proxy trend following model during crisis periods. After all, that’s one of the main reasons people look at managed futures – to get access to that crisis period performance; and if bonds aren’t showing up during those periods – it probably doesn’t matter what they do the rest of the time.  We first checked to see that this test trend following model correlated highly to managed futures in general during the past six crisis periods, and it did with positive performance in all six crisis periods. We then looked at what the performance of just the bond sector was during each of those periods, and finally calculated what share of the model’s performance during those crisis periods was due to the bond sector. Turns out about 1/3 of the performance during the crisis periods comes from Bonds.

crisis_period_updated

Why does this happen…well crisis periods in the stock market are usually met with a ‘flight to safety’ trade where investors dump risky assets for perceived less risky assets like US Treasury Notes, German Bunds, and Japanese Govt. Bonds. All that money rushing into bonds tends to push their prices up, causing a trend the models can identify and ride higher.  What about a market crisis caused by rates going higher (bond prices lower) – when the flight to safety might not happen? Good question, but the answer is likely to be the same thing will happen, just in reverse; with trend followers equal opportunity employers – meaning they are just as willing and able to be short bonds (prices down, interest rates up).  Indeed, we wouldn’t be surprised to see some 2016 headlines reading algo futures traders cause interest rates to rise, pushing the stock market into the red – just as they were blamed for the stock sell off in August.

So there you have it – trend following models crave trends and volatility in bond markets as if it is a third of their performance profile.  And if you’re into the WHY beyond the performance, of how that can work without the bonds being more than 1/3 of the risk the portfolio takes – we’ll cover that in a follow up post next week. Make sure not to miss it by getting our weekly emails of our latest findings in the alternative investment space.

One comment

Write a Comment

Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, RCM's own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.

Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, RCM's own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.