We recently delved into nitty gritty details of HOW Managed Futures utilize the bond market to find return drivers, finding among other things that a generic trend following model had about 1/3 of its profits come from the bond market. But as an old history teacher used to say… that begs the question, WHY do they love Bonds so much.
So just why do managed futures love bonds so…
Volume & Liquidity
One of the main reasons that bonds play such an integral role in managed futures is because there are a lot of bond futures markets (just think of the US government’s debt instruments alone: 2yrs, 5yr, 10yrs, 30yrs, ultra bonds) and more importantly – a lot of good volume and liquidity in those bond futures markets. What exactly does that mean… good volume and liquidity?
Well, traders often refer to a market’s liquidity as their ability to get into and out of that market relatively unscathed.
Good liquidity means you can get in and out with hardly any effort.
Poor liquidity means you’ll have to search around for a buyer/seller and potentially lower/raise your price to entice them.
Liquidity is a function of the spread between the bid and ask price of the market. For example, the average spread between the bid (the highest price someone is willing to buy at) and offer (the lowest price someone is willing to sell at) in the emini S&P 500 futures market is around 1 tick, or $12.50. In a market like Palladium with much less volume, the spread between the bid and ask may be something more like 20 ticks, or $100.
How does volume fit in? Now consider trying to trade multiple contracts in each of those markets. In the emini S&P futures with its much higher volume where thousands of contracts bid and offered on each side of the last price at seemingly all times of the day, trying to trade hundreds of contracts could be done at the bid or offer price without the market having to rise or fall to find additional takers for your order. Contrast that with the aforementioned Palladium market, whereby there may be only 10 contracts or so bid and offered within a handful of ticks of the last price. Doing 100 contracts in that case would mean the market would need to move up or down (depending on whether you are trying to buy or sell) to find more bids and offers to fill your order. The less contracts that are bid or offered at each level, the more the market needs to move to fill your multiple contract order.
Which brings us back to the bond future markets and their more than 3.3 Billion bond futures contracts traded in 2014 (or about 14 million contracts per day or 10,000 contracts per minute). That’s about 3 times more contracts than traded in energy futures, to give you some perspective, making bond futures a favorite of large managers who need good size on the other side of trades to not move the market when getting into and out of trades.
[Tweet “That’s about 3 times more contracts than traded in energy futures, to give you some perspective”]
Here’s a breakdown of the annual volume and top 20 interest rate products , per the FIA:
Another reason managed futures love bonds – because they are affordable in terms of their contract size and volatility. Most managed futures programs size their trades using variations of a formula which essentially multiplies a futures contract’s size by the volatility of that market (to basically find out how much money you could lose). We teamed up with Integrated Managed Futures Corp. (IMFC) – who’s the manager of the Attain Global Macro Fund, to analyze the per contract VaR on each of the markets in the previous trend following test, then averaging that risk amount per sector.
We found that bonds are quite affordable from a risk budget using this simple risk proxy. However, portfolio manager Rob Koloshuk is quick to point out such an analysis is skewed because it ignores the embedded leverage in bonds, and skews the bond sector towards short term rates (Euro Dollars and 2 year notes and what not) have much lower notional contract sizes as compared with 30 year bonds, for example. Although that’s sort of the point… there’s all these low value, small moving bond markets.
While this isn’t overly important for larger minimum programs, as they will do more contracts of the lower risk markets in order to balance the risk across sectors; it is very important for smaller minimum managed futures programs who may not have the luxury of doing single contract trades of energy and stock indices. Imagine a $500,000 minimum program which risks ½ of 1% of equity per trade, equating to a risk budget of $2,500. That program would have to skip the bulk of trades in the F/X, energy, and stock index sectors per the risk proxies above, thereby skewing their performance to trades in the remaining sectors, including bonds.
One of the more unique and interesting aspects of futures markets, is that there is dynamic pricing between different contract months. Put another way, investors may price a contract which is deliverable in 2015 different than one deliverable in 2016. They may, for example, think rates will be higher next year than they are this year, thus price the bond futures contract deliverable next year less (lower price/higher rate) than they price the contract due now. This is called backwardation Backwardation and is exactly what is happening right now in interest rate future markets.
(Disclaimer: Past performance is not necessarily indicative of future results)
Data Courtesy: Barchart
What’s this mean for managed futures and why they love bonds. Well, this curve means traders can make money going long bonds (essentially a bet that rates will go higher) even if rates don’t go higher at all. What ^%*? Here’s how. Imagine a trend following program buying the Dec 2017 Eurodollar futures contract, which are at essentially 98.3 in the graph above. This is telling us that traders expect rates to go from their current level of nearly 0 (Eurodollars are quoted as 100 minus the interest rate, and are currently at 99.55) to a rate of 1.7%. But if rates don’t go to 1.7%, that futures contract will move to equilibrium with the real Eurodollar rate over time, pushing prices higher and higher as the rate doesn’t go higher and higher – creating a trend where there really shoulnd’t be one because rates didn’t move.
Interest Rate Policy is Adjusted Slowly
Looking beyond structural reasons such as volume, curve structure, and volatility of bond markets – one non-scientific reason systematic programs have done well in bond markets is that interest rate decisions are purposely telegraphed and usually implemented at a snail’s pace over many months, quarters, or years. Sure, there is the monthly FOMC meeting in the US, and foreign countries have been known to do surprise rate hikes. But you don’t see a case where a country hikes interest rates today, and then reverses course and lowers rates the next week. Such policy changes are generally part of a long term plan to stimulate or slow down an economy, and thus given the proper time to work their way through the economy before changing. Of course, the market can move wildly in anticipation of the next policy decision – but we can’t help but think the smoothness of the policy decisions has something to do with the positive performance in the bond sector.
What’s more – bonds remain the premiere flight to quality investment where investors flock out of riskier assets during crisis periods. This flight to quality characteristic nearly insures that there will be bond trends during times of market stress. The trick, of course, is in how long that trend lasts. If there is a single day’s scare which sees bond prices spike up, and then come down – that is of no use to trend followers and will result in managed futures programs likely getting in at the spike high and out a few days later. But if the crisis has legs, and markets remain weak – the flight to quality can endure weeks if not months, creating a nice upwards trend in bonds.
So next time you check on your managers futures positions and see Aussie 90 Day Bank Bills, EuroDollars, and US 2 year Notes – feel secure that this isn’t some guesswork by your manager throwing world bonds at the board to see what sticks. Know that there’s a bunch of history on your side with those markets.