The Chart that Makes Worriers Smile
Investing can be an ongoing tug-of-war between FOMO (fear of missing out) and FOLA (fear of losing assets1). When the Dow was pushing all-time highs, as it had been for the last couple years, investors were loath to sacrifice even an ounce of equity gains. But when the market plummets, as it did amid the onslaught of the COVID-19 crisis, some regret not having played it safer. Steep, rapid sell-offs can create investment craters that require a sizable bounce just to climb back to par.
So in our efforts to reduce risk, we diversify portfolios with assets that behave differently. But external market shocks can leave investors questioning whether they were diversified enough. How can one allocate assets in hopes of success across both bull to bear market cycles?
The trick is to complement growth-oriented equity holdings with investments that have low correlation plus the potential to add value throughout an entire market cycle. Our AXS Investments research shows that managed futures can satisfy both criteria. This “convexity” chart (defined below) reveals the complementary relationship between US equities and managed futures, showing that selecting the right managed futures strategy can enable investors’ portfolios to perform in both up and down markets.
What’s Behind the Smile
The data points represent combinations of quarterly returns over the past 20 years of the S&P 500 and a widely used managed futures benchmark called the SG CTA Index. When we draw a line to show the relationship between them, a bright blue smile emerges. What the upturned pattern tells us is that on average:
- When equity returns were largely positive, managed futures tended to be up, too.
- When equity returns were strongly negative, managed futures posted positive returns or smaller losses than equities.
- When equity returns were relatively flat or even, the correlation of returns were very low, so a small move in one investment did not say much about how the other will move.
The significance of this smile phenomenon is that investors who worry about extreme markets can benefit from the diversification managed futures offers. They have the potential to add extra return to further participate in equity upside. In bad market conditions, investors can possibly offset equity losses — that is, they will find themselves in a shallower hole.
Managed futures can play both ends of the investment spectrum this way because they can invest in well over 100 global markets and can pivot to go long or short, depending on circumstances. Good investment managers, armed with time-honed quantitative models and unique portfolio management expertise, respond to changing markets to seek profit in price movements of futures contracts. These strategies are highly independent of what’s happening to the S&P 500, Russell 2000, MSCI EAFE and other traditional benchmark indices. That explains why institutions favor managed futures, and now everyday investors who understand the value of diversification can access similar strategies through liquid mutual funds.
Equities have been a core growth driver for traditional investment portfolios, and investors have paid for their potential rewards by taking on commensurate risks. The smile chart demonstrates how an investment with positive convexity can potentially drive portfolio growth, while easing some of the worry about big up and down moves and other risks inherent in equities.
1 Ok, we may have made up that acronym.
*Sources: Morningstar. US equities are represented by the S&P 500 Index, a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies. Managed Futures are represented by SG CTA Index, a reliable daily performance benchmark of major commodity trading advisors (CTAs). The trend line is the non-linear regression of SG CTA quarterly returns versus the S&P 500.
Past performance is not a guarantee of future results. Investors cannot invest directly in an index. Index returns do not reflect any fees, expenses or sales charges. Returns are based on price only and do not include dividends. This chart is for illustrative purposes only, does not represent the AXS Investments Funds and is not indicative of any actual investments. These returns were the result of certain market factors and events that may not be repeated in the future.
Convexity is a measure of the curvature in the relationship between two variables determined by using non-linear regression. Long is the buying of a security such as a stock, commodity or currency with the expectation that the asset will rise in value. Short is a sale that is completed by the delivery of a security borrowed by the seller. Short sellers assume they will be able to buy the stock at a lower amount than the price at which they sold short.
This information is educational in nature and does not constitute investment advice. These views are subject to change at any time based on market and other conditions and no forecasts can be guaranteed. These views may not be relied upon as investment advice or as an indication of any investment or trading intent. This content should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security by AXS Investments or any third-party. You are solely responsible for determining whether any investment, investment strategy, security or related transaction is appropriate for you based on your personal investment objectives, financial circumstances and risk tolerance. AXS Investments does not provide tax or legal advice and the information herein should not be considered as such. AXS Investments disclaims any liability arising out of your use of the information contained herein. You should consult your legal or tax professional regarding your specific situation. All investing is subject to risk, including the possible loss of the money you invest. Alternative investments may not be suitable for all investors.
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