Another simple test to determine whether managed futures returns will do better than average is through looking at economic growth. Now, we know that bonds and other defensive assets like managed futures will do better in “bad times” such as a recession, but there just are not many recessions. The cost of being defensive can be very high if you have to pay for downside protection through either explicit insurance or through holding assets that have a lower expected return.
The alternative is to think a little more broadly about the definition of “bad times”. The deviations for growth or growth recessions are also periods when defensive assets should do better. If there is a slowdown in economic growth firms and market prices will adjust. Price discounting will occur when growth slows. Inventories will build during growth slowdowns. Investors will be more cautious.
A more straightforward test for defensive assets is to look at the deviations from trend growth. A simple index of deviations from trend growth that incorporates a significant amount of economic information is the Chicago Fed National Activity Index. If the index is negative, then economic activity is below trend. Positive values suggest economic activity is above trend. The switches between above and below-trend growth are clear and these are the transitions that offer opportunity.
It is noticeable that there has been little deviation from trend since the Great Financial Crisis. The current period may be a better representation of the Great Moderation than the mid 1990’s. The difference is that the deviations seem to be closer to the trend. This does to mean that we have exception growth in the current environment but only growth that is closer to trend. We show in green the 12-month rolling average value.
This research on “bad times” is ongoing but we have found that returns for managed futures are slightly higher during periods of declining or negative deviations from trend. This mean difference has a p-value of .2 for a one-tailed test, suggesting a weak difference. Our analysis shows that performance for managed futures is higher than normal when there is a deterioration of financial condition versus periods of just slower economic growth. Our ongoing research is to look at the impact of “growth recessions” on other hedge fund strategies.
The crisis alpha that may exist in managed futures shows stronger performance during market downturns, but more importantly, managed futures performance is tied to changes in economic performance. Deterioration of financial conditions or growth, the harbinger of a possible asset price crisis, are the more primal cause of excess returns.