Trends Watch: Managed Futures

EisnerAmper’s Trends Watch is a weekly entry to our Alternative Investments Intelligence blog, featuring the views and insights of executives from alternative investment firms. If you’re interested in being featured, please contact Elana Margulies-Snyderman.   

This week, Elana talks to Tom O’Donnell, Managing Director, 3D Capital Management.

What is your outlook for alternatives and more specifically, managed futures?

Over the course of my 30-year investment career, investors have become more and more reliant on the stock market. The 40/60 portfolio of stocks and bonds became the 60/40 portfolio of stocks and bonds, and today it’s not uncommon for investors to have over 60% of their portfolio in the stock market. The stock market risk represents, either directly or indirectly, the biggest risk in many investor portfolios. Assuming investors want to avoid significant stock market losses, like the two 50% declines that occurred in the stock market within seven years (2001 and 2008), the outlook for alternatives and managed futures should be overwhelmingly positive. After all, these industries exist to provide diversification and help investors achieve better risk-adjusted returns.

As a reminder, the diversity of strategies and the diversity of talent in the alternative investment industry including managed futures is significant. Picking the right strategies and identifying the best managers is essential to achieving success.

What is your outlook for the economy?

I’m a stock market investor, and as such, I’m thrilled with the current expansion and economic growth for the stock portion of my portfolio. I also invest in alternative investments and managed futures because history reminds us that the stock market moves in two directions: up and down. The stock market has a tendency to grind higher and sell off sharply. The stock market’s downside volatility showed up a few times in 2018:

• February 2018 was the fastest stock market correction in history with an 11% decline in three days, and
• Q4 2018 the S&P 500 was down approximately -14% in three months.

Fortunately, I have investments in my portfolio that were able to capitalize on these events.

Many will argue that the stock market always rebuilds itself. This insight is often espoused by the buy-and-hold crowd and might prove true for those investors who have unlimited time on their side, but none of us have unlimited time.  

Recovering from significant stock market losses can take a long time. As a reminder, it took the stock market 14 years to recover from the two 50% corrections I mentioned previously. 

My outlook for the economy and the stock market is that they will move up and down forever. Being prepared, and building portfolios that can take advantage of both outcomes, is prudent.

What keeps you up at night?

Misinformation and half-truths. Here is an example of a half-truth that is often cited by the buy-and-hold stock market investment professionals and financial advisors: If you miss a certain number of the best performing days in the stock market, you will run the risk of cutting your return in half or even turning a positive return into a negative return. Therefore, you can’t afford to get out of the stock market. Buy-and-hold wins.

The logic supporting this buy-and hold philosophy is only half of the truth. Avoiding the worst performing days in the stock market can have an even more dramatic impact on your performance.

Your readers can find numerous studies online, which compare these outcomes, including this example.

The linked article above shows the following results for an S&P 500 investment held during the 20-year period from January 1, 1998 through December 31, 2017:

• Missing out on the 40 best performing days in the stock market turns a 7.20% annualized return in the S&P 500 into a -2.80% return. A $10,000 investment becomes $5,670; a -114% impact. Compelling!
• Missing out on the 40 worst performing days in the stock market turns a 7.20% annualized return in the S&P 500 into a 19.05% return. A $10,000 investment becomes $327,107; a +952% impact. Even more compelling!

No investor wants to be guaranteed a loss. That wouldn’t be prudent. However, the fact is that long-only stock market investors are guaranteed to lose when the stock market goes down. Being guaranteed a loss is counterintuitive. As the example above clearly demonstrates, avoiding stock market losses has a dramatic impact on performance. My sincere hope is that this information will rekindle meaningful conversations among investment professionals and their clients.

At a minimum for investors it begs this question: What do I have in my portfolio that makes money when the stock market goes down?  Investment professionals who are responsible for managing client money should ask themselves: What have I added to my clients’ portfolio that can make money when the stock market goes down? Doing nothing is an active decision. Just make sure you have the evidence to back it up.