The Other Side of Uncorrelated
In a meeting last year, an experienced investment advisor explained to me what he looks for in an “alternative” strategy:
“Low correlation, low volatility, no downside, and high returns. I want to have my cake and eat it too.”
That is a verbatim quote. The advisor went on to tell me story after story on how he was “burned” by various alternative investments, none of which measured up to his lofty expectations.
One such story featured the first managed futures ETF, launched in January 2011. Following the crash in 2008, managed futures were all the rage. They performed extremely well in the crisis (Barclays CTA Index up 14% in 2008) and investors did what they do best: fight the last war by chasing past returns. A quick description of the product which currently has over $200 million in assets:
“The WisdomTree Managed Futures Strategy (ticker: WDTI) seeks to achieve positive total returns in rising or falling markets that are not directly correlated to broad market equity or fixed income returns.”
“Positive total returns”
“Rising or falling markets”
“Not directly correlated”
What’s not to like?
Six years later, WDTI is down 19% versus a gain of 103% for the S&P 500 (SPY) and 20% for U.S. Bonds (AGG). Needless to say, the aforementioned advisor is no longer invested, bailing out in late 2012 after a 20% drawdown. Where did the money go? Into the next hot alternative product, and then the next, and then the next.
Each time, the blame was laid squarely on the investment product/manager and not the unrealistic expectations of the investor:
“They all sound great on paper and then do nothing but lose money or provide no return. I can do that myself. Am I right?”
Perhaps, but by doing it himself there would be no one to blame but himself, a far more tenuous position. Much easier to outsource the blame and show that you are taking action by “cutting your losses” and always investing in the next hot product/manager. How could anyone fault you for doing that?
In the end, nearly all of these investors in so-called “alternatives” are doomed to fail because of unrealistic expectations and unreasonably short holding periods. They don’t know what they own and they are unwilling to take the time to understand the why, relying solely on past returns (damned lies and statistics).
The WisdomTree Managed Futures product was in fact uncorrelated to stocks (-.04) and bonds (.01). But it was the other side of uncorrelated that transpired, the side no one wants to talk about or accept: the times when the “alternative” is down when the other things in your portfolio are up. If something is truly “alternative” and uncorrelated, these times will inevitably happen.
That’s not a defense of WDTI but a reality of diversification: if everything in your portfolio is “working” at the same time, you’re probably not as diversified as you think. I have no idea if WDTI is a good or bad investment. That may seem silly to some because its returns have been subpar.
How could something that has lost money for six years possibly be anything but bad?
- Well, while six years seems like an eternity, we know some of the best strategies in history have had negative 6-year returns. How can we be sure that WDTI is not one them and just happened to start out with a bad string of luck? We can’t.
- We also know that past performance tells you nothing about the future. If investing was as simple as picking the best performing strategies and asset classes ex-post (after-the-fact), we would all be infinitely wealthy. But the market doesn’t work like that, does it? In fact, the opposite is more likely to be true (see “The Harm in Selecting Funds that Have Recently Outperformed.“)
- And finally, we have the overall market environment. This has not been a particularly favorable time period for managed futures. Looking at the Barclays CTA Index since 2011, that much is clear, with five out of the last six years showing negative returns.
Does that mean the next six years will look the same? I doubt it but many are assuming so and will wait until there is a string of positive years before considering an investment. They will wait until there is “proof” that managed futures “work” again and the only real proof to them will come from past performance.
I have come to understand that this thinking, while unfortunate, is inevitable. Investors love the idea of non-correlation and diversification so long as everything is going up and to the right – and at the same time.
That’s true of stocks, bonds, gold, hedge funds, value, momentum, and any other asset class or strategy you can think of. So long as it’s going up, it is “working” and there is no risk. But the minute it starts going down, that’s a problem that requires immediate action, for the other side of uncorrelated is simply intolerable.
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This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
CHARLIE BILELLO, CMT
Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.
You can follow Charlie on twitter here.
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