Trend is your friend say investors flocking to futures

The trend, they say, is your friend. Following the crowd in financial markets has been a successful investment strategy over the long run, since asset classes that start to go up, continue going up more than they go down, and vice versa.

That might be confounding to efficient market theorists, but it makes sense given investors' propensity to chase performance and to find comfort in the herd.

It turns out that investors exhibit just the same tendencies when it comes to trend-following hedge funds and mutual funds.

Such funds, also known as managed futures funds or CTAs, were haemorrhaging assets well into last year after several years of poor performance, but then it turned out that 2014 was their most profitable year since 2003, and investor sentiment has abruptly shifted. Trend-following funds have been one of the most sought-after investments so far this year, regardless of the questions over their long-term suitability.

What changed? For several years since the financial crisis, markets seemed to move in lock-step, making it hard for these funds to play different asset classes off against each other. Last year, though, saw diverging monetary policies in the US, Europe and Japan, causing dramatic shifts in currency markets, plus an unexpected and prolonged slide in the price of oil.

According to the Newedge CTA index, trend-followers produced returns of almost 16 per cent in 2014. They are up a further 6.2 per cent so far this year, compared to 1.1 per cent for the S&P 500 and 2.1 per cent for the US bond market, as measured by the Barclays Aggregate.

It is a trend that investors want a piece of Managed futures hedge funds attracted $10bn in new money in the first quarter, equivalent to 8 per cent of their total assets at the start of the year. It was their first positive quarter for flows in three years, and their best since 2008, and more than half the money came during March, reflecting the accelerating demand. Mutual fund versions of the strategy, designed to appeal to retail investors, attracted record inflows in January.

The last time managed futures attracted this much attention was after the financial crisis, from which these funds were just about the only investments to emerge unscathed, having shorted the equity market most of the way down. Investors lured in at that point endured three down years out of the next four.

One fear is that big inflows beget underperformance, as the greater amount of money chasing the same trades may dampen profits, but supporters say that trend followers remain too tiny a fraction of the overall market to have that impact.

A potentially greater worry is the effect rising interest rates will have when the US Federal Reserve is finally able to tighten monetary policy. A recent Morningstar analysis suggests that a bond bear market would undercut managed futures' promise of being a hedge against a falling equity market.

Looking at 10 years of data, it found that long positions in fixed income accounted for more than 100 per cent of the returns generated by the funds in months when the equity markets fell. In a secular bear market for bonds, the funds are much less likely to be long fixed income; in fact, they may have short positions that would likely suffer losses during equity market reversals - a potential double whammy.

While some researchers have attempted to create models for trend-follower returns going back a century or more, real time data only extends to the beginnings of the strategy in the Eighties, which is also the start of the bond market bull run.

The debate will be settled only after the Fed makes its move. In the meanwhile, one fact should stand out for investors: managed futures are among the highest cost funds available to them.

A recent JPMorgan survey found the average annual management fee for a managed futures hedge fund was 1.86 per cent, the highest of any category and well above the industry average of 1.69 per cent.

As for mutual funds in the US, the fee is usually well over 2 per cent, and there may be additional disguised charges, too, if the underlying investments are accessed through a total return swap with a sub-adviser, whose own fees would not then have to be broken out.

Never mind the trend, such high fees are certainly not an investor's friend.

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