1

Bemystifying Nanageu Futuies

Brian Hurst, Yao Hua Ooi, and Lasse Heje Pedersen



Forthcoming Journal of Investment Management




Practitioner's Digest

We show that the returns of Managed Futures funds and CTAs can be explained by
simple trend-following strategies, specifically time series momentum strategies. We
discuss the economic intuition behind these strategies, including the potential sources of
profit due to initial under-reaction and delayed over-reaction to news.

We show empirically that these trend-following strategies explain Managed Futures
returns. Indeed, time series momentum strategies produce large correlations and high R-
squares with Managed Futures indices and individual manager returns, including the
largest and most successful managers. While the largest Managed Futures managers have
realized significant alphas to traditional long-only benchmarks, controlling for time series
momentum strategies drives their alphas to zero.

Finally, we consider a number of implementation issues relevant to time series
momentum strategies, including risk management, risk allocation across asset classes and
trend horizons, portfolio rebalancing frequency, transaction costs, and fees.



Key words

Managed futures, time series momentum, trends, commodity trading advisor (CTA),
hedge funds, trading strategies




2





Bemystifying Nanageu Futuies


Brian Hurst, Yao Hua Ooi, and Lasse Heje Pedersen
*







Abstract

We show that the returns of Managed Futures funds and CTAs can be explained by time
series momentum strategies and we discuss the economic intuition behind these
strategies. Time series momentum strategies produce large correlations and high R-
squares with Managed Futures indices and individual manager returns, including the
largest and most successful managers. While the largest Managed Futures managers have
realized significant alphas to traditional long-only benchmarks, controlling for time series
momentum strategies drives their alphas to zero. We consider a number of
implementation issues relevant to time series momentum strategies, including risk
management, risk allocation across asset classes and trend horizons, portfolio rebalancing
frequency, transaction costs, and fees.

*
Brian Hurst and Yao Hua Ooi are at AQR Capital Management, LLC. Lasse Heje Pedersen is at New
York University, Copenhagen Business School, AQR Capital Management, CEPR, and NBER, web:
http://people.stern.nyu.edu/lpederse/ . We are grateful to Cliff Asness, John Liew and Antti Ilmanen for
helpful comments and to Ari Levine and Vineet Patil for excellent research assistance.
3
1. Introduction
Managed Futures hedge funds and commodity trading advisors (CTAs) have existed
at least since Richard Donchian started his fund in 1949 and they have proliferated since
the 1970s when futures exchanges expanded the set of tradable contracts.
1
BarclayHedge
estimates that the CTA industry has grown to managing approximately $320B as of the
end of the first quarter of 2012. Though these funds have existed for decades and
attracted large amounts of capital, they have not been well understood, perhaps because
they have been operated by opaque funds that charge high fees. Fung and Hsieh (2001)
find that portfolios of look-back straddles have explanatory power for Managed Futures
returns, but these look-back straddles are not implementable as they use data from future
time periods.
We show that simple implementable trend-following strategies specifically time
series momentum strategies can explain the returns of Managed Futures funds. We
provide a detailed analysis of the economics of these strategies and apply them to explain
the properties of Managed Futures funds. Using the returns to time series momentum
strategies, we analyze how Managed Futures funds benefit from trends, how they rely on
different trend horizons and asset classes, and we examine the role of transaction costs
and fees within these strategies.
Time series momentum is a simple trend-following strategy that goes long a market
when it has experienced a positive excess return over a certain look-back horizon, and
goes short otherwise. We consider 1-month, 3-month, and 12-month look-back horizons
(corresponding to short-term, medium-term, and long-term trend strategies), and
implement the strategies for a liquid set of commodity futures, equity futures, currency
forwards and government bond futures.
2

Trend-following strategies only produce positive returns if market prices exhibit
trends, but why should price trends exist? We discuss the economics of trends based on

1
Elton, Gruber, and Rentzler (1987).
2
Our methodology follows Moskowitz, Ooi and Pedersen (2012), but to more closely match practices
among Managed Futures managers, we focus on weekly rebalanced returns using multiple trend horizons
rather than the monthly-rebalanced strategy using only 12-month trends in Moskowitz, Ooi and Pedersen
(2012). Section 5 considers the effect of rebalancing frequencies. Baltas and Kosowski (2013) consider the
relation to CTA indices and perform an extensive capacity analysis. Time series momentum is related to
cross-sectional momentum discovered in individual stocks by Asness (1994) and Jegadeesh, and Titman
(1993), and studied for a wide set of asset classes by Asness, Moskowitz, and Pedersen (2009) and
references therein.
4
initial under-reaction to news and delayed over-reaction as well as the extensive literature
on behavioral biases, herding, central bank behavior, and capital market frictions. If
prices initially under-react to news, then trends arise as prices slowly move to more fully
reflect changes in fundamental value. These trends have the potential to continue even
further due to a delayed over-reaction from herding investors. Naturally, all trends must
eventually come to an end as deviation from fair value cannot continue indefinitely.
We find strong evidence of trends across different look-back horizons and asset
classes. A time series momentum strategy that is diversified across all assets and trend
horizons realizes a gross Sharpe ratio of 1.8 with little correlation to traditional asset
classes. In fact, the strategy has produced its best performance in extreme up and extreme
down stock markets. One reason for the strong performance in extreme markets is that
most extreme bear or bull markets historically have not happened overnight, but have
occurred over several months or years. Hence, in prolonged bear markets, time series
momentum takes short positions as markets begin to decline and thus profits as markets
continue to fall.
Time series momentum strategies help explain returns to the Managed Futures
universe. Like time series momentum, some Managed Futures funds have realized low
correlation to traditional asset classes, performed best in extreme up and down stocks
markets, and delivered alpha relative to traditional asset classes.
When we regress Managed Futures indices and manager returns on time series
momentum returns, we find large R-squares and very significant loadings on time series
momentum at each trend horizon and in each asset class. In addition to explaining the
time-variation of Managed Futures returns, time series momentum also explains the
average excess return. Indeed, controlling for time series momentum drives the alphas of
most managers and indices below zero. The negative alphas relative to the hypothetical
time series momentum strategies show the importance of fees and transaction costs.
Comparing the relative loadings, we see that most managers focus on medium and
long-term trends, giving less weight to short-term trends, and some managers appear to
focus on fixed-income markets.
The rest of the paper is organized as follows. Section 2 discusses the economics and
literature of trends. Section 3 describes our methodology for constructing time series
momentum strategies and presents the strong performance of these strategies. Section 4
shows that time series momentum strategies help explain the returns of Managed Futures
5
managers and indices. Section 5 discusses implementation issues such as transaction
costs, rebalance frequency, margin requirements, and fees. Section 6 concludes.
2. TheLifecycleofaTrend:EconomicsandLiterature
The economic rationale underlying trend-following strategies is illustrated in Figure
1, a stylized lifecycle of a trend. An initial under-reaction to a shift in fundamental
value allows a trend-following strategy to invest before new information is fully reflected
in prices. The trend then extends beyond fundamentals due to herding effects, and finally
results in a reversal. We discuss the drivers of each phase of this stylized trend, as well as
the related literature.

Start of the Trend: Under-Reaction to Information.
In the stylized example shown in Figure 1, a catalyst a positive earnings release, a
supply shock, or a demand shift causes the value of an equity, commodity, currency, or
bond to change. The change in value is immediate, shown by the solid blue line. While
the market price (shown by the dotted black line) moves up as a result of the catalyst, it
initially under-reacts and therefore continues to go up for a while. A trend-following
strategy buys the asset as a result of the initial upward price move, and therefore
capitalizes on the subsequent price increases. At this point in the lifecycle, trend-
following investors contribute to the speeding-up of the price discovery process.
Research has documented a number of behavioral tendencies and market frictions that
lead to this initial under-reaction:

i. Anchor-and-insufficient-adjustment. Edwards (1968), and Tversky and
Kahneman (1974) find that people anchor their views to historical data and
adjust their views insufficiently to new information. This behavior can cause
prices to under-react to news (Barberis, Shleifer, and Vishny (1998)).
ii. The disposition effect. Shefrin and Statman (1985), and Frazzini (2006)
observe that people tend to sell winners too early and ride losers too long.
They sell winners early because they like to realize their gains. This creates
downward price pressure, which slows the upward price adjustment to new
positive information. On the other hand, people hang on to losers because
6
realizing losses is painful. They try to make back what has been lost. Fewer
willing sellers can keep prices from adjusting downward as fast as they
should.
iii. Non-profit-seeking activities. Central banks operate in the currency and
fixed-income markets to reduce exchange-rate and interest-rate volatility,
potentially slowing the price-adjustment to news (Silber (1994)). Also,
investors who mechanically rebalance to strategic asset allocation weights
trade against trends. For example, a 60/40 investor who seeks to own 60%
stocks and 40% bonds will sell stocks (and buy bonds) whenever stocks have
outperformed.
iv. Frictions and slow moving capital. Frictions, delayed response by some
market participants, and slow moving arbitrage capital can also slow price
discovery and lead to a drop and rebound of prices (Mitchell, Pedersen, and
Pulvino (2007), Duffie (2010)).

The combined effect is for the price to move too gradually in response to news,
creating a price drift as the market price slowly incorporates the full effect of the news. A
trend-following strategy will position itself in relation to the initial news, and profit if the
trend continues.

Trend Continuation: Delayed Over-Reaction
Once a trend has started, a number of other phenomena exist which may extend the
trend beyond the fundamental value:

i. Herding and feedback trading. When prices have moved in one direction for
a while, some traders may jump on the bandwagon because of herding
(Bikhchandani et al. (1992)) or feedback trading (De Long et al. (1990), Hong
and Stein (1999)). Herding has been documented among equity analysts in
their recommendations and earnings forecasts (Welch (2000)), in investment
newsletters (Graham (1999)), and in institutional investment decisions.
ii. Confirmation bias and representativeness. Wason (1960) and Tversky and
Kahneman (1974) show that people tend to look for information that confirms
what they already believe, and look at recent price moves as representative of
7
the future. This can lead investors to move capital into investments that have
recently made money, and conversely out of investments that have declined,
both of which cause trends to continue (Barberis, Shleifer, and Vishny (1998),
Daniel, Hirshleifer, Subrahmanyam (1998)).
iii. Fund flows and risk management. Fund flows often chase recent
performance (perhaps because of i. and ii.). As investors pull money from
underperforming managers, these managers respond by reducing their
positions (which have been underperforming), while outperforming managers
receive inflows, adding buying pressure to their outperforming positions.
Further, some risk-management schemes imply selling in down-markets and
buying in up-markets, in line with the trend. Examples of this behavior
include stop-loss orders, portfolio insurance, and corporate hedging activity
(e.g., an airline company that buys oil futures after the oil price has risen to
protect the profit margins from falling too much, or a multinational company
that hedges foreign-exchange exposure after a currency moved against it).

End of the Trend
Obviously, trends cannot go on forever. At some point, prices extend too far beyond
fundamental value and, as people recognize this, prices revert towards the fundamental
value and the trend dies out. As evidence of such over-extended trends, Moskowitz, Ooi,
and Pedersen (2012) find evidence of return reversal after more than a year.
3
The return
reversal only reverses part of the initial price trend, suggesting that the price trend was
partly driven by initial under-reaction (since this part of the trend should not reverse) and
partly driven by delayed over-reaction (since this part reverses).
3. TimeSeriesMomentumAcrossTrendHorizonsandMarkets
Having discussed why trends might exist, we now demonstrate the performance of a
simple trend-following strategy: time series momentum.

Identifying Trends and Sizing Positions

3
Such long-run reversal is also found in the cross-section of equities (De Bondt and Thaler (1985)) and the
cross-section of global asset classes (Asness, Moskowitz, and Pedersen (2012)).
8
We construct time series momentum strategies for 58 highly liquid futures and
currency forwards from January 1985 to June 2012 specifically 24 commodity futures,
9 equity index futures, 13 bond futures, and 12 currency forwards. To determine the
direction of the trend in each asset, the strategy simply considers whether the assets
excess return is positive or negative: A positive past return is considered an up trend,
and leads to a long position; a negative return is considered a down trend, and leads to
a short position.
We consider 1-month, 3-month, and 12-month time series momentum strategies,
corresponding to short-, medium-, and long-term trend-following strategies. The 1-month
strategy goes long if the preceding 1-month excess return was positive, and short if it was
negative. The 3-month and 12-month strategies are constructed analogously. Hence, each
strategy always holds a long or a short position in each of 58 markets.
The size of each position is chosen to target an annualized volatility of 40% for that
asset, following the methodology of Moskowitz, Ooi, and Pedersen (2012).
4
Specifically,
the number of dollars bought/sold of instrument s at time t is 4u%
t
s
so that the time
series momentum (TSMOM) strategy realizes the following return during the next week:

ISH0H
t+1
X-month,Assct-s
= sign(excess return of s over past X months)
40%
c
t
s
r
t+1
s
(1)

The ex-ante annualized volatility o
t
s
for each instrument is estimated as an exponentially
weighted average of past squared returns

(o
t
s
)
2
= 261 (1 - o)o

(r
t-1-I
s
- r
t
s
)
2
(2)

where the scalar 261 scales the variance to be annual and r
t
s
is the exponentially weighted
average return computed similarly. The parameter is chosen so that the center of mass
of the weights, given by (1 -o)o

i, is equal to 60 days.

4
Our position sizes are chosen to target a constant volatility for each instrument, but, more generally, one
could consider strategies that vary the size of the position based on the strength of the estimated trend. E.g.,
for intermediate price moves, one could take a small position or no position and increase the position
depending on the magnitude of the price move. However, the goal of our paper is not to determine the
optimal trend-following strategy, but to show that even a simple approach performs well and can explain
the returns in the CTA industry.
9
This constant-volatility position-sizing methodology of Moskowitz, Ooi, and
Pedersen (2012) is useful for several reasons: First, it enables us to aggregate the
different assets into a diversified portfolio which is not overly dependent on the riskier
assets this is important given the large dispersion in volatility among the assets we
trade. Second, this methodology keeps the risk of each asset stable over time, so that the
strategys performance is not overly dependent on what happens during times of high
risk. Third, the methodology minimizes the risk of data mining given that it does not use
any free parameters or optimization in choosing the position sizes.
The portfolio is rebalanced weekly at the closing price each Friday, based on data
known at the end of each Thursday. We therefore are only using information available at
the time to make the strategies implementable. The strategy returns are gross of
transaction costs, but we note that the instruments we consider are among the most liquid
in the world. Sections 5 considers the effect of different rebalance rules and discusses the
impact of transaction costs. While Moskowitz, Ooi, and Pedersen (2012) focus on
monthly rebalancing, it is interesting to also consider higher rebalancing frequencies
given our focus on explaining the returns of professional money managers who often
trade throughout the day.

Performance of the TSMOM Strategies by Individual Asset
Figure 2 shows the performance of each time series momentum strategy in each asset.
The strategies deliver positive results in almost every case, a remarkably consistent result.
The average Sharpe Ratio (excess returns divided by realized volatility) across assets is
0.29 for the 1-month strategy, 0.36 for the 3-month strategy, and 0.38 for the 12-month
strategy.

Building Diversified TSMOM Strategies
Next, we construct diversified 1-month, 3-month, and 12-month time series
momentum strategies by averaging returns of all the individual strategies that share the
same look-back horizon (denoted, ISH0H
1M
, ISH0H
3M
and ISH0H
12M
). We also
construct time series momentum strategies for each of the four asset classes:
commodities, currencies, equities, and fixed income
(uenoteu, ISH0H
C0M
, ISH0H
PX
, ISH0H
L
, ISH0H
PI
). E.g., the commodity
10
strategy is the average return of each individual commodity strategy for all 3 trend
horizons. Finally, we construct a strategy that diversifies across all assets and all trend
horizons that we call the diversified time series momentum strategy (denoted simply,
TSMOM). In each case, we scale the positions to target an ex ante volatility of 10% using
an exponentially-weighted variance-covariance matrix estimated analogously to Equation
(2).
Table 1 shows the performance of these diversified time series momentum strategies.
We see that the strategies realized volatilities closely match the 10% ex ante target,
varying from 9.5% to 11.9%. More importantly, all the time series momentum strategies
have impressive Sharpe ratios, reflecting a high average excess return above the risk-free
rate relative to the risk. Comparing the strategies across trend horizons, we see that the
long-term (12-month) strategy has performed the best, the medium-term strategy has
done second best, and the short-term strategy, which has the lowest Sharpe Ratio out of
the 3 strategies, still has a high Sharpe Ratio of 1.3. Comparing asset classes,
commodities, fixed income, and currencies have performed a little better than equities.
In addition to reporting the expected return, volatility, and Sharpe ratio, Table 1 also
shows the alpha from the following regression:

ISH0H
t
= o + [
1
r
t
Stocks
+[
2
r
t
Bonds
+ [
3
r
t
Commodities
+ e
t
(3)

We regress the TSMOM strategies on the returns of a passive investment in the MSCI
world stock index, the Barclays US Aggregate Government Bond index and the S&P
GSCI commodity index. The alpha measures the excess return, controlling for the risk
premia associated with simply being long these traditional asset classes. The alphas are
almost as large as the excess returns since the TSMOM strategies are long/short and
therefore have small average loadings on these passive factors. Finally, Table 1 reports
the t-statistics of the alphas, which show that the alphas are highly statistically
significant.
The best performing strategy is the diversified time series momentum strategy with a
Sharpe ratio of 1.8. Its consistent cumulative return is seen in Figure 3 that illustrates the
hypothetical growth of $100 invested in 1985 in the diversified TSMOM strategy and the
S&P500 stock market index, respectively.
11

Diversification: Trends with Benefits
To understand this strong performance of time series momentum, note first that the
average pair-wise correlation of these single-asset strategies is less than 0.1 for each trend
horizon, meaning that the strategies behave rather independently across markets so one
may profit when another loses. Even when the strategies are grouped by asset class or
trend horizon, these relatively diversified strategies also have modest correlations as seen
in Table 2. Another reason for the strong benefits of diversification is our equal-risk
approach. The fact that we scale our positions so that each asset has the same ex ante
volatility at each time means that, the higher the volatility of an asset, the smaller a
position it has in the portfolio, creating a stable and risk-balanced portfolio. This is
important because of the wide range of volatilities exhibited across assets. For example, a
5-year US government bond future typically exhibits a volatility of around 5% a year,
while a natural gas future typically exhibits a volatility of around 50% a year. If a
portfolio holds the same notional exposure to each asset in the portfolio (as some indices
and managers do), the risk and returns of the portfolio will be dominated by the most
volatile assets, significantly reducing the diversification benefits.
The diversified time series momentum strategy has very low correlations to
traditional asset classes. Indeed, the correlation with the S&P500 stock market index is -
0.02, the correlation with the bond market as represented by the Barclays US Aggregate
index is 0.23, and the correlation with the S&P GSCI commodity index is 0.05. Further,
the time series momentum strategy has performed especially well during periods of
prolonged bear markets and in sustained bull markets as seen in Figure 4. Figure 4 plots
the quarterly returns of time series momentum against the quarterly returns of the
S&P500. We estimate a quadratic function to fit the relation between time series
momentum returns and market returns, giving rise to a smile curve. The estimated
smile curve means that time series momentum has historically done the best during
significant bear markets or significant bull markets, performing less well in flat markets.
To understand this smile effect, note that most of the worst equity bear markets have
historically happened gradually. The market first goes from normal to bad, causing a
TSMOM strategy to go short (while incurring a loss or profit depending on what
happened previously). Often, a deep bear market happens when the market goes from
bad to worse, traders panic and prices collapse. This leads to profits on the short
12
positions, explaining why these strategies tend to be profitable during such extreme
events. Of course, these strategies will not always profit during extreme events. For
instance, the strategy might incur losses if, after a bull market (which would get the
strategy positioned long), the market crashed quickly before the strategy could alter its
positions to benefit from the crash.
4. Time Series Momentum Explains Actual Managed Futures Fund
Returns
We collect the returns of two major Managed Futures indices, BTOP 50 and DJCS
Managed Futures Index,
5
as well as individual fund returns from the Lipper/Tass
database in the category labeled Managed Futures. We highlight the performance of the
5 Managed Futures funds in the Lipper/Tass database that have the largest reported
Fund Assets as of 06/2012. While looking at the ex post returns of the largest funds
naturally bias us toward picking funds that did well, it is nevertheless interesting to
compare these most successful funds to time series momentum.
Table 3 reports the performance of the Managed Futures indices. We see that the
index and manager returns have Sharpe ratios between 0.27 and 0.88. All of the alphas
with respect to passive exposures to stocks/bonds/commodities are positive and most of
them are statistically significant. We see that the diversified time series momentum
strategy has a higher Sharpe ratio and alpha than the indices and managers, but we note
that time series momentum index is gross of fees and transaction costs while the
managers and indices are after fees and transaction costs. Further, while the time series
momentum strategy is simple and subject to minimal data-mining, it does benefit from
some hindsight in choosing its 1, 3, and 12-month trend horizons managers
experiencing losses in real time may have had a more difficult time sticking with these
strategies through tough times than our hypothetical strategy.
Fees make a significant difference given that most CTAs and Managed Futures hedge
funds have historically charged at least 2% management fees and 20% performance fees.
While we cannot know the exact before-fee manager returns, we can simulate the

5
These index returns are available at the following websites:
http://www.barclayhedge.com/research/indices/btop/index.html
http://www.hedgeindex.com/hedgeindex/secure/en/indexperformance.aspx?cy=USD&indexname=HEDG_
MGFUT
13
hypothetical fee for the time series momentum strategy. With a 2-and-20 fee structure,
the average fee is around 6% per year for the diversified TSMOM strategy.
6
We calculate
this average fee using a 2-and-20 fee structure, high water marks, quarterly payments of
management fees, and annual payments of performance fees. Further, transaction costs
are on the order of 1-4% per year for a sophisticated manager and possibly much higher
for less sophisticated managers and higher historically.
7
Hence, after these estimated fees
and transaction costs, the Sharpe ratio of the diversified time series momentum strategy
would historically have been near 1, still comparing well to the indices and managers, but
we note that historical transaction costs are not known and associated with significant
uncertainty.
Rather than comparing the performance of the time series momentum strategy to
those of the indices and managers, we want to show that time series momentum can
explain the strong performance of Managed Futures managers. To explain Managed
Futures returns, we regress the returns of Managed Futures indices and managers (r
t
MF
)
on the returns of 1-month, 3-month, and 12-month time series momentum:

r
t
MF
= o + [
1
ISH0H
t
1M
+ [
2
ISH0H
t
3M
+ [
3
ISH0H
t
12M
+ e
t
(4)

Similarly, we regress the returns of Managed Futures indices and managers on the
returns of TSMOM strategies in commodities (ISH0H
t
C0M
), equities (ISH0H
t
L
), fixed
income (ISH0H
t
PI
), and currencies (ISH0H
t
PX
):

r
t
MF
= o + [
1
ISH0H
t
C0M
+ [
2
ISH0H
t
L
+ [
3
ISH0H
t
PI
+ [
4
ISH0H
t
PX
+ e
t

(5)

Table 4 reports the results of these regressions. We see the time series momentum
strategies explain the Managed Futures index and manager returns to a large extent in the
sense that the R-squares of these regressions are large, ranging between 0.36 and 0.64.

6
The average fee is high due to the high Sharpe Ratio realized by the simulated TSMOM strategy. In
practice, Managed Futures indices have realized lower Sharpe Ratios.
7
This estimate of transaction costs is based on proprietary estimates of current transaction costs in global
futures and forward markets combined with the turnover of these strategies for a manager with about USD1
Billion under management. These estimates do not account for the fact that transaction costs were higher
in earlier years when markets were less liquid and trading was not conducted via electronic markets.
14
Table 4 also reports the correlation of the Managed Futures indices and managers with
the diversified TSMOM strategy. These correlations are large, ranging from 0.66 to 0.78,
which provides another indication that time series momentum can explain the Managed
Futures universe.
The intercepts reported in Table 4 indicate the excess returns (or alphas) after
controlling for time series momentum. While the alphas relative to the traditional asset
classes in Table 3 were significantly positive, almost all the alphas relative to time series
momentum in Table 4 are negative. Even though the returns of the largest managers are
biased be to be high (due to the ex post selection of the managers), time series
momentum nevertheless drives these alphas to be negative. This is another expression
that time series momentum can explain the Managed Futures space and an illustration of
the importance of fees and transaction costs.
Another interesting finding that arises from Table 4 is the relative importance of
short-, medium-, and long-term trends for Managed Futures funds, as well as the relative
importance of the different asset classes. We see that all the indices and managers have
positive loadings on all the trend horizons and all the asset classes, and almost all the
loadings are statistically significant. Focusing on the DJCS Managed Futures index,
Figure 5 illustrates the relative loadings on the different trend horizons and the different
asset classes. As seen in Table 4 and Figure 5, most managers put most weight on
medium- and long-term trends, with less weight on short-term trends. In terms of asset
classes, most managers put more weight on fixed income, perhaps because of the
liquidity of these markets and the strong performance of fixed income trend following in
the past decades.
In summary, while many Managed Futures funds pursue many other types of
strategies besides time series momentum, such as carry strategies and global macro
strategies, our results show that time series momentum explains the average alpha in the
industry and a significant fraction of the time-variation of returns.
5. Implementation:HowtoManageManagedFutures
We have seen that time series momentum can explain Managed Futures returns. In
fact, this relatively simple strategy has realized a higher Sharpe ratio than most managers,
at least on paper. This suggests that fees and other implementation issues are important
15
for the real-world success of these strategies. Indeed, as mentioned in Section 4, we
estimate that a 2-20 fee structure implies a 6% average annual fee on the diversified time
series momentum strategy run at a 10% annualized volatility. Other important
implementation issues include transaction costs, rebalance methodology, margin
requirements, and risk management.
To analyze the effect of how often the portfolio is rebalanced, Figure 6 shows the
gross Sharpe ratio for each trend horizon and the diversified time series momentum
strategy as a function of rebalancing frequency. Daily and weekly rebalancing perform
similarly, while the performance trails off with monthly and quarterly rebalancing
frequencies. Naturally, the performance falls more quickly for the short and medium-term
strategies as these signals change more quickly, leading to a larger alpha decay.
As mentioned, the annual transaction costs of a Managed Futures strategy are
typically about 1-4% for a sophisticated trader, possibly much higher for less
sophisticated traders, and higher historically given higher transactions costs in the past.
Transaction costs depend on a number of things. Transaction costs increase with
rebalance frequency if the portfolio is mechanically rebalanced without transaction-cost
optimization, although more frequent access to the market can also be used to source
more liquidity. Garleanu and Pedersen (2012) derive an optimal portfolio rebalancing
rule for many assets with several returns predictors (such as trend signals) and transaction
costs. They find that transaction cost optimization leads to a larger optimal weight on
signals with slower alpha decay, that is, longer-term trends. Hence, larger managers may
allocate a larger weight to medium- and long-term trend signals and relatively lower
weight to short-term signals, as seen in Figure 5B. Transaction costs rise with the weight
given to more illiquid assets, and rise with the size of the fund for a given trading
infrastructure, although large funds should have the ability to develop better trading
infrastructure and negotiate lower commissions. Transaction costs are lower for managers
who have more direct market access (saving on commissions and indirect broker costs)
with advanced trading algorithms that can partly provide liquidity and have minimal
information leakage.
To implement managed futures strategies, managers must post margin to
counterparties, namely the Futures Commission Merchant and the currency
intermediation agent (or currency prime broker). The time series momentum strategy
would typically have margin requirements of 8-12% for a large institutional investor, and
16
more than double that for a smaller investor. Hence, time series momentum is certainly
implementable from a funding liquidity standpoint as it has a significant amount of free
cash.
Risk management is the final implementation issue that we discuss. Our construction
of trading strategies is systematic and already has built-in risk controls due to our
constant-volatility methodology. This methodology is important for several reasons. First,
it controls the risk of each security by scaling down the position when risk spikes up.
Second, it achieves a risk-balanced diversification across securities at all times. Third,
our systematic implementation means that our strategies are not subject to behavioral
biases. Moreover, our methodology can be overlaid with an additional layer of risk
management and drawdown control and some Managed Futures managers further seek to
identify over-extended trends to limit the losses from sharp trend-reversals, and try to
identify short-term countertrends to improve performance in range-bound markets.
6. Conclusion
We find that 1-month, 3-month, and 12-month time series momentum strategies have
performed well over time and across asset classes. Combining these into a diversified
time series momentum strategy produces a gross Sharpe ratio of 1.8, performing well in
both in extended bear and bull markets. Time series momentum can explain Managed
Futures indices and manager returns, even for the ex-post largest and most successful
funds, demystifying the strategy. Indeed, time series momentum has a high correlation to
Managed Futures returns, large R-squares, and explains the average returns (that is,
leaves only a small unexplained intercept or alpha in a regression). Thus investors can get
exposure to Managed Futures using time series momentum strategies, and should pay
attention to implementation issues such as fees, trading infrastructure and risk
management procedures used by different managers.

17
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19
Figure 1. Stylized Plot of the Lifecycle of a Trend.



20
Figure 2. Performance of Time Series Momentum by Individual Asset and Trend
Horizon. This figures shows the Sharpe ratios of the time series momentum strategies for
each commodity futures (in blue), currency forward (yellow), equity futures (orange), and
fixed income futures (green). We show this for strategies using look-back horizons of 1-
month (top panel), 3-month (middle panel), and 12-month (bottom panel).



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22
Figure 3. Performance of the Diversified Time Series Momentum Strategy and the
S&P 500 Index over Time. The figure shows the cumulate return gross of transaction
costs of the diversified TSMOM strategy and the S&P500 equity index on a log-scale,
1985-2012.

























$100.00
$1,000.00
$10,000.00
$100,000.00
1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011
DiversifiedTSM S&P500
23
Figure 4. Time Series Momentum Smile. This graph plots quarterly non-overlapping
hypothetical returns of the Diversified Time Series Momentum Strategy vs. the S&P 500,
1985-2012.

























20%
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S&P500Quarterl yTotal Returns
24

Figure 5. Managed Futures Exposures across Asset Classes and Trend Horizons.
This figure shows the regression coefficients from a regression of the DJCS Managed
Futures Index on the time series momentum strategies by asset class (Panel A) and by
trend horizon. The regression coefficients are scaled by their sum to show their relative
importance.
Panel A: Exposures across Asset Classes


Panel B: Exposures across Trend Horizons

Commodities
TSM, 21%
Equities
TSM, 21%
FixedIncome
TSM, 35%
Currencies
TSM, 23%
1Month
TSM, 24%
3Month
TSM, 54%
12Month
TSM, 22%
25

Figure 6. Gross Sharpe Ratios at Different Rebalance Frequencies. This figure shows
the Sharpe ratios gross of transaction costs of the 1-month, 3-month, 12-month, and
diversified time series momentum strategies as a function of the rebalancing frequency.




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Diversifed
TSM
26
Table 1. Performance of Time Series Momentum Strategies. This table shows the
performance of time series momentum strategies diversified within each asset class
(Panel A) and across each trend horizon (Panel B). All numbers are annualized. The
alpha is the intercept from a regression on the MCSI World stock index, Barclays Bond
Index, and the GSCI commodities index. The t-statistic of the alpha is shown in
parentheses.

Panel A: Performance of TS-Momentum across Asset Classes



Panel B: Performance of TS-Momentum across Signals






Commodities
TSM
Equities
TSM
FixedIncome
TSM
Currencies
TSM
Diversifed
TSM
AverageExcessReturn 11.5% 8.7% 11.7% 10.4% 19.4%
Volatility 11.0% 11.1% 11.7% 11.9% 10.8%
SharpeRatio 1.05 0.78 1.00 0.87 1.79
AnnualizedAlpha 12.1% 6.8% 9.0% 10.1% 17.4%
TStat (5.63) (3.16) (4.15) (4.30) (8.42)
1Month
TSM
3Month
TSM
12Month
TSM
Diversifed
TSM
AverageExcessReturn 12.0% 14.5% 17.2% 19.4%
Volatility 9.5% 10.2% 11.3% 10.8%
SharpeRatio 1.26 1.43 1.52 1.79
AnnualizedAlpha 11.1% 13.3% 14.4% 17.4%
TStat (6.04) (6.70) (6.74) (8.42)
27
Table 2. Correlations of Time Series Momentum Strategies. This table shows the
correlation of time series momentum strategies across asset classes (Panel A) and trend
horizons (Panel B).

Panel A: Strategy Correlations across Asset Classes



Panel B: Strategy Correlations across Trend Horizons





Commodities
TSM
Equities
TSM
FixedIncome
TSM
Currencies
TSM
CommodiesTSM 1.0
EquiesTSM 0.2 1.0
FixedIncomeTSM 0.1 0.1 1.0
CurrenciesTSM 0.1 0.2 0.1 1.0
1Month
TSM
3Month
TSM
12Month
TSM
1MonthTSM 1.0
3MonthTSM 0.6 1.0
12MonthTSM 0.4 0.6 1.0
28
Table 3. Performance of Managed Futures Indices and Managers. This table shows
the performance of Managed Futures indices and the 5 largest managed futures managers
in the Lipper/Tass database as of 6/2012. All numbers are annualized. The alpha is the
intercept from a regression on the MCSI World stock index, Barclays Bond Index, and
the GSCI commodities index. The t-statistic of the alpha is shown in parenthesis.






































BTOP50 DJCSMF ManagerA ManagerB ManagerC ManagerD ManagerE
BeginDate 30Jan87 31Jan94 30Apr04 31Oct97 31May00 29Mar96 31Dec98
AverageExcessReturn 5.2% 3.2% 12.4% 13.3% 11.8% 12.3% 8.1%
Volatility 10.3% 11.7% 14.0% 17.7% 14.8% 17.2% 16.4%
SharpeRatio 0.50 0.27 0.88 0.75 0.80 0.72 0.49
AnnualizedAlpha 3.5% 1.1% 10.7% 9.3% 8.5% 9.4% 5.1%
TStatofAlpha (1.69) (0.41) (2.15) (2.05) (2.05) (2.22) (1.17)
29


Table 4. TS-Momentum Explains Managed Futures Returns. This table shows the
multivariate regression of Managed Futures indices and managers on time series
momentum returns by asset class (Panel A) and by trend horizon (Panel B). T-statistics
are reported in parenthesis. Managers 1-5 are the largest managed futures managers in the
Lipper/Tass database as of 12/2012. The bottom row reports the percentage of all funds
in the Lipper/Tass database with positive coefficients. The right-most column reports the
correlation between the Managed Futures returns and the diversified TSMOM strategy.

Panel A: Managed Futures Loadings across Asset Classes




Panel B: Managed Futures Loadings across Trend Horizons





RSq
Correlto
Diversified
TSM
DJCSManagedFutures 0.26 (3.65) 0.56 (7.69) 0.23 (3.86) 8.8% (4.58) 0.58 0.73
BTOP50 0.27 (4.87) 0.53 (9.00) 0.08 (1.78) 6.6% (4.24) 0.53 0.69
ManagerA 0.39 (2.85) 0.59 (4.51) 0.31 (2.69) 2.8% (0.80) 0.54 0.73
ManagerB 0.66 (5.00) 0.35 (2.56) 0.47 (4.03) 0.8% (0.23) 0.46 0.66
ManagerC 0.55 (4.93) 0.52 (4.47) 0.25 (2.55) 0.6% (0.19) 0.55 0.72
ManagerD 0.50 (4.54) 0.80 (6.85) 0.22 (2.25) 3.6% (1.19) 0.57 0.70
ManagerE 0.35 (3.32) 0.70 (6.42) 0.48 (5.29) 6.0% (2.09) 0.64 0.78
%PositiveBetas,allMF
FundsinLipper/TassDB
76% 78% 76%
1Month
TSM
3Month
TSM
12Month
TSM
Intercept
(annualized)
RSq
Correlto
Diversified
TSM
DJCSManagedFutures 0.28 (5.70) 0.28 (4.98) 0.47 (8.52) 0.31 (6.13) 7.2% (3.56) 0.53 0.73
BTOP50 0.30 (7.35) 0.14 (3.27) 0.34 (8.85) 0.30 (7.89) 6.2% (3.71) 0.47 0.69
ManagerA 0.43 (4.41) 0.38 (3.43) 0.38 (3.37) 0.26 (2.43) 5.5% (1.46) 0.48 0.73
ManagerB 0.51 (5.05) 0.31 (2.69) 0.61 (5.49) 0.23 (2.30) 1.2% (0.32) 0.36 0.66
ManagerC 0.22 (2.88) 0.33 (3.82) 0.68 (8.13) 0.49 (6.50) 1.7% (0.60) 0.59 0.72
ManagerD 0.41 (4.82) 0.51 (5.47) 0.57 (6.32) 0.37 (4.44) 1.6% (0.48) 0.49 0.70
ManagerE 0.49 (5.94) 0.42 (4.54) 0.65 (6.98) 0.38 (4.58) 3.1% (0.99) 0.55 0.78
%PositiveBetas,allMF
FundsinLipper/TassDB
83% 72% 82% 73%
FixedIncomeTSM CurrenciesTSM
Intercept
(annualized)
CommoditiesTSM EquitiesTSM