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Combining Emerging Markets with Managed Futures
By Chidem Kurdas

Increased allocation to emerging markets is one of the notable investment trends of recent years. Another large flow of capital to EM may be imminent. The chairman of Goldman Sachs Asset Management, Jim O'Neill, has remarked that at recent meetings he heard repeated discussions of "pending significant asset allocations to the brave new world."

Many institutions like Harvard University's endowment turned to fast-growing countries, in particular China and India, for higher returns. There was also a hope that EM holdings would help diversify portfolios heavy in US and other developed economy stocks. That hope was to an extent dashed by the 2008 crisis. Emerging markets went down together with developed markets, though they recovered quicker.

With a lot of money going to EM, this is a good time to look at how this asset class does in a portfolio that contains managed futures. A study from MF Global Alternative Investment Strategies has an interesting set of comparisons.

Drawdowns

For the 14-year period from January 1997 through May 2010. Emerging markets - represented by the MSCI EM EMEA Index - were significantly more volatile than US stocks. The largest drawdown in the EM index during this time was more than 64%, compared to 57.8% for the S&P 500.

A 50-50 blend of EM and US stocks has less volatility than EM on its own, but with lower return-Portfolio One vs. Portfolio Two in the table. No surprise there. By contrast, a portfolio that combines EM with managed futures in equal parts substantially lowers volatility while achieving a higher return (Portfolio Three).
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Source: MF Global Alternative Investment Strategies
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Why does combining managed futures with an allocation to equities, in particular EM equities, benefit both risk and return? Adam Rochlin, head of MF Global Alternative Investment Strategies, points out distinct factors that operate in different stock market environments.

Down vs. Up Markets

During periods of drawdown, managed futures behaves differently from equity investments, including international and EM equities. In times of distress such as 2008, futures investing has the ability to deliver positive returns-because commodity trading advisors take advantage of trends or use their ability to short contracts.

But there is also a surprising benefit during stock market booms. Managed futures becomes positively correlated with EM in the up part of the cycle.

In down-markets there is no or negative correlation. Why the positive relationship in up-markets? Mr. Rochlin suggests one reason. Emerging economies are heavily dependent on commodities for consumption. So when they grow fast, they create more demand for commodities. As a result you get positive returns for both EM stocks and commodity-oriented contracts in up-markets.

This is good news for investors, Mr. Rochlin says. You can take advantage of the negative correlation during stock market declines-when EM goes down there is a high probability that managed futures will gain. In run-ups, the correlation turns positive due to the consumption effect that powers both EM stocks and commodity-related investments. Then you can benefit from higher returns on both asset classes.