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Opalesque Futures Intelligence

Futures Lab: New handbook by Mark Melin offers comprehensive guidelines for managed futures investing, including ways to deal with risk.

Tuesday, November 16, 2010

Nuts and Bolts for Investors
By Chidem Kurdas

Just in time to meet the growing interest in managed futures, there's a new handbook for investors, High-Performance Managed Futures: The New Way to Diversify Your Portfolio by Mark Melin (Wiley, 2010). Below is a review and some highlights, in particular on how investors can control specific risks.

Mr. Melin is a director at PFG Best, a futures commission merchant. He's written and edited other books, including The Chicago Board of Trade Handbook of Futures and Options.

In the new book, he points out that assets have grown 700% in 10 years, yet managed futures remains something of a mystery to the investing public. "It is amazing that managed futures is one of the fastest growing asset classes and yet it remains relatively unknown and misunderstood," he says.

The book starts with an overview, which will be useful to beginner investors, and a description of the regulatory system. There is an excellent chapter on volatility, arguing that volatile but uncorrelated investments can be used to reduce the volatility of the overall portfolio - as pioneering research by Lintner and Markowitz showed.

Mr. Melin explains the managed futures account structure and how it protects investors, how to establish performance and risk targets and how to identify successful commodity trading advisors and construct a portfolio of them. He discusses reward-adjusted deviation, principal-protected investments and a variety of related subjects.

His opinions are a useful part of the discussion, though not everybody will agree with him on every topic.

Thus the chapter on risk not only lays out various hazards in managed futures investing but also Mr. Melin's useful comments on each and suggested ways of avoiding bad outcomes. He identifies three basic categories of risk, or choke points (Table 1). Of these, he sees individual manager risk as presenting the most significant problem.



Three Major Choke Points

Risk Comment How to Control
Unmonitored Margin and Leverage most common watch margin-to-equity ratio

Individual Manager

most significant avoid concentration
Fraud most preventable get segregated account


Source: High-Performance Managed Futures, discussion in chapter 11.

Individual manager risk is a catchall bucket that includes all decisions made by a CTA. It ranges from the time frame of trade execution to business operations. Mr. Melin occasionally describes this as unsupervised manager risk, but a CTA might have the wrong time frame for tracking a trend, for instance, and make a loss, no matter how carefully the clients watch their investments.

As he notes, the source of individual manager risk is concentration in a single CTA program or an undiversified portfolio of CTAs. Hence investing in a group of CTAs with diverse strategies and performance characteristics is the way to manage the risk. Mr. Melin compares multi-manager CTA portfolios to a single top-performing CTA to illustrate the power of diversification (Table 2). The drawdowns and risk-adjusted returns (Sharpe ratios) tell the story.



Hypothetical Combinations of CTAs vs. Single CTA

Compounded Annual Return Worst Drawdown Sharpe Ratio
Conservative portfolio 7.7% 6.6% 0.85
Aggressive portfolio 35% 32% 1.02
Top CTA 22.6% 43% 0.43


Source: High-Performance Managed Futures, p. 44.

Most of the writing in the book is clear and straightforward, if not very engaging. This is not light reading. It requires patience, attention to numbers and willingness to follow abstract arguments. A website, contains much useful material and is to be updated regularly.

None of the points made in the book will surprise seasoned managed futures investors, but this wide-ranging primer should be a valuable resource for newcomers to the industry.

This article was published in Opalesque Futures Intelligence.
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