Wed, Sep 17, 2014
A A A
Welcome Guest
Free Trial RSS
Get FREE trial access to our award winning publications
Opalesque Futures Intelligence

Futures Lab: Professor Harry Kat demonstrates that combining managed futures and hedge funds is a match made in heaven!

Tuesday, May 05, 2009

A Match Made in Heaven: Combining Managed Futures and Hedge Funds

The following is a summary of a working paper by Harry Kat, professor of risk management at Cass Business School, City University, London. While written in 2002, this analysis is extremely timely as investors turn to the question of portfolio re-construction after last year's crisis decimated most assets. The original paper is available at http://papers.ssrn.com.

The 2008 experience vividly demonstrated the correctness of Professor Kat's conclusion that managed futures can be used to reduce risk in a portfolio of alternative and traditional investments. Managed futures were almost unique in not correlating with major markets during the turmoil and their positive skew –or right tail – showed up as robust returns in an otherwise terrible year for investors.

Mr. Kat is widely known for his studies on replicating hedge fund returns.

In this paper we investigate how managed futures mix with stocks, bonds and hedge funds and how they can be used to control the undesirable skewness effects that arise when adding hedge funds to portfolios of stocks and bonds.

We find that managed futures combine extremely well with stocks and bonds as well as hedge funds and that the combination allows investors to significantly improve the overall risk characteristics of their portfolio without giving up much expected return.

In the analysis below, stocks are represented by the Standard & Poor's 500 index, bonds by the Salomon Brothers Government Bond index, and hedge funds by the median equally weighted portfolio of 20 individual funds. Managed futures are represented by the Stark 300 index. This asset-weighted index is compiled using the top 300 trading programs from the Daniel B. Stark & Co. database. The top 300 programs are determined quarterly, based on assets under management. Currently the index contains 248 systematic and 52 discretionary traders.

Throughout we use monthly return data over the period June 1994 to May 2001. For bonds, hedge funds and managed futures we use the sample mean as our estimate of expected return. For stocks, however, we assume a 1% per month expected return as we feel it is unrealistic to expect an immediate repeat of the 1990s bull market.

From Table 1 we see that the correlation of managed futures especially with stocks and hedge funds is extremely low. This means that managed futures are potentially very good diversifiers.

Correlations

 S&P 500BondsHFMF
S&P 5001    
Bonds0.151 
HF0.63-0.051 
MF-0.070.20-0.141

We study the impact of managed futures for investors that always invest an equal amount in stocks and bonds. Adding hedge funds and managed futures to the portfolio, these 50/50 investors will reduce their stock and bond holdings by the same amount. For instance, a 20% hedge fund allocation means 40% stocks and 40% bonds. Ditto a 20% managed futures allocation.

The first step is to see if there are any significant differences in the way hedge funds and managed futures combine with stocks and bonds.

We see in Table 2 that increasing the hedge fund allocation reduces the standard deviation and skewness of a 50/50 portfolio. Increasing the managed futures allocation, however, results in a faster drop in the standard deviation. More remarkably, skewness rises instead of declining and becomes positive. Although hedge funds offer a somewhat higher return, from an overall risk perspective managed futures clearly are better diversifiers than hedge funds.

Monthly Return Statistics, 50/50 Stock/Bond Portfolio

Adding Hedge Funds
%HFMeanSDSkew
00.722.49-0.33
100.742.38-0.46
200.772.29-0.60
300.802.22-0.72
500.852.16-0.87
Adding Managed Futures
%MFMeanSD Skew
00.722.49-0.33
100.712.26-0.21
200.712.08-0.06
300.711.950.1
500.711.910.34

Following table shows how hedge funds and managed futures combine with each other. Adding managed futures to a hedge fund portfolio puts some downward pressure on returns because the expected return on managed futures is lower. However, from a risk perspective the benefit of managed futures is very substantial.

Adding managed futures results in a large decline in the portfolio return's standard deviation. Giving up 10 to 15 basis points expected return does not seem an unrealistic price to pay for the improvement in overall risk.

Adding Managed Futures to Hedge Fund Portfolio
%MFMeanSDSkew
0 0.992.44-0.47
100.962.18-0.27
200.931.96-0.03
300.901.810.20
500.851.760.39

In summary, the inclusion of hedge funds boosts a portfolio's expected return while reducing the standard deviation. But introducing hedge funds has a negative skewness effect. An allocation to managed futures neutralizes this unwanted side effect of hedge funds. Hence overall portfolio risk can be reduced by combining both hedge funds and managed futures with stocks and bonds.

To make sure the findings have general validity and are not due to the particular choice of index, we repeated the analysis with different CTA indexes, including indexes calculated by the Barclay Group. In all cases the results were very similar to what we reported above.



 
This article was published in Opalesque Futures Intelligence.
Opalesque Futures Intelligence
Opalesque Futures Intelligence
Opalesque Futures Intelligence
Today's Exclusives Today's Other Voices More Exclusives
Previous Opalesque Exclusives                                  
More Other Voices
Previous Other Voices                                               
Access Alternative Market Briefing


  • Top Forwarded
  • Top Tracked
  • Top Searched
  1. SEC charges 19 investment firms and one trader for breach of Rule 105[more]

    Benedicte Gravrand, Opalesque Geneva: The Securities and Exchange Commission (SEC) started a push to enhance the enforcement of Rule 105 of Regulation M last year to uncover hedge funds and private equity firms that have illegally participated in an offering of a stock after short selling it duri

  2. Fund managers, bullish on Europe, anticipate monetary policy separation of Fed and ECB[more]

    Komfie Manalo, Opalesque Asia: At least 202 fund managers with $556bn of assets under management said that while the European Central Bank (ECB) has eased its monetary policy that sent sentiments towards Europe to pick up, the Fed is expected to hike its rate in the spring of 2015. Investor

  3. Investors looking at other sources for hedge fund-like returns[more]

    Komfie Manalo, Opalesque Asia: Investors who are always on the lookout for higher gains are looking at alternative sources of income, particularly exchange-traded fund industry that generates hedge fund-like returns, according to

  4. News Briefs - Limited partners of investment managers may be subject to self-employment taxes, Just one week left until NYC's Rocktoberfest[more]

    Limited partners of investment managers may be subject to self-employment taxes On September 5, 2014, the Internal Revenue Service (“IRS”) issued Chief Counsel Advice 201436049, concluding that members of an investment manager were subject to self-employment taxes with respect to their e

  5. Opalesque Exclusive: Old Hill Partners launches specialty finance fund[more]

    Bailey McCann, Opalesque New York: Asset-backed lending is starting to heat up again after a prolonged credit squeeze. The Financial Times reports that a record £18.9bn was borrowed from asset-based lenders in the three months to the end of June. Much of this lending is driven by advanc