In this series, we present research-based insights to help develop the understanding of managed futures, an often misperceived investment area. Sometimes people assume that, because the industry consists of money managers called commodity trading advisors, it is about just commodities. In fact the managers trade futures contracts in a wide variety of underlying markets—grains, foods, fibers, energy and metals, but also currencies, stock indexes and interest rate instruments ranging from Australian government bonds to US Treasury notes.
That's not the only misunderstanding. Some investors believe that managed futures add risk to a portfolio. Here Tim Merryman, a managed futures consultant at Intercontilimited.com and a CTA (Quant-Trade LLC), analyzes certain key risk and return characteristics of futures markets. His point: managed futures represent an ideal way to mitigate both market and systemic risk.
Reliable Portfolio Diversification
Futures markets are not the “casinos” many believe them to be. Rather, they act as insurers, like Lloyd's of London or Swiss RE. But unlike traditional insurance or the more recently developed and much criticized credit default swaps, futures have long traded in centralized venues. In these futures exchanges, risk can be passed on by those who seek price stability – such as farmers or oil companies – to others who are willing to take this risk in order to earn extra profit.
The two sides negotiate transactions to the satisfaction of both parties. Pork belly producers hedge the price of pork bellies by locking in a certain price for delivery at a future date, while meat processors use the futures contract to ensure they get an adequate supply of pork bellies. Many people who are unaware of futures instruments benefit from the steady, reliable and reasonably-priced supply of goods and services created by this mechanism.
This has been going on in agriculture for two centuries in its current form and for millennia in the form of barter. The mechanism has developed way beyond pork bellies—though that specific market continues to be active. Financial futures have been trading for two generations and new instruments like weather futures have created new possibilities for transferring unwanted risk.
For the modern investor, futures offer a way to offset risk in the portfolio. The past two years showed that diversification, the Holy Grail of modern portfolio theory, is elusive in a severe downturn. As the credit crisis of 2007 morphed into economic recession in 2008, investments that previously appeared to be diversified went down together. Everybody was forcibly reminded of an old adage—the only thing that goes up when markets go down is correlation.
In contrast to other investments, managed futures proved to be a real diversifier and risk reducer. This is not surprising when you look at the historical track record of commodity trading advisors as a group and compare it to other asset classes.
Managed futures add real diversification to a portfolio for several reasons. For one, futures represent potential hedges against such factors as business cycle movements and inflation or deflation risk.
Also, CTAs often target many markets using multiple strategies. These traders are almost uniquely flexible. Unlike mutual funds, managed futures programs are not limited in what they do. CTAs can buy and sell futures, write or purchase options, and speculate in bull or bear markets. They do not need to pursue a single view as a bull or a bear.
A trader in futures markets can nimbly take positions across the world. Foreign exchange and financial index futures allow for global diversification without the need for a fine-grained focus on several thousand stocks or bonds worldwide. Moreover, by their very nature commodities are dependent upon global factors.
These characteristics make managed futures diverge from major markets, unlike certain hedge fund strategies. Long/short equity returns, for instance, strongly track the US stock market with a correlation of 93%, whereas this correlation is negative 23% for managed futures.
What is more, CTA performance is not much related with fixed income—the correlation is 30%, according to Barclay Hedge. As last year demonstrated, managed futures tend to do well when equity and credit markets slump.
Correlation of Alternative Strategies to US Stock Market
Long/short Equity* 93%
A study published by the Chicago Mercantile Exchange concluded that for a 20-year period ending in 2008, portfolios with up to 20% of assets in managed futures yielded as much as 50% more returns than portfolios consisting only of stocks and bonds, with comparable risk. The graph below shows that a traditional portfolio (50% stocks, 50% bonds, and no managed futures) presents an investor with the greatest risk and lowest return. A portfolio comprising 39% stocks, 39% bonds and 22% managed futures offers the best combination of return and risk.
Countless investors might have been spared at least some of the financial destruction they endured in 2008 had they seen fit to allocate a small portion of their investment capital to this sector as a hedge against just the type of economic tsunami we're experiencing. Indeed, the term “hedge” applies to this asset class much more accurately than it does to a hedge fund strategy like long/short equity or even distressed debt investing.
No Fat Tails
There is a common misconception that futures-related investing is a form of “speculation” and hence poses high risk. If anything, the opposite is true for the industry as a whole. While individual CTA programs can have large drawdowns, as a group they have a remarkably stable profile compared to almost any other asset class over the past decade.
In a performance scorecard for both traditional and alternative investments from 1998 through 2007, futures returns are remarkable in being persistently positive and avoiding extremes. One expects the worst and best performers to vary from year to year, but some asset classes show up frequently in either category. Thus commodity index returns often move from the very top of the ranking to the very bottom from one year to the next.
There is a sharp contrast in this respect between the commodity index and managed futures, despite the commodity component of CTAs. Managed futures are never at the bottom of the ranking. Neither are they at the top. Through the market cycles, managed futures come out consistently in the middle of the distribution.
Unlike equities or the commodity index, managed futures as a whole does not yield more than 30% a year – although individual managers can make very high annual returns in some conditions – but neither does it lose money. It stays within a relatively narrow band, ranging from 3% to 18%. In view of this history, CTAs stayed true to form during the 2008 storm. Far from adding to the danger, managed futures acted as a hedge.
Ten Years' Markets Comparison*
** An asset class performance comparison for 2008 is on p.2.