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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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Comparison of Portfolios, January 1997- May
2010
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Annualized Return |
Volatility
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Portfolio One
100% EM |
7.2% |
26.7% |
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Portfolio Two
50% EM, 50% US Equities |
6.5% |
20.1%
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Portfolio Three
50% EM, 50% Managed Futures |
7.5% |
13.8% |
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EM= MSCI EM EMEA Index
US Equities = S&P 500
Total Return Index
Managed futures =
Barclay CTA Index
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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.
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