Managed Futures introduced
Return characteristics
Strategies explained
By Evan Cooperman
Raise your hand if you own a cell phone. Raise your other hand if you are locked into a contract with your cell phone’s service provider. If you are sitting at your desk, staring at your screen with both hands up in the air then you are a futures trader! By entering into a contract with the cell phone company to receive a specific number of minutes at a certain price every month for the next two years you have secured your price, regardless of whether the price of cell phone plans rises or falls during that time. By entering into this agreement you have reduced your risk of higher prices, but cannot take advantage of lower prices. This contract is similar to a futures contract in that you have agreed to receive a product/service at a future date, with a specified price and terms. (OK, you can put your hands down now.)
History
Before the advent of futures markets, farmers would grow their crops and then cart their harvests to major population centers in search of buyers. Unfortunately, since most farmers came to the market at the same time, supply usually exceeded demand and prices fell. In fact, supply was so great that un-purchased crops were often left to rot in the streets or dumped into lakes for lack of storage. On the other hand, if commodities like wheat were out of season, then products made from it became very expensive due to lack of supply.
In the mid-19th century, a central marketplace was created for farmers to sell their produce either for immediate or forward delivery. Forward delivery or, forward contracts, were the forerunners to today's futures contracts. The forward contract allowed farmers to sell a certain quantity of their produce at a future date for a pre-determined price. This handy risk management tool helped farmers lock in production profits, thereby stabilizing supply and prices in the off-season.
Modern futures markets serve the same purpose – to provide an efficient medium that allows producers and consumers to manage price risks.
Our focus this month
When considering investment vehicles, most people look at stocks and bonds. Others invest in real estate and perhaps some private equity. In past newsletters, I made the case for alternative investments, and we have looked at hedge fund investing in general and long/short equity in particular. This month we look at managed futures and how its inclusion impacts a portfolio’s performance. We also try to get a better understanding of the characteristics of managed futures, with a key focus on the strategy’s risks. Most important, we will see how including managed futures in your portfolio can save your tail when markets go the wrong way.
Managed Futures
A managed futures strategy seeks to generate returns through long and short positions in various futures contracts. In this manner, the manager may make a call on the direction of market prices of commodities, equity indices, fixed income and currencies. In most cases, the strategies are executed by Commodity Trading Advisors (CTAs). Before we take a look at individual strategies let’s examine the implications of including this asset class in your portfolio.
On correlation
Remember that in portfolio design our objective is to include non-correlated assets. Alternative investments are generally non-correlated to traditional investments like stocks and bonds. Let’s see if this applies to managed futures.
|
Table 1: Comparing the Correlations of Managed Futures, Commodities and Equities (January 1980 – February 2005) | ||||
|
|
Barclay CTA Index |
Tuna CTA / Managed Futures |
S&P 500 |
S&P/TSX Composite |
|
Barclay CTA Index |
1.00 |
|
|
|
|
Tuna CTA/Managed Futures |
0.88 |
1.00 |
|
|
|
S&P 500 |
0.01 |
-0.02 |
1.00 |
|
|
S&P/TSX Composite |
0.04 |
0.04 |
0.76 |
1.00 |
Have a look at Table 1 above. The Barclay and Tuna CTA Indices have very low correlations to both the S&P and the TSX. Read on to see how these low correlations and their resultant diversification benefits can translate into more dollars in your pocket!
A look back in time
We assess historical returns in Table 2, by comparing the typical ‘balanced portfolio’ to one that includes hedge funds and one that includes hedge funds AND managed futures over the period January 1990 to February 2005.
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Table 2: Effect of Adding Hedge Funds and Managed Futures to a Portfolio Annualized Risk / Return Statistics (January 1990 – February 2005) | ||||
|
Allocation |
Return (%) |
Std Dev (%) |
Growth of $1MM invested |
Alpha vs. Benchmark |
|
1. Benchmark Traditional Balanced Portfolio: S&P 500 60%, Lehman Bonds 40% |
9.8 |
9.1 |
$3,118,800 |
0.0 |
|
2. Adding Hedge Funds: S&P 500 50%, Lehman Bonds 30%, HFR Equity Hedge 20% |
11.4 |
8.8 |
$4,143,100 ($1,024,300 better than benchmark) |
1.7 |
|
3. Adding Hedge Funds AND Managed Futures: S&P 500 40%, Lehman Bonds 20%, HFR Equity Hedge 20% AND CTAs* 20%, |
12.1 |
7.4 |
$4,638,300 ($1,519,500 better than benchmark) |
3.3 |
|
*CTAs represented by Barclay CTA Index 10% and Tuna CTA/Managed Futures Average 10% | ||||
Allocation 3 proves that adding hedge funds AND managed futures to a traditional balanced portfolio increases returns and decreases the portfolio’s risk. In fact, the compound return over 15 years leads to an additional $1,519,500!
This may be enriching, but the true value of including managed futures in a portfolio is demonstrated in a period when markets are falling. The S&P 500 began its decline in March 2000, finally digging its way out in March 2003. Table 3 examines whether managed futures would have saved us during this downturn.
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Table 3: Effect of Adding Managed Futures and Hedge Funds to a Portfolio in Falling Markets (Annualized Risk / Return Statistics: March 2000 – February 2003) | ||||
|
Allocation |
Return (%) |
Std Dev (%) |
Growth of $1MM invested |
Alpha vs. Benchmark |
|
1. Benchmark Traditional Balanced Portfolio: S&P 500 60%, Lehman Bonds 40% |
-4.3 |
10.8 |
$876,600 (Loss of $123,400) |
0.00 |
|
2. Adding Hedge Funds: S&P 500 50%, Lehman Bonds 30%, HFR Equity Hedge 20% |
-4.3 |
10.4 |
$876,500 (Loss of $123,500. $100 worse than benchmark) |
-0.4 |
|
3. Adding Hedge Funds AND Managed Futures & Commodities: S&P 500 40%, Lehman Bonds 20%, HFR Equity Hedge 20% AND CTAs 20% |
-1.6 |
8.0 |
$952,500 (Loss of $47,500. $75,900 better than benchmark) |
0.4 |
Volatility can be good
Managed futures strategies entail significant amounts of volatility. However, a large part of this volatility is to the upside. In other words, the return distribution for managed futures is positively skewed. This means that managed futures will generate a larger than expected number of extreme returns, which are more likely to be positive than negative. What does this mean in context of your portfolio? As Table 3 above highlights, when markets are down, including hedge funds and managed futures in a portfolio leads to a better risk/return profile with smaller drawdowns.
So, if these investments are so good, why aren’t people piling money into this strategy?
The answer of course is that they are! In fact, the smart money has been doing so for quite some time. In my March 2005 newsletter I noted that the hedge fund industry is growing at a fantastic rate. In fact, it is estimated that in 1980 the industry had US$193 million under management, rising to US$7.2 billion by 1990 and according to HFR the industry just hit the US$1 trillion benchmark. For those who like to crunch numbers this is an annual compound growth rate of approximately 40%!
There is a similar story for Managed Futures. In 1980 the industry had $310 million under management, rising to $38 billion by 1990 and $131 billion today. So what do these people know that we don’t? Growth in demand for managed futures is indicative of investors’ recognition of the benefits – namely reduced portfolio risk, potential for enhanced returns and the ability to make money in varying economic environments. Let’s take a closer look.
The strategies
CTA trading disciplines are generally systematic or discretionary in nature. Systematic managers use price and market-specific information (often technical) to follow trends. Discretionary managers use a less quantitative approach, relying on both fundamental and technical analysis.
Systematic trading
This strategy uses proprietary computerized models to generate buy and sell decisions. The ‘system’ incorporates rules based on quantitative analysis of market trends and indicators, hence the term ‘trend followers’. Trend followers will invest when the market is trending in a particular direction and exit the trade when they think market indicators signal a turn.
Systematic models can be divided into long-term and short-term. Long-term models are mostly momentum based. CTAs analyze momentum indicators, such as moving averages, to detect extended price trends. Most trades in this strategy will lose money but, if the CTA’s models are optimized, they can generate profits by closing losing positions quickly but remaining in profitable trades longer. Short-term models use a greater number of statistical tools and sophisticated analytics to exploit measurable short-term market inefficiencies.
Discretionary trading
This active management approach primarily involves fundamental analysis but can also combine technical analysis. Trading decisions are largely based on the study of external factors that affect the supply and demand of a particular security or asset. The key to success in this strategy is to invest with managers with extensive experience in the commodity or currency markets. These managers have an edge in their knowledge of market fundamentals, and can anticipate changes in supply and demand factors affecting security prices. By monitoring relevant factors, managers can opportunistically trade when markets are in a state of disequilibrium.
Risks
First we will look at the risks associated with discretionary and systematic managers and then we examine the risks inherent in managed futures investing.
The main risk of systematic strategies is market risk, that is, the risk of the market moving against an established position. Trend-following strategies face the risk of steady losses in non-trending, directionless market environments. Since systematic trading models are based on research of past performance, there is the risk that the model may be flawed or unsuited for today’s markets. This is known as model risk.
As with systematic strategies, discretionary managers are also susceptible to market risk. Directional positions based on fundamental analysis are exposed to event risk as external events can have a negative impact on the portfolio.
A major risk inherent with all managed futures and commodities strategies is that of leverage combined with highly volatile markets. There are different margin requirements depending on the futures contract or exchange on which they are traded, but it is not uncommon to have the ability to lever up to 20X on an investment. If managers are highly levered and the market moves against them, it will not take long until they are forced out of the game.
Conclusion
In our opinion the best way to gain exposure to managed futures is by having a diversified basket of carefully chosen CTAs. These CTAs should be best of breed, with years of experience and a focused niche strategy.
Adding managed futures to your portfolio further increases the depth of your investor toolkit. By including these non-correlated strategies, you can diversify your portfolio to earn better returns with less risk. In short, think of managed futures as an insurance policy that can increase your chances of weathering the financial storms that are sure to ensue in an uncertain world.
To summarize, managed futures can be used as a means to:
§ Reduce portfolio volatility;
§ Enhance portfolio returns in economic environments in which traditional stock and bond investment vehicles offer limited opportunities, and;
§ Gain access to a variety of new financial products and markets not available in the traditional investors toolkit.
Graduation
Now that we have had a good introduction to alternatives and due to time constraints I am going to graduate the newsletter to quarterly publication. I appreciate your comments to date and look forward to continuing our examination of alternative investment strategies.
Note:
If you have requests or suggestions on subject matter for future e-letters I would greatly appreciate your letting me know. If you do not wish to receive these emails in the future, please email ecooperman@primequad.com. If this email has been forwarded to you and you would like to subscribe, please contact me at ecooperman@primequad.com
Past results are no guarantee of future performance.
This newsletter is for educational and informational purposes only and is not a solicitation to invest, and should not be construed as such.
Prime Quadrant LP®
Your Financial Navigator™
Evan Cooperman: (416) 410-3648 x2
M4V 1N6