Diversification with Managed Futures

Riddle - What investment class did very well in 2008, which is highly liquid, and a good addition to most Institutional Portfolios?

Over 25 years ago, Harvard professor John Lintner presented a treatise on the benefits of adding managed futures (also known as “Commodity Trading Advisors” or “CTAs”) to institutional portfolios of equities and fixed income instruments. Lintner’s findings demonstrated that managed futures exhibited greater risk adjusted returns than traditional asset classes, and that the addition of managed futures reduced the overall risk profile of the portfolio substantially.

In the concluding remarks of his paper, Lintner noted “The Potential Role of Managed Commodity Financial Futures Accounts (and/or Funds) in Portfolios of Stocks and Bonds”, he said that managed futures have historically offered benefits of low correlation to stocks and bonds.

Professor Lintner’s analysis remained salient throughout the recent meltdown in financial markets, which was in many ways, the ultimate litmus test.

While equity markets plummeted, managed futures traders saw solid returns in 2008. The Barclay BTOP 50 index, which replicates the managed futures industry by aggregating the performance of the largest commodity trading advisers, returned 13.50 per cent for the year which saw the S&P 500 drop 38.50 per cent. During the fourth quarter of 2008, in which the bear market for equities created the largest drawdown in the S&P 500 since Black Monday, the index fell 22.56 per cent while the BTOP 50 gained 8.73 per cent.

2008 was representative of a trend that was glaring over the past two decades: managed futures have consistently outperformed the traditional asset classes during market dislocations, ranging from the recent credit crisis to the Dotcom bust to Iraq’s invasion of Kuwait in the early 90’s.

Managed futures as a trading style are characterised by low, sometimes negative correlations to equities and fixed income instruments. From the period of January 1990 to December 2009, the BTOP 50 index has a correlation of -0.14 with the S&P 500 and a 0.27 correlation with the Barclays Bond Composite Global index. Managed futures traders are also generally uncorrelated with hedge funds.

In a three-year rolling timeframe from 1990 to 2009, the Barclay CTA index has not posted a negative period. CTAs tend to have risk management protocols that emphasise strict adherence to stop-loss limits.

CTAs may generate profits during difficult periods for traditional assets. As markets become dislocated and trends surface, CTAs employing trend following strategies are able to capture profitable moves as assets flow across markets as they attempt to reestablish equilibrium. The volatility that may negatively impact equity markets can also create profitable opportunities for CTAs. In general, managed futures programs have the ability to go long, short, or market neutral which can help to quickly recover losses by generating returns in markets trending in the opposite direction.

Trend following may be the most predominate trading strategy among CTAs, but it is far from the only tool in the trading manager’s arsenal. The trading strategies a CTA can implement include more discretionary, fundamentally driven strategies. Counter-trend and arbitrage are common as well. Quantitative strategies can develop advanced techniques derived from neural networks, genetic algorithms, and other scientific disciplines.

High frequency, short term trading strategies have also grown in recent years as the technologies and models used by commodity traders have become more sophisticated. The managed futures universe is comprised of a variety of trading strategies that can generate absolute returns in different market environments.

The benefits of managed futures extend well beyond its low correlations and versatility. CTAs trade highly liquid instruments in transparent markets and exchanges. These managers generally employ disciplined risk management geared toward limiting losses with well defined stops. Commodity traders are highly regulated and required to undergo extensive government background checks and register with the Commodity Futures Trading Commission before they can manage an investor’s allocation. CTAs are also generally required to submit disclosure documents and independent financial audits to the National Futures Association for regulation. The value of liquidity and transparency of managed futures are tremendous to the institutional investor.

The case for diversifying into managed futures is as strong as when Mr. Lintner argued for the inclusion of managed futures in institutional portfolios in 1983. The enhanced risk adjusted performance, transparency and liquidity of managed futures offer institutional investors an excellent opportunity to obtain exposure to a diversified, global array of instruments. While some portfolio managers seem to have amnesia about the 2008 turmoil in the capital markets and seem doomed not to learn from history, other savvy groups are making prudent allocations to managed futures and know the answer to the riddle posed at the beginning of this article.

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