DC Spotlight: Managed Futures — The Ultimate Diversification
Managed Futures — The Ultimate Diversification
We all are familiar with the phrase, “There is no such thing as a free lunch.”
It is a slightly cynical adage based on the idea that all things come with a cost, even if that cost is not immediately visible. Wikipedia cites its origins to the practice of Old West-era saloons offering free lunch to paying bar customers. They provided salty foods to patrons to create thirst, which caused them to drink more. This practice continues in various forms to this day.
A more recent example of this concept is the idea that free access to search engines and social media platforms like Facebook are not necessarily free. A corollary to the “no free lunch” adage is “If you are not paying for it… you are the product.” Here, in exchange for what appears to be a free service, people expose themselves to advertising targeted to the footprint they leave in searches and social media likes.
The “no free lunch” concept has risen to the level of a truism or a law of economics in many circles but was challenged in the investing arena by Michael Dever in his book, “Jackass Investing: Don’t Do it, Profit From it.”
Dever, founder and CEO of Commodity Trading Advisor Brandywine Asset Management Inc. argues that the concept of no free lunch is a myth and that diversification in investing offers a proverbial free lunch. He defines the myth of no free lunch as: “If you desire to earn a higher return on your money, you must be willing to accept higher risk.”
While diversification has been touted for many decades in investment circles, Dever points out that most traditional investment strategies still get this wrong. That is because they cite diversification within an all-stock portfolio or creating the standard 60/40 stock and bond mix to achieve it.
The key to Dever’s argument is a more detailed view of diversification. To not simply mix small cap and large cap stocks, or build a typical mix of stocks and bonds, or even stocks, bonds and real estate, but to dig deeper and find the underlying return drivers of each investment. You need investments with different, non-correlated return drivers to achieve that free lunch.
While a unique and compelling argument, Dever does not present anything new. Numerous studies over the years have proven that when you add a managed futures allocation to a traditional portfolio it improves returns and reduces risk, or the net return-to-risk ratio.
Thirty-five years of academic research highlight the value of adding managed futures to traditional investments to reduce risk and enhance risk-adjusted returns.
In 1983, John Lintner examined “The Potential Role of Managed Commodity-Financial Futures Accounts (and/or Funds) in Portfolios of Stocks and Bonds,” at the annual conference of the Financial Analysts Federation. He noted, “The combined portfolios of stocks (or stocks and bonds) after including judicious investments in appropriately selected sub-portfolios of investments in managed futures accounts (or funds) show substantially less risk at every possible level of expected return than portfolios of stock (or stocks and bonds) alone.”
The idea of adding a futures strategy to a traditional investment portfolio was a new concept in 1983, as you can tell by the overly qualified description in the Lintner paper. In fact, the traditional investment world strictly adhered to the Efficient Market Hypothesis (EMH), which believes stocks are priced efficiently and traders cannot gain an edge. The EMH completely discounts any value in trend following, the dominant managed futures approach. In a sense, EMH argues for the “no free lunch” concept.
But with the growth of financial futures providing more products and the expansion of systematic trading programs, managed futures — particularly trend-following managers — were gaining followers and allocations. And Modern Portfolio Theory (MPT) introduced by Harry Markowitz, was gaining followers. MPT highlights the benefits of including numerous non-correlated strategies in a portfolio to enhance returns and reduce risk.
Proponents of managed futures jumped on the non-correlated benefits of futures when included in a traditional portfolio mix. A 2005 paper by Ibbotson Associates titled “Managed Futures and Asset Allocation” makes a strong case for managed futures. It concludes, “Including managed futures improves the risk-return tradeoff of the long-term asset allocation portfolios, thus benefiting long-term investors…managed futures exhibit superior performance while most other asset classes underperform.”
Notice the difference in language from the Lintner paper, though the results were similar.
A 2018 white paper by Coquest Advisors titled “Managed Futures Strategies in a Portfolio,” builds on the growing consensus. It points out that managed futures is not only non-correlated to traditional stock and bond investments, but also to other hedge fund alternatives (Figure 1).
This is important because there has been strong resistance to futures strategies by institutional investors and many portfolio managers choose to diversify with equity-based hedge funds rather than managed futures.
This proved to be a disaster for investors during the 2008 credit crisis when managed futures outperformed all traditional asset classes as well as all hedge fund strategies (with the possible exception of short-sellers).
Researchers now began to explore the performance of managed futures during highly volatile periods for stock and tout a new benefit called “Crisis Alpha,” (Figure 2).
As you can see, managed futures performed extremely well during some of the worst periods for stocks. As Dever would put it, the volatility or market dislocations that harmed stocks was a strong return driver for managed futures.
The Coquest paper also highlighted many additional benefits of managed futures. Not only does it provide diversification and non-correlation, but it provides greater transparency, liquidity and capital efficiencies than most traditional investments.
Still, the key benefit of adding managed futures to a traditional portfolio is the improved risk-adjusted returns. Figure 3 shows the impact on various risk metrics when you combine the performance of the Barclay CTA Index (managed futures) with the S&P 500 total return index.
Despite strong academic research on the value of managed futures, there has been a great deal of resistance in traditional portfolio management.
Even for those brave enough to venture in, the leverage allowed in futures is seen as an impediment. How do you select a manager? This can be difficult because track records can be hard to decipher. Since a great deal of leverage is allowed in futures trading, it is important to understand a manager’s return and what they risk to achieve that return.
Seeing this, Coquest Advisors looked for a way investors could make a more informed decision when investing in managed futures. In 2013, Coquest launched the CTA Challenge to highlight the best commodity trading advisors, and more importantly, to provide potential investors a stronger tool to select managers and allow them to make an apples-to-apples comparison based on risk-adjusted returns.
Next week: the launch of the CTA Challenge.
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Disclosure: The risk of loss in trading futures and/or options is substantial. Past performance is not indicative of future results. The information in this message derived from third-party sources is believed to be accurate and reliable; Coquest does not guarantee the accuracy or completeness of the information. Opinions expressed in this material are subject to change without notice. This report should not be interpreted as a request to engage in any transaction of futures, options, and/or OTC derivatives. The information contained in this material is not to be relied upon in substitution for the exercise of your independent judgment. Seek independent financial, tax, legal, and accounting advice from your own professional advisers, based upon your particular circumstances.