Using Managed Futures To Lower Volatility

By lwmdemo4,

In recent years the mutual fund industry has seen an enormous expansion of alternative investing strategies which have made a variety of investment approaches that had historically been available only to the high net worth investor, available to the general public. There are a whole host of alternative strategies to choose from, each with the same ultimate objective of lowering investment correlations with traditional assets like stocks and bonds.

Among these strategies is the Managed Futures strategy. Managed Futures have demonstrated the lowest historical correlation to both stocks and bonds among all alternative investment strategies. Simultaneously, this approach has performed well across both bull and bear markets. As an alternative strategy, Managed Futures collectively posted positive returns during the 2008 financial crisis, the 2000 bursting of the dot.com bubble, as well as the oil crisis of the mid 1970s.

This is an investment strategy that has been actively pursued by hedge funds and commodity trading advisors (CTA’s) since the late 1970’s as the number of contracts available to be traded in different areas of the markets were expanded by futures exchanges. Futures contracts are very similar to options contracts on stocks, which many investors commonly use. Futures contracts are contractual agreements made on the floor of a futures exchange which may represent trades in equity indices, currencies, fixed income or commodities. Some contracts are settled in cash, and others are settled with physical delivery.

In a Managed Futures strategy, the CTA may use a number of approaches to implement their trades in the futures market. These strategies can be very narrow in their focus, while some are very broad in the approach. The primary driving strategy of the futures market, which is also the most broad based and consistently successful are the momentum trading strategies. This is an approach that attempts to capture changes in trading momentum using both short and long-term signals. These changes in momentum are often linked to studies on behavioral finance which demonstrate how our bias as a collective group of investors often leads to changes in underlying asset prices. This “herd” mentality creates opportunities for the Managed Futures CTA to capitalize on both positive and negative momentum changes.

Since 1980, the Barclays CTA Index has had an average return of 10.04% annually (Gross of Fees). During that time the correlation to the S&P 500 Index has been about .01. Simultaneously, their correlation to the US Bond Market has been 0.14. (A correlation of 1.00 represents two assets that move in tandem, while a correlation of 0.00 represents two assets which are totally uncorrelated.) The worst single drawdown loss was -15.66%. Due to the fact that many CTA’s have historically used a much higher fee structure than what is typically acceptable in most publicly traded mutual funds, the returns net of fees are more likely lower on an annualized historical basis. What this demonstrates is that managed futures for several decades have delivered investment returns comparable with equities in an uncorrelated manner. That lower correlation when combined with traditional stocks and bonds has historically meant similar returns with lower overall portfolio volatility.

It should be noted that there is a fairly wide grouping of results across the CTAs in the Managed Futures market, as is true with all alternative strategies. This is partially the result of the skill level of the manager, as well as whether the environment is particularly favorable for a given strategy. Managed Futures tend to fare well when there are more clearly defined trends of an asset class experiencing a significant change in pricing, regardless of whether they are positive or negative trends. In environments when markets are choppy and move in a sideways direction, many CTAs will have difficulty identifying a specific set of trends.

What is most important to note, is that Managed Futures, like all alternative strategies are not intended to be an independent investment approach to be used on a stand-alone basis. Nor is it intended to be compared directly to a specific market index as a choice between one versus the other. These types of alternatives are designed to be used in conjunction with a typical asset allocation of stocks and bonds, serving as yet another diversifier of an individual portfolio to lower overall volatility, with nominal impact to investment returns.

All alternative strategies should be thoroughly understood before being implemented. Many alternative strategies often sound similar, yet after more close evaluation we may find they take on a substantially larger degree of risk, and may be much narrower in their focus as compared to their peers. It is important to complete your due diligence before implementing these strategies, or consult with your financial advisor.

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