High-Performance Managed Futures E-Book

Mark H. Melin

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 503

Veröffentlichungsjahr: 2010

Beschreibung

A provocative and insightful look at using managed futures todiversify investment portfolios Financial advisors have long ignored managed futures. Yet, inthe past thirty years, managed futures have significantlyoutperformed traditional stock and bond investments. InHigh-Performance Managed Futures: The New Way to Diversity YourPortfolio, author Mark H. Melin advises investors to questionthe commonly held belief of stocks and bonds, buy and hold. Thefirst book of its kind, Melin advances a Nobel Prize winninginvestment method that's been updated for today's worldto describe how managed futures can be used to design portfoliosindependent of the ups and downs of the stock market. Thebook: * Details a new path for managinginvestments that's not entirely dependent on the economy atlarge * Describes meaningful assetdiversification, while exposing Wall Street myths on thesubject Many of today's investor's are betrayed by eithershort-term thinking or the now outdated buy and hold investingphilosophy. High-Performance Managed Futures details how todevelop a stock market neutral investment portfolio designed forsuccess in the long-term.

Leseprobe

Table of Contents

Title Page

Copyright Page

Preface

WELCOME TO HIGH-PERFORMANCE MANAGED FUTURES

IT’S NOT FOR EVERYONE

A HIGHLY REGULATED INDUSTRY

DISCOVERY FOR THE RIGHT REASONS

Acknowledgments

Disclaimer

CHAPTER 1 - Understand It

WHAT IS THIS “MANAGED FUTURES” I’VE NEVER HEARD ABOUT?

STOCK MARKET “SAFETY” AND OTHER MYTHS

INVEST WITH STOCK MARKET NEUTRAL PROGRAMS

THE STOCK MARKET IS NOT “SAFE” OR “CONSERVATIVE” AND DOES NOT OFFER TRUE DIVERSIFICATION

IT WORKS IN PRACTICE BUT DOES IT WORK IN THEORY?

WALL STREET’S MOTIVATION FOR KEEPING MANAGED FUTURES A SECRET

CHAPTER 2 - Define It

THE SIMPLE MANAGED FUTURES DEFINITION

TARGET RISK/REWARD PROFILES

CHAPTER 3 - Work With It

PORTFOLIO DIVERSIFICATION VERSUS INDIVIDUAL MANAGER SELECTION

INDIVIDUAL CTA ANALYSIS AND PORTFOLIO CONSIDERATIONS

CHAPTER 4 - Realize It

THE FASTEST-GROWING ASSET CLASS?

THIS UNIQUE AND VERY SPECIAL ASSET CLASS

MANAGED FUTURES DEFINED

DECODING THE D DOC

CHAPTER 5 - Don’t Be a Victim

MANAGED FUTURES REGULATION, ACCOUNT STRUCTURE, AND PROTECTION

TRANSPARENCY: THE ABILITY TO SEE AND UNDERSTAND AN INVESTMENT

AUDITING PERFORMANCE AND MONEY FLOW

TIGHT REGULATORY CONTROL: MEET THE NFA AND CFTC

CHAPTER 6 - Recognize It

VOLATILITY USED TO REDUCE VOLATILITY

ALL VOLATILITY IS RISKY... TO DIFFERENT DEGREES

STANDARD DEVIATION AS MEASURE OF VOLATILITY

CHAPTER 7 - Use It

STUDY 1: EXPLORING RAD WITH MATH

THE TEST OF SUCCESS

STUDY 2 : AVERAGE DRAWDOWN: RAD VERSUS STD WHEN ACTUAL RISK IMPROVES

STUDY 3: WHERE CTAS FALL BASED ON RAD

RISK “INDICATORS” DON’T INDICATE RISK

CHAPTER 8 - Protect it

DON’T BE FOOLED

FOUR STEPS TO CREATING PRINCIPAL-PROTECTED PRODUCTS

STRATEGIES TO MAXIMIZE RETURN

CHAPTER 9 - Use All of It

IS MANAGED FUTURES THE WORLD’S MOST NONCORRELATED ASSET?

BALANCE RISK AND RETURN: MANAGED FUTURES CUSHION DURING STOCK TURBULENCE

CORRELATION STUDY: MAJOR INDEXES

MANAGED FUTURES NONCORRELATION IS NOT AN ACCIDENT

TRADITIONAL RETURNS-BASED CORRELATION LOGIC IS FAULTY

NONCORRELATION WITH STOCKS COULD BE THE INVESTOR’S BEST FRIEND

CHAPTER 10 - Build It

TRANSLATING INVESTOR GOALS INTO PORTFOLIO DESIGN STRATEGY

WHAT IS THE BEST METHOD TO IDENTIFY SUCCESSFUL CTAS?

PORTFOLIO BUILDING WITH VOLATILITY SKEWING

HIGH-PERFORMANCE MANAGED FUTURES PORTFOLIO-BUILDING EXERCISE

WHY INVESTORS MUST LOOK PAST SIMPLE AVERAGE RETURN HEADLINES

THE HIDDEN RISK IN UNEVEN RETURNS DISTRIBUTION

DON’T JUDGE BY LOOKS ALONE

CHAPTER 11 - Understand It

THE SIMPLE WAY TO LOOK AT RISK MANAGEMENT: CHOKE POINTS

LEVERAGE CAN MAGNIFY WINS AS WELL AS LOSSES JUST ASK A BANKER

EXPLORING INDIVIDUAL MANAGER RISK

FRAUD RISK

CHAPTER 12 - Don’t Sit Back

ARE THE BIGGEST RISKS THOSE THAT ARE UNKNOWN?

A GRAPHICAL LOOK AT THE MANAGED FUTURES ACCOUNT

INDIVIDUAL MANAGER RISK

THE FUTURE OF MANAGED FUTURES CAN BE FOUND IN ITS HISTORY

CONCLUSION

APPENDIX A - HPFM Strategy Benchmark Performance Study

APPENDIX B - Twelve Questions Investors Should Ask ... of Themselves

APPENDIX C - Selecting a Commodity Trading Advisor

APPENDIX D - Identifying True Risk and Utilizing the Best Managed Futures ...

APPENDIX E - Regulated versus Unregulated Entities

APPENDIX F - Markowitz and Lintner: A “Modern” Investment Method Half a ...

Notes

About the Author

Index

Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding.

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Copyright © 2010 by Mark H. Melin. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Melin, Mark H.

High-performance managed futures : the new way to diversify your portfolio / Mark H. Melin.

p. cm. - (Wiley finance series ; 598)

Includes index.

ISBN 978-0-470-63793-7 (cloth); ISBN 978-0-470-88667-0 (ebk); ISBN 978-0-470-88684-7 (ebk); ISBN 978-0-470-88685-4 (ebk)

1. Portfolio management. 2. Investments. 3. Risk. I. Title.

HG4529.5.M45 2010

332.64́́́́́′52-dc22

2010012326

Preface

This book reveals a unique method of investing independent of stocks and the economy—a method that studies have shown has outperformed the stock market for the past 27 years, judging success by the major indexes, their drawdown statistics, recovery time, and total returns.

The investment method is derived from a Nobel Prize-winning theory that was later revised by a legendary Harvard University professor. But what is most amazing is that many investors and even financial professionals are not aware of the asset class, or they misunderstand the investing method.

WELCOME TO HIGH-PERFORMANCE MANAGED FUTURES

This book is divided into two sections: The fundamental section from Chapters 1-5 contains information that might surprise even the most experienced investor. Here performance is discussed—and performance can be both positive and negative. The book then reveals managed futures portfolio-building fundamentals, showing how risk targets are established and basic portfolios built. After these headlines have been discussed, the book dives into the structure of the asset class and industry regulation, including performance auditing. Upon completing Chapter 5 readers should posses a basic understanding of the managed futures asset class, at which point sophisticated investors are encouraged to move to the second section of the book, Chapters 6-12, where unique portfolios are built, traditional academic thought is challenged, and most importantly, risk and risk management are discussed in frank detail, a topic for all investors.

IT’S NOT FOR EVERYONE

Some investors might consider the book’s ideas exciting and cutting edge with significant potential; call this group the optimists. Others, the traditionalists, might be less receptive to changing their fundamental belief system and will complain and nitpick. Still others, call them the intelligent risk managers, might say “there is no free lunch,” as my father always told me. Everything is a matter of understanding true risk and reward. While realistic optimists are welcome, this book is written for sophisticated, intelligent risk managers.

This book is appropriate for intelligent, qualified investors who desire higher performance and consider acceptable risk an intelligent concession to appropriate reward, and recognize some risks simply deserve a polite “no thank you.” It is written for investors who use only risk capital to diversify investments with the goal of not becoming entirely dependent on the stock market or the economy at large; for those who understand performance measures are tools that measure past performance and do not indicate future results. For that matter, they recognize no one has a magical crystal ball or can predict the future; future projections are based on logical thought process and making intelligent connections, but any projection into the future is nothing more than opinion—pure conjecture. If this describes you, then read on and discover a truly interesting investing method.

This book provides insight into what for many is a very different concept: a new world; indeed, the world of High-Performance Managed Futures. It will be new for those who live their lives in the confines of a stock-centric world. The reason for this starts in the educational system that all but ignores futures and options, with a few exceptions, and mirrors societal values and dictates the source of investing power is centered on the stock market and a little island in New York. This book indeed leads a stock-centric world on a journey of discovery.

A HIGHLY REGULATED INDUSTRY

Managed futures is a highly regulated investment. The tight industry regulation can be a major benefit to investors, particularly when it comes to audited returns performance and specific intelligent regulations regarding transparency and how client investment capital cannot be directly manipulated by the investment manager under the limited protection of account segregation. These investor protections should be used as an international template when considering prevention of hedge fund fraud.

Communication with potential investors is highly regulated. While this book is considered free speech, anyone regulated in this industry is required to provide a reasonably balanced view of risk and reward. Facts must be supported by reality and anything deceptive is considered fraud, plain and simple. While it may be annoying, in this regulated environment participants are also required to consistently point out that past performance is not indicative of future results. Readers must also understand opinions can be right or wrong; no guarantees available. This book is significantly based on the author’s opinions and in many cases those opinions may be evident to some but not stated.

DISCOVERY FOR THE RIGHT REASONS

The trend in managed futures has started, as evidenced by what has been one of the fastest growing major asset classes over the past decade. In part, the goal of this book is to educate investors and nudge a powerfully emerging investing trend over its tipping point. While this is exciting, it is not a reason to invest in anything. Investing involves intelligent risk-reward decisions that all investors must individually make; all will not travel this path, as it should be. The hope is those that venture down what can be an exciting and rewarding path first focus on intelligently understanding and managing risk and avoid being dazzled by powerful returns alone. It is when risk is properly managed that sweet reward comes into most appealing focus.

In addition, to the valuable information and concepts provided in this book, I have also developed a web site—www.wiley.com/go/managedfutures—that expands upon the information provided in each chapter. It also links you to valuable white papers, videos, interactive calculators, and recommendation tools; grants you access to CTA performance data and portfolio building tools; and provides you with discounts on books, white papers, and software products. Although most of this material will be available to the general public, some information will only be available to registered book users. (Since you bought this book, you will receive a free six month standard membership. Your membership code and password instructions will be provided on the web site.) So, at the end of each chapter, be sure to look for the “On the Book’s Web site” icon and continue learning of new ways to diversity your portfolio. I hope you enjoy reading this book as much as I enjoyed writing it.

MARK H. MELIN

Acknowledgments

This book has been written in a number of different environments, with thanks to friends and family at each location. It started with the fresh ocean breeze of L.A.’s South Bay, constantly annoying a friend by the reciting of book passages and analogies while he was trying to watch his Saturday morning EPL soccer; to the edgy, invigorating force contained in Chicago’s Wicker Park, where the laptop often shared a park bench with those who called the street home; to the gritty power of the West Loop where friends would congregate to watch Sunday football and I tackled my laptop; to the more trendy River North and then out to the leafy suburbs where much time was spent on a long, wide back porch overlooking the ever-changing beauty of a tranquil lake, with a supportive father and family when it mattered.

The futures and options industry is really a community. A cultural foundation in a Midwestern city of strong shoulders, it is dominated by an innovative futures exchange that fosters growth in what could be one of the fastest growing investment opportunities in history.

This community has several anchors, including the brokerage community, which was once dominated by strong families. I had the good fortune of entering this world first as a managed futures program manager, a consultant to many of the exchanges, and then by working for a trading family that found its origins in the hog pits of Chicago. The family patriarch was one of the legendary figures during the heyday of pit trading, a bygone era to be sure. His sons and daughter, forging their own identity, first started an introducing brokerage (IB) business out of a college dorm room that stepped up and later became one of the top 50 futures commission merchant (FCM) brokerages in the world. They later sold this company to another legendary Chicago family who traces its roots to Iowa and Hollywood. This company was founded by a former movie producer who had a vision of a commodity future while shooting a film in Japan, just as the Nixon administration issued a soybean embargo on the island nation. The family business was essentially passed from father to son, who shares the father’s vision but runs the firm with his own professionalism, flair, and mission to create sustainable futures investing—the perfect home for a managed futures focus.

These are stories from a powerful industry that has a small-town feel, where people know the players, centered in one of the country’s largest cities that at times doesn’t feel large at all. A place where futures trading is integrated into the strong cultural identity, an industry that is an icon surrounded by urban legends, with stories upon stories of interesting personalities and situations—of which I consider myself fortunate to be a part.

This book doesn’t mention many names, but now is an exception. Dr. Carl Peters is one of the industry’s original commodity trading advisors (CTAs), along with the likes of Boston Red Sox owner John Henry. Carl is the noted author of the book Managed Futures, which was an industry standard when published in 1992. Carl visited Chicago in 2006 as the managed futures industry was in liftoff mode. Greeted by an exchange official, our group lunched at the Union League Club and visited with an algorithmic electronic option market maker, a hot topic at the time. As the September sun dimmed to orange, Carl ended the day by walking down Monroe Street and turned south onto LaSalle, when he was struck by majesty.

The canyon-like view looking south on LaSalle ended at the Chicago Board of Trade (CBOT), topped by the statue of Ceres, the mythological Greek goddess of the harvest that stood as a citadel over the CBOT building since 1930. Now with an iridescent glow, the moment took Carl’s studied breath away, if for just a second. The educated man who spent more time on either coast than in “fly-over territory” made an interesting observation:

“This is an interesting place . . . at an interesting time.”

There is no predicting the future; at that point Carl didn’t know for certain the industry he helped build was about to embark on an industry growth spurt. But more exciting, he didn’t know the one-time second-class asset class would emerge to take an important place in investment history as new paradigms for diversification are developed. Innovative solutions for uncorrelated portfolios are required for a new age, driven by forces of economic uncertainty as well as massive governmental and societal debt. The need for true uncorrelated performance from the stock market and the economy at large is knocking and an asset class will answer. This thought might not have crossed Carl’s mind at that exact moment in time. But the realization that a point in history is upon an industry is more poignant than ever; a light will shine on a solution designed to work regardless of the stock market fluctuation, spotlighting how true uncorrelated asset diversification could matter most ... right here, right now.

This book is dedicated to my kids: Life has practical limits that everyone must recognize and respect. Live life by giving 100 percent. Know in your heart that when the horn ending the third period sounds, you left everything inside you on the ice. All anyone can expect is you do your best.

Disclaimer

Everything expressed in this book is the sole opinion of the author, and is based on his investing perspective, experience, and research. Nothing in this book is to be construed as individual recommendations or advice but rather broad conjecture, and is not represented as a complete look at any topic. The author’s opinions are not right for all investors. Much of the author’s opinions are based on past performance, and past performance is not indicative of future results. The opinions and content in this book have not been endorsed or approved by any exchange, brokerage firm, regulatory body, or managed futures program. While the opinions are clearly biased in favor of managed futures, the facts speak volumes and are outlined in what the author believes is a balanced and fair approach.

The names of many firms have been masked throughout this book for several reasons. First, performance is a relative concept and with book production delay, the most recent performance information, both positive and negative, is available online. Second, in itself this book is about an entire industry and does not seek to promote any single managed futures program, brokerage firm, or exchange. Third, the goal of this book is not to provide individual recommendations or advice but rather expose broad concepts. The goal is to shine a light on an entire industry and achieve academic enlightenment; readers can conduct individual research online.

Managed futures risk is outlined in a frank and transparent format, but no attempt is made to diminish the risk in managed futures investing. When stock market risk is compared to managed futures risk, it is a comment on true stock market risk and not a comment on the lack of risk in managed futures investing. Managed futures investing involves significant risk, it is not right for everyone, and only risk capital should be used. Risk and risk management are topics for sophisticated individuals and if a reader does not understand the risk issues or is generally uncomfortable with the investment they should not invest in managed futures.

CHAPTER 1

Understand It

The Truth about Risk and Misunderstood Investments

There is an asset class that has been generally ignored by Wall Street—despite outperforming the stock market over 27 years, according to one of the most recent studies on the topic from the Chicago Mercantile Exchange (CME). (See Figure 1.1.)

While many Wall Street institutions benefit through their portfolio investments in this asset class, the investment has been misunderstood by many financial advisors, as well as generally and perhaps deliberately obscured from qualified investors.1 This is despite the asset class performing positively in nine of the last ten stock market declines with such low drawdown numbers it would even make the most talented hedge fund manager blush.2

The asset class is managed futures, a relatively unknown and misunderstood investment. Managed futures has provided investors several benefits, including diversification, tax benefits, the potential for high returns, lowered portfolio volatility, and lack of correlation to the stock market.

In fact it could be argued that managed futures is the most uncorrelated major asset class in history, the most diversified from stocks.3 Here is why:

Success in managed futures investing is not necessarily dependent on the positive or negative price movement of any market. This is relatively unique in the history of investing.

To illustrate this point, some market-neutral managed futures investments are designed to be profitable regardless of core price movements in the underlying markets in which they invest. Further, it is common in popular trend trading, and discretionary programs, for strategies to be designed so as not to be tied to the positive price movement in any market in which they trade.

FIGURE 1.1 Comparison of Performance, 1/1980-2/2008

Source: Courtesy CMEGroup.

This bold statement is based on empirical correlation statistics outlined in this chapter and throughout the book. But it also comes from a conceptual knowledge of the unique and very different option and spread strategies that are based on futures and option contract structures: different delivery time frames for spread trading, option premium collection strategies, and other opportunities only available in the regulated derivatives markets. This book isn’t about technical details of futures and option contracts, but it is about how to use these unique structures to create truly powerful investments using what is an interesting asset class.

WHAT IS THIS “MANAGED FUTURES” I’VE NEVER HEARD ABOUT?

Managed futures is similar in some ways to a mutual fund for the commodities industry in that talented money managers with audited past track records invest client assets in worldwide futures and options markets.4 The core structure of the futures contract allows for very unique investment strategies; sometimes long, sometimes short, and at times market neutral, indifferent to the up or down price movement of any market or economic factor at large. Managed futures is defined further over the next three chapters, and throughout the book, as is the idea that managed futures could be the world’s most uncorrelated asset class.

Stock investors should understand managed futures and consider it as a component in their portfolio. However, this investment method is not for everyone. It involves risk and managing risk, as does all investing, to varying degrees. The key is to understand true risk and then appropriately manage it. The word true is used because investing risk is at times unclear, obscured behind a veil of mistaken perception. This is true in the stock market when one considers real drawdown and volatility as it is in hedge funds and managed futures when different hidden risks are exposed. In this book the investor will discover the truth—for better or worse.

And it’s about time.

This chapter lays the foundation for the book, calling into question commonly held investing beliefs—societal norms, really. This book in part echoes the voices of Lintner and countless ignored academic studies since that have compared stock market risk to more diversified risk that includes managed futures, and the book does so in what the author believes to be a balanced and fair approach. Chapter 1 highlights risk statistics that those beholden to stocks might not want you to see:

• Stocks are not as “conservative” as you might think—just ask several Nobel Prize winners.5

• The truth about risk: The new “conservative” is asset diversified with risk.

• Conservative should be defined by the level of diversification, not based only on the risky assets inside a portfolio.

• Intelligent investing, and this book, are about using diversification and reducing correlation to stocks and the economy; performing under a variety of economic circumstances—the good, the bad, and the ugly of economic times.

STOCK MARKET “SAFETY” AND OTHER MYTHS

Prior to September 2008, investors might have considered stock portfolios reasonably diversified, conservative, and maybe even the unthinkable: “safe,” to a degree. Investors might have believed that buy and hold was the best long-term strategy and that stocks were the only traditional investment that met their needs. These images, call them core societal beliefs, were generally marketed by the same firms that were kind enough to give birth to the credit-default swap and mortgage-backed securities that were so beneficial to the economy. Yes, these societal beliefs are wrong. Dead wrong.

For some, the consequences of these incorrect beliefs have been dramatic—a nightmare of life-altering proportions. For others, stock market stagnation represents just a number change on paper, nothing altering daily life. But in either case, the impact, the scare, the failure, and the realization of investor vulnerability can lead to emotions that foster bad dreams. The problem is that nightmares don’t end until you wake up.

It is time to wake up.

Waking up is a process, and investors may have problems, particularly if they support the societal value that says the source of investing power—its heart, its liver, all its vital organs—is only centered on the stock market and a little island of thought. It is time to challenge tired traditions and usher in new choice, the option for real asset diversification.

As stock investors look upon a decade without financial reward, commonly called the “lost decade,” they shake their heads with a disgust that comes from a man hoodwinked by a trusted friend. Ten years without capital gain or any appreciation in their stock investments; not even a thank you. How could the “safe” stock market fall off a cliff . . . again?

But here’s the unwanted punch line: The coming 10 years could bring more uncertainty, kind of like raising a child. Stock investing could exhibit patterns of moody, unpredictable behavior with volatile price swings driven by economic forces beyond the control of mere politicians and governments, not to mention investors. At times everything might smell like roses; the stock market will experience bull runs to profitable ground; a new day will appear to be born. The market will rise in price along with investor hopes and dreams. Investors’ emotions will drive them to think happy days are here again, the stock market is “normal,” back on track. However, normal in most contexts is relative. Investors entirely dependent on their equity savior will also realize that hope is a four-letter word, because the stock market will likely have difficulty navigating what can only be described as a unique and uncertain economic environment. It is said that a stock market crash is an anomaly, like a 100-year flood. If so, investors will do well to prepare a sturdy boat, because stock market 100-year floods might occur on a more regular basis.

And this leads to one point of this book:

Wouldn’t it be nice if investing wasn’t entirely dependent on the stock market or the economy at large?

INVEST WITH STOCK MARKET NEUTRAL PROGRAMS

To be clear, this book does not seek to replace stock investments. Stocks are too engrained as a cultural norm. The goal is to create a balanced portfolio that includes stocks, but uses uncorrelated assets so that the portfolio is balanced and more neutral to wild stock fluctuations.

True asset diversification and uncorrelated returns performance is something to which all investors should aspire. In fact, those who regulate the investing industry advocate diversification. In Ten Tips for 2010 the Financial Industry Regulatory Authority (FINRA), one of two regulators of U.S. securities investments, advocates spreading investments among different asset classes and within each asset class, a sentiment echoed by the National Futures Association (NFA), which is one of two organizations that regulates the managed futures industry and audits its performance.6 “Although the concept may sound simple, the National Survey found that one-quarter of those who rated their financial knowledge as ‘very high’ could not correctly answer a question about risk and diversification,” the FINRA report noted. Separate studies have found that only a small but growing number of financial professionals understand how to properly diversify a portfolio from stocks and the economy using managed futures.

FINRA is not just a singular pillar in the stock-centric world that recognizes the value of diversification.

“In 2008 investors discovered what financial advisors touted as a ‘diversified portfolio’ was not,” noted Nadia Papagiannis, the Alternative Investment Strategist at Morningstar, a highly respected equity research firm. “Investors didn’t realize the true volatility in the stock market—nor understand their individual risk tolerance—until in 2008 when they experienced firsthand the true risk and volatility in the stock market.”

Papagiannis views managed futures from a unique vantage point as one who provides alternative investing insight for Morningstar, but more pointedly her previous experience as a commodity trading advisor (CTA) auditor at the NFA has allowed a firsthand knowledge of the strong performance reporting requirements demanded of the managed futures industry.

“Most investors had no idea managed futures and their uncorrelated strategies existed and that they are not as volatile as people think,” she observed. “What’s more, investors didn’t really understand they can manage volatility (dialing it up and dialing it down).”

There is indeed valuable information on managed futures and related diversification opportunities of which both professional and individual investors should be aware. The way to achieve enlightenment on the world of true asset diversification using managed futures involves an interesting formula of Nobel Prize-winning lineage, a graphical risk measurement technique developed over 60 years ago. This concept was later advanced by a legendary Harvard University professor: a man who showed the world how to create portfolios diversified from stock market risk and volatility. It is a formula that in fact uses a volatile and risky investment, managed futures, with the goal to reduce overall portfolio volatility. In short, uncorrelated volatility will be used to reduce overall portfolio volatility, an interpolation of the work of Harvard’s Dr. John Lintner.

To understand this formula and recognizing the reality in risk and reward is important, particularly when an opinion is drawn about stock market safety.

THE STOCK MARKET IS NOT “SAFE” OR “CONSERVATIVE” AND DOES NOT OFFER TRUE DIVERSIFICATION

Considering potential outside activities, driving to the local store for a gallon of milk in the morning is generally considered a safe activity; alternatively, flying as a plane passenger could be considered risky. But did you know, on a statistical basis, flying as a plane passenger is much safer than driving down the street? It is all a matter of perception.

Managed futures and hedge funds are risky investments. So is the stock market, when considered on a cold, statistical basis. It is all about understanding the degree of risk versus the degree of reward. Author Emanuel Balarie points out in his book Commodities for Every Portfolio that “concluding commodities are more volatile than stocks is purely a myth.” Balarie cites several studies, including a 2004 Yale University study, a tilting academic opinion that showed over a 45-year period of time a portfolio would have been more volatile invested in stocks than commodities.7

This isn’t something investors are being told. But that’s not all.

Always Understand, Then Balance Risk and Reward

When considering managed futures risk and reward it is difficult to avoid the work of two legendary minds: Harvard’s Dr. John Lintner and Nobel Prize winner Harry Markowitz. For those unfamiliar, details are revealed in Appendix F of the amazing work of these bright minds, work that has been generally overlooked by those blinded by a stock-centered world. Here is the point of their work for this chapter:

Understand, then balance, risk along with reward and only take risks for which the investor is compensated.

FIGURE 1.2 Comparison of Worst Drawdowns, 11/1990-2/2008

Source: Courtesy CMEGroup.

That sounds so simple and logical. But if it is so logical, why have investors not been largely exposed to the following information?

One measure of past risk is an index’s inevitable drawdown, or negative return. Consider Figure 1.2. This is interesting because drawdown is such a blatant measure of risk in any investment: bottom line risk in many respects. It shows the worst sustained losses of the major stock indexes and a managed futures index. For most investors, Figure 1.2 may come as a surprise. The NASDAQ had a worst drawdown of 70 percent, an amazing dilution of investor wealth. Based on index drawdown alone, any investment that loses close to three-quarters of its value in the blink of an eye can only be described as a very risky investment, indeed. By contrast, the managed futures index in the CME study had a worst drawdown of 9.3 percent. This is not to claim that managed futures is not risky; managed futures is risky. The point is to take an honest look at stock market risk. If managed futures is even a twinkle of a thought on investors’ investment horizon, they might consider the asset class as risky. It is risky, but in some very different ways than that of the stock market. Judging the asset class through the lens of the index’s worst drawdown, risk becomes a relative concept, and 70 percent is a massive drawdown number in any investment—the sign of a very risky investment, indeed.

To provide balance, this interesting managed futures index drawdown might not tell the whole story. There is currently no single investment that allows access to invest in the CASAM CISDM managed futures index, unlike stocks. While the CASAM CISDM index was used by the CME for their study and Barron’s magazine utilizes data from the index for publication, there are a wide variety of credible managed futures indexes to consider that vary in performance. Further, when investing in a single manager, as opposed to a diversified basket of managed futures programs, the investor may experience different performance from that of the broad index. Much like investing in a single stock, performance might differ from that of the index.

Drawdown Recovery Time: An Underutilized but Significant Risk Measure

If investors think the stock market is safe, consider the time to recover from negative returns performance. The length of time it takes to recover from sustained investment loss is a very interesting statistical measure of risk, particularly as it relates to managed futures. In Chapter 10, readers will discover a unique managed futures portfolio building method that features drawdown recovery time, volatility management and true diversification across five key points of correlation as a key risk management features. As the different drawdown recovery times are considered, understand that drawdown recovery is an underutilized yet potentially powerful risk statistic.

Figure 1.3 from the CME is illuminating. Managed futures in the CME study are represented by the CASAM CISDM managed futures index, and stocks by the S&P 500 Total Return index. The study shows the worst stock market meltdown took two years to recover, essentially working in the red from September 2000 to September 2002 with a 44.7 percent loss at its worst point, as measured by the S&P 500 Total Return index. By comparison, the managed futures index in the study had a relatively quick drawdown recovery period, lasting just two months. Its worst period of back-to-back negative monthly performance lasted just three months, from January 1992 to April 1992, with only a 9.3 percent negative performance.8

FIGURE 1.3 Comparison of Drawdown Duration, 1990-2008

Source: Courtesy CMEGroup.

Not only did stocks have the worst drawdown, they also exhibited the longest recovery time from this prolonged negative loss. That is the worst of all possibilities. Not only did stock hangovers hurt with a harshness not often experienced, but they took an excruciatingly long time to recover.

While these “headline performance numbers” are interesting, the book is about digging beyond the headlines, looking past strong returns alone and considering risk. In fact, this book advocates an approach that considers risk before return. In large part this risk is managed through uncorrelated diversification. Sometimes admittedly volatile and risky investments, as measured by standard deviation, can be used as a tool to properly diversify a portfolio and potentially reduce standard deviation in the overall portfolio, which sums up several academic conclusions.

Standard Deviation: Markowitz’s Measure of Risk

Standard deviation was used by University of Chicago economist Harry Markowitz as a measure of risk in his Nobel Prize-winning Modern Portfolio Theory, and is the basis upon which much of this book’s risk measurement techniques are based.9

In Figure 1.4, standard deviation is plotted along with past returns. The book’s second section explains this graphic and certain alterations to Markowitz’s Modern Portfolio Theory. For now, understand that investments nearest the right are considered most risky, based on volatility, and investments to the left the least volatile, based on standard deviation; investments nearest the top have the highest expected or past returns and investments near the bottom have the lowest returns. Thus investments in the rarified upper left are most desirable: the lowest risk, highest return.

FIGURE 1.4 Graphic Measure of Risk/Reward

The stock market’s statistical risk is evident when one views a Modern Portfolio Theory graphic on a cold, numeric basis. Investors should take an objective look at where the stock market falls on a risk-adjusted basis. For most traditional investors the fact that their beloved equity market falls in the same risky, unsafe neighborhood as truly risky managed futures can be quite a shock—as when the wrong turn off a city expressway lands the unknowing minivan in a very unsavory and foreboding urban neighborhood.

This is not a comment on the risk in hedge funds or managed futures. They are risky investments and no implication is being made otherwise. The point is to lay the stock market bare with its real risk. While the traditions of society might view the stock market as safe when compared to hedge funds and managed futures, it can look downright risky when viewed on a cold, hard statistical basis.

Investors may have been sold the approach that diversification using only stocks and bonds is appropriate, avoiding managed futures due to its risk. But this stock diversification is fallacy, according to a Nobel Prize winner who proved real diversification cannot be achieved with stocks alone.

The Nobel Prize Winner Who Questioned Stock “Diversification”

For years investors have been indoctrinated with a tonic that leads them to believe they can enjoy the protection of diversification with stocks and other traditional assets tied to the economy at large. However, this popular myth flies in the face of Nobel Prize-winning academic thought and common sense, which shows diversification among equities is not true diversification because of the systematic risk, or beta, associated with the stock market. Nobel Prize winner William Sharpe made the call, noting that investors cannot be diversified with stocks due to this problem:

Sharpe concluded that systematic (market) risk cannot be eliminated through stock diversification because stocks move more or less in tandem, causing wide fluctuations in price that even well-diversified stock portfolios cannot protect against.10

Sharpe noted the two primary drivers of a stock’s price: factors associated with the company itself, such as management decisions, strikes, earnings, and so on, known as unsystematic risk, or alpha; and factors associated with the general stock market or economy at large, known as systematic risk, or beta. About one-third of the variability of stock prices is due to systematic risk, or the general market factors that affect all stocks. It is this systematic risk Sharpe identified, which again points to the fact that stock diversification is a relative misnomer. This is confirmed by a Brinson study that notes that 92 percent of a portfolio’s return is due to asset class selection as opposed to the selection of particular underlying securities.11

In other words, all that time spent picking stocks would have been better spent diversifying among uncorrelated asset classes.

Even though stock investors may be diversified among different sectors and geographic regions, they are not really diversified due to the systematic market risk. Said another way, negative economic conditions generally impact all stocks across a variety of market sectors; just ask diversified stock investors in 2008. This leads to a conclusion:

True asset diversification is conservative, not the stock market.

Diversified Portfolio versus Same Old Same Old Take the concept one step further by comparing portfolio results with and without managed futures since 1986 (Table 1.1). The CME expanded on Lintner’s academic work in 2008, updating his study of true asset diversification and volatility for modern times. Table 1.1 shows updated results of the same portfolio study the CME conducted. While this is not a complete view of risk, these portfolio statistics tell a very different story than what is being fed most investors.

Table 1.1 is a fascinating study. The “risky investment” with managed futures (B) reduced past overall portfolio risk statistics, which is the message of several academic studies. Consider that when returns go up when managed futures are included, past portfolio risk statistics actually decline. Look at volatility, measured by standard deviation, sink by over 20 percent when a volatile managed futures investment was added. Worst drawdown, for instance, is more than cut in half when the managed futures index is added to the stock and bond portfolio. While the returns when adding managed futures are higher, the significant benefit comes with lowered portfolio volatility in the form of reduced standard deviation, a significantly smaller worst drawdown, and quicker drawdown recovery time. This study’s conclusion mirrors several academic findings and does not diminish the risk in managed futures investing, but rather shines light on the real risk in overexposure to stock investing. It is difficult to understand how this information can be so ignored by traditional Wall Street. The indexes utilized in the CME study were high-performing indexes designed to be a relative reflection of the market in general and individual performance may vary from that of the indexes in both stocks and managed futures. Past performance is not indicative of future results.

TABLE 1.1 Advancing the CME Study: Hypothetical Portfolio Results with and without Managed Futures in the Portfolio

Source: Barclay MAP.

Stocks & Bonds (A)Managed Futures, Stocks & Bonds (B)Correlation to EconomyHighMediumMonthly Standard Deviation2.72.2Win Percentage62.59%64.43%Worst Drawdown27.39%12.94%Drawdown Recovery Time3.30 months2.76 monthsSharpe Ratio0.400.63Compounded Annual Returns8.08%9.15%(A) Stocks and bonds portfolio included 50 percent stocks (MSCI World Index) and 50 percent bonds (JP Morgan Government Bond Index).(B) This is compared to similar portfolio components with the addition of 20 percent managed futures as represented by the CASAM/CISDM Equal Weighted Index, 40 percent stocks (MSCI World Index), and 40 percent bonds (JP Morgan Government Bond Index). Past performance is not indicative of future results. Index performance may be different from that of individual investments in single stocks or CTAs.

This study of past portfolio performance using general indexes is interesting, but the portfolio allocation above is not our ideal managed futures portfolio because, in part, most managed futures indexes are unbalanced and might be difficult to replicate. There is no easily investible managed futures index that accurately replicates the diversity of the strategy. The current managed futures indexes are not the ideal, but a balanced approach that will be revealed through the book as a unique method to manage volatile investments. The simple point of this demonstration is to show a little-known diversification opportunity: Managed futures is an investment that should be considered in risk-appropriate investment portfolios, particularly by those who wish to design their overall portfolio to reduce their debilitating stock market exposure and its related volatility, as measured by standard deviation.

This overview chapter won’t waste much more time documenting the obvious risk in the stock market. Throughout the book interesting studies are revealed regarding various markets and how to mitigate stock market risk exposure, providing additional meat on this bone. The only reason any time at all is spent on the topic is because investors have been so effectively brainwashed into thinking traditional buy and hold equity investing was safe, it takes the hard reality of a little intervention to bring reality back.

Academic Reports Consider Managed Futures Risk

A variety of academic reports on managed futures question stock market risk by comparing it to managed futures risk, and this academic discovery should be explored further. In summer of 1998 Thomas Schneeweis, a leading alternative investment academic, penned an article in the Journal of Alternative Investments titled “Dealing with Myths of Managed Futures.”12 The article noted that during the period 1990-1997 a single CTA on average had a monthly standard deviation of 6.26 percent, while the average S&P 500 listed stock had a higher standard deviation at 8.08 percent.

Further, in summer of 2004 academics Greg Gregoriou and Fabrice Rouah conducted a study of large CTAs in the Journal of Wealth Management noting the positive performance of CTAs during extreme market events and concluded: “. . . the trend by pension fund managers as well as wealthy individuals toward increasing their exposure to CTAs ... makes sense.”13 This general line of thought is echoed by academic Richard Spurgin in his summer 1998 article “Managed Futures, Hedge Fund and Mutual Fund Performance.” 14 Another interesting report was written by B. Wade Brorsen and John Townsend in the spring 2002 issue of the Journal of Alternative Investments. In “Performance Persistence for Managed Futures” the authors concluded “there could be some advantage to picking CTAs based on past headline performance when a long time series of data is available and precise methods are used.”15 These studies can be categorized as eye opening, but voices exist on both sides of the topic.

Providing Balance: Dissenting Views of Managed Futures Performance

Differences in performance exist between major managed futures indexes, such as the Barclay CTA index and the CASAM CISDM index, similar to differences between the S&P 500, the Dow Jones Industrial Average, and the NASDAQ stock indexes. Further, academic studies have questioned certain aspects of how the managed futures indexes collect and calculate managed futures index performance. Many of these critical managed futures studies fail to recognize the pivotal role that auditing by independent regulatory bodies plays in performance reporting accuracy. These studies fail to make appropriate distinction between different account structures and their impact on governmental regulation, performance auditing, marketing regulations, and transparency. Further, when considering survivorship bias academic studies must not treat stock and equity markets with undue favor. All major managed futures index performance is listed on the High-Performance Managed Futures web site, as are all credible and publicly available managed futures studies, both positive and negative, along with a frank review of each study. Sol Waksman of BarclayHedge, one of the industry-leading managed futures performance reporting services notes four primary issues with all managed futures databases that essentially point to the core structural differences between managed futures and stock investments:

1. Managed futures categorization and inclusion is not standard.

2. The index performance is not standard in terms of weighting based on capitalization or equal weighting.

3. Differing methodologies exist for calculating returns and managing administrative methods, such as how they add and subtract CTAs from the index and deal with survivorship bias.

4. All managed futures databases are proprietary.

Further, it is appropriate to wonder why a certification method has not been introduced nor a more consistent and timely profit/loss reporting system for CTAs developed. These industry issues and many more are discussed in detail on the High-Performance Managed Futures web site, along with CTA performance reporting and analysis.

The point of mentioning this is to provide balance. There is no perfect investment. This book shows both the pros and cons of what is considered a misunderstood investment, because the belief is all will benefit when the investment, its risk, and its reward are properly understood.

To this point, considerable academic theory has been discussed, but does it have practical application?

IT WORKS IN PRACTICE BUT DOES IT WORK IN THEORY?

Two economists were discussing the successful implementation of a municipal tax levy that was not theoretically analyzed by academia before it was implemented.

“Sure, it works in practice,” one academic said to the other, “but will it work in theory?”

This book is more than academic theory. It is practical application that has been working for investors, proving itself day in and day out. And that’s the beauty of what is discussed.

Consider Tom O’Donnell.16 In the early 1990s, as the managed futures industry was poised for significant growth, as Markowitz and Sharpe won the Nobel Prize, and after Lintner released his landmark report, O’Donnell was a portfolio manager at the Virginia Retirement System, a major institutional investor. The chief investment officer of the pension fund asked O’Donnell and one of his colleges to embark on a task that would change the course of his life in an unexpected way.

“Investigate managed futures and see if it is an asset class we should consider,” was the request handed down.

Managed futures? “Are you kidding?” O’Donnell said to his colleague, likely with the condescending tone stock investors typically use when discussing the asset class they don’t understand. “That’s pork bellies, leverage, and shorting!” At the time of the request, O’Donnell might have thought he had all the data he needed to determine that he shouldn’t invest; perhaps thinking the fund would have better luck venturing off to Las Vegas and “investing” there.

O’Donnell then conspired with his colleague to write a research paper about managed futures that he thought might be so negative that the chief investment officer would have little choice but to scuttle this foolish idea forever. While the researchers clearly possessed a bias, they also approached the task with the intellectual honesty of a fiduciary. They looked at both the negative and positive claims and then dug deep to get a significant grasp of the issues. All the issues were thoroughly investigated.

And then came the day for the report: judgment day.

The report was honest. It detailed the risks of managed futures investing, which clearly must be understood by all investors. It pointed out the negative aspects of the investment. It considered the strategies and how this very different asset class operated. It pointed to negative stereotypes upon which many unfortunately base their investing decisions, and then it uncovered the naked truth.

Its recommendation?

The Virginia Retirement System, one of the largest pension funds in the country, began diversifying its portfolio with alternative assets and included managed futures in 1991. They followed the path that Markowitz and Lintner had so eloquently outlined, conducted their own research, and made their decisions without undue political interference.

Fast forward to 2009. In a speech about institutional investing, O’Donnell, now firmly engrained and working in the alternative asset investing arena, recalled their interesting experience: Once they got their feet wet in managed futures, they started to feed the data into their computerized asset allocation models. And here is where they ran into problems. The numbers looked so good that the computer program recommended that they place the vast majority of the fund’s assets into managed futures, ignoring the stock market and other alternatives, an interesting comment about the nonemotional and bias-free computer-based decision logic.

In fact, O’Donnell said people might have to put artificial constraints in their computer models so that they wouldn’t always recommend managed futures.

At first it was also difficult understanding the unique CTA strategies. They worked with Nobel Prize winner William Sharpe, who built a computer model to understand all the equity strategies that their various fund investments employed. With a 93 percent accuracy rate, the computer could decipher the strategies many of the mutual funds were using just by feeding in the stock holdings. However, when the managed futures investment positions were fed into the computer it had no idea how to interpret these rather odd positions, underscoring the complication of the strategies underneath the surface of this asset class.

But here is a truism that you will discover in coming chapters: It is these very complicated strategies and the unique futures and options contract structures that make uncorrelated diversification work. Readers of this book might just be witness to the world’s most uncorrelated major asset classes, and perhaps one of the world’s fastest growing. (Go to the High-Performance Managed Futures web site or www.cme.com to listen to a recent speech given by O’Donnell discussing his experiences in managed futures while at a pension fund.)

WALL STREET’S MOTIVATION FOR KEEPING MANAGED FUTURES A SECRET

The growing attention paid to managed futures is done for obvious reasons. It is rare for an index to perform positively in nine of the last ten stock market declines, have worst drawdown statistics much lower than that of stocks, and to have much quicker index drawdown recovery times. These are key statistics. Past performance is never indicative of future results, but from the perspective of history the past lack of correlation in managed futures performance stands out in all of investing.

The fact that some investors try to diversify with stock investments alone is as ridiculous as the fact that managed futures is misunderstood by all but the most knowledgeable; but this, too, is starting to change. Bright professionals are recognizing investing is about balancing risk and return through true asset diversification. Financial professionals have a duty to understand the latest products and methods of investing; at minimum, they have an obligation to understand an asset class that performed positively in nine of the last ten stock market declines and offers such uncorrelated diversification opportunities. So the question exists:

Why does traditional Wall Street thinking ignore managed futures?

In the recent past, broker-dealers (BDs) who restrict in-house financial advisors generally don’t receive compensation on direct managed futures accounts unless they are registered as an Introducing Broker (IB), an effort requiring a new layer of regulatory supervision which few have been willing to undertake. Some Wall Street firms do offer limited selection of managed futures funds (as opposed to direct accounts), but the whisper is these nontransparent investments might be placed on the broker’s platform only after the fund manager has agreed to pay a fee to the broker-dealer—a pay-for-play system that might not always be disclosed to the investor. Fund of fund investments in particular can charge an extra layer of fees and net investor performance can be lower. A study of the Barclay MAP database indicated that all fund investments, including funds of funds, reported compounded annual returns 27.26 percent lower than the same study group that included direct managed futures accounts. 17 (This is not to say that fund investments are all bad; there are definitely pros and cons of different direct and fund account structures that are discussed throughout this book and on the book’s web site.)

But there is more motivation for a financial advisor not to offer managed futures to investors: It takes extra time and effort.

For a financial advisor, there is significantly more work involved in offering and supervising managed futures, all for what can be the same fee they receive for managing stock investments, where it is comparatively easy for a financial advisor to manage a simple “buy and hold” approach. Managed futures, on the other hand, can require active supervision of many unfamiliar components, including complicated strategies, sophisticated margin-to-equity ratio management techniques and the understanding of market exposure that in some cases is only evident when the strategy risk is understood. Further, with certain account types the advisor can encounter financial risks not associated with traditional stock investments, particularly with aggressive investments. In the past, advisors might have had honest concerns regarding the complexity and volatility of the investment. Managed futures can be a volatile investment and unsophisticated investors who cannot stomach volatility should not enter these waters. But it is also appropriate to raise the same issues regarding stock market volatility.

Even if Wall Street did have the motivation, learning about this investment is difficult. Futures and options are not a part of the normal educational curriculum, even at some of the more advanced institutions of higher learning. What’s more, even in their in-house training, financial advisors don’t appear to gain futures and options knowledge outside basic risk talking points.

There is more to this story, and investors should not be hypnotized by simple risk definitions or strong returns alone. This book is about balancing risk with reward. Managed futures can be a risky investment, particularly if it is not properly structured and managed. And here is one secret behind managing risk as well as an explanation for a significant degree of the amazing managed futures index performance statistics: diversification.

In Managed Futures Diversification, Not Cash, Is King

The next two points are not widely disclosed in the cloistered managed futures world, but they should be.

1. Diversification is a primary reason behind the amazing managed futures index performance numbers and alluring risk statistics.

2. Investing in an individual managed futures program, or even a single strategy, can expose the investor to more risk than the managed futures index performance indicates, more so than when investing in a truly diversified portfolio of solid managed futures programs.

The book has strong opinions in this regard, because proper diversification is one key to success in managed futures investing. As you will see from studies throughout this book, proper diversification among solid programs can be vastly superior to investing in a single manager and a key to reducing an important component of risk in managed futures. In part, this book shows investors how to design programs with this goal.

Diversification is important in all investing. Proper diversification could be more important in managed futures than stock investing due to enhanced individual manager risk, or nonsystematic risk. A significant degree of volatility, or risk, in managed futures is on the individual manager level; the often complicated strategies they use, the markets in which they invest, and how they manage leverage, margin, and risk in their trades. All of these will be revealed as methods used to manage risk. But perhaps the most successful method found to mitigate this risk is through diversification among solid investment managers. A deep industry insight, however, is to question the core validity of the diversification within the managed futures indexes, which can be understood in part by considering 2009 index performance.

Managed Futures Waterloo: 2009 Performance Fourth Worst in History

In 2009 managed futures, as represented by the Barclay CTA index, exhibited its fourth worst year in returns performance, down 0.10 percent. The worst year in the history of the Barclay CTA index was 1999, down 1.09 percent. In 2009 major stock indexes crowed gains of 26.46 percent, as highlighted by the S&P 500.18

There are financial professionals who proclaimed 2009 “managed futures Waterloo” because “managed futures failed in 2009 while stocks ended with stout gains.” These statements are illuminating for several reasons. First, and most obviously, it shows that some, but not all, in financial services are resistant to change and closed to new paradigms for diversification. Second, and most interesting, it potentially points to a future where two camps exist. The first camp of financial professionals and investors is open to new concepts for uncorrelated asset diversification. The second camp will resist change at all costs, finding fault with everything, regardless of the facts or situation. Third, and perhaps most significant, the period from 2008 to 2009 provides perhaps one of the best laboratories to understand a misunderstood asset class. Current times are more relevant to study managed futures for several reasons. Assets under management are much more significant in 2009 than 1999, for instance. The CTAs are much more sophisticated with more diverse strategies, the sheer number within the ranks of CTAs makes study of the current period statistically significant, and current CTA performance auditing and industry regulation provide significant benefits to the investor. While there are many insights that can be garnered from recent times, there is one insight from 2009 that illuminates the investment more than any other—and it is not the obvious insight.