Brad Zigler: Packaged Managed Futures Aren’t (Mostly)

April 28, 2011

Managed futures can be a good source of risk diversification, but are the packaged products worth your investment dollars?

 

While commodity prices soar, some investors—remembering similar run-ups in 2008—grow more and more uncomfortable about the prospect of another blowoff top.

Three years ago, speculation—bolstered by the proliferation of exchange-traded commodity trusts—helped to send prices into the stratosphere, before demand destruction and a credit market collapse teamed up to snap the rally's back. Then, paradoxically, while commodity prices swooned in the latter half of 2008, one asset class stood out for its gains: managed futures.

Unlike long-only commodity index trackers, managed futures are just that—alpha-seeking accounts run by commodity trading advisors (CTAs) who are free to buy or sell short futures on a discretionary basis. CTAs did a good job of preserving client capital in the latter half of 2008.

While the S&P 500 Composite sank 33.4 percent, the value of managed futures metered by the BarclayHedge CTA Index actually rose by 4.4 percent. Managed futures, in fact, provided better risk diversification for equity investors than bonds (see Chart 1).

 

Chart 1 - Managed Futures Vs. Stocks And Bonds

Chart 1 - Managed Futures Vs. Stocks And Bonds

 

The diversification effect bestowed by managed futures isn't fleeting. Over the past three years, the correlation of stocks to bonds, proxied by the Barclays Capital Aggregate Bond Index, has been 20.9 percent. That's positive 20.9 percent. The coefficient for stocks and managed futures? Negative 21.3 percent.

Managed futures provide as much "zag" to a stock portfolio as the "zig" supplied by bonds. As shown in Table 1, managed futures are negatively correlated to both stocks and bonds. That makes managed futures an ideal portfolio carve-out:

 

Table 1 - Performance Metrics (March 2008 - March 2011)

BarclayHedgeCTA Index S Barclays CapitalAggregate Bond Index
Average Annual Return 5.1% 0.2% 5.6%
Annualized Volatility 4.5% 21.6% 4.1%
Sharpe Ratio 0.78 -0.06 0.98
Correlation to CTA Index -- -21.3% -6.6%

 

But if you're considering commodity investments, throwing money into managed futures shouldn't be done willy-nilly. First of all, you have to address the question of how to gain exposure—through separately managed accounts, public commodity pools, mutual funds, exchange-traded fund or notes? Then there's the issue of size—just how much capital should be allocated and from what source?

Let's work backward on these questions. With portfolio diversification as our objective, it makes sense to fund a managed futures allocation from the asset class most likely to be hedged by its inclusion. Table 1's correlation numbers tell us that's equities. Managed futures are more negatively correlated to stocks than bonds, so more benefit would likely be derived by peeling equity money off to establish a managed futures position.

So, how much do we carve out of our stock allocation to gain futures exposure? A look back in time may help us get our arms around this.

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