How can an investor protect his wealth against possible future adverse events? We propose three basic approaches and variants therein.
First, the investor can choose ultraconservative funds, including cash management accounts and Treasury bills, as his primary investment vehicle. While protecting nominal wealth, short-term fixed-income securities will inevitably lead to low returns, especially under the current close-to-zero interest rate environment throughout much of the world.
Safe short-term cashlike instruments fail as a hedge against inflation risks. For long-term investors such as pension plans, low asset return performance will result in the need for relatively high contributions over time, which can be an expensive approach for achieving short-term protection over extended periods.
A second approach to wealth preservation is to attempt to anticipate turbulent periods. Here, the investor lowers risk dynamically by moving from risk-bearing assets such as stocks to safe investments such as short-term government bonds. Such a flight-to-quality approach can be difficult to implement for large institutional investors, however, due to their size, organizational structure and shift to illiquid alternative investments [Swensen 2000]. Also, dynamic asset allocation can be expensive due to market impact costs, false positive indicators and time delays.
A third approach is to invest in assets and strategies that are likely to perform well during turbulent crash periods. There are two primary variants: a) tail risk strategies; and b) strategies or asset categories that have done well historically during turbulent periods. The former is designed to pay off during a crash, whereas the latter is not guaranteed but may be less expensive to implement.
As we discuss in this paper, managed futures strategies in general, and commodities futures strategies in particular, fall under the third approach and accordingly should be considered an important component of a long-term investor's portfolio.
Managed futures encompass four general asset categories: commodities (agricultural markets, energy products and metals); currencies; bonds; and equity indexes. In each of these cases, a futures (or forward) market is established by participants to either hedge or speculate on the underlying instrument. At any given time, a futures pricing curve can be constructed by plotting the prices of futures contracts expiring across the expiration spectrum.
There can be some confusion in futures/commodities nomenclature due to historical circumstances and regulatory issues. In the United States, the Commodity Futures Trading Commission and the National Futures Association regulate futures markets and their participants. The first futures markets were commodities markets such as grains, softs (e.g., cotton) and metals; energy products then followed. Eventually, futures markets have expanded significantly to include currencies, fixed-income instruments and equity indexes. Today, professional money managers who trade primarily futures are designated as commodities trading advisors (CTAs), regardless of which sectors they trade. In this report, we differentiate the broader managed futures area from the original commodities futures markets.
Commodities investments have gained in interest by individual and institutional investors over the past decade. For example, trading volume in exchange-traded commodities has increased dramatically. Furthermore, assets under management more than doubled between 2008 and 2010 to nearly $380 billion (Figure 1); and commodities prices have increased. Market participants attribute the recent price increases in commodities to increased demand for consumer goods, particularly from the populous countries of India and China. In contrast, the size of the world stock market was estimated at about $46.8 trillion at the end of March 2010.
As we show, for traditionally diversified investors, an allocation to a fund that invests exclusively in commodities markets offers not only a hedge against inflation but also effective diversification because of its low correlation with traditional asset classes. In the long run, commodities investment funds show equitylike returns, but are accompanied by lower volatility and shortfall risk.