Managed Futures: Fear Not Volatility

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Fear, as defined by Merriam-Webster dictionary, is an unpleasant often strong emotion caused by anticipation or awareness of danger. Uncertainty in the markets and increased volatility1 seem to bring fear to the forefront of many investors’ minds, with many anticipating poor portfolio performance due to past experiences during similar market conditions. Volatility in the markets will always exist to some degree, so we contend it is important for portfolios to incorporate investments that are not only able to withstand volatility, but also perhaps profit from it.

Volatility Measure: The VIX

A common measure of expected market volatility is the Chicago Board Options Exchange Volatility Index, commonly known as the “VIX.” The VIX measures implied near-term volatility of S&P 500 index option prices. Basically, it represents the market’s expectation of stock market volatility over the next 30-day period, measured on an annual basis. A VIX of 25 indicates an expected annualized change of 25%, or, a 1.88% market move up or down over the next 30-day period. The higher the VIX the higher expected near-term volatility in the markets, and vice-versa, the lower the VIX the lower near-term expected volatility in the markets. A high VIX, however, does not necessarily mean that the prices of stocks or equities will go down as it is not a fear index; instead it means volatility in the near term is expected to be higher, which could be price movement either up or down. Figure 1 shows the average monthly VIX since 1990.

Looking at the past two decades, from 1990 through 2011, the average historical monthly VIX was 21. However, if you compare the last ten years versus the 1990s, it’s clear that expected volatility has increased dramatically. The monthly VIX was at least 20% above its historical average during the 1990s only 13% of the time. In comparison, during the 2000s the monthly VIX was at least 20% above its historical average 33% of the time, more than double the number of times of the previous decade. The more frequent occurrences of elevated monthly VIX levels during the 2000s does not necessarily mean that stocks or equities were expected to go down, only that there was an increase in expected volatility. In 2001 when US stocks lost nearly -12%, the average monthly VIX for the year was 26. The average monthly VIX during 2009 was 32, but US stocks did not drop in value that year, in fact, US stocks returned over 26% during 2009.

Another indication of elevated expected volatility is a comparison of the number of months the VIX has historically been above its long-term average.2 Significant difference in expected volatility between the two decades demonstrates a rise in volatility expectations. During the 1990s, 16 months had a VIX level that exceeded the index’s average by at least 20%. Since 2000 has been a different story: monthly values have been 20% or more than the average 48 times. Further, after January 2000 it only took until October 2002 for the VIX to accrue the same number of months (16) with values at the same above average threshold. That is, it took less than three years for the frequency of elevated volatility expectations to equate to the entire decade of the ’90s.

It of course is unknown whether future decades will resemble either of those of the past 20 years. However, the VIX may be a useful tool of measure to understand how certain investments may react to varying levels of expected volatility surrounding future markets.

VIX Levels

Volatility in the markets will always exist to some degree, at some times greater than others. We believe it is important for portfolios to incorporate investments that are able to not only withstand, but potentially profit, in times of increased market volatility. While investing in the equity markets during periods of high volatility has been historically difficult, managed futures may be one such investment that has the potential to thrive. Although clearly, there is no guarantee that any investment will achieve profits or avoid losses.

In the past, as the VIX has moved above its historical average, the average annualized return of US stocks progressively worsened (Figure 3). US stocks experienced an annual historical loss near -4% during months when the VIX was greater than its historical average. Even more striking, US stocks experienced an annualized historical return near -24% during those months when the monthly VIX was 40% or greater than its historical average. When the VIX has been below its historical average, indicating lower expected near-term volatility, US stocks historically delivered positive returns. On average, performance actually incrementally improved the lower the value of the VIX. Of course, these results may not repeat themselves in the future.

Managed futures’ behavior during volatile markets has been a completely different story. In

fact, on average, managed futures have achieved positive returns even when the VIX has been

at significantly elevated levels (Figure 3). During months when the VIX was 40% or greater above its historical average managed futures realized an annualized historical return of 13%. This represents a difference of nearly 37% on an annualized basis compared to US stocks during such periods. Even as the VIX was below its historical average, indicating lower expected volatility, managed futures still delivered historically consistent positive returns. Of course, past performance is not indicative of future results.

Many investors allocate portions of their portfolios to asset classes besides US stocks, perhaps to investments such as international stocks, commodities or real estate investment trusts (REITs). A closer look at these investments when the VIX was higher than average may help put into perspective previously unknown characteristics about these investments in times of expected increased volatility surrounding the markets.

A strikingly similar story to that of US stocks emerges, with performance gradually worsening during months the monthly VIX was incrementally higher than its historical average. However, managed futures has been the exception to this tale. The ability of managed futures to perform historically well in various market environments, regardless of expected volatility, depicts the typically flexible nature of managed futures; managed futures managers have the ability to react to changes by taking long or short positions across multiple asset classes in various global markets. Of course, there is no guarantee any investment will achieve its objectives, generate profits, or avoid losses.

VIX Shifts

The ability of an investment to be nimble may be another important aspect in a portfolio, especially with short term expected volatility shifts. A change in the VIX from 12 to 13.2, a 10% increase, will have the same weight in this analysis as a change from 30 to 33, a 10% increase from the previous month as well. In other words, this analysis ignores the absolute level of the VIX, but instead looks at its upward or downward movement. By looking at the monthly percentage change of the VIX, it may give additional insight to how investments perform when short-term expected volatility change surrounds the market.

Historically, US stocks’ monthly returns have progressively worsened as the percentage change of the VIX from the previous month increased (Figure 5). During those months when the VIX increased by 20% or more from the previous month, US stocks experienced historical returns near -5% per month on average. This may be a significant statistic as changes in the VIX from the previous month have occurred with greater regularity and magnitude over the past three years. Whether this trend will continue or not is not known, but having an investment that may be able to perform when the VIX shifts could be beneficial. Of course, these results may not repeat themselves in the future.

Managed futures experienced historical returns of nearly 2% per month, almost a 7% historical monthly advantage over US stocks, when the percentage change of the VIX from the previous month increased by 20% or more (Figure 5). Not only have managed futures performed historically well when the percentage of the VIX has increased from the previous month, but consistently returned historical positive monthly performance when the percentage change of the VIX decreased from the previous month. Of course, past performance is not indicative of future results.

A comparison of other investments should also be examined to find if other traditional investments perform well during short-term fluctuations in the market. International stocks, commodities and REITs follow a similar path to that of US stocks, as the historical monthly returns worsen as the percentage change of the VIX from the previous month increases. The consistent historical monthly returns managed futures have shown during shortterm shifts in volatility may be an important investment to include in a portfolio.

Conclusion

Market volatility to some degree is inevitable. The VIX measures the near-term expected volatility of the markets and may be a good indicator as to the expectation of how certain investments may perform in various market volatility environments. Many investors may fear the word volatility when it comes to investments, but at Altegris, we believe this should not be the case. Managed futures have historically performed well whether expected volatility is high or merely shifting. The ability of managed futures to perform despite market volatility may be beneficial to those seeking an alternative to counter market uncertainty.

Important Risk Disclosure

Hedge funds, commodity pools and other alternative investments involve a high degree of risk and can be illiquid due to restrictions on transfer and lack of a secondary trading market. They can be highly leveraged, speculative and volatile, and an investor could lose all or a substantial amount of an investment. Alternative investments may lack transparency as to share price, valuation and portfolio

holdings. Complex tax structures often result in delayed tax reporting. Compared to mutual funds, hedge funds and commodity pools are subject to less regulation and often charge higher fees. Alternative investment managers typically exercise broad investment discretion and may apply similar strategies across multiple investment vehicles, resulting in less diversification. Trading may occur outside the United States which may pose greater risks than trading on U.S. exchanges and in U.S. markets. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

There are substantial risks and conflicts of interests associated with Managed Futures and commodities accounts, and you should only invest risk capital. The success of an investment is dependent upon the ability of a commodity trading advisor (CTA) to identify profitable investment opportunities and successfully trade. The identification of attractive trading opportunities is difficult, requires skill, and involves a significant degree of uncertainty. CTAs have total trading authority, and the use of a single CTA could mean a lack of diversification and higher risk. The high degree of leverage often obtainable in commodity trading can work against you as well as for you, and can lead to large losses as well as gains. Returns generated from a CTA’s trading, if any, may not adequately compensate you for the business and financial risks you assume. CTAs may trade highly illiquid markets, or on foreign markets, and may not be able to close or offset positions immediately upon request. You may have market exposure even after the CTA has a request for closure or liquidation. You can lose all or a substantial amount of your investment. Managed Futures and commodities accounts may be subject to substantial charges for management and advisory fees. It may be necessary for accounts that are subject to these charges to make substantial trading profits in order to avoid depletion or exhaustion of their assets. The disclosure document contains a complete description of each fee to be charged to your account by a CTA. If you use notional funding, you may lose more than your initial cash investment. If you purchase a commodity option you may sustain a total loss of the premium and of all transaction costs. If you purchase or sell a commodity future or sell a commodity option you may sustain a total loss of the initial margin funds and any additional funds that you deposit with your broker to establish or maintain your position. If the market moves against your position, you may be called upon by your broker to deposit a substantial amount of additional margin funds, on short notice, in order to maintain your position. If you do not provide the requested funds within the prescribed time, your position may be liquidated at a loss, and you will be liable for any resulting deficit in your account. This brief statement cannot disclose all the risks and other significant aspects of the commodity markets, and you should carefully study the disclosure document before you trade, including the description of the principal risk factors of an investment. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

About Altegris

Altegris searches the world to find what we believe are the best alternative investments. Our suite of private funds, actively managed mutual funds and managed accounts provides an efficient solution for financial professionals and individuals seeking to improve portfolio diversification.

With one of the leading Research and Investment groups focused solely on alternatives, Altegris follows a disciplined process for identifying, evaluating, selecting and monitoring investment talent across a spectrum of alternative strategies including managed futures, global macro, long/short equity, event-driven and others.

Veteran experts in the art and science of alternatives, Altegris guides investors through the complex and often opaque universe of alternative investing.

Alternatives are in our DNA. Our very name, Altegris, highlights our singular focus on alternatives, the highest standards of integrity, and a process that constantly seeks to minimize investor risk while maximizing potential returns.

The Altegris Companies, wholly owned subsidiaries of Genworth Financial, Inc., include Altegris Investments, Altegris Advisors, Altegris Funds, and Altegris Clearing Solutions. Altegris currently has approximately $3.36 billion in client assets, and provides clearing services to $774 million in institutional client assets.*

* Altegris and its affiliates are subsidiaries of Genworth Financial, Inc. and are affiliated with Genworth Financial Wealth Management, Inc. and include: (1) Altegris Advisors, L.L.C., an SEC registered investment adviser; (2) Altegris Investments, Inc., an SEC-registered brokerdealer and FINRA member; (3) Altegris Portfolio Management, Inc. (dba Altegris Funds), a CFTC-registered commodity pool operator, NFA member and SEC-registered investment adviser; and (4) Altegris Clearing Solutions, LLC, a CFTC registered futures introducing broker and commodity trading advisor and NFA member. The Altegris Companies and their affiliates have a financial interest in the products they sponsor, advise and/or recommend, as applicable. Depending on the investment, the Altegris Companies and their affiliates and employees may receive sales commissions, a portion of management or incentive fees, investment advisory fees, 12b-1 fees or similar payment for distribution, a portion of commodity futures trading commissions, margin interest and other futures-related charges, fee revenue, and/or advisory consulting fees.

Genworth Financial, Inc. (NYSE:GNW) is a leading Fortune 500 insurance holding company with more than $100 billion in assets and employs approximately 6,500 people. Genworth has leadership positions in offerings that assist consumers in protecting themselves, investing for the future and planning for retirement, and also offers mortgage insurance to help consumers achieve homeownership while assisting lenders manage risk and capital.

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