Commodities are big news nowadays. Not that that’s anything new. After all, the market breakdown of 2008 was preceded by huge run-ups in oil, precious metals and foodstuff futures. Speculation—fostered by a proliferation of exchange-traded commodity trusts—helped to send prices soaring 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. Managed futures proved their value as non-correlated assets in the financial firestorm that singed more traditional investment allocations.
While the S&P 500 Composite sank 33.4 percent in the second half of 2008, the value of managed futures metered by the BarclayHedge CTA Index actually rose 4.4 percent. Managed futures, in fact, provided better risk diversification for equity investors than bonds (see Chart 1).
The advantage enjoyed 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.
From the April Issue: Mad for Managed Futures
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.
Throwing money at managed futures shouldn’t be done willy-nilly, of course. First, there’s the question of how to gain exposure—through 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, equally important, from what source?
Let’s work backwards 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 allocation.
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.
How Much Is Enough?
Let’s posit a basic 60/40 portfolio as our starting point—60 percent stocks and 40 percent bonds. We’ll sample the effect of 10- and 20-percent carve-outs from stocks to managed futures—with monthly rebalancing—over the past three years in Chart 2. We’ll use the Chart 1 indexes as stand-ins for our portfolio components.
From the track record, two things become readily apparent. First, adding managed futures boosts overall portfolio performance by enhancing returns and dampening volatility. The portfolio’s risk-adjusted return, indicated by its Sharpe ratio, doubled when a managed futures allocation was added. Second, more is better. Doubling the managed futures allocation increased the risk-adjusted return by a further 75 percent.
How To Invest
Before 2003, the recommendation and brokering of managed futures products was effectively foreclosed to anyone lacking Series 3 registration. The commodity pools and separately managed accounts then available were also heavily fee-laden. Changes in the regulatory scheme have since allowed the creation of lower-cost commodity-based mutual funds and exchange-traded products which can be marketed by Series 7 folk and RIA associates.
Read more: Absolute Returns for the Masses
The first generation of commodity securities was index-based. It’s only been within the past two or three years that actively-managed products have debuted. Of those, the first to market were mutual funds. It’s the rare exchange-traded fund or note that can claim to be actively managed. And some of those, in fact, are really index trackers in disguise.
The short track record of these products necessarily limits our analysis, but we’ll look at the performance of a half-dozen portfolios and benchmark them against the returns generated by a commodity index tracker.
- MutualHedge Frontier Legends (MHFAX), the newest portfolio, is closest to a classic multi-advisor commodity pool, including its rich fee structure.
- DWS Enhanced Commodity Strategy (SKNRX) is in fact, a closet index tracker. SKNRX managers overweight or underweight the sectors within its commodity benchmark in an attempt to boost returns and minimize losses.
- ELEMENTS S&P CTI ETN (LSC), an exchange-traded note which offers exposure to Standard & Poor’s proprietary Commodity Trends Indicator. Investors, in addition to bearing commodity market risk, also undertake credit risk. The note’s issuer is the Swedish Export Credit Bank.
- Direxion Commodity Trends Strat Inv (DXCTX) tracks the Alpha Financial Technologies Commodity Trends Indicator, a momentum-following mechanism that allocates short and long exposures over a diversified spectrum of futures.
- Rydex|SGI Managed Futures Strategy (RYMTX) is also a tracker. RYMTX tries to match to match the performance of the Standard & Poor's Diversified Trends Indicator, a index similar to the Commodity Trends Indicator, but which incorporates financial futures.
- iShares Diversified Alternatives Trust (ALT), an exchange-traded fund that’s truly active. The fund trades futures and currency forwards, endeavoring to produce non-correlated absolute returns.
- ELEMENTS S&P CTI ETN (LSC), an exchange-traded note which offers exposure to Standard & Poor’s proprietary Commodity Trends Indicator. Investors, in addition to bearing commodity market risk, also undertake credit risk. The note’s issuer is the Swedish Export Credit Bank.
- PowerShares DB Commodity Index Tracking (DBC), the passive benchmark that will provide the basis for calculating all the other products’ beta and alpha coefficients. DBC is an exchange-traded fund that track changes in the Deutsche Bank Liquid Commodity Index, a long-only portfolio of diverse commodity futures.
As you can see from the product descriptions, only two portfolios—MFHAX and ALT—don’t somehow track an index. And, as you can see from Table 3, the very best return was obtained by the SKNRX portfolio—an index hugger which limits its active management to tinkering with its benchmark’s sector weights.
These results shouldn’t be taken as an indictment of managed futures. There’s just a paucity of true managed futures products that have built up track records. The commodities markets, too, have been skewed upwards recently, along with equities. These products have all been positively correlated to stocks and commodities for the past year.
The numbers tell us this: given the limited menu of managed strategies and the recent upward bias of the markets, a long-only index approach—vanilla or enhanced—has been a better stand-alone bet. That could very well change as more actively managed futures products season themselves in the coming months.
