on public futuresfunds. These organizations include:Managed Account Reports (MAR)220 Fifth Avenue, 19th FloorNew York, NY 10001-7781TASS Investment Research LimitedCharter House13-15 Carteret StreetLondon SW1H 9DJUnited KingdomBarclay Trading Group508 North Second StreetFairfield, IA 52556Stark Research Inc.875 Prospect, Suite 201La Jolla, CA 92037The data in Table 4.1 provide comparison between the returns achieved by theMAR Universe of qualified CTAs for each year from 1980 through 1999, and thereturns for investing in the S&P 500 or bonds for the same years. Note that althoughthe CTA returns were higher, their volatility was also higher. Nevertheless, $1,000compounded at the average annual rate and invested with the CTAs in 1980 wouldhave grown to $6,924, while the returns for the same $1,000 invested in the S&P 500or in bonds would have been $7,246 and $3,585 respectively, by the end of 1999.33
Chapter 4
Table 4.1 Comparison of Annual Returns 1989–1999MAR CTA INDEX(Qualified Universe)
S&P 500
Bonds*
19801981198219831984198519861987198819891990199119921993199419951996199719981999
52.991.115.090.2818.0527.113.0857.7814.637.2527.2916.829.9019.86–0.7015.1214.6410.069.373.77
32.45–4.9521.5622.556.2731.7518.685.2616.6131.68–3.1230.487.6410.021.3237.5722.9633.3728.4021.05
5.179.3827.757.4014.4820.4315.312.197.0314.238.7215.337.1710.66–3.3518.342.769.589.85–2.25
AverageAnnualRate$1,000**
14.75$6,924
17.87$7,246
9.77$3,585
*Shearson Lehman Long Term Government Bond Index**$1,000 compounded annually at the average annual rate
SELECTING A CTA TO MANAGE YOUR MONEYSelecting a CTA to manage your account can be a puzzling process. First, youneed to know who is available as a CTA. Second, you need to get informationabout them, and, third, you need to negotiate with them.Finding out who is available can be done easily through any of the servicesmentioned above, such as MAR or TASS. Subscriptions to their monthly reports34
Managed Futures—A Good Alternative
are expensive. However, a good independent broker also can help you identifypossible prospects.Once identified, contact your selected CTAs and ask them to send you theircurrent Disclosure Document. That document, which is required by law to be presented to each investor at the time of first sales efforts, contains all the basic (generic) information about the CTA—e.g., full name, address, educational and businessbackground; number of years registered as a CTA; the method of trading; futurescontracts traded; specialties (spread trading, arbitrage, financial futures only, agricultural futures only, etc.); minimum size account; fee schedule; affiliation, if any,with a broker; statement regarding civil, regulatory, or criminal suits or actionsduring the last five years; and, finally, a track record if the CTA has actually beenmanaging other people’s money.The track record, if one exists, must be presented in a certain way prescribedby the regulators so that potential investors can do their own analysis of the results(see Table 4.1). For example, the record must clearly show for each month howmuch money was actually being managed; how much of the month-to-monthchange resulted from trading gains or losses, and how much from additionalinvestment or withdrawals; the brokerage fees charged; the interest earnings; themanagement and incentive fees paid; and the net return on investment after fees,expenses, etc., stated either in percent or as the change in the value of a unitinvestment.It can be difficult to get precisely comparable analyses of all track recordsbut the CFTC’s required 13-column format for presenting track records helps. Toget the most realistic picture of the CTA’s performance, you should deduct fromthe profits all interest earned. Table 4.1 depicts a sample track record report.After you have the numbers adjusted, do some very basic calculations ofeach CTA and compare them on:a. Compound annual return.b. Largest single losing month.c. Largest loss from peak to valley.d. How many months were involved in (c).e. How many months it took to recover to a new high.f. Sharpe ratios.The Sharpe ratio, named after Nobel Prize winner Professor William Sharpe,measures relative reward and risk by subtracting the monthly average T-bill ratefrom the monthly average investment return and then dividing by the standarddeviation of the monthly returns. The higher the Sharpe ratio, the better thereward/risk ratio.35
Chapter 4
Investment Return – T - Bill Return= Sharpe RatioStandard Deviation of Investment ReturnStatistical analyses and number manipulations will take you only so far. It maybe misleading to use statistical analyses that are based on less than three or fouryears of data as reliable guides about future performance. Indeed, several studieshave shown that past performance of a CTA is a very poor guide to future performance. Hence, you have to rely on other qualitative factors.
Which CTA Is the Best?Consider the data in Table 4.2. If you were going to give your money to one of thoseCTAs, which would have provided you the highest average annual return over thefour-year period shown?If you are like most people, you would have answered “A” or “C.” Theanswer is they all provided equal average annual returns—5.5 percent. At firstglance, that seems preposterous, but look closely at “C.” If that CTA started with$100, at the end of year 2, he has $150. After the 30 percent loss in year 3, he isback almost to $100. The 18 percent return in year 4 brings him back only to equalthe plodding, but positive, return of “B.”Actually, from the data shown you cannot answer the question posed aboveof which CTA is best. Statistical data, and especially returns data alone, can bevery misleading. To answer the question you need to look also at the volatility ofthe returns, the Sharpe ratio, the trend in returns, etc. Further, you have to consider qualitative factors.
Qualitative FactorsYou should meet the CTA you are hiring to manage your account. If you are putting your money in a futures fund, the CPO or GP will take care of this for you.Just check the fine print in the prospectus to be sure that the CPO, GP, and CTAdo not have conflicts of interest that reward them in a mutually beneficial way
Table 4.2 CTA ReturnsYear1234
A
B
C
–6%–6%+20%+17%
+7%+6%+5%+4%
+20%+25%–30%+18%36
Managed Futures—A Good Alternative
while possibly harming you, e.g., brokerage arrangements that reward the CPO, GP,or broker for selecting a CTA that tends to trade a lot.The best guides to selecting a CTA are:➥ Number of years experence—the more the better. He is a survivor.➥ A record of stability in business procedures and methodology of trading.➥ A record of consistency in returns. High returns are not so important assteady positive returns.➥ Attitude toward risk and discipline or attention to detail in controllingrisk. This is best reflected in: (a) the CTA’s responses to questions dealing with how he leverages and de-leverages an account as he makes profits or suffers losses; (b) the explanations of the size of the largest loss todate—why it occurred and what safeguards are in place to see that it won’toccur again; and (c) the Sharpe ratio.
Single Advisor or Multi-Advisor?Almost all individually managed accounts are managed by a single CTA. Mostcommodity funds issued are private placements and most of them are single advisor funds. Almost all large public futures funds are multi-advisor funds.Even casual perusal of the records of individual CTAs reveals the very highprobability that with any single advisor there is a very high risk of having very substantial losses at any point in time. Diversification across several advisors, whosetrading patterns are non-correlated, provides a substantial reduction in risk, reducesthe peak-to-valley drawdown substantially, and significantly increases the probability that one will have a superior investment. Of course, such multi-advisor diversification can be accomplished only if you have enough capital to do it yourself,or if you participate only in multi-advisor funds where the CTAs are selected withdiversification and risk-control in mind.Figure 4.3 illustrates the point. If you select a single advisor, you live and diewith that CTA. The Sharpe ratio (reward to risk) will usually be lower than if youselect two CTAs. Similarly, three will be better than two, four will be better thanthree, etc., all the way up to seven or eight.If you spend some effort in researching and selecting CTAs that are truly different, it is easy to see how you can really improve the quality of your investment.One important measure to use in assembling a diversified group of CTAs iscorrelation. Conduct a correlation study of their monthly returns. Select the groupthat has the highest returns and the lowest correlations with each other. Generally,you would not want any two CTAs that have an inter-correlation of returns above60 percent unless there are other offsetting factors. Select one of them, not both ofthem. The data in Table 4.3 illustrate the point.37
Chapter 4
Figure 4.3 Fund Structure: Efficient Portfolios Optimal Portfolio Size
CTA “A” and CTA “D” in Table 4.3 are so highly correlated that to select bothof them is almost like doubling up.Of course, you don’t need to make equal allocations to each CTA. Varyingthe allocations among CTAs also adds to diversification.You also can diversify within a single CTA. Many CTAs, especially the larger, more experienced ones, offer several different programs, thus allowing one todiversify within a single CTA by selecting several programs and allocating moniesamong them. Putting equal dollar amounts in each of the separate programs couldprovide substantial diversification and lessen risk significantly, while still providing reasonable returns.
THE VALUE OF ADDING COMMODITY FUTURES TOYOUR INVESTMENT PORTFOLIOMany studies have been conducted over the last several decades to determinewhether it was worthwhile for investors to add a managed futures investment totheir total investment portfolios. In other words, whether the Sharpe ratio (reward/
38
Managed Futures—A Good Alternative
Table 4.3 Multi-Advisor Correlation Coefficients(Eight Trading Advisors)
ABCDEFGHAverage
A1001–18033–275814
B
C
D
E
F
G
H
1100–39049–612–3
–1–39100–30–6–291710–11
800–3010012511–2–11
334–6121002311513
–279–2952100212–2
5–6171131211001313
81210–2152131008
risk) would be improved if investors diversified their investments by allocating sayonly 90 percent of their investments to stocks and put 10 percent in a futures fund.The answer has been a resounding yes. Virtually all studies, academic aswell as commercial, agree.The earliest of these studies was done in the early 1980s by Professors Bodieand Rosansky of Boston University and by the late Professor John Lintner ofHarvard.They applied Modern Portfolio Theory, named after Professors Sharpe andMarkowitz who won the Nobel prize, to the question of efficient allocation of dollars among investments to get the most attractive reward/risk combination. Theyconcluded that allocating even a small percentage of the investment dollar to futuresfunds improved the investors’ return/risk ratio over keeping all their investmentsin stocks and bonds. They established the concept of an “efficient frontier,” whichis created by plotting on a graph the measure of risk (standard deviation of monthly returns) and the measure of reward (monthly returns) for various combinationsof investments in stocks, bonds, and futures funds. The combination that lies furthest to the right is the best reward/risk combination, i.e., highest return/lowestrisk. The line connecting the dots representing the different combinations is calledthe efficient frontier (see Figure 4.4 for an illustration).Many other studies have concluded that one’s investment quality could benefit by allotting as much as 20 percent of a portfolio to futures funds.Recent studies by the Russell Corporation and Powers Capital Corporation concluded that a passive (buy and hold) strategy involving a basket of world-producedcommodities would improve the reward/risk ratio of an investment portfolio, evenif the basket contributed a return as low as only 1/8 to 1/4 of 1 percent per year.
39
Chapter 4
Figure 4.4 Efficient Frontier
All the research points in the same direction and says the same thing. Investorscan improve their returns without making their risks worse if they allocate somesmall percent of their money to an investment in a managed futures product.Clearly, some qualifiers have to be added to that statement. First, the resultsreported are based on a presumption of long-term trends where the returns fromfutures funds are very lowly correlated with stock returns. Second, it presumesthat the CTA(s) selected or the fund selected will be at least as profitable as the fundsor the average of funds the researchers selected in their research.
GETTING HELP—USE A TRADING MANAGERDon’t worry if all of the above discussion leaves you feeling uncertain as to howto proceed and still asking, “How do I select a CTA or a fund?” or even, “How much40
Managed Futures—A Good Alternative
improvement should I expect in my investment reward/risk ratio if I allocate 5percent, 10 percent, or even 15 percent of my money to futures?” There is help—the trading manager.Trading managers are like investment counselors. They are supposed to actindependently in evaluating and selecting CTAs, futures funds, and brokers. Theyare normally paid a small fee, plus a percent of profits, so they have great incentive to hold your costs down and select CTAs who do not lose money. Normallythey are most appropriate and affordable for large investments seeking to placeseveral million dollars singly or in a fund.The trading manager normally provides the following services:
1. Product DesignFutures fund products can be devised to provide:➥ Annual dividends to the investors.➥ Guaranteed return of capital.➥ A potential hedge against inflation.➥ Diversified investment in foreign economies, i.e., German stock market,French bonds, Australian bonds, Swiss currency, etc.➥ Foreign exchange protection against devaluation.A good trading manager can structure a product to meet the needs of theinvestor whether it be an individual, a pension, a trust, or whatever.
2. CTA Evaluation, Selection, and NegotiationAs noted earlier there are about 3,000 CTAs registered in the U.S. Sorting throughtheir records, evaluating them, and matching them with investors’ needs and desiresis the job of the trading manager. The trading manager also negotiates the deals withthe CTAs. Often the trading manager can get a better rate than an individual.
3. Allocation and Re-Allocation of AssetsSelection of the appropriate CTAs is only part of the job. Equally important isdetermining how much money to allocate to each CTA. It is rare that one wouldwant to allocate equal amounts to all CTAs, and it is even rarer that one would wantto keep the allocations the same after trading starts and profits or losses accumulate. Trading managers do that job of monitoring CTAs’ trading activity, gains,and losses, and adjusting the allocations among them.
41
Chapter 4
4. AdministrationClearly, research has shown that investors are better off with more than one CTAmanaging their money. Sometimes investors need a special product. Oftentimes,they want the limited liability of a limited partnership. All of this requires someone to gather the documents, see that the proper legal niceties are followed, thatall signatures are in place, and to provide all reports about performance, net assetvalue, etc., back to the investors. The trading manager does this.In short, a trading manager makes futures investing convenient, easy, andpersonalized for the investor.When selecting a trading manager, ask about their independence. They shouldbe protecting you from conflicts of interest and should not be compensated bybrokers or CTAs for bringing them business.Trading managers can be very worthwhile by reducing your costs, protecting your interests, and improving enormously the odds that you will not lose moneywith your first foray into managed futures.
A LONG-TERM PERSPECTIVE NEEDEDDid you know that if you missed only 20 days of being invested in the stock market (S&P 500) during the entire decade of the 1980s, your average annual returnswould not have been much better than if you left your money in Treasury billsduring the decade?The average annual return on stocks from January 1980 to January 1990 was17.5 percent. The average return on U.S. T-bills during that period was 8.9 percent.If you were a market timer (i.e., buying when you thought the short- or intermediate-term trend was up, selling when you thought it was down, standing asidewhen you thought there was no trend) and you were standing aside when youshould have been long, your return would have averaged 9.3 percent. It wouldhave been much worse, of course, if you had been short!Unless investors are very good at market timing or very lucky, it’s the longterm investors who tend to have the greatest probability of making extraordinaryreturns in the stock market. The same thing is true in managed futures and selecting CTAs. Get help in selecting good ones and keep a long-term perspective on theirperformance.
42
Chapter 5
Commodity Index Futures—The Basket Approach to Investing
One of the challenges facing all traders and especially new traders is selecting oneor two commodities on which to focus attention. Most traders can’t trade everything. They do not have the time, the money, the information, or the inclination.That is especially true if they are just getting started.Enter the commodity index futures. A futures on a commodity index is exactly what the name suggests. The index represents the price movement of a basketof commodities. The commodities’ prices may be weighted or unweighted in theindex. The futures represents a contract on the expected value of that index at somefuture period.Commodity index futures have been popular for another reason. Thoseinvestors such as institutional investors who want commodities in their portfolio,perhaps as a hedge against inflation, can cover a broad range of commodity priceswith a single product. The two most popular commodity indexes represented onfutures contracts include futures on the Commodity Research Bureau (CRB) FuturesPrice Index and the Goldman Sachs Commodity Index (GSCI).43Copyright 2001 The McGraw-Hill Companies. Click Here for Terms of Use.
Chapter 5
The CRB Future Price Index was developed as a commodity price indicatorin the middle part of the 20th century. The index is traded on the New York FuturesExchange. Price calculations on the index are based on several futures contractmonths for each of 21 different commodities. The base year for the index is currently set at 1967.The GSCI is based on a single, near-month futures traded on the majorexchanges in Western countries. At present, the index is composed of futures pricesfor 19 commodities. The weighting is based on world production. It started tradingin July of 1992. Each year it is evaluated and adjusted for the next year’s trading.The oldest of these indices, the CRB, is an equally weighted index. None ofits 21 commodities has any more influence over the index than any other. A 10percent increase in the futures price of any component of the index will causeabout a 1/2 percent increase in the index itself. So if soybean futures go from $6to $6.50 a bushel, the index will go up roughly one point; similarly, if crude oil goesfrom $20 to $22 a barrel.Developers of the GSCI wanted a product that was more specifically designedto reflect the impact of commodity price inflation on the cost of living. Ideally, theywould have liked to base their index weights on consumption, but that is an extremely difficult thing to do, so they settled for weighting on production. They selectedworld production as reported by the United Nations; hence, the GSCI is heavilyweighted toward energy, because crude oil is the single largest produced commodity in the world. Only five commodities compose nearly three-fourths of the index.The GSCI also embodies one other unique and very important concept called“roll yield.” Five major commodities included in the index are subject to a tendencycalled backwardation in the price structure. (Backwardation refers to prices inexcess of futures being successively lower than the futures month preceding.)Since the GSCI is based on only the nearby futures months, when a contract expiresthe index automatically picks up the next futures month. In a backwardation market, one is continually buying futures months that are cheaper than the month justcalled “rolled out of.” Profits emanate from rolling the positions over into lowerpriced futures. Because the GSCI is heavily weighted toward commodities whosefutures prices reflect backwardation, this creates an extra “investment yield” foran investor in the index. Although this yield would technically be available in otherindices, it is virtually impossible to achieve it in the CRB because that index reflectsequal weighting among all futures price months rather than a single month.Those who like the GSCI insist that it fits nicely in an investment portfoliobecause it can act in a way similar to real estate—hard asset classes. The GSCI isnegatively correlated with stocks and bonds. Second, it can act as a hedge againsta sideways whipsaw in the market. That, in fact, is the attractiveness of the roll yieldfeature of the index. Third, Goldman Sachs has created a class of bonds whoseyields are based on changes in the GSCI. These bonds are a proxy for a hedgeagainst a change in interest rates as a result of fears over inflation. Lastly, there seems44
Commodity Index Futures—The Basket Approach to Investing
to be a definite seasonal pattern to the GSCI as a result of the weightings of the individual commodities, or baskets of commodities, and the index. This arbitrage isdesigned very similarly to the so-called “program trading” in stock indexes.Defenders of the CRB contend it is a more balanced product and betterreflects fundamental commodity-world and general-commodity inflation. Its equalweighting does not make it susceptible to price controls or other external eventsthat might more directly impact a single commodity that has inordinate weightingwithin the index.
SUMMARYEither the CRB Index or the GSCI could play an important investment role in a portfolio. For example, adding either or both of them to an efficient institutional portfolio should have a positive impact on the portfolio’s Sharpe ratio. Various studies of both the CRB Index and the GSCI show that adding even small amounts ofeither of them improve the Sharpe ratio. Further, both of them tend to be negativelycorrelated with inflation. Lastly, taking a passive investment in either of themshows positive returns over time.
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Chapter 6
The Trading Plan
People who trade commodities without a plan are like Christopher Columbus.When they start, they don’t know where they’re going. When they arrive, theydon’t know where they’ve been. They differ from Columbus in one importantaspect, however. They usually aren’t as lucky in their discoveries.As was pointed out in Chapter 3, many speculators lose money because theytrade without a plan. All good traders build trading plans. If you are a beginningtrader, put it on paper. That way you will be less likely to forget an important element and you will have something to help instill discipline. Your success as a trader will depend, to a great extent, on your ability to minimize the common mistakes made by losers. That ability grows and develops with well-made writtenplans and experience.A good subtitle for this chapter might be “Money Management,” because aplan forces you to think about how you will manage your money. It is also anexcellent way to control the emotional involvement that clouds the judgment of somany traders. A plan should help reduce the frequency with which one takes profits too early or lets losses run too long. It should also help you determine yoursuitability for commodity futures trading.47Copyright 2001 The McGraw-Hill Companies. Click Here for Terms of Use.
Chapter 6
A well-prepared plan considers all aspects of your participation as a commodity futures speculator, including emotional as well as financial suitability and the strategy you will follow in achieving a goal. Plans range from the simple, which includeonly general considerations, to elaborate systems with completely mechanized orcomputerized rules of action. Some plan is better than none at all. Even a poor planis better than none, because no plan would provide for losing all of one’s capital.
YOUR ATTITUDE TOWARD RISKCertainly no investor or commodity trader wants to lose money but when one takesrisks, one obviously has a chance to lose money. On the other hand, there are fewopportunities to make money without taking some risks. Considerations of thenature and the amount of risk that one is willing to take are the real keys to determining customer suitability and to designing an appropriate money managementplan for a commodity trader.Exactly how much risk should a trader take at any point in time? How doesone protect oneself from the risks one has taken? In answering these questions, keepin mind that your need or desire to take risks seldom is equal to your capacity totake risks. You need to evaluate whether you are in a position to take risks separately from whether you should take risks. One should always distinguish betweenpotential of loss on any one transaction and the consequences of the loss to the trader. Look at a transaction always in terms of the appropriateness of the risk in viewof your need and capacity to assume risk. In making that evaluation you want totake a cold and objective look at your family responsibilities, your financial circumstances, and your overall emotional suitability for trading. Weighing the consequences of gain against the consequences of loss is ultimately a subjective calculation, but it is absolutely essential in determining how much risk to take.
THE PLANAs noted above, plans may be simple or complex, written or mental. The best aresimple and written. The ideas and procedures for developing a plan expressed inthis chapter are illustrated in a set of sample planning forms included at the endof this chapter. Use it for your own plan or as a guide to developing one of yourown.The elements of a plan can be separated into four broad categories:1. Capital availability and needs.2. Getting into positions.48
The Trading Plan
3. Getting out of positions.4. Review.We’ll cover each of these in turn.
PART I—CAPITALWhat Do You Have and What Do You Need?The basic questions to ask yourself are:➥ How much money do I have available for trading? Put another way—What is my financial suitability for trading?➥ How much money can I afford to risk?➥ How much capital do I need to trade successfully?
What Do You Have Available?Like a building, a plan needs a good foundation. The place to begin is with a complete review of your financial suitability for trading by determining your net worthand liquid assets. Net worth provides a guide to how much you can afford to riskin trading, and liquid assets are the only ones you can use in trading. Part I of thesample forms at the end of this chapter are for determining your net worth, liquidassets, and income available for futures trading.You should ascertain the amount of money you will need to meet your fixedliving expenses—food, clothing, shelter, education, life insurance, savings, retirement account, and investment portfolio. Only the extra money left after meetingyour regular needs should be considered as eligible for use in commodity trading.To put it bluntly, prudence dictates that you segregate from everything elseyou own the money you deem available for use in trading in the futures market.This makes it easier to control the urge to overtrade, and helps you to manage yourmoney intelligently.How much of this extra money that you allocate to trading commoditiesdepends on many considerations. Among them are your age, the size of your family, the type and security of the job you hold, the attitude of your family toward trading, your emotional suitability, and your own personal desire for risk-taking. Allof these factors should also be considered in determining your own personal trading philosophy.If you have a family and a net worth of less than $200,000, you probablyshould not be trading. But if you insist, a good guideline to follow is to commit no49
Chapter 6
more than 10 percent of your liquid assets. If you are experienced and have largeamounts of capital, you may want to go as high as 20 percent of your liquid assets.It would seldom be recommended to commit more than 25 percent of your liquidassets, no matter how great your assets are.Once you have determined how much capital you have available to risk, younext have to decide how much capital you need to execute your plan. Scale yourplan to your capital
How Much Do You Need?One of the key reasons people lose money trading commodity futures is they basetheir trading plan on too little capital.As a trader you want to establish favorable trading plans based on logic, probabilities, and sufficient capital. The first two will help you establish the last one.Risk and reward should be studied only in the context of probabilities, e.g., whatis the probability that I will achieve a particular profit versus the probability that Iwill lose a certain amount. Our purpose here is not to make you an expert in probability theory, but rather to give you an appreciation of how knowledge of probabilities will help you establish a plan that gives you a successful trading experience.A word of caution is in order. Although the illustrations that follow use gambling examples, don’t be fooled into thinking that the certainty with which probabilities can be calculated at the roulette wheel can be applied to trading in futures.They can’t. And it is dangerous to think so. You will always be tempted to placetoo high a level of accuracy on probability numbers that are themselves loose estimates based on other loose estimates. At best, the probabilities you generate willbe numbers that emanate from an ever-changing market environment and an everchanging set of market conditions. Thus, you can get only rough estimates of probabilities. Nevertheless, the exercise of establishing a set of probabilities will makeyou a better trader.
Probabilities