move, unable and, even worse, unwilling tochange my opinion. As the market broke, I continued buying the dips, hopingfor a bounce and a chance to make back the small fortune that I had justlost. In hindsight, trying to buy the market when it starts to break with theemotion and intensity of a panic sell-off is like trying to catch a falling knifewithout sustaining a cut. The term for losing everything in the account isblowing out. It had just dawned on me that I was one of many in the historyof trading who was on the verge of blowing out my account.
I remember spending the entire next day trying to analyze the smallportfolio that my new wife and I had built over the ﬁrst few years of ourmarriage and realizing that I had put all my eggs in one basket, my tradingaccount. I was never a big fan of diversiﬁcation in the portfolio because,watching market makers risk their entire net worth every day, I felt that if Ihad an opinion on the market, I should have the courage to back it up withcapital at risk. Luckily, I still remembered some of what Bing had taughtme and managed to maintain a small sum in my account, hoping to, as Bingwould say, have some ammunition left for the next day. By taking a largeloss in the account but holding on to enough money to return the followingday, I was able to survive that character-building experience and use theknowledge to improve as a trader and broker.
MODERN PORTFOLIO THEORY
One of the ﬁrst things I remember doing, after the near-blowout experience,was creating an investment strategy that allowed for a diversiﬁed approachto the market conditions. Bing Sung had taught me the concept of allocatingassets according to modern portfolio theory. When he was a manager of theHarvard Endowment Fund, he insisted on trading derivatives to enhancethe return on the university’s positions, and he was known as a pioneer byhis peers. As I looked at the possible investment vehicles at my disposal,I quickly realized that as a small investor I was not allowed to allocateassets to managers in the alternative asset class. Simply put, modern port-folio theory teaches that to achieve true diversiﬁcation in the portfolio, theinvestments should be divided among different asset classes such as equi-ties and bonds, but that a small percentage—10 to 15 percent—should beallocated to investments that have no correlation to the rest.
It came to my attention that if I wanted to incorporate an alternativeinvestment vehicle in my portfolio, I would have to do it myself throughtrading futures. As the concept of alternative investing proliferated among
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institutional users, the use of futures as the alternative became much moreacceptable as a practice and slowly became an important segment of anyintuitive search to ﬁnd investments that had no correlation to the stock orbond markets. Over the last decade, we in the ﬁnancial services industryhave witnessed an explosion in the creation of hedge funds and the hedgefund style of investment.
Many who invest in these products do so hoping to gain the sought-afterdiversiﬁcation that they’ve been promised, but what has happened is that 90percent of the thousands of funds that have sprung up have morphed intonothing more than high-priced risk takers. It has also become quite clear thatthese funds don’t create a true diversiﬁed investment, but, rather, furtherstudy indicates that their performance is directly linked with the other assetclasses. That’s why many managers have turned to managed futures anduse them, consciously or not, as an alternative investment. Many universityendowments and corporate planning sponsors have allocated a percentageof assets to managed futures programs in order to create real returns andﬂatten out the volatility curve for the capital at risk. One of the problemsof the day was that the best-managed futures funds, which had consistentlyshown positive returns in periods of stock and bond market declines, hadminimum investments in the neighborhood of $500,000 and higher, makingany participation on my part very unlikely. The closed-door environment ofthe legitimate alternative investment universe has since changed, and withthat comes a revolution for the average investor.
If ever there was a secret that all traders share no matter what theytrade, it is that the public order ﬂow is the best ﬂow to trade against.Since the beginning of trading, professional traders have made a wonderfulliving trading off the uneducated customer base, which turns over rapidly. Asthe president of Commerz Futures, a futures commission merchant (FCM)in Chicago and a division of Commerzbank AG of Germany, I witnessedﬁrsthand the pattern of customers opening accounts from abroad only toclose them a few weeks and thousands of dollars later.
It was a troubling period, as we tried in vain to make sure the customers,trading from Europe, had the proper information and product education be-fore putting on their initial positions. At that time we insisted that the bankauthorize a program that would allow the creation of structured productssuch as managed futures that Commerz Futures could market to the growingretail customer base. Unfortunately, the vision for the future of the deriva-tives industry was not shared with the board of directors from Frankfurt,leaving the division with no genuine managed futures products to marketand, even worse in my opinion, neglecting to give our retail clients some-thing they desperately needed—a vehicle for creating true diversiﬁcation intheir portfolios.
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ALTERNATIVE INVESTMENTS ANDTHE EFFICIENT FRONTIER
One of the interesting facts I came across when doing my due diligence forthe bank on the concept of managed futures is that most retail customerslast six months before ﬁnding the process either too time consuming ortoo costly. The customer who is placed in a managed futures program,however, is likely to last for years. In order to fully grasp the entire conceptbehind these products and the power they wield in the ﬁnancial universe,it’s important to step back and understand the basics, which have neverfully been exposed to the average investor who was new to this world, asopposed to the qualiﬁed investor who had had access to these types ofinvestments for years.
Anyone familiar with the concept of managed futures has heard of theefﬁcient frontier, but very few understand the nature of the concept. Sales-people, hoping to land a large allocation for the fund that they’re peddling,throw around buzzwords such as efﬁcient frontier but have a vague under-standing at best of the topic they’re discussing.
Producing maximum risk-adjusted returns is the objective of all capitalmanagement. The object is to give the investor a true alternative vehiclewith zero correlation to the rest of the asset classes in the portfolio, withrisk and reward dynamically managed to a point along an efﬁcient frontierthat reﬂects the investor’s appetite for each.
Dr. Harry Markowitz, in laying the foundations for modern portfoliotheory, described this efﬁcient frontier and the effects it can have on theoverall returns of an investment portfolio. Markowitz wrote that given achoice, an investor would look for a similar portfolio with the same returnas the one he or she has, but would search for less risk.
Alternatively, the same investor would want a higher return than thatof the existing portfolio, but with the same risk. It only makes sense—ifyou can make the same return and expose less capital to risk, then therisk-to-reward ratio shifts to their favor. Taking it one step further, for agiven level of risk, there is an optimal portfolio with the highest return.Likewise, for a given return, there is an optimal portfolio for the lowestrisk. Portfolios whose yield can no longer be increased without increasingthe risk and whose risk cannot be lowered without lowering the yield liealong this efﬁcient frontier.
John Lintner took the Markowitz model and extended it to include man-aged futures speciﬁcally as a diversifying vehicle for the traditional portfoliomanagers of equities and bonds. In both Markowitz’s and Lintner’s work,risk is measured by variance and standard deviation around an average re-turn. A student of the markets can ﬁnd many pertinent lessons on the useof alternative investments during periods of market turmoil. When I was at
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Commerz Futures in 2000, I noticed that the amount of new money ﬂowinginto hedge fund investments went from under $10 billion to roughly $25billion in one year.
While the S&P 500 index was down almost 13 percent in 2001, hedgefund investments, as measured by the Hennesee Hedge Fund Index, showeda positive return of 2.5 percent for the same period. I realized that for thebank’s FCM to compete, it must ﬁnd a way to involve itself in this explodingsegment of the industry. As I did my due diligence on the use of hedge funds,it became clear that the protection that investors were searching for in theiralternative investments was misleading in that many of the strategies em-ployed by the funds were not diversiﬁed at all. It took the effects of the long-term credit management debacle to show the investment community thatalmost every type of strategy used by the hedge fund community from thelong-only strategies to market-neutral trading showed negative returns. Theonly group of managers who consistently performed well throughout thatperiod of price dysfunction was the commodity trading advisors (CTAs)—managed futures!
One of the things I quickly noticed is that most of the managers wereshocked, as were the investors, when the countless hedge fund strategiescreated concentrated positions in many of the markets and ended up takinga loss together. How could this have happened when so many differenttraders are managing funds in so many different styles? The answer liesin the fact that during the late 1990s a long bias seemed to unconsciouslywork its way into every strategy used, with the exception of traditional bearfunds. What was even more fascinating is that this long bias was workingits way not only into strategies that were equity related but also into thosethat were designed to be neutral. The problem was that they were makingproﬁts from the same conditions that drove the stock market to nosebleedlevels.
As soon as the market conditions turned for the worse, many of thesehedge funds found liquidity scarce and that their performance was closer tothat of an index fund than a true alternative investment. It was very mislead-ing to see the performance of a given fund while the market was advancing;the test of the fund’s true nature is when the market turns down. Most in-vestors experienced negative returns because the hedge fund universe hadbecome correlated with the stock market instead of using strategies thatwould give them protection during downturns.
However, the CTA universe, which was managing an estimated $35billion—a fraction of the $500 billion run by the hedge fund communitytaking long or short positions in the futures markets—delivered stellar re-sults during the same period. One important difference between the twoworlds is that back in 2001, a large percentage of the assets allocated tothe CTA community were divided among 30 large traders. This has since
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changed, and qualiﬁed CTAs now number in the hundreds, a ﬁgure that isgrowing every day.
A large problem that had to be overcome was the high level of feesattached to the managed futures products. It’s the dilemma of high fees thatcaused the industry to miss the explosive growth that was experienced byother segments of the ﬁnancial services world. But with the recent prolifer-ation of these funds, we have seen a move to dramatically reduce the feesand make the products more desirable as they become more competitivewith one another. With the drop in fees comes an overall drop in the volatil-ity of the given advisors. The trading has become much more quantitativein nature, and along with that, the ideals of capital preservation have over-taken triple-digit returns. This also demonstrates the law of diminishingreturns, as Bing taught me. When a fund gets too large, with more capitalto manage, it becomes much more difﬁcult to deliver results at the samepercentage. Many of the best advisors have become conservative in theirapproach because investors have asked for real noncorrelated returns withlimited drawdowns.
Bing showed me that there were many different strategies used by man-agers running money in the various markets. The most common CTA strat-egy is a long-term trend-following system in which the trader captures theextended price movements in any accessible futures market. It used tobe that we would ﬁnd the large CTA ﬂow only in the equity or ﬁxed-incomepits of the exchanges, but it’s now common for large futures funds to tradeeverything from Malaysian palm oil to pork bellies as long as open interestand other critical-mass elements exist for the trade.
I remember that as the stock market stalled in the middle of 2000, itwas this strategy of following trends in other U.S. and European marketsthat contributed to record returns while equity prices began to crumble. Itwasn’t only the ability to short the stock market via index futures as it wentdown—as a matter of fact, many advisors simply ignored the equity marketsduring the downturn—but, rather, having access to other global futuresmarkets that yielded high-percentage trades and created opportunities forsubstantial returns. Through having access to the various markets aroundthe globe, advisors can take advantage of deﬂationary periods in commodityprices as we witnessed in 1998 or a sharp rise in base materials as we’veseen in recent months.
Another strategy used by the CTAs is momentum trading. There areshort-term and long-term momentum trades. Simply put, momentum tradersfollow the trend as it’s breaking out of a given technical formation and hopefor instant gratiﬁcation. Most of these trades are put on with a limited timehorizon in mind. For some momentum traders, holding a position for morethan a day or two is absolutely torture. The momentum trade is meant tobe put on in accordance with the direction of large and fast movements
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in the price of a market that might last hours or maybe a day. A short-term trader is looking for a move in a matter of hours, while the long-termmomentum trader might sit with a position for a few days. Another strategyused by many of the advisors today is contrarian thinking. A contrarian isone who typically will fade the general direction of the market and ﬁght theprevailing trend. Most contrarians make money in an atmosphere chargedwith emotion, as in times when stocks drop or commodity prices experienceparabolic moves up or down.
Most CTAs offer managed accounts to their clients, allowing full disclo-sure of positions and trades. These accounts usually offer daily redemptionsand additions, though some may have lockup periods that could last up toa month. The leverage used by these funds ranges from zero to two timestheir equity, which has been closely monitored after a string of highly lever-aged funds almost destroyed the system—reports had Long Term CapitalManagement’s leverage ratio at an amazing 50:1! The best CTAs have trackrecords that date back 10 to 20 years, which gives the investor a sense ofsecurity in the fact that the chosen advisor has managed funds in bull andbear markets with consistent positive returns.
The last few months have reminded us that at times commodities haveoutperformed the stock market. As we’ve experienced the explosion incommodity prices, the stock market, as measured by the S&P 500, has notfared nearly as well. But this is not a new phenomenon. It came to myattention in the fall of 1987 that during the last few months of the year,commodities outperformed the stock market. This was primarily becauseof the loss of value of the equity markets, but it was also a measure of theimportance of diversiﬁed asset classes in a portfolio.
REAL PORTFOLIO DIVERSIFICATION
The year 1987 taught me many lessons in money management, but the mostcritical part of my education came as I began to learn about the power ofdiversifying a portfolio properly. During the months before and after thecrash, the stock market lost 30 percent of its value, while commoditiesgained 10 percent. I quickly realized the power of this alternative type ofexposure and began to formulate a method by which I could acquire thesame type of coverage as the institutions create in order to give them aproper diversiﬁed model. Doing my due diligence, I learned that there hadbeen other, more drastic disparities between the performance of equitiesand that of raw materials.
During the oil embargo days of the early 1970s, well before I startedmy career, commodity prices rose a staggering 114 percent while the stock
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market dropped nearly 40 percent in the same period. But it wasn’t onlycommodity exposure that I was looking for; instead, I was searching forthe elusive noncorrelated vehicle that would give my portfolio protection,even if commodity and equity prices began to slip simultaneously. That wasthe true nature of the alternative investment. In order to create the typeof model needed to take advantage of the volatility in price action, it wasnecessary to trade various markets using different styles. This was done inorder to give a multi advisor, multistrategy approach to the methodology.
The logic behind the approach is very simple. Have many different stylesof traders trading different markets in various forms to create a diversiﬁedinvestment strategy that doesn’t correlate to the any other asset class. Thiswas the way the large institutions allocated their assets, but it became veryclear from the start of my academic exercise that it would be nearly im-possible for me to re-create the same model alone. For an individual backin 1987 to create a multistrategy, mutliadvisor model using the best fundmanagers of the day and produce the wanted results, it would have costover $3 million in minimum investment with the various managers.
As the hedge fund world began to see the power and proliferation offutures managers, not to mention higher fees, it quickly shifted into highgear and allowed smaller qualiﬁed investors into the funds with minimumsin the range of $250,000 to $500,000. These high-net-worth individuals sawﬁrsthand the importance of these investments when, during the ﬁrst Gulfwar, equity markets lost nearly 15 percent as managed futures yielded pos-itive returns in the range of 20 percent. It was one of the ﬁrst times in thehistory of managed futures that the individual investor was able to beneﬁtfrom a structured investment creating a noncorrelated asset class.
These same investors found a safe haven in managed futures during theworst period for the stock market in recent history. During the third quarterof 1998, when the averages on the NYSE and Nasdaq fell almost 50 percentfrom the 52-week highs, Managed Accounts Report, the industry watchdog,showed a positive return in the Trading Advisor Qualiﬁed Universe Indexcomposed of the top fund managers of the day. There were many on WallStreet who didn’t like the idea that markets out of their control in Chicagobecame the engine for these structured products that seemed to ﬁt intoevery portfolio’s needs. The New York crowd had been the masters of theuniverse in the ﬁnancial services world from the beginning and now felt athreat from the Second City. The entire industry received a big boost whenin August 1999 the result of a ﬁve-year study was published in the Wall StreetJournal concerning the best of the big brokerage ﬁrms and their respectiveasset allocation performances.
The study included all the big names of the day, including Merrill Lynch,Goldman Sachs, Salomon, Morgan, and Dean Witter. The ﬁndings showed
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that Goldman had the best record for assets under management becauseit was the only ﬁrm that included futures in its asset allocation. Havingmany friends who went through the training programs of the largest andbest houses on Wall Street, I found out that most were told to drop futuresfrom the model they present to customers. This was done for a number ofreasons, the two biggest being regulatory uncertainty and a lack of educationon the part of registered representatives. But what began to draw seriousattention was when Morningstar reported that in a single month, November2000, the fully diversiﬁed average technology fund lost an average of 15 to25 percent, while Managed Accounts Report showed the Trading AdvisorQualiﬁed Universe Index with a positive gain of a little over 5 percent.
MANAGED FUNDS AS AN ASSET CLASS
In 1983, a few years before I began to work with Bing, one of his colleagues atHarvard, John K. Lintner, wrote a revolutionary paper entitled “The PotentialRole of Managed Commodity-Financial Futures Accounts in Portfolios ofStocks and Bonds,” which took a historical and academic perspective onthe industry. The Lintner study was exactly what the institutional investorsneeded to give the asset class the credibility necessary for the board ofdirectors of the various funds to authorize the use of the products in theirportfolios. Lintner wrote:
. . . [T]he improvements from holding an efﬁciently selected portfolioof managed accounts or funds are so large . . . and the correlation be-tween returns on the futures portfolios and those on the stock and bondportfolio are so surprisingly low (sometimes even negative) . . . thatthe return/risk tradeoffs provided by augmented portfolios . . . clearlydominate the tradeoffs available from a portfolio of stocks alone orfrom portfolios of stocks and bonds.
This was the ammunition that many in the institutional trading com-munity were looking for so that they could begin to employ the strategiesthat had become so very proﬁtable for others. Using the composite of the15 largest trading advisors of the day and studying the periods between1979 and 1982, Lintner showed that the risk-to-reward ratio of a portfolioof CTAs is higher than that of a well-diversiﬁed stock and bond portfolioalone. Taking it one step further, he found that there was very low correla-tion between the returns of the advisors and those of a combined stock andbond portfolio.
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The concept of having noncorrelated asset classes became the center-piece of any argument to include futures in an asset allocation model. Whyshould we expect low or zero correlation between a portfolio of managedfutures and equity, ﬁxed-income portfolios, or foreign exchange risk? Thereare many explanations for why this might be the case. Many in the industryhave known for years that markets react differently to the various forcesdriving prices up and down; that’s why it is critical to understand why certainasset classes have no correlation to others in the ﬁnancial world.
To a student of the markets, it becomes painfully obvious that cer-tain conditions not favorable to the cash markets in equities, ﬁxed income,and currencies are usually favorable to managed futures. The very thingsthat drive the price of stocks and bonds down—inﬂation, deﬂation, andeconomic uncertainty—often cause major price movements in commoditymarkets around the world. It’s this disruption in price action that manymanagers ﬁnd as the panacea for a portfolio in desperate need of real posi-tive returns. Just recently, as we’ve witnessed a skyrocketing commoditiesmarket, the ﬁnancial services industry has come to the conclusion thatthe investment in commodities alone is not sufﬁcient to capture the pricevolatility of a marketplace.
Most investors who seek commodity exposure make the mistake ofthinking they’re buying a noncorrelated asset when in reality they’re pur-chasing exposure that makes them strictly long the underlying commodi-ties as opposed to a genuine alternative investment that takes advantageof price swings up and down. Another of the reasons for noncorrelation ofassets is that the global and market sector diversity of available futures con-tracts contributes to the diversiﬁed performance between managed futuresstocks, ﬁxed-income securities, and foreign exchange. Most individual in-vestors fail to understand that an investment in the proper foreign exchangefutures fund creates a de facto hedge of the currency risk that comes witha volatile dollar.
Lately, as we’ve experienced an increase in currency volatility, Forexproducts have become the hottest vehicle in the investment industry. Un-like stocks or bonds, investment in the currency markets is very easy forthe nonprofessional to understand; it usually becomes the ﬁrst foray intofutures for new traders. One thing to always keep in mind when making aninvestment into an alternative asset class is that there is no long bias in thefutures markets, as there is in the traditional investment markets. When afutures position is taken, it can as easily be a long position as a short posi-tion. Unlike traditional investing, where buy and hold is often the strategy,managed futures can easily capitalize on bidirectional proﬁt opportunitiesand low transaction costs. The most important feature of noncorrelation isthat any good managed futures program itself internally uses risk manage-ment controls that seek to limit correlation among the various managers in
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the program. This has the effect of further diversifying the correlation withthe investor’s portfolio.
VARIOUS MANAGED FUTURES STRUCTURES
There are four basic ways an investor might utilize managed futures inan overall return/risk enhancement program. The ﬁrst is a simple overlaythat offers maximum transparency, with the advantage of being off balancesheet. An account is opened in the investor’s name at the broker of his orher choice. A limited power of attorney allows the pool manager to managethe account. The entire amount of the overlay is not funded. Otherwiseunpledged U.S. Treasury securities may be used in the account for initialmargin and sometimes maintenance margin requirements.
The investor may sweep the account as frequently as he or she deemsoptimal. Minimal funding is therefore required. Duplicate trade conﬁrma-tions are sent to the investors daily. Further account information is availableintraday from a secured Web site maintained by the pool manager. As at-tractive as this transparency may appear to the investor, care must be takenin the risk management procedures. It would be a mistake to incorporateindividual managed futures positions into the positioning.
The pool manager and the investor can agree on risk tolerances andvolatility parameters that are then monitored daily. The managed futuresoverlay is not a bona ﬁde hedge as deﬁned by FASB 133. As such, every-thing must be marketed-to-market. The second is the overlay/contingentimmunization method, which combines the structure and the beneﬁts ofan overlay with contingent immunization techniques. Immunization tech-niques, in general, refer to strategies used by portfolio managers to shieldeither their current net worth or future income requirements from exposureto interest rate ﬂuctuations.
Suppose a portfolio manager has decided to pursue a reward/risk en-hancement overlay strategy with a sample pool’s managed futures on his$100 million ﬁxed-income portfolio. Assume interest rates are presently 7percent and that the manager can lock in, via conventional immunizationtechniques, a future portfolio value of $141 million after ﬁve years. How-ever, the manager is willing to risk losses from the pool overlay portion onlyto the extent that the terminal value of the overall portfolio will not droplower than $136 million.
In an example such as this one, only $98 million is required to achievethis minimum acceptable terminal value. Therefore, since the portfoliois currently worth $100 million, the manager can afford to risk somelosses at the outset and might start off with an active overlay/contingent
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immunization strategy rather than immediately locking in or immunizingthe portfolio. This value becomes the initial trigger point, which functionsmuch like a barrier option. If and when the actual portfolio value dips tothe trigger point, the managed futures overlay will cease. Contingent uponreaching the trigger, an immunization strategy is initiated instead, guar-anteeing that the minimum acceptable performance can be realized. Thetrigger point needs to be periodically assessed as interest rates and time tothe effective horizon change.
The third method of investing in a program is direct allocation. Thisinvolves investing in a managed futures fund or pool directly using the duediligence required to allocate to various managers trading differing productlines. There are increased funding requirements under this structure. Ac-count sweeping and the investment of excess funds are handled by the poolmanager. There is some loss in transparency as well. Individual positionswould not be disclosed as completely as with the overlay structure.
The fourth method, and my personal favorite, is the structured productapproach. This method can offer both a guaranteed principal feature and anunderlying managed futures portfolio component placed within the frame-work of a conventional security (e.g., note, bond, certiﬁcate of deposit).An example might be a variable-coupon, ﬁve-year note with a par put atmaturity. The limited liability feature comes at the price of reduced fundperformance. Depending on how the product is designed, this may reducethe return/risk enhancement beneﬁts to the overall portfolio. As with a di-rect allocation, there are increased funding requirements as opposed to theoverlay method, and transparency is also usually more complete with anoverlay strategy.
Because of the intricacies involved in selecting the various fund man-agers, an investor should consider outsourcing this valuable function to anoutside ﬁrm.
The biggest reason to seek expertise in the fund industry is the addi-tional layer of specialized research, technological infrastructure, risk man-agement, and oversight, which becomes an effective extension of the port-folio manager’s staff without adding ﬁxed cost.
Most pool operators have an extensive commodity trading advisordatabase and the staff to perform in-depth due diligence, both quantita-tively and qualitatively. In addition, a pool manager’s extensive network ofindustry contacts provides information about traders that would be difﬁcultfor those not in the industry to obtain.
At the same time, this addition to the manager’s staff has valuable au-tonomy. Subsequent psychological factors as senior management’s opinionat macro and micro levels are discounted by professionalism and objectiv-ity. Subsequent trader biases can easily build correlations that can destroythe entire enhancement process.
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