55/35/10 Stocks/Bonds/Global Macro55/35/10 Stocks/Bonds/Market Timing55/35/10 Stocks/Bonds/Merger Arbitrage55/35/10 Stocks/Bonds/Short Selling
2.54%
2.42%
2.40%
2.45%
2.49%
2.36%
2.51%
2.50%
2.43%
1.00%
0.93%
0.92%
0.95%
0.95%
0.90%
0.97%
0.95%
0.93%
2.02%
2.45%
0.92%
0.85%
2.60%
0.91%
StandardDeviation
0.198
0.196
0.198
0.207
0.189
0.201
0.204
0.195
0.197
0.215
0.191
0.177
SharpeRatio
404142434241404041
−2.03%−1.88%−1.83%−1.84%−1.91%−1.86%−2.04%−2.03%−1.90%
37
42
−1.90%
−1.63%
42
Number ofDownsideMonths
−2.07%
AverageDownside
Downside Risk Protection Using Hedge Funds
ExpectedPortfolio Composition Return
TABLE 11.2
26.63%
9.04%
5.74%
5.34%
10.68%
6.72%
8.25%
10.08%
9.86%
5.74%
7.14%
N/A
CumulativeDownsideProtection
−7.92%
3.57%
7.18%
9.86%
−1.32%
5.28%
4.37%
1.32%
3.57%
13.88%
1.32%
N/A
CumulativeUpsidePotential
18.71%
12.61%
12.92%
15.20%
9.36%
12.00%
12.62%
11.40%
13.43%
19.62%
8.46%
N/A
CumulativePerformanceImprovement
226
RISK AND MANAGED FUTURES INVESTING
The cumulative performance improvement of 8.46 percent may besplit into two parts, the cumulative return earned from downside risk protection (7.14 percent) and the amount earned from upside return potential(1.32 percent).Table 11.2 presents several interesting results. In every case, the downside risk was reduced. The cumulative downside protection for each hedgefund strategy is positive. Average monthly downside risk ranged from −1.63percent for short sellers to −2.04 percent for global macro hedge funds. Itis not surprising that global macro hedge funds offered the least in downside protection because these funds tend to take significant market risk thesame as stocks and bonds. (See Anson 2000.) Also, it is not surprising thatshort sellers offered the best downside risk protection because the verynature of this strategy is to profit in months when the stock and bond markets perform poorly.In every case but two (short sellers and fixed income arbitrage), theaverage monthly return of the whole return distribution increased whenhedge fund strategies were added to the initial stock/bond portfolio. Moreimportant, for every hedge fund strategy, the cumulative performanceimprovement is positive. Also, Sharpe ratios improved uniformly for allhedge fund strategies. Last, in only one strategy, distressed debt, did thenumber of downside months increase (by one, to 43), but the averagedownside return was much lower (−1.84 percent) compared to the stock/bond portfolio.In conclusion, we found that hedge funds uniformly offered downsiderisk protection, and in many cases, this protection was considerable. Also,in only two cases did this downside risk protection come at the sacrificeof upside return potential (for short sellers and fixed income arbitrage),but the cumulative downside protection received was sufficient to offsetthe reduction of cumulative return potential. In every other instance,downside risk protection was achieved in combination with increasedreturn potential.
Managing Downside Risk with Managed FuturesManaged futures refers to the active trading of futures contracts and forward contracts on physical commodities, financial assets, and currencies.The purpose of the managed futures industry is to enable investors to profitfrom changes in futures prices. This industry is another skill-based style ofinvesting. Investment managers attempt to use their special knowledge andinsight in buying and selling futures and forward contracts to extract a positive return. These futures managers tend to argue that their superior skillis the key ingredient to derive profitable returns from the futures markets.
Managing Downside Risk in Return Distributions
227
Within this framework, an asset class distinct from financial assets hasthe potential to diversify and protect an investment portfolio from hostilemarkets. It is possible that skill-based strategies such as managed futuresinvesting can provide the diversification that investors seek. Managedfutures strategies might provide diversification for a stock and bond portfolio because the returns are dependent on the special skill of the commodity trading advisor (CTA) rather than any macroeconomic policy decisionsmade by central bankers or government regimes. (See, e.g., McCarthy,Schneeweis, and Spurgin 1996; Schneeweis, Spurgin, and Potter 1997; andEdwards and Park 1996.)To analyze the impact of managed futures on the distribution of returnsin a diversified portfolio, we use the Barclay CTA managed futures indices.There are four actively traded strategies: CTAs that actively trade in agricultural commodity futures, CTAs that actively trade in currency futures,CTAs that actively trade in financial and metal futures, and CTAs thatactively trade in energy futures. If managed futures can provide downsideprotection, we would expect the average monthly downside return to besmaller than that observed for our initial stock/bond portfolio.Once again, we build a blended portfolio of 55 percent U.S. stocks, 35percent U.S. treasury bonds, and 10 percent CTA strategy. We then develop afrequency distribution of monthly returns over the period 1990 to 2000. InTable 11.3 we present the results from the return distribution generated bythis CTA-blended portfolio for each CTA strategy. For example, for CTAagriculture, the average downside return is −1.81 percent. This is an improvement of 26 basis points over the average downside return observed with thestock/bond portfolio. The number of downside months with CTA agriculturemanaged futures added to the portfolio increased by one month to 43.Unfortunately, some upside potential was sacrificed, as the expectedmonthly return of the investment portfolio declined from 0.91 percent to0.88 percent when CTA agriculture managed futures are added. Still, evenwith the decrease in expected return for the portfolio, the reduction indownside risk would have added 5.15 percent of cumulative performanceimprovement to the portfolio over this time period:[(−1.81% × 43 months) − (−2.07% × 42 months)]+ [(0.88% − 0.91%) × 132 months] = 5.15%Table 11.3 indicates that the 5.15 percent of cumulative performanceimprovement can be split into 9.11 percent of cumulative downside protection and −3.96 percent of cumulative return potential. The table also presents results for the other CTA managed futures strategies. In every case,
2280.1770.1820.1900.1820.197
2.37%2.39%2.39%2.38%
4243394031
−1.81%−1.96%−1.95%−1.86%
Number ofDownsideMonths
−2.07%
Sharpe AverageRatio Downside
2.60%
StandardDeviation
6.24%
8.94%
10.50%
9.11%
N/A
CumulativeDownsideProtection
−10.80%
−0.86%
1.38%
−3.96%
N/A
−4.56%
8.08%
11.88%
5.15%
N/A
Cumulative CumulativeReturnPerformancePotential Improvement
aThe downside protection and cumulative performance improvement for CTA energy is adjusted to reflect data ending in 1998.
60/40 US Stocks/US Bonds0.91%55/35/10 Stocks/Bonds/CTA Agriculture0.88%55/35/10 Stocks/Bonds/CTA Currency0.90%55/35/10 Stocks/Bonds/CTA Financial & Metals 0.89%55/35/10 Stocks/Bonds/CTA Energya0.92%
ExpectedReturn
Downside Risk Protection Using Managed Futures
Portfolio Composition
TABLE 11.3
Managing Downside Risk in Return Distributions
229
downside risk protection is observed. However, with respect to CTA energymanaged futures, this downside risk protection came at the expense of significant upside return potential; the cumulative Performance Improvementis −4.56 percent.3These results highlight the concept that managed futures productsshould not be analyzed on a stand-alone basis. The downside risk protection demonstrated by managed futures products is consistent with theresearch of Scheeweis, Spurgin, and Potter (1996). Their true value is bestachieved in a portfolio context.
MANAGING DOWNSIDE RISK WITH COMMODITYFUTURESHedge funds and managed futures fall into the category of skill-basedinvesting. That is, the returns derived from these strategies are dependenton the active skill of the individual hedge fund or managed futures manager.However, downside risk protection may be achieved without active management. To demonstrate, we blend passive commodity futures into the initial stock and bond portfolio.A commodity futures index represents the total return that would beearned from holding only long positions in an unleveraged basket of commodity futures. Commodity futures indices are constructed to be unleveraged. The face value of the futures contracts are fully supported(collateralized) either by cash or by treasury bills. Futures contracts are purchased to provide economic exposure to commodities equal to the amountof cash dollars invested in the index. Therefore, every dollar of exposure toa commodity futures index represents one dollar of commodity price risk.We consider four commodity futures indices: the Goldman Sachs Commodity Index (GSCI), the Dow-Jones/AIG Commodity Index (DJ-AIGCI),the Chase Physical Commodity Index (CPCI), and the Mount Lucas Management Index (MLMI).4 The GSCI, DJ-AIGCI, and the CPCI are unleveraged indices of long-only positions on physical commodities. The MLMI
3Data for the CTA energy managed futures index is available only through 1998.
Therefore, the data are not strictly comparable to the other managed futures indices,particularly with respect to the number of downside months. However, in Table11.3, the cumulative downside protection, cumulative return potential, and thecumulative performance improvement have been adjusted to reflect the differenttime period examined for this trading strategy.4More details regarding these indices can be found in Anson (2001).
230
RISK AND MANAGED FUTURES INVESTING
differs from the other three indices in that it holds physical, financial, andcurrency futures; it may invest long or short; and it follows a 12-monthtrend-following rule.It is the last difference, the 12-month moving-average rule, that is themost distinguishing feature of the MLMI. The 12-month moving average isdesigned to provide a mechanical rule to capturing price trends in thefutures markets. In this respect, the MLMI represents a good benchmark bywhich to measure the returns associated with managed futures accountsbecause it reflects a naive rule for active trading.We perform the same portfolio construction rule as described in theprevious sections. We construct a portfolio that is 55 percent U.S. stocks,35 percent U.S. treasury bonds, and 10 percent commodity futures index.We then observe the distribution of returns and measure the downside riskof the distribution. Table 11.4 presents the results.Taking, for example, the MLMI, we observe that the average downsidereturn is −1.88 percent, a considerable improvement over the initialstock/bond portfolio. We also observe that the stock/bond/MLMI portfolioexperiences two less months of downside performance (40) than that forthe stock/bond portfolio. Also, the expected return declines slightly to 0.90percent per month. Therefore, the cumulative performance improvement is:[(−1.88% × 40 months) − (−2.07% × 42 months)]+ [(0.90% −0.91%) × 132 months] = 10.42%The return amount of 10.42 percent may be split between cumulativedownside protection of 11.74 percent, and cumulative return potential of−1.32 percent. Similar results are obtained for the other three indices. Wenote that while the DJ-AIGCI provided downside risk protection, this protection came at the sacrifice of significant upside return potential.5 Thecumulative performance improvement was −5.45 percent.Last, we compare the MLMI to the CTA strategies presented above. Wenote that the cumulative performance improvement with respect to theMLMI exceeded that for every CTA strategy. Therefore, a simple trendfollowing strategy such as that presented in the MLMI may provide better downside protection and upside return potential than active managedfutures strategies.
5The DJ-AIGCI was available only through 1991 and therefore is not strictly comparable to the other indices, particularly with respect to the number of downside months.In Table 11.3 we adjust the cumulative downside protection, the cumulative returnpotential, and the cumulative performance improvement for this shorter time period.
231
2.60%2.39%2.38%2.33%2.30%
0.91%
0.90%
0.91%
0.90%
0.92%
0.205
0.191
0.192
0.187
0.177
SharpeRatio4243414037
−1.79%−1.86%−1.88%−1.81%
Number ofDownsideMonths
−2.07%
AverageDownside
4.09%
11.74%
10.68%
9.97%
N/A
CumulativeDownsideProtection
−9.54%
−1.32%
0.09%
−1.32%
N/A
−5.45%
10.42%
10.68%
8.65%
N/A
Cumulative CumulativeReturnPerformancePotentialImprovement
1991.
aThe downside protection and cumulative performance improvement for the DJ-AIGCI is adjusted to reflect data beginning in
60/40 US Stocks/US Bonds55/35/10 Stocks/Bonds/GSCI55/35/10 Stocks/Bonds/CPCI55/35/10 Stocks/Bonds/MLMI55/35/10 Stocks/Bonds/DJ-AIGCIa
Expected StandardReturn Deviation
Downside Risk Protection Using Passive Commodity Futures Indices
Portfolio Composition
TABLE 11.4
232
RISK AND MANAGED FUTURES INVESTING
CONCLUSIONWe examined the downside return protection offered by internationalstocks, hedge funds, managed futures, and commodity futures. We foundthat hedge funds, managed futures, and commodity futures all offer downside protection to a traditional stock and bond portfolio. In most cases, thisprotection accumulated to several percentage points over the time period1990 to 2000. We did not, however, find any downside risk protectionoffered by international stocks. International stocks were poor portfoliodiversifiers during the observed period.
PART
Three
Managed FuturesInvesting, Fees,and Regulation
Chapter 12 focuses on managed futures. As one of many different tradingstrategies in the alternative investment universe, managed futures investinginvolves speculative investments in gold, oil, and other commodities thatchange in value in accordance with price fluctuations. Managed futuresimprove portfolio performance because they typically have zero correlationto traditional markets. The chapter also addresses various styles of CTAs,classifying them as discretionary, trend followers, and systematic. However,these categories tend to overlap. As investors become increasingly educatedabout the universe of alternative investments and, in particular, managedfutures, CTAs will continue to grow in popularity.Chapter 13 empirically investigates the effect of incentive compensationcontracts of commodity trading advisors on their performance. The analysis, an extension of Golec (1993), examines the effects of incentive compensation contracts on the risk and return of commodity trading advisors.The results of cross-sectional regression models shed light on how the management and incentive fees of CTAs are related both to the returns CTAsgenerate, and to the volatility in those returns.Chapter 14 examines the Australian regulatory model for managedfutures funds and other fiduciary investment products whose returns are
233
234
MANAGED FUTURES INVESTING, FEES, AND REGULATION
derived from the trading of futures products. All fiduciary investment products are regulated in the same manner in Australia, under a combination ofthe managed investment scheme and financial product provisions of theAustralian corporations legislation. This chapter considers the difficulties ofapplying this model to the diverse range of fiduciary futures products anddiscusses recent proposals to reform the regulation of individually managedfutures accounts.
CHAPTER 12
CHAPTER
12
Managed Futures InvestingJames Hedges IV
anaged futures investing is increasing in popularity as investors look forways to profit in a volatile environment. Managed futures involvesspeculative investments in gold, oil, and other commodities that change invalue in accordance with price fluctuations and improves portfolio performance because they typically have zero correlation to traditional markets. The analysis investigates how commodity trading advisors use globalfutures and options markets as an investment medium.
M
INTRODUCTIONAs global investors continue to seek ways to diversify their portfolios, anincreasingly popular approach is managed futures investing, which constitutes one of the many different trading strategies in the alternative investmentuniverse. Simply defined, managed futures investing involves speculativeinvestments in gold, oil, and other commodities that change in value inaccordance with price fluctuations. There is approximately $40 billioninvested in managed futures today, a number that has expanded tremendously over the last 20 years. Managed futures had net inflows of $2.10 billion during the first quarter of 2003, reports Bloomberg (see Figure 12.1).This growth is largely attributable to demand from institutional investorssuch as pensions, endowments, and banks, but lower minimum investmentlevels are also attracting more high-net-worth investors than ever.Managed futures had a banner year in 2002, with an approximate 20percent surge in performance (see Figure 12.2). Part of the allure of managed futures are their ability to profit in a volatile environment. Indeed,today’s economic conditions, war-related concerns, global instability, andregulatory environment set the stage for them to prosper.A 25-year study recently conducted by Goldman Sachs (2003) concluded that a 10 percent allocation of a securities portfolio to managed
235
236
MANAGED FUTURES INVESTING, FEES, AND REGULATION
7060504030201001988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003*
FIGURE 12.1 Growth of Managed Futures, 1988–2002Source: Barclay Trading Group, Ltd. “Money Under Management in ManagedFutures,” www.barclaygrp.com.Copyright © 2002–2004 Barclay Trading Group, Ltd.*First quarter 2003.
–23.37%
S&P 500
–31.52%
NASDAQ–16.75
DJIA
Composite Index –1.19%Short Selling IndexEmerging Markets
25.06%4.58%
Macro Index
8.28%
Fixed Income
6.75%
Equity Market Neutral
1.80%
Fund of Funds
1.11%
Managed Futures–35 –30 –25 –20 –15 –10 –5 0
15.22%5 10 15 20 25
FIGURE 12.2 Performance Comparison 2002Source: Equities: International Traders Research (ITR), an affiliate of AltegrisInvestments; Hedge Funds; Hedge Fund Research, Inc. © HFR, Inc. [15 January2003], www.hfr.com; Managed Futures; ITR Premier 40 CTA Index.Note: Stocks offer substantially greater liquidity and transparency than thealternative investment products noted and may be less costly to purchase.
237
Managed Futures Investing
15.6%15.4%15.2%15.0%
45% Stocks 135% Bonds 220% Managed Futures 3
14.8%
37% Stocks27% Bonds36% Managed Futures
Traditional Portfolio55% Stocks45% Bonds0% Managed Futures
14.6%14.4%
50% Stocks40% Bonds10% Managed Futures
14.2%14.0%8.6%
8.8%
9.0%
9.2%
*Results obtained by adding managedfutures component at an incremental rate of 1%while simultaneously reducing the stock andbond portions by 1% each. Based on monthlydata from 1980 to 1995 on an annualized basis
9.4%
9.6%
9.8%
1 Stocks: S&P 500 Index(dividends reinvested)2 Bonds: ML Domestic Master Bond index(over one year with coupons reinvested)3 Managed Futures: MAR CTA Index
FIGURE 12.3 Impact of Incremental Additions of Managed Futuresto the Traditional PortfolioSource: www.marhedge.com.
futures (commodities) helps investors to vastly improve performance. A similar study conducted by the Chicago Board of Trade (2002) concurred, stating that “portfolios with as much as 20 percent of assets in managed futuresyielded up to 50 percent more than a portfolio of stocks and bonds alone.”One feature of managed futures that enables them to improve portfolio performance is that they typically have zero correlation to traditionalmarkets. Managed futures are able to profit in both bear and bull markets,and consistently demonstrate their ability to capitalize on price movementsto the benefit of investors. However, it is important to realize that as a speculative investment strategy, managed futures investing is best pursued overthe long term. The strategy’s cyclical nature means that it should not berelied on as a short-term investment strategy. Indeed, most experts recommend a minimum three-year investment.As is the case with any investment strategy, investors must evaluateboth qualitative and quantitative factors before determining whether toallocate capital to managed futures. Such factors include, but are not limited to, investment time horizon, level of risk aversion, level of diversification of existing portfolio, and intended market exposures (see Figure 12.3).Advantages of managed futures investing include: low to negative correlation to equities and other hedge funds; negative correlation to equitiesand hedge funds during periods of poor performance; diversified opportunities, in both markets and manager styles; substantial market liquidity;
238$10,000$9,000$8,000$7,000$6,000$5,000$4,000$3,000$2,000$1,000$0
MANAGED FUTURES INVESTING, FEES, AND REGULATION
Managed Futures Index(Zurich CTA–$)StockMarketCorrection
MideastOilCrisis
Global BondMarket Reversal
Stocks(S&P 500 Index)+16%
+11%
–6%
–4%
+15%+9%–9%
S&P 500 Index
–24%Sep–Dec1987
Managed Futures Index+8%
TechFalloutInternationalSepMarket11Uncertainty
Aug–Dec1990
Mar–Jun1994
+1%–8%–23%
Aug–Sep1998
Sep 00– SepMar 01 01
FIGURE 12.4 Low Correlation to Traditional Investments, January1987–December 2001Source: www.smithbarney.com.
transparency of positions and profits/losses; and multilayer level of regulatory oversight. The strategy’s disadvantages may include a high degree ofvolatility, high fees, and the high level of advisor attention required (seeFigure 12.4).Commodity trading advisors (CTAs) who use global futures and optionsmarkets as an investment medium note that managed futures investing differs from hedge fund and mutual fund investing in a number of fundamental ways, including transparency, liquidity, regulatory oversight, and the useof exchanges. These underlying distinctions provide support for addingmanaged futures investments to a portfolio that includes both traditionaland alternative investments.Because futures contracts are, by definition, traded on organized exchanges across the globe, the bid and offer prices on specific contracts arepublicly quoted. Consequently, investors can ascertain the current valueand calculate the gain or loss on outstanding positions with relative ease.Additionally, open interest, which is the number of contracts that are currently outstanding on a particular asset, are quoted too. In contrast, hedgefunds often engage in transactions involving esoteric over-the-counter (OTC)derivatives, whose market values may not be readily available. This canpotentially inhibit managers’ ability to monitor their positions effectively(see Figure 12.5).Again, the exchange-based nature of futures contracts plays a significant role. Positions can be entered into and exited continuously, regardless
239
Managed Futures Investing
Financial MarketsInterest Rates
Currencies
Stock Indices
The Americas
Major
U.S.
Europe
Minor
Europe
Asia
Exotic
Asia
Commodity MarketsAgricultureGrains
Metals
Energy
Precious
Crude Oil
Base
Gasoline
LivestockCoffee, Sugar, Etc.
FIGURE 12.5
Heating Oil
Investment Opportunities of Managed Futures Programs
of size. This fact becomes critical when a CTA believes that a large positionneeds to be liquidated to avoid huge losses. A hedge fund may have significant positions in a particular type of instrument that it wishes to unloaddue to adverse market conditions, but the illiquidity of that particular market may inhibit it from doing so. Liquidity allows CTAs to reduce and/oreliminate significant positions during periods of sharp declines.Mutual funds offer investors many of the same benefits as managedfutures, such as diversification, daily liquidity, and professional management, yet they lack the potential to profit in bear markets (see Table 12.1).TABLE 12.1
Mutual Funds versus Managed Futures
Mutual Funds
Managed Futures
DiversificationProfessional ManagementHighly Regulated: SEC & StatesLiquidity: DailyPotential Profit in Bull Markets: YesPotential Profit in Bear Markets: No
DiversificationProfessional ManagementHighly Regulated: CFTC & NFALiquidity: DailyPotential Profit in Bull Markets: YesPotential Profit in Bear Markets: Yes
Source: www.usafutures.com
240
MANAGED FUTURES INVESTING, FEES, AND REGULATION
REGULATORY ISSUESThe Commodity Futures Trading Commission (CFTC) was created by Congress in 1974 as an independent agency with the mandate to regulate commodity futures and option markets in the United States. The agency protectsmarket participants against manipulation, abusive trade practices, andfraud. Essentially, the CFTC is the Securities and Exchange Commissionequivalent of the traditional securities markets. The commission performsthree primary functions: (1) contract review, (2) market surveillance, and(3) regulation of futures professionals.To ensure the financial and market integrity of U.S. futures markets, theCFTC reviews the terms and conditions of proposed futures and optioncontracts. Before an exchange is permitted to trade futures and options contracts in a specific commodity, it must demonstrate that the contract reflectsthe normal market flow and commercial trading practices in the actualcommodity. The commission conducts daily market surveillance and can, inan emergency, order an exchange to take specific action or to restore orderin any futures contract that is being traded.CTAs must be registered with the CFTC, file detailed disclosure documents, and be members of the National Futures Association (NFA), a selfregulatory organization approved by the commission. The CFTC also seeksto protect customers by requiring registrants to disclose market risks andpast performance information to prospective customers, by requiring thatcustomer funds be kept in accounts separate from those maintained by thefirm for its own use, and by requiring customer accounts to be adjusted toreflect the current market value at the close of trading each day (markedto market). In addition, the CFTC monitors registrant supervision systems,internal controls, and sales practice compliance programs. Last, all registrants are required to complete ethics training.Additionally, the NFA serves to protect the public investor by maintaining the integrity of the marketplace. The association screens all firmsand individuals wishing to conduct business with the investing public. Itdevelops a wide range of investor protection rules and monitors all of itsmembers for compliance. The NFA also provides investors with a fast, efficient method for settling disputes when they occur.Member exchanges provide an additional layer of investor protection.Exchange rules cover trade clearance, trade orders and records, positionand price limits, disciplinary actions