This post falls under the Advanced Investing category – in other words, lots of people will find this to be pretty dry stuff. :)
Those who have studied portfolio construction will be familiar with the concept of how adding risky asset classes can in some cases lower the overall risk of a portfolio as a whole. While it sounds counter-intuitive, it works when the added asset class exposure experiences small or negative correlation with other asset classes in the portfolio (or the entire portfolio for that matter). Essentially, if you can find something that goes up when everything else is going down, and vice versa, then so long as the new asset class itself has a long term expectation of positive returns you can decrease the volatility of your portfolio.
One of the problems in 2008 is that asides from high quality, short term bonds nearly everything went down. Had emerging market exposure? Didn’t matter. Small caps AND large caps – who cared. Tech and financials? Whoop-dee-doo. Commenters posited that during extreme market events, correlations of any equity-based asset classes approach 1 – meaning the benefit of diversifying between them disappeared just when you needed it most.
However, I didn’t see many reports which looked at managed futures during 2008. The Altegris 40 Index, which is an equal weighted index of 40 managed futures trading programs adjusted for survivorship bias, returned +15.47% for the 2008 calendar year. (This is not a recommendation to blindly add managed futures to your portfolio, fyi. Talk to your advisor or someone who knows more about managed futures – they can be very risky.)
Managed Futures added to a portfolio
Lest ye accuse me of cherry picking data for the sake of something to write, it is worth noting that for the nineteen full calendar years between 1990 and 2008, there was not a single year when both the Altegris 40 Index and the S&P500 Total Return Index both produced negative annual numbers. More importantly, if we look at stress testing the respective indices we find that the single worst month’s performance for each index was -8.16% for the managed futures (January 1992) and -16.79% for stocks (October 2008). If we further look at the worst overall draw-down periods: -15.00% for the managed futures between December 1992 and April 1992 (that’s only five months) versus -50.95% for stocks between October 2007 and February 2009 (a full seventeen months). So is it managed futures that warrant discomfort? Or stocks?
When we look at certain systemic events, returning to our draw-down analysis theme, we see that holding managed futures can really save a portfolio. The CME Group reports that during the market crash of 1987 and the days that followed, managed futures reported returns over +20%. At the time of the terrorist attacks of 9/11 the US stock market dropped by 16.3% while managed futures added 8.3% during the same time.
If there is interest, I’ll write about CTAs (Commodity Trading Advisors) and CPOs (Commodity Pool Operators) and the various types of managed futures trading programs. To skip ahead, they can be completely algorithmic and they can also be discretionary. There probably should be interest, especially as the assets invested in this asset class have grown 700% over the last 10 years – which is normally a warning sign. You’ll certainly want to watch this space.