RISK DISCLOSURE STATEMENT TRADING FUTURES AND OPTIONS INVOLVES SUBSTANTIAL RISK OF LOSS AND IS NOT SUITABLE FOR ALL INVESTORS. THERE ARE NO GUARANTEES OF PROFIT NO MATTER WHO IS MANAGING YOUR MONEY. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.THE RISK OF LOSS IN TRADING COMMODITY INTERESTS CAN BE SUBSTANTIAL. YOU SHOULDTHEREFORE CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OFYOUR FINANCIAL CONDITION. IN CONSIDERING WHETHER TO TRADE OR TO AUTHORIZE SOMEONE ELSETO TRADE FOR YOU, YOU SHOULD BE AWARE OF THE FOLLOWING:IF YOU PURCHASE A COMMODITY OPTION YOU MAY SUSTAIN A TOTAL LOSS OF THE PREMIUM AND OFALL TRANSACTION COSTS.IF YOU PURCHASE OR SELL A COMMODITY FUTURES CONTRACT OR SELL A COMMODITY OPTION YOUMAY SUSTAIN A TOTAL LOSS OF THE INITIAL MARGIN FUNDS OR SECURITY DEPOSIT AND ANYADDITIONAL FUNDS THAT YOU DEPOSIT WITH YOUR BROKER TO ESTABLISH OR MAINTAIN YOURPOSITION. IF THE MARKET MOVES AGAINST YOUR POSITION, YOU MAY BE CALLED UPON BY YOURBROKER TO DEPOSIT A SUBSTANTIAL AMOUNT OF ADDITIONAL MARGIN FUNDS, ON SHORT NOTICE, INORDER TO MAINTAIN YOUR POSITION. IF YOU DO NOT PROVIDE THE REQUESTED FUNDS WITHIN THEPRESCRIBED TIME, YOUR POSITION MAY BE LIQUIDATED AT A LOSS, AND YOU WILL BE LIABLE FORANY RESULTING DEFICIT IN YOUR ACCOUNT.UNDER CERTAIN MARKET CONDITIONS, YOU MAY FIND IT DIFFICULT OR IMPOSSIBLE TO LIQUIDATE APOSITION. THIS CAN OCCUR, FOR EXAMPLE, WHEN THE MARKET MAKES A ‘‘LIMIT MOVE.’’THE PLACEMENT OF CONTINGENT ORDERS BY YOU OR YOUR TRADING ADVISOR, SUCH AS A ‘‘STOP-LOSS’’ OR ‘‘STOP-LIMIT’’ ORDER, WILL NOT NECESSARILY LIMIT YOUR LOSSES TO THE INTENDEDAMOUNTS, SINCE MARKET CONDITIONS MAY MAKE IT IMPOSSIBLE TO EXECUTE SUCH ORDERS.A ‘‘SPREAD’’ POSITION MAY NOT BE LESS RISKY THAN A SIMPLE ‘‘LONG’’ OR ‘‘SHORT’’ POSITION.THE HIGH DEGREE OF LEVERAGE THAT IS OFTEN OBTAINABLE IN COMMODITY INTEREST TRADING CANWORK AGAINST YOU AS WELL AS FOR YOU. THE USE OF LEVERAGE CAN LEAD TO LARGE LOSSES ASWELL AS GAINS.IN SOME CASES, MANAGED COMMODITY ACCOUNTS ARE SUBJECT TO SUBSTANTIAL CHARGES FORMANAGEMENT AND ADVISORY FEES. IT MAY BE NECESSARY FOR THOSE ACCOUNTS THAT ARESUBJECT TO THESE CHARGES TO MAKE SUBSTANTIAL TRADING PROFITS TO AVOID DEPLETION OREXHAUSTION OF THEIR ASSETS. THE CTA DISCLOSURE DOCUMENT CONTAINS A COMPLETEDESCRIPTION OF THE PRINCIPAL RISK FACTORS AND EACH FEE TO BE CHARGED TO YOUR ACCOUNTBY THE COMMODITY TRADING ADVISOR (“CTA”).A COMPLETE DISCUSSION OF FEES AND CHARGES ARE REPORTED IN THE CTAs DISCLOSUREDOCUMENT. SPECIFICALLY, ONE SHOULD RECOGNIZE THAT AN INTRODUCING BROKER MAY CHARGEA FRONT-END START UP FEE OF UP TO 6% OF THE INITIAL CONTRIBUTION. PLEASE NOTE THAT THISCHARGE IS NOT REFLECTED IN THE PERFORMANCE OF THE COMMODITY TRADING ADVISOR ANDCOULD HAVE A SIGNIFICANT IMPACT ON THE CUSTOMERS ABILITY TO ACHIEVE SIMILAR RETURNS.MANAGED FUTURES MAY NOT NECESSARILY BE PROFITABLE UNDER ALL MARKET CONDITIONS ANDALSO MAY NOT NECESSARILY REDUCE VOLATILITY.
LINTNER REVISITEDA QuantitativeAnalysis ofManaged FuturesMay 2012Ryan Abrams Ranjan Bhaduri, PhD, CFA, CAIA Elizabeth Flores, CAIASenior Investment Analyst Chief Research Officer and Executive Director, ClientWisconsin Alumni Research Head of Product Development Development & Sales –Foundation AlphaMetrix Alternative Asset Managers Investment Advisors, LLC CME Group
As the world’s leading and most diverse derivatives marketplace, CME Group (www.cmegroup.com)is where the world comes to manage risk. CME Group exchanges offer the widest range of globalbenchmark products across all major asset classes, including futures and options based on interestrates, equity indexes, foreign exchange, energy, agricultural commodities, metals, weather and realestate. CME Group brings buyers and sellers together through its CME Globex electronic tradingplatform and its trading facilities in New York and Chicago. CME Group also operates CME Clearing,one of the largest central counterparty clearing services in the world, which provides clearing andsettlement services for exchange-traded contracts, as well as for over-the-counter derivativestransactions through CME ClearPort. These products and services ensure that businesseseverywhere can substantially mitigate counterparty credit risk in both listed and over-the-counterderivatives markets.ABSTRACT:Managed futures comprise a wide array of liquid, transparent alpha strategies which offer institutionalinvestors a number of benefits. These include cash efficiency, intuitive risk management, and aproclivity toward strong performance in market environments that tend to be difficult for otherinvestments. This paper revisits Dr. John Lintner’s classic 1983 paper, “The Potential Role of ManagedCommodity-Financial Futures Accounts (and/or Funds) in Portfolios of Stocks and Bonds,” whichexplored the substantial diversification benefits that accrue when managed futures are added toinstitutional portfolios. As Dr. Lintner did, it analyzes the portfolio benefits that managed futuresoffer through the mean-variance framework, but it draws on more complete techniques such as theanalysis of omega functions to assess portfolio contribution. The paper also conducts a comparativequalitative and quantitative analysis of the risk and return opportunities of managed futures relativeto other investments, and includes a discussion as to why managed futures strategies tend to performwell in conditions that are not conducive to other investment strategies. It provides an overview ofthe diversity of investment styles within managed futures, dispelling the commonly held notion thatall CTAs employ trend following strategies. Finally, it highlights the opportunities the space offersto pension plan sponsors, endowments and foundations seeking to create well-diversified, liquid,transparent, alpha generating portfolios.Dedicated to the late Dr. John Lintner
TABLE OF CONTENTS2 Introduction3 Revisiting Lintner4 Managed Futures – Some Basic Properties6 Growth of Futures Markets and Managed Futures7 Manager Style and Selection11 Managed Futures Risk, Return, and the Potential for Enhanced Diversification12 Risk and Return: Omega – A Better Approach15 Hidden Risk: The Importance of Liquidity, Transparency and Custody17 The Lack of Correlation and Potential for Portfolio Diversification22 Managed Futures and Performance during Financial Market Dislocations30 Benefits to Institutional Investors32 Conclusion34 Conclusion in Context of Lintner35 References
cmegroup.comINTRODUCTIONManaged futures comprise a diverse collection of active hedge This paper also gives a brief treatment of risk management andfund trading strategies which specialize in liquid, transparent, the importance of liquidity. From there, we analyze historicalexchange-traded futures markets and deep foreign exchange correlations among managed futures, traditional investments,markets. Some of the approaches taken by managed futures and other alternative investment strategies, demonstrating themanagers exploit the sustained capital flows across asset classes diversification benefits that may be reaped from the introductionthat typically take place as markets move back into equilibrium of managed futures’ uncorrelated variance into traditionalafter prolonged imbalances. Others thrive on the volatility and portfolios and blended portfolios of traditional and alternativechoppy price action which tend to accompany these flows. Others investments. We explore the proclivity of managed futuresdo not exhibit sensitivity to highly volatile market environments strategies toward strong performance during market dislocationsand appear to generate returns independent of the prevailing due to their tendency to exploit the massive flows of capital to oreconomic or volatility regime. This explains in part why managed from quality that tend to coincide with these events. Althoughfutures often outperform traditional long-only investments and managed futures have often produced outstanding returns duringmost alternative investment and hedge fund strategies during dislocation and crisis events, it must be emphasized that managedmarket dislocations and macro events. futures are not and should not be viewed as a portfolio hedge, but rather as a source of liquid transparent return that is typically notThis paper endeavors to re-introduce managed futures as a liquid, correlated to traditional or other alternative investments.transparent hedge fund sub-style which actively trades a diversifiedmix of global futures markets and attempts to dispel some of the Finally, we conclude with a discussion of some of the uniquemore common misconceptions many institutional investors hold benefits offered to pension plan sponsors, endowments andregarding the space. We discuss the likely effects and implications foundations, namely, the ability to use notional funding toof the proliferation of futures markets and managed futures assets efficiently fund exposure to managed futures, diminish the risksunder management on the performance and capacity of trading associated with asset-liability mismatches, and capitalize onmanagers. We also address trading manager selection and style, favorable tax treatment. We also close the loop in relation to howand differentiate among the myriad unique trading strategies Lintner’s insights on the role of managed futures in an institutionalwhich currently encompass managed futures. An assessment portfolio have held up after nearly 30 years.of the performance and risk characteristics of managed futuresrelative to traditional investments and other alternatives isconducted, including a critique of the mean-variance frameworkin which many practitioners and investment professionals analyzeperformance and risk. The Omega performance measure is offeredas an alternative to traditional mean-variance ratios since itaccounts for the non-Gaussian nature of the distributions typicallyencountered in finance; the Omega function was invented bymathematicians in 2002, and thus was not available to Lintner.2 Past performance is not necessarily indicative of future results.
A Quantitative Analysis of Managed Futures in an Institutional PortfolioREVISITING LINTNERThe late Dr. John Lintner (1916 – 1983), a Harvard University Finally, all the above conclusions continue to hold when returns areProfessor, had an illustrious and prolific career, including measured in real as well as in nominal terms, and also when returnsrecognition as one of the co-creators of the Capital Asset Pricing are adjusted for the risk-free rate on Treasury bills.” [Lintner, pagesModel (CAPM). Lintner also published a classic paper entitled 105-106]“The Potential Role of Managed Commodity-Financial Futures Sadly, Lintner died shortly after presenting his treatise on the roleAccounts (and/or Funds) in Portfolios of Stocks and Bonds,” of managed futures in institutional portfolios.which he presented in May 1983 at the Annual Conference ofthe Financial Analysts Federation in Toronto. Lintner found the The objectives of this paper are not at all modest, namely, torisk-adjusted return of a portfolio of managed futures to be higher furnish a modern-day Lintner paper, and also to dispel somethan that of a traditional portfolio consisting of stocks and bonds. common myths regarding managed futures. While Lintner’s studyThe Lintner study also found that portfolios of stocks and/or bonds has been applauded by scholars and practitioners who have readcombined with managed futures showed substantially less risk at it, there still seems to be a gap and disconnect between manyevery possible level of expected return than portfolios of stocks institutional investors and the managed futures space. Is thisand/or bonds alone. The following passage from Lintner’s scholarly because through the passage of time the kernel of Lintner’s findingswork furnishes good insight on his findings: is no longer true? Or have some institutional investors simply not performed their fiduciary duty in a completely satisfactory“Indeed, the improvements from holding efficiently selected portfolios manner?of managed accounts or funds are so large – and the correlationsbetween the returns on the futures portfolios and those on the stock and Updating the Lintner paper will help to supply the answer tobond portfolios are surprisingly low (sometimes even negative) – that this question. In order to do this properly, it is best to lay thethe return/risk trade-offs provided by augmented portfolios consisting framework of what managed futures are in terms of the currentpartly of funds invested with appropriate groups of futures managers landscape before exploring the impact of adding them to(or funds) combined with funds invested in portfolios of stocks alone (or traditional portfolios.in mixed portfolios of stocks and bonds), clearly dominate the trade-offsavailable from portfolios of stocks alone (or from portfolios of stocksand bonds). Moreover, they do so by very considerable margins.The combined portfolios of stocks (or stocks and bonds) after includingjudicious investments in appropriately selected sub-portfolios ofinvestments in managed futures accounts (or funds) show substantiallyless risk at every possible level of expected return than portfolios ofstock (or stocks and bonds) alone. This is the essence of the “potentialrole” of managed futures accounts (or funds) as a supplement to stockand bond portfolios suggested in the title of this paper. Past performance is not necessarily indicative of future results. 3
cmegroup.comMANAGED FUTURES – SOME BASIC PROPERTIESA discussion of managed futures performance, particularly during Managed futures traders are commonly referred to as “Commodityperiods of market dislocation, may be more illuminating if preceded Trading Advisors” or “CTAs,” a designation which refers to aby a brief discussion of what managed futures are and are not. As manager’s registration status with the Commodity Futures Tradingpreviously mentioned, managed futures encompass a variety of Commission and National Futures Association. CTAs may tradeactive trading strategies which specialize in liquid, transparent, financial and foreign exchange futures, so the Commodity Tradingexchange-traded futures, options, and foreign exchange, and may Advisor registration is somewhat of a misnomer since CTAs arebe thought of as a liquid, transparent hedge fund strategy. Like not restricted to trading only commodity futures. The highlylong/short equity and equity market neutral hedge fund strategies, diversified and global nature of the markets included in mostmanaged futures strategies may take long and short positions in managed futures programs makes the selection of a passive long-the markets they trade, are available only to qualified investors, only index for analysis of value added through active managementand may employ leverage. An important difference, however, extremely difficult since many CTAs trade portfolios of futuresis that equity hedge fund leverage requires borrowing funds at contracts which span across all asset classes. The name Commoditya rate above LIBOR, whereas managed futures investing allows Trading Advisor also results in the common mistake of usingfor the efficient use of cash made possible by the low margin passive long-only commodity indices, such as the Goldman Sachsrequirements of futures contracts. Rather than allowing cash not Commodity Index (GSCI), DJ AIG Commodity Index (DJ AIG),being used for margin to collect interest at the investor’s futures and Rogers International Commodity Index (RICI) as performancecommission merchant (FCM), the investor can deploy it to gain a benchmarks. These indices are not appropriate because they includehigher notional exposure when investing using a managed account. only a small fraction of the futures markets most CTAs trade,Consequently, the investor is not paying interest, since they did and do not account for active management or the ability to takenot need to borrow money to get the extra exposure. The following short as well as long positions, all of which should result in lack ofexample helps to highlight this important point. correlation over time.Example: A pension plan sponsor has $50 million (USD), and Active management and the ability to take long and short positionswishes to get $50 million exposure in a managed futures strategy are key features that differentiate managed futures strategiesthat allows for a funding factor of two. The investor then only needs not only from passive long-only commodity indices, but fromto invest $25 million to the managed futures strategy and may put traditional investments as well. Although most CTAs trade equitythe other $25 million in Treasury bills to receive interest. index, fixed income, and foreign exchange futures, their returns should be uncorrelated and unrelated to the returns of these assetAnother critical difference between futures and equities is that classes because most managers are not simply taking on systematicthere are no barriers to short selling in futures. Since two parties exposure to an asset class, or beta, but are attempting to add alphaagree to enter into a contract, there is no need to borrow shares, pay through active management and the freedom to enter short ordividends, or incur other costs associated with entering into equity spread positions, which can result in totally different return profilesshort sales. Thus, in that sense, it is easier to invoke a long-short than the long-only passive indices.strategy via futures than it is using equities.4 Past performance is not necessarily indicative of future results.
A Quantitative Analysis of Managed Futures in an Institutional PortfolioNot all managed futures managers are trend followers. Many The existence of these risk premia is consistent with futures prices’of the earliest and most successful futures traders employed role as biased predictors of expected spot prices. The futures pricetrend following strategies, as do some of the largest CTAs today, equals the discounted present value of the expected spot pricewhich might help to explain the prevalence of this overly casual plus a risk premium, which can be positive or negative dependinggeneralization. Trend following may be the most common on the skewness or bias of distribution of expected spot prices.managed futures strategy, but it certainly is not the only one. The If all financial assets, including futures contracts, have a zero netmyriad other approaches to futures trading offer institutional present value (NPV), then:investors access to a variety of sources of return, including trendfollowing, which are uncorrelated to traditional and alternative E(ST) = Fe(μ -r)T sinvestments, and oftentimes, to one another. These includediscretionary fundamental or global macro managers who express where T represents the delivery date, E(ST) the expected spottheir views using futures, short-term traders whose strategies vary price, F the futures price, and (μs-r) the risk premium, the sign oftremendously, chartists who scan the markets for patterns, and which depends on whether or not the risk premium is positive orcontrarian traders. The wide availability of clean data has also negative. Equity index futures, for example, tend to be downward-converted academics, researchers, and scientists to trading. These biased predictors of expected spot prices since the natural riskindividuals apply advanced quantitative techniques to the markets in equities markets is to the downside. CTAs offer liquidity tothat go beyond basic rules-based systems to forecast the direction in hedgers in order to capture positive risk premia (CISDM 2006, 4).price or changes in volatility. Managed futures programs that rely It is also important to account for transactions, storage, and otheron strategies other than trend following are becoming a larger and costs which may affect futures prices.more important part of the space.Another common misconception about managed futures strategiesis that they are a zero sum game. This would be the case if CTAswere trading exclusively against other CTAs, but academics andpractitioners have demonstrated that some futures marketsparticipants are willing to hedge positions, or buy or sell forwardeven if they expect spot prices to rise or fall in their favor (CISDM2006, 4). Past performance is not necessarily indicative of future results. 5
cmegroup.comGROWTH OF FUTURES MARKETS ANDMANAGED FUTURESThe growth in open interest in futures markets has led to a substantial growth in managed futures assets under management.Electronic exchanges and technology have also contributed to the scalability and capacity of managed futures.EXHIBIT 1: Managed Futures Growth in Assets Under Management 1980-2011 Source: AlphaMetrix Alternative Investment Advisors, BarclayHedge Alternative Investment DatabaseThe substantial influx of assets into the futures markets in the It has also augmented the capacity of the more sectarian orform of passive long-only money in commodity markets as well as niche strategies and large diversified trend followers alike.the explosion of assets under management for active traders has The proliferation of passive long-only indices has created newhad numerous important implications for CTAs. The tremendous opportunities and risks for CTAs as exchange traded funds andincrease in open interest has resulted in increased depth and notes attempt to roll massive numbers of contracts each month.liquidity in many markets, allowing managers to add previously Fundamental discretionary traders, for instance, must incorporateinaccessible markets to their domain of traded instruments. the augmented interest from the long side when making trading decisions.6 Past performance is not necessarily indicative of future results.
A Quantitative Analysis of Managed Futures in an Institutional PortfolioMANAGER STYLE AND SELECTIONAs previously mentioned, most observers associate managed Although certain voices in the investment managementfutures closely with trend following strategies. The liquidity community have heralded the death of trend following many timesof futures contracts and copious amounts of available data, over the years, there is a high probability of generating stronghowever, facilitate the application of numerous other variations returns over sufficiently long rolling time periods, 36 monthsof quantitative systematic trading strategies to these instruments or more, for instance. The “long volatility” profile associatedand the time series associated with them. The influence of with most CTAs and trend followers in particular often meansfundamental economic variables on commodities and futures that returns are lumpy and a given manager’s performance willmarkets provides opportunities for niche sector and market usually depend on a few large positive months. As such, it mayspecialists to trade programs which generate returns that are often take some time to draw from this right tail of the distribution ofuncorrelated to most trend following programs. returns, and the likely interim outcome is flat lining or entering a drawdown as the program searches for opportunities in theA useful analogy for the different managed futures trading markets it trades. Those who do not hold these investments overprograms and styles, as well as for alternative investments sufficiently long time horizons will typically experience frustrationin general, consists of thinking of the various trading styles or and disappointment since the events that drive performance,programs as radio receivers, each of which tunes into a different typically massive flights of capital to or from quality, only takemarket frequency. Simply put, some strategies or styles tend to place occasionally.perform better or “tune in” to different market environments. Exhibit 2, on the following page, illustrates the maximum,Trend Following minimum and mean rolling return of the Barclays Capital BTOP 50Trend following has demonstrated performance persistence over Index over different holding periods since January 1987. Each bluethe more than 30 years since the first “turtle” strategies began bar represents the range of all rolling returns for that number oftrading, and roughly 70 percent of CTA strategies belong to this months over the life of the index. For example, the bar furthest tomanaged futures strategy sub-style. Trend following is dominated the left represents all 3-month rolling returns since the inceptionby momentum and/or breakout strategies, both of which attempt of the BTOP 50 Index. The minimum, depicted by the green dot,to capture large directional moves across diversified portfolios shows the worst 3-month rolling return in the distribution. Theof markets. It also tends to be diversified across time frames, orange square indicates the mean, and the blue triangle shows thealthough some trend followers may be exclusively long-term best 3-month rolling return in the distribution for this particular(multiple months) or very short-term (days, hours, or minutes). example.Subtle differences in risk budgeting across markets, time horizons,and parameter selection may result in trend following programswhich yield vastly different performance statistics and/or exhibitnon-correlation to one another. Even within the trend-followingspace, there can be large differences between managers; thesedifferences range from multi-billion dollar institutional quality firmsemploying an array of sophisticated and diversified techniques, tosmall shops trading with discretion. Past performance is not necessarily indicative of future results. 7
cmegroup.comEXHIBIT 2: Maximum, Minimum, and Mean Rolling Return of Barclays Capital BTOP 50 Index OverDifferent Holding Periods Source: AlphaMetrix Alternative Investment Advisors, BloombergThe conclusion readers should draw from the graph is that the Managers rarely make material changes to their strategies orpossibility of making money increases dramatically if the investor models for this same reason, especially during drawdowns, sincemaintains the allocation to managed futures three to five years. this would be tantamount to redeeming in the same way as in the example. Initial research and testing are critical, however, to ensureDuring periods of flat or underperformance, the trend follower robustness and performance persistence, as are ongoing efforts tostops out of or exits stale positions and begins to put on new ones refine the program and ensure it evolves with markets over time.for which the profit expectation is greatest. This often results in a Evolution and research have always been essential to successfulmean-reversion or “rubber band” effect which manifests itself as trend followers, and any perceived “shifts” typically involvea sudden burst of positive performance after an extended drought incremental improvements or innovations designed to enhanceof opportunities during which the program’s money management the program rather than depart from it materially (Fischer andsystem strived to preserve capital. Experienced investors often Bunge 2007, 2).choose to add to trend followers in a drawdown in anticipationof this effect. Likewise, inexperienced or impatient investors alltoo often redeem at the bottom of a manager’s drawdown, only towitness the surge in performance shortly thereafter.8 Past performance is not necessarily indicative of future results.
A Quantitative Analysis of Managed Futures in an Institutional PortfolioOther Managed Futures Strategies Managed Futures Equal Black Box Trading?Although the majority of quantitative CTAs employ some variation The quantitative nature of many managed futures strategies makesof trend following strategies, other managed futures quantitative it easy for casual observers to mistakenly categorize them as blackstrategies abound, many of which exhibit no statistical relationship box trading systems. “The irony is that most CTAs will providewhatsoever with trend following programs. Counter-trend strategies uncommonly high levels of transparency relative to other alternativeattempt to capitalize on the often rapid and dramatic reversals that investment strategies” (Ramsey and Kins 2004, 131). Ramsey andtake place at the end of trends. Some quantitative traders employ Kins suggest that CTAs will describe their trading models andeconometric analysis of fundamental factors to develop trading risk management in substantial detail during the course of duesystems. Others use advanced quantitative techniques such as diligence, “short of revealing their actual algorithms” (Ramsey andsignal processing, neural networks, genetic algorithms, and other Kins 2004, 131). CTAs are also typically willing to share substantialmethods borrowed and applied from the sciences. Recent advances position transparency with fund investors, and the real-time, fullin computing power and technology as well as the increased transparency of positions and custody of cash and instruments madeavailability of data have resulted in the proliferation of short-term possible by investments via separately managed accounts. “As such,trading strategies. These employ statistical pattern recognition, it is difficult to call CTAs black box considering they disclose theirmarket psychology, and other techniques designed to exploit methodology and provide full position transparency so that investorspersistent biases in high frequency data. Toward the end of 2008, can verify adherence to that methodology” (Ramsey and Kins 2004,short-term strategies were in high demand among fund of funds 131).and institutional investors searching for sources of return whichappeared to be statistically independent from the factors drivingperformance across both the traditional and alternative investmentsuniverses.The very short holding periods of short-term traders allow themto rapidly adapt to prevailing market conditions, making it easyfor them to generate returns during periods which are difficultfor traditional and alternative investments. The countlesscombinations and permutations of portfolio holdings that thesetrading managers may hold over a limited period of time also tendto result in returns that are not correlated to any other investment,including other short-term traders. Past performance is not necessarily indicative of future results. 9
cmegroup.comFurthermore, any systematic or algorithmic trading system has Manager Selectiona large human element. Namely, in the coding of this system, Peer analysis is often complicated by the blending of managedseveral decisions were made concerning the techniques invoked. futures sub-styles or other subtle differences that frustrateWhat limits should be used? Should there be a component of the creation of peer groups of managers. The exception tendsoptimization? There are countless questions and decisions that to be the rule. It might be difficult to categorize an eclecticgo into the codification of a systematic trading program that manager who combines a price-based model with fundamentalare qualitative in nature – after all, the coding and creation was analysis to discretionarily arrive at trading decisions, or a graindone by humans! Those who are not quantitatively minded often trader whose returns are 0.9 correlated with a number of trendcompletely overlook this fact. There are both pros and cons followers. It is possible to overcome these hurdles, however, byin systematic trading, as well as in discretionary trading, thus taking a quantitative approach to peer analysis. Managers whosediscriminating purely on the basis of systematic or discretionary returns are correlated likely have similar risk factors or exposuresis not warranted; indeed many managed futures programs are a embedded in their programs or trading styles. Creating peerhybrid of both. groups of highly correlated managers simplifies the basis for comparison across metrics of interest, and facilitates the analysisDiscretionary Trading of programs which have historically tended to perform similarly inNot all CTAs employ quantitative or systematic trading different market environments. The implications of quantitativeapproaches. In fact, some of the most unique alternative peer group analysis of this sort for manager selection are obvious.investment programs consist of discretionary CTAs and nichesector or market specialists. Like their systematic counterparts, The importance of manager selection varies somewhat dependingdiscretionary CTAs may use fundamental and technical inputs upon the objectives of the managed futures investor. Ramseyto make trading decisions and may trade one or many markets and Kins suggest that “an investment with large CTAs shouldacross a continuous domain of time horizons. Some discretionary focus on picking the very best managers with less thought ofCTAs do analyze chart patterns or other technical indicators, but diversification,” given their methodological similarities andmany discretionary CTAs employ fundamental analysis of supply tendency to highly correlate to one another (Ramsey and Kinsand demand as the basis for their programs. The most successful 2004, 134). Selection among large, diversified trend followersdiscretionary traders tend to have clearly defined, well-articulated is more important, but blending two or more of these managersrisk management coupled with unique experience and background typically enables investors to enjoy some of the benefits ofrelevant to the market or markets they trade. The fact that most diversification. The question of selection becomes less importantdiscretionary managers have the flexibility to trade in a completely for investors seeking to capture the benefits of smaller, “emerging”opportunistic fashion often results in returns which tend to be CTAs. Ramsey and Kins recommend a “strategy of employinguncorrelated to trend following, managed futures and other hedge a large cross sample of these CTAs in order to reduce businessfund styles, as well as passive long-only commodity indices. risk and take advantage of the ability to diversify across trading methodologies and markets.” (Ramsey and Kins 2004, 134)10 Past performance is not necessarily indicative of future results.
A Quantitative Analysis of Managed Futures in an Institutional PortfolioMANAGED FUTURES RISK, RETURN, AND THEPOTENTIAL FOR ENHANCED DIVERSIFICATIONThe exploitation of trends or other price behaviors that tend to Since then, the importance of alternative investments toaccompany large macro dislocations or events by CTAs produces institutional investors as sources of absolute return and portfolioboth a positive return expectation and uncorrelated variance, diversification has grown tremendously, especially over themaking them additive to most portfolios. Although CTAs tend last decade. Managed futures strategies should continue toto have high volatility and lower Sharpe ratios relative to other play a prominent role in the increasingly important alternativealternative investments, the addition of an uncorrelated element portion of institutional portfolios, due not only to their role inwhich often contributes positive gamma, enhances the return and dampening portfolio variance, but also their ability to improvedecreases the variance of most portfolios. (It is important to recall other important performance statistics, including semideviation,that this volatility comes from large, infrequent positive returns drawdown, skewness, kurtosis and the Omega performanceand that the Sharpe ratio is flawed as a measure of risk-adjusted measure, which incorporates all of the information embedded inperformance, as we will soon demonstrate.) The fact that an the distribution of returns of an investment, as well as an investor-investment is volatile on a stand-alone basis does not necessarily determined threshold of loss.mean that it will increase the volatility of the entire portfolio. Lintner performed his analysis on mean-variance portfolios ofModern Portfolio Theory suggests that adding uncorrelated traditional and managed futures investments using stock andvariance actually decreases overall portfolio variance. The addition bond indices, and two sets of managed futures account and fundof uncorrelated variance may also help investors reduce other investment returns, likely due to the paucity of managed futuresimportant measures of risk, including drawdown, semideviation, performance data. This study employs index data exclusively, dueand kurtosis in the left tail. to its wide availability, as well as to minimize selection bias. ItLintner’s paper found that the low and occasionally negative also attempts to maximize robustness and statistical validity bycorrelations between futures portfolios and traditional equity calculating all statistics using as many observations as possible,and fixed income portfolios enable the creation of portfolios with resulting in comparisons across heterogeneous time horizonssubstantially less variance at every possible level of expected when historical index data is not available. As such, the number ofreturn relative to traditional portfolios consisting solely of observations used for calculations varies.stocks or mixtures of stocks and bonds (Lintner 1996, 105-106).He alludes to the growing interest of institutional investorsin alternative investments as means to tap additional sourcesof uncorrelated return, pointing to real estate, venture capitalinvestments and “diversified holdings of oil-well exploration pools”as examples before turning to managed futures (Lintner 1996,102). Past performance is not necessarily indicative of future results. 11
cmegroup.comRISK AND RETURN: OMEGA – A BETTER APPROACHPopular culture and the media often portray futures trading as one Moreover, from a practical point of view, there is an obviousof the riskiest and most speculative forms of investment. Several difference between upside volatility and downside volatility.intrinsic characteristics of futures contracts make them substantially The Omega function and performance measure, first presented byless risky, however, than investments in other instruments Con Keating and William Shadwick, overcome the shortcomingswhich have not been branded with many of the same negative of the mean-variance framework and allow investors to refer to theconnotations. Most casual observers and even many experienced risk-reward characteristics of portfolios with respect to a referencepractitioners attribute this volatility to the underlying instruments point or threshold other than the mean. Omega fully incorporatestraded, but such a conclusion would be fallacious. the impact of all of the higher moments of the distributionFutures garnered their reputation as a risky largely due to the of returns into an intuitive performance measure that allowsvolatility of individual commodity markets, which many observers practitioners to assess risk and return in the context of their ownclosely associate with the futures markets. The volatility of the loss threshold without burdensome utility functions (Keating andpassive long-only commodity indices, such as the Goldman Sachs Shadwick 2002, 2). Investors specify what they constitute as theirCommodity Index (GSCI), also explains in part the perception of own loss threshold or minimum acceptable return, which serves ashigh risk. The nearly 20 percent annualized volatility of the GSCI, the benchmark return. The Omega function makes a probability-combined with its maximum historical drawdown of more than 60 weighted comparison of “profits” and “losses”, however defined,percent certainly justifies this perception. However, it is important relative to this investor-determined threshold. The Omega functionto make a number of critical distinctions here. First, there are is defined as:substantial differences between passive long-only indices like theGSCI and actively managed trading strategies like those which bthis paper highlighted earlier. “Commodities,” loosely defined, are ∫ [1-F(x)]dx Ω(r):= ralso different than futures contracts, which are nothing more than r ∫ F(x)dxexchange traded instruments linked to the prices of a diversified avariety of global markets.Those assessing risk must also carefully define it. Modern Portfolio where F(x) is the cumulative distribution function for the returns,Theory equates risk with variance (or volatility as measured by bounded by the endpoints a and b, with a threshold of r (Keatingstandard deviation), which measures the dispersion of outcomes and Shadwick 2002, 12). Exhibit 3 illustrates the cumulativefrom the mean. Using volatility to measure risk, however, penalizes distribution function for an investment, along with depictions of thethose outcomes which are greater than the expected, or upside threshold and profit and loss integrals.volatility. Outcomes which exceed expectations (most rationalinvestors would not select investments for which the return Omega provides practitioners with an extremely useful tool sinceexpectation is negative), or exceed a necessary or desired threshold, it accounts for the non-normal distributions of returns which arecannot truly be said to be risky in the sense that they do not imply commonplace in finance, particularly for alternative investments.loss or failure to meet an objective. In other words, volatility ignores Despite the apparent intuitiveness of the Sharpe ratio, the fact thatthe skewness and kurtosis of a manager’s distribution of returns. it ignores skewness and kurtosis and penalizes upside volatility, essentially renders it useless for investment performance analysis.Managed futures may be more volatile than long/short equity orequity market neutral hedge funds, but not necessarily more risky.Measuring risk by volatility is dangerous to do in the alternativesspace since the distributions are typically non-Gaussian.12 Past performance is not necessarily indicative of future results.
A Quantitative Analysis of Managed Futures in an Institutional PortfolioEXHIBIT 3: Cumulative Distribution and Omega Functions y (F(X)) numerator of Ω y=1 y=0 x (returns) denominator of Ω x=r Source: Bhaduri and Kaneshige, 2005The Omega function is a powerful tool in the risk toolbox [Bhaduri The BTOP 50 Index, HFRI Fund Weighted Composite Index,and Kaneshige, 2005]. Furthermore, the selection of a threshold and HFRI Equity Hedge Index all exhibit excess kurtosis, or “fatas the focus dovetails well with the needs of pensions. Pensions tails” in their distributions of returns as well (2.66, 2.41, and 1.76,typically take an asset-liability lens, consequently, the return they respectively), consistent with the vast majority of hedge fundseek is a function of the liabilities they face. The Omega function strategies.lends itself well to this framework since a natural threshold for a The fact that a given investment or strategy displays fat tails ispension to select is a return which will at least cover its liabilities. not as important as the location of the extreme deviations whichExhibit 4, “Statistics: Traditional and Alternative Investment cause them. Skewness describes the relative length of the tails orBenchmarks,” illustrates the shortcomings of evaluating the degree of asymmetry of a distribution of outcomes. Positiveinvestment performance solely through the lens of mean and skewness suggests that a number of relatively large positivevariance, particularly for managed futures. The Barclays Capital deviations inflate the mean of the distribution, resulting in a fatBTOP 50 returns display significantly more variance than those of right tail. Conversely, negative skewness occurs when a number ofthe Hedge Fund Research, Inc. (HFRI) Fund Weighted Composite relatively large negative deviations pull the mean down, resulting inIndex, or the HFRI Equity Hedge (Total) Index, as measured by a fat left tail.standard deviation (10.47 percent compared to 7.08 percent and The BTOP 50 displays large positive skewness (1.00) relative to the9.31 percent). The variance of all negative observations of the HFRI Fund Weighted Index (-0.71) and HFRI Equity Hedge IndexBTOP 50 and HFRI hedge fund indices in question, however, were (-0.25). The positive skewness exhibited by most CTAs explains thecomparable (semideviation of 4.76 percent versus 5.29 percent majority of the differences in variance between the BTOP 50 andand 6.20 percent), as were worst drawdowns (-13.31 percent HFRI hedge fund indices. This paper explores the reasons for excessversus -21.42 percent and -30.59 percent). kurtosis in hedge fund returns, and for differences in skewness for different hedge fund strategies, in a later section. Past performance is not necessarily indicative of future results. 13
cmegroup.comEXHIBIT 4: Statistics: Traditional and Alternative Investment Benchmarks HFRI Fund Weighted Index DJ UBS Commodity Index HFRI Equity Hedge Index Composite Global Index Barclay BTOP 50 Index MSCI World Daily Total Barclays Capital Bond Barclays Capital Bond Newedge Short-Term S&P/Citigroup World Composite US Index Return Net (USD) LPX Buyout Index S&P 500 Total REIT TR Index Traders Index Return Index GSCI TR Annualized ROR 8.99% 11.06% 7.12% 6.41% 9.04% 6.32% 5.36% 11.23% 12.89% 5.20% 8.55% 0.89% Annualized Standard Deviation 10.47% 15.62% 15.42% 3.45% 6.30% 19.56% 15.02% 7.08% 9.31% 27.61% 16.77% 3.56% Annualized Semideviation 4.76% 11.55% 11.47% 2.26% 3.69% 13.66% 11.36% 5.29% 6.20% 19.97% 14.87% 2.17% Worst Drawdown -13.31% -50.95% -55.37% -3.63% -12.43% -67.65% -54.26% -21.42% -30.59% -80.95% -67.56% -8.28% Sharpe Ratio (Risk Free Rate = 0%) 0.86 0.71 0.46 1.86 1.44 0.32 0.36 1.59 1.38 0.19 0.51 0.25 Sortino Ratio (Risk Free Rate = 0%) 1.89 0.96 0.62 2.84 2.45 0.46 0.47 2.12 2.08 0.26 0.57 0.41 Skewness 1.00 -0.63 -0.64 -0.41 1.03 -0.21 -0.59 -0.71 -0.25 0.28 -1.26 -0.06 Excess Kurtosis 2.66 2.09 1.56 1.60 6.85 2.49 2.83 2.41 1.76 4.47 8.33 -0.10 Omega (3% Threshold) 1.60 1.53 1.42 1.85 2.18 1.23 1.20 2.29 2.17 1.20 1.40 0.67 Months 300 384 384 170 382 384 251 264 264 168 264 48 Positive Months 170 243 227 121 264 218 149 188 182 102 159 19 Negative Months 130 141 157 49 117 166 102 76 82 65 105 29 Percent Winning Months 56.67% 63.28% 59.11% 71.18% 69.11% 56.77% 59.36% 71.21% 68.94% 60.71% 60.23% 39.58% Average Month 0.76% 0.98% 0.67% 0.52% 0.74% 0.67% 0.53% 0.91% 1.05% 0.74% 0.81% 0.08% Average Positive Month 2.67% 3.58% 3.50% 1.01% 1.55% 4.31% 3.17% 1.90% 2.40% 5.19% 3.52% 1.11% Average Negative Month -1.72% -3.49% -3.42% -0.67% -1.09% -4.10% -3.32% -1.52% -1.95% -6.24% -3.31% -0.60% Modern Portfolio Theory Correlation to S&P 500 -0.04 1.00 0.88 -0.10 0.19 0.17 0.30 0.74 0.73 0.75 0.61 -0.50 Total Return R Squared 0.00 1.00 0.77 0.01 0.04 0.03 0.09 0.55 0.53 0.56 0.38 0.25 Beta -0.02 1.00 0.87 -0.02 0.08 0.21 0.30 0.34 0.44 1.24 0.68 -0.09 Alpha 0.78% 0.00% -0.17% 0.54% 0.66% 0.47% 0.29% 0.65% 0.71% 0.22% 0.29% 0.08%Sources: AlphaMetrix Alternative Investment Advisors, Bloomberg, LPX GmbH. All statistics calculated to maximize number of observations; as such, number of observations used forcalculations varies (Starting Dates: BTOP 50 - Jan 1987, S&P 500 Total Return Index - Jan 1980, MSCI World - Jan 1980, Barclays Capital Bond Composite US Index - Sep 1997, BarclaysCapital Bond Composite Global Index - Feb 1980, GSCI TR - Jan 1980, DJ UBS Commodity Index - Feb 1991, HFRI Fund Weighted Index - 1990, HFRI Equity Hedge Index - Jan 1990, LPXBuyout Index - Jan 1998, S&P/Citigroup World REIT TR Index - Jan 1990, Newedge Short-Term Traders Index - Jan 2008). All statistics calculated through Dec 2011 with the exception ofthe Barclays Capital Bond indices, which did not report returns for Sep 2008 or Oct 2008.14 Past performance is not necessarily indicative of future results.
A Quantitative Analysis of Managed Futures in an Institutional PortfolioHIDDEN RISK: THE IMPORTANCE OF LIQUIDITY,TRANSPARENCY AND CUSTODYModel risk always exists, as no model is perfect by definition. The lack of transparency and difficulty involved in pricing illiquidWhat is less appreciated by many in the investment community instruments magnifies model risk. Infrequent pricing of instrumentsis that model risk and liquidity risk are entangled. There are no obfuscates the relationships among market price and the differentvaluation issues with exchange-traded instruments, and model risk factors or variables used in pricing or trading models, complicatingis magnified when dealing with illiquid instruments. In general, the their testing and design. Lack of transparency and illiquidityless liquid the instruments traded, the more hidden risk, and the substantially reduce the margin of error during the research andmore dangerous model risk becomes. The historic 2008 financial development of trading or risk models. The losses that will ensuemeltdown is a vivid example of this statement [Bhaduri and Art, in the event that models fail to account for a critical piece of2008]. information, will be of an order of magnitude many times larger for illiquid instruments due to the relative thinness of these markets.Most managed futures programs by definition trade exclusively The seller will likely have to accept a deep discount in price toexchange-listed futures or options on futures. Settlements on exit an illiquid position, particularly during a “fire sale” or crisisall futures contracts are determined by the various exchanges event. The credit debacle of 2007-2008, for example, exposed manyat the end of each trading day, compelling managers to mark hedge funds and other sophisticated investors who had invested intheir books to market. Many CTAs also trade the inter-bank FX structured debt products whose models failed to incorporate manyforward market, where the process of price discovery takes place of the hidden risks. The investors and portfolio managers holding24 hours a day. It is also one of the deepest and most liquid in the these instruments suffered deep losses as they struggled to findworld. These qualities enable hedge fund investors to mitigate or liquidity in thin markets, or watched other positions go to zero duecompletely eliminate some of the more deleterious risks associated to poor assumptions made by the rating agencies.with investing in alternatives. The liquidity of the underlyinginstruments traded as well as the high level of transparency Conversely, risk managers can monitor and control risk with relativeavailable through managed account investments with CTAs ease due to the transparency and liquidity of futures contracts.facilitates tactical asset allocation. Investors and CTAs alike can Instead of relying on complex models with numerous assumptions,easily exit unprofitable positions, or positions that they expect to risk managers are free to focus on monitoring margin to equity,become unprofitable in the near future, with minimal slippage, counting contracts and testing for disaster scenarios, such asusually in a matter of minutes. correlation convergence with a multiple standard deviation shock. Transparency and constant price discovery facilitates simple, noIronically, the liquid, transparent, marked-to-market nature of the nonsense testing and monitoring. Investing via separately managedinstruments traded by liquid hedge funds may make their returns accounts, a common practice among managed futures investors,appear more volatile or risky than those of many hedge funds facilitates risk management tremendously by providing the investortrading esoteric or illiquid instruments, which trade infrequently with full transparency and in extreme cases, the ability to interveneand are therefore marked to a stale price or a model. As a result, against the trading manager by liquidating or neutralizing positions.these hedge funds often intentionally or unintentionally smooththeir returns, artificially dampening their volatility and depth oftheir drawdowns. Past performance is not necessarily indicative of future results. 15
cmegroup.comHidden sources of risk that many hedge fund investors do not fully Returning to the ever-important topic of liquidity, it is worthappreciate are the structural and operational risks associated with pointing out that from a behavioral finance point of view, it is easyinvesting directly into a fund vehicle. Fund investments require the for investors to underestimate the value of liquidity [Bhaduri andinvestor to transfer money to the trading manager with an implicit Whelan, 2007]. If a hedge fund is trading illiquid instruments andguarantee that it will be returned at some future date. Wiring has a long lock-up, then simply comparing its return statistics to amoney to the manager exposes the investor to the risk of fraud or CTA that is trading exchange-traded instruments and does not havetheft of the investment. Managed account investments mitigate a lock-up is incorrect, since it does not assign a value to liquiditythis risk by giving the manager limited power of attorney to trade [Bhaduri and Art, 2008]. Lock-ups by private equity funds andon behalf of the investor, who maintains legal custody of the cash hedge funds trading illiquid instruments cost the investor in termsand instruments at his FCM. Wiring money to a manager also of reduced flexibility, and they should be rewarded with higherexposes the investor to operational risks, and requires expensive and returns to compensate for this. There are not yet many measurestime-consuming due diligence on the manager’s middle and back or instruments to deal with this problem [Bhaduri, Meissner, andoffice processes, as well as its service providers. Fund investments, Youn, 2007].including those in liquid instruments, often attempt to imposelockups, gates, or onerous redemption terms on investors. Mostfund documents also give the general partner the right to suspendredemptions, in effect providing the manager with a call optionon the liquidity it had previously offered investors. There is no realvalue added by having the money housed with the manager whois being paid to try and provide an attractive risk-adjusted returnover time with proper risk controls. Managers who refuse to grantmanaged accounts are in essence refusing to give transparency andare subjecting their clients to additional risks.16 Past performance is not necessarily indicative of future results.
A Quantitative Analysis of Managed Futures in an Institutional PortfolioTHE LACK OF CORRELATION AND POTENTIALFOR PORTFOLIO DIVERSIFICATIONAfter highlighting the attractive risk and return properties of Exhibit 7 on page 20, “Correlation Matrix: Traditional andmanaged futures, Lintner turns to a discussion of the lack of Alternative Investment Benchmarks,” illustrates the low andcorrelation of managed futures with other investments. He then occasionally negative correlations between managed futures andconcludes his paper by presenting evidence of the substantial other investments. The highest of these were 0.20 and 0.22 withimprovements in risk and return that managed futures contribute the bond indices, and the lowest was -0.21 with the Listed Privateas part of a diversified portfolio of equities and fixed income Equity (LPX) Buyout Index, suggesting that significant benefits(Lintner 1996, 105). The absence of correlation between managed would accrue to investors who added managed futures to portfoliosfutures, traditional investments, and other alternative investments including some or all of these investments. These correlations willcreates a prominent role for this liquid, transparent hedge fund be explored in more detail later in this section.strategy in institutional portfolios. Exhibit 5 demonstrates that managed futures greatly improveThe long-term correlations among equities, fixed income and the efficient frontier from a mean-variance framework. This ismanaged futures remain low even 25 years after Lintner’s study, congruent with the earlier findings of Lintner.suggesting a continuing relevance to investors interested inattaining the “free” benefits of diversification.Exhibit 5: Efficient Frontier: BTOP 50 Index and Traditional Portfolio of Equities and Fixed IncomeJanuary 1987 – December 2011 Source: AlphaMetrix Alternative Investment Advisors, Bloomberg. Barclays Capital Bond Composite Global Index did not report returns for Sep 2008 and Oct 2008 Past performance is not necessarily indicative of future results. 17
cmegroup.comRecall that when the Omega score drops below one, the quality The Omega graph in Exhibit 6 indicates that for low thresholds,of the investment with respect to achieving the threshold is poor. the combination of managed futures and a traditional portfolio is(For a review of Omega graphical analysis, please refer to Ranjan best, and for higher thresholds, a portfolio of managed futures isBhaduri and Bryon Kaneshige, “Risk Management – Taming the dominant.Tail,” Benefits and Pensions Monitor, December 2005.) Studying These Omega results yield a very compelling argument for thethe potential role of managed futures in traditional portfolios of inclusion of managed futures in an institutional portfolio.stocks with the Omega lens for risk-adjusted performance is takinga modern approach to the Lintner study. As stated earlier, Lintnerdid not have the benefit of the Omega tool during the time heconducted his work, and the Omega function encodes all the higherstatistical moments and distinguishes between upside and downsidevolatility.EXHIBIT 6: Omega Graph: BTOP 50 Index and Traditional Portfolio of Equities and Fixed IncomeJanuary 1987 – December 2011 Source: AlphaMetrix Alternative Investment Advisors, Bloomberg. The Barclays Capital Bond Composite Global Index did not report Sep 2008 and Oct 200818 Past performance is not necessarily indicative of future results.
A Quantitative Analysis of Managed Futures in an Institutional PortfolioCorrelations Between Managed Futures and Other Lintner analyzed the portfolio benefits of combining managedInvestments account investments in fifteen different futures programs usingThe variety of trading sub-styles within managed futures and the different weighting schemes. For our purposes, the weightinglack of correlation among them, as well as to other traditional and schemes are not important since these may vary according to thealternative investments, makes it possible to enhance the return portfolio manager’s objectives. Instead, this section will focus onor diminish the risk of portfolios through the addition of managed the correlations among managers since these provide the mostfutures “alpha” strategies. These include sub-styles such as short- information about potential benefits to be had from diversification.term trading, niche discretionary strategies, relative-value, etc. For simplicity, it also will distill correlations among managers intoThese qualities make it possible to construct diversified, liquid, average pair-wise correlation.transparent fund of funds and portfolios by combining uncorrelated This section also draws upon the performance of the constituentsprograms. Lintner’s pioneering research demonstrated that there of the Newedge Short-Term Traders Index, a theoretical index ofare substantial benefits which accrue from “selective diversification” 10 trading programs whose holding period is less than ten days onacross a number of different futures managers and funds due to the average, trade two or more market sectors, and which are open for“rather moderate” correlations among them (Lintner 1996, 105). investment (Burghardt et.al. June 9, 2008, 4). There is some risk ofThe astronomically high number of combinations and permutations survivorship bias since all of the constituent programs remain openof portfolio holdings and investment horizons of short-term traders, for investment. Selection bias appears to be less of a concern sinceand accordingly, the unique and uncorrelated returns which result, this index contains managers of all trading styles, track records ofmake them a fascinating case for revisiting Lintner’s analysis of various lengths, and various levels of assets under management.diversification among futures managers. Regardless, while the constituents of the index do not provide an exhaustive sample, it is likely that they provide one which is representative of short-term trading and its correlation properties. Past performance is not necessarily indicative of future results. 19
cmegroup.comEXHIBIT 7: Correlation Matrix of Traditional Alternative Investment Benchmarks S&P 500 Total Return Index HFRI Fund Weighted Index DJ UBS Commodity Index HFRI Equity Hedge Index Composite Global Index Barclay BTOP 50 Index Barclays Capital Bond Newedge Short-Term S&P/Citigroup World Composite US Index MSCI World Index LPX Buyout Index Barclays Capital Traders Index REIT Index GSCI TR Barclay BTOP 50 Index 1.00 S&P 500 Total Return Index -0.04 1.00 MSCI World Index -0.01 0.88 1.00 Barclays Capital Composite 0.20 -0.10 -0.09 1.00 US Index Barclays Capital Bond 0.22 0.19 0.23 0.89 1.00 Composite Global Index GSCI TR 0.12 0.17 0.23 -0.03 0.00 1.00 DJ UBS Commodity Index 0.17 0.30 0.40 0.01 0.11 0.90 1.00 HFRI Fund Weighted Index -0.02 0.74 0.75 -0.08 0.06 0.30 0.44 1.00 HFRI Equity Hedge Index -0.02 0.73 0.72 -0.08 0.06 0.35 0.43 0.95 1.00 LPX Buyout Index -0.21 0.75 0.77 -0.10 -0.14 0.30 0.31 0.77 0.78 1.00 S&P/Citigroup World -0.02 0.61 0.64 0.18 0.26 0.22 0.37 0.51 0.49 0.60 1.00 REIT Index Newedge Short-Term 0.54 -0.50 -0.44 0.00 0.08 -0.14 -0.09 -0.34 -0.40 -0.48 -0.42 1.00 Traders IndexSources: AlphaMetrix Alternative Investment Advisors, Bloomberg, LPX GmbH, Newedge. All statistics calculated to maximize number of observations; as such, number ofobservations used for calculations varies (Starting Dates: BTOP 50 - Jan 1987, S&P 500 Total Return Index - Jan 1980, MSCI World - Jan 1980, Barclays Capital Bond Composite USIndex - Sep 1997, Barclays Capital Bond Composite Global Index - Feb 1980, GSCI TR - Jan 1980, DJ UBS Commodity Index - Feb 1991, HFRI Fund Weighted Index - 1990, HFRI EquityHedge Index - Jan 1990, LPX Buyout Index - Jan 1998, S&P/Citigroup World REIT TR Index - Jan 1990, Newedge Short-Term Traders Index - Jan 2008). All statistics calculated throughDec 2011 with the exception of the Barclays Capital Bond indices, which did not report returns for Sep 2008 or Oct 2008.Lintner found that the “average correlation between the monthly The average pair-wise correlation among the constituents of thereturns of each manager with those of every other manager,” or Newedge Short-Term Traders Index was 0.175, another very lowaverage pair-wise correlation, among the fifteen managers in his value which supports the conclusion that short-term traders, likesample was 0.285, with a minimum of 0.064 and a maximum of those managed futures programs in Lintner’s sample, generally0.421 (Lintner 1996, 110). This extremely low average pair-wise exhibit low correlations to one another (Burghardt et.al. June 9,correlation, and the sample maximum of 0.421 suggests that 2008, 4).the trading programs Lintner analyzed would generally havecontributed to a portfolio in which any of them were part of thewhole.20 Past performance is not necessarily indicative of future results.
A Quantitative Analysis of Managed Futures in an Institutional PortfolioThe minimum pair-wise correlation within the sample was -0.142 of diversified, liquid, transparent “alpha” strategies. If managedand the maximum was 0.556, comparable to the results from futures consisted solely of trend following strategies, this wouldLintner’s sample albeit with slightly wider dispersion. Pair-wise be a difficult if not impossible exercise, given the tendencycorrelations are displayed in Exhibit 8. toward high correlation among trend followers. The diverse and uncorrelated investments offered by CTAs, however, allowThe lack of correlation among managed futures strategies, as institutional investors access to an entire universe of liquid,well as with traditional and other alternative investments, allows transparent hedge fund strategies.them to contribute to most portfolios. The analysis of pair-wise correlation also provides an illuminating example of howfutures trading programs can be combined to create a portfolioEXHIBIT 8: Distribution of Pair-Wise Correlations Newedge Short-Term Traders Index Source: AlphaMetrix Alternative Investment Advisors, Newedge Group, Burghardt et.al Past performance is not necessarily indicative of future results. 21
cmegroup.comMANAGED FUTURES AND PERFORMANCE DURINGFINANCIAL MARKET DISLOCATIONSThe volatility and market dislocation that accompanied the Although managed futures returns tend to be uncorrelated to othersubprime mortgage crisis, credit crunch, and explosion and collapse investments over the long run, correlations are non-stationary overof commodities prices during the second half of 2007 and 2008, shorter time horizons and may temporarily converge during crisiswas briefly alluded to earlier in this paper. The diversified mix of conditions. Ramsey and Kins point to “the case of exogenous eventsinvestments many institutional investors had relied upon failed to like the failed Russian coup in the 1990s or September 11, 2001”generate returns. The major U.S. and Global equities market indices, as examples where managed futures would not have been effectivethe S&P 500 and MSCI World, performed dismally, returning -37.94 as a portfolio hedge and would have experienced losses alongsidepercent and -39.90 percent, respectively, from August 2007 when other investments and actively managed strategies (Ramsey andthe credit crisis began, through December 2008. Kins 2004, 130). Not all market dislocations are the same, making CTAs vulnerable to rapid reversals or the sudden onset of volatility.Most alternative investments, which had promised absolute returns, The reaction of managed futures strategies to price action is pathdisappointed investors as well. The HFRI Fund Weighted Composite dependent, and the response of the program to prevailing priceIndex, an equally weighted index designed to represent the returns of action during a crisis determines performance, at least in the short-hedge funds across all strategies, returned -17.21 percent from August term.2007 through December 2008. The HFRI Equity Hedge (Total)Index, which includes hedge funds whose core holdings consist of Certain generalizations about CTA returns and the marketequities and therefore does not benefit as much from diversification conditions that generate them do tend to result in bouts of strong,as the HFRI Fund Weighted Composite Index, returned -25.06 positive performance during certain kinds of market dislocations.percent. Private Equity and Real Estate Investment Trusts, The majority of CTAs trade “long volatility” strategies, which tendrepresented by the LPX Buyout Index and the S&P/Citigroup World to produce a positively skewed distribution of monthly returns. TheREIT Index, returned an atrocious -71.91 percent and -47.40 percent, long option/positive gamma returns profile originates from the tightrespectively, from August 2007 through December 2008. CTAs, control of downside risk relative to less frequent outsized returns,however, capitalized on the market dislocations of 2007 and 2008, suggesting that these managers generate the majority of theirproviding managed futures investors with returns of 17.57 percent returns during lower frequency, high impact events. In contrast,over the same period, as measured by the BTOP 50 index. most hedge fund strategies have fat left tails in their distributions of returns since they perform well under normal conditions but sufferRamsey and Kins posit that “though not a hedge, CTAs often infrequent, large losses under highly volatile conditions and shouldperform very well when markets are under extreme stress, and therefore be considered short volatility strategies (Ramsey and Kinshave a high probability of adding value to an existing portfolio 2004, 130). These “tail events” for CTAs and hedge funds tend toduring difficult market conditions” (Ramsey and Kins 2004, coincide with massive shifts of capital which create trends in global134). This is because managed futures tend to capture massive equity, interest rate, and commodities markets stemming from aflows of capital as markets reestablish equilibrium in the wake of flight to or from quality. Any dislocations which catalyze trends ofnew information or in the transition from one economic cycle to this sort can and often do result in strong performance for managedanother. It cannot be emphasized enough that managed futures futures.are not and should not be treated as a portfolio hedge, but ratheras an additional source of non-correlated returns, as this paper hasdemonstrated.22 Past performance is not necessarily indicative of future results.