Brad Zigler: While commodity prices soar, some investors—remembering similar run-ups in 2008—grow more and more uncomfortable about the prospect of another blowoff top.
Three years ago, speculation—bolstered by the proliferation of exchange-traded commodity trusts—helped to send prices into the stratosphere, before demand destruction and a credit market collapse teamed up to snap the rally’s back. Then, paradoxically, while commodity prices swooned in the latter half of 2008, one asset class stood out for its gains: managed futures.
Unlike long-only commodity index trackers, managed futures are just that—alpha-seeking accounts run by commodity trading advisors (CTAs) who are free to buy or sell short futures on a discretionary basis. CTAs did a good job of preserving client capital in the latter half of 2008.
While the S&P 500 (NYSE:SPY) Composite sank 33.4 percent, the value of managed futures metered by the BarclayHedge CTA Index actually rose by 4.4 percent. Managed futures, in fact, provided better risk diversification for equity investors than bonds (see Chart 1).
Chart 1 – Managed Futures Vs. Stocks And Bonds
The diversification effect bestowed by managed futures isn’t fleeting. Over the past three years, the correlation of stocks to bonds, proxied by the Barclays Capital Aggregate Bond Index, has been 20.9 percent. That’s positive 20.9 percent. The coefficient for stocks and managed futures? Negative 21.3 percent.
Managed futures provide as much “zag” to a stock portfolio as the “zig” supplied by bonds. As shown in Table 1, managed futures are negatively correlated to both stocks and bonds. That makes managed futures an ideal portfolio carve-out:
Table 1 – Performance Metrics (March 2008 – March 2011)
Aggregate Bond Index
|Average Annual Return||5.1%||0.2%||5.6%|
|Correlation to CTA Index||—||-21.3%||-6.6%|
But if you’re considering commodity investments, throwing money into managed futures shouldn’t be done willy-nilly. First of all, you have to address the question of how to gain exposure—through separately managed accounts, public commodity pools, mutual funds, exchange-traded fund or notes? Then there’s the issue of size—just how much capital should be allocated and from what source?
Let’s work backward on these questions. With portfolio diversification as our objective, it makes sense to fund a managed futures allocation from the asset class most likely to be hedged by its inclusion. Table 1’s correlation numbers tell us that’s equities. Managed futures are more negatively correlated to stocks than bonds, so more benefit would likely be derived by peeling equity money off to establish a managed futures position.
So, how much do we carve out of our stock allocation to gain futures exposure? A look back in time may help us get our arms around this.
How Much Is Enough?
Let’s posit the classic 60/40 portfolio as our starting point: 60 percent stocks and 40 percent bonds. We’ll sample the effect of 10- and 20-percent carve-outs from stocks to managed futures—with monthly rebalancing—over the past three years in Chart 2. We’ll use the Chart 1 indexes as stand-ins for our portfolio components.
Table 2 – Three-Year Portfolio Performance (March 2008 – March 2011)
|Average Annual Return||2.9%||3.3%||2.2%|
From the track record, two things become readily apparent. First, adding managed futures boosts overall portfolio performance by enhancing returns and dampening volatility. The portfolio’s risk-adjusted return, indicated by its Sharpe ratio, doubles when a managed futures allocation is added.
Second, more is better. Doubling the managed futures allocation increases the risk-adjusted return by a further 75 percent.
Chart 2 – Managed Futures’ Portfolio Impacts
Limited Investment Options
Before 2003, the recommendation and brokering of managed futures products was effectively foreclosed to anyone who wasn’t a commodity broker. The commodity pools and separately managed accounts then available were also heavily fee-laden. Changes in the regulatory scheme have since allowed the creation of lower-cost commodity-based mutual funds and exchange-traded products that can be marketed by stock brokers or bought by self-directed investors.
The trouble is, many products touted as “managed,” really aren’t. The first generation of commodity securities was index-based. It’s only been within the past two or three years that actively managed products have debuted. Of those, the first to market were mutual funds. It’s the rare exchange-traded fund or note that can claim to be actively managed. And some of those, in fact, are really index trackers in disguise.
A flurry of new products have launched recently, but their short track records necessarily limits analysis. We’ll look at representative managed futures products that have been around for more than a year, benchmark their performance against the returns generated by a commodity index tracker and see if any alpha’s been earned recently.
MutualHedge Frontier Legends (MHFAX), the newest portfolio, is closest to a classic multi-advisor commodity pool, including its rich fee structure.
- DWS Enhanced Commodity Strategy (SKNRX) is in fact, a closet index tracker. SKNRX managers overweight or underweight the sectors within its commodity benchmark in an attempt to boost returns and minimize losses.
- Direxion Commodity Trends Strategy (DXCTX) tracks the Alpha Financial Technologies Commodity Trends Indicator, a momentum-following mechanism that allocates short and long exposures over a diversified spectrum of futures.
- Rydex|SGI Managed Futures Strategy (RYMTX) is also a tracker. RYMTX tries to match the performance of the Standard & Poor’s Diversified Trends Indicator, an index similar to the Commodity Trends Indicator, but that incorporates financial futures.
- iShares Diversified Alternatives Trust (NYSE:ALT) is an exchange-traded fund that’s truly active. The fund trades futures and currency forwards, endeavoring to produce noncorrelated absolute returns.
- Elements S&P CTI ETN (NYSE:LSC) is an exchange-traded note that offers exposure to the Standard & Poor’s proprietary Commodity Trends Indicator. Investors, in addition to bearing commodity market risk, also undertake credit risk. The note’s issuer is the Swedish Export Credit Bank.
- PowerShares DB Commodity Index Tracking (NYSE:DBC) is the passive benchmark that will provide the basis for calculating all the other products’ beta and alpha coefficients. DBC is an exchange-traded fund that tracks changes in the Deutsche Bank Liquid Commodity Index, a long-only portfolio of diverse commodity futures.
Now, about the portfolio metrics. Sharpe ratios indicate the degree of payback—in terms of return—derived by taking on a security’s risk; higher ratios indicate better risk-adjusted returns or bigger paybacks. R2 (r-squared) represents the percentage (0.00 to 1.00, or 0 to 100 percent) of a security’s movements that can be explained by movements in DBC’s price. Beta is a measure of a security’s volatility relative to that of the DBC; a beta coefficient of 0.75 indicates the security exhibits less volatility—specifically, 75 percent—than the benchmark. Finally, alpha describes a portfolio’s comparative performance on a risk-adjusted basis. An alpha of 0.09, for example, means the portfolio bettered the beta-adjusted DBC return by 9 percent.
As you can see from the product descriptions, only two products—MHFAX and ALT—don’t somehow track an index. And, as you can see from Table 3, the very best return was obtained by the SKNRX portfolio – an index-hugger that limits its active management to tinkering with its benchmark’s sector weights.
Table 3 – Performance Metrics (January 2010 – April 2011)
|Average Annual Return||4.7%||29.6%||9.1%||1.8%||2.6%||5.3%||21.1%|
These results shouldn’t be taken as an indictment of managed futures. There’s just a paucity of true managed futures products that have built up track records.
Keep in mind that the commodities markets, too, have been skewed upward recently, along with equities. All the products listed have been positively correlated to stocks and commodities for the past year.
The numbers tell us this: Given the limited menu of managed strategies and the recent upward bias of the markets, a long-only index approach—vanilla or enhanced—has been a better stand-alone bet. That could very well change as more actively managed futures products season themselves in the coming months, however.
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