From the September 2009 issue of Investment Advisor • Subscribe!

September 1, 2009

Danger & Opportunity: Futures Education

Michael Bulley on what you should know about managed futures

You've all heard the common wisdom about investing in 2008, and perhaps you've even said it yourself: Diversification didn't work in 2008, because in that devastating year, all correlations went to one. The problem with that received wisdom, however, is that it's not true. Yes, far wiser minds, like Mohammed El-Erian at PIMCO, to name just one, and his colleagues are exiting the Church of Markowitz, arguing that asset allocation has some fundamental flaws. "You were increasingly seeing a breakdown" of perceived relationships between asset classes, PIMCO's El-Erian told Tom Lauricella of The Wall Street Journal in July.

But not everything declined in 2008. If you had the prescience to put everything into Treasuries on January 1, 2008, you'd have been happy at year end. The Barclays Capital Aggregate Bond Index (formerly the Lehman Aggregate U.S. Government Bond index) was up 5.2% for the year, while the Newedge CTA Index (formerly the Calyon Financial Barclay Index) of managed futures was up a whopping 13.2% for the year. While there are certainly advisors who understand managed futures and use them on behalf of clients--I've talked to several who were able to smooth clients' portfolios by using them last year, and there's some $200 billion invested in managed futures--there are many more who don't quite get them, or equate them with derivatives or think they're risky.

Enter Michael Bulley, senior VP for research and risk management for Steben & Co. in Rockville, Maryland, a firm that has specialized in managed futures funds for 20 years. He has a degree in electrical engineering from the University of Wisconsin-Madison and an MBA from Johns Hopkins, but he is also "busting at the seams" to help advisors and investors "to get a handle not just on managed futures," but their place not just last year, but any year, if you hold them long enough. Bulley spoke with Group Editor-in-Chief Jamie Green by telephone in late July.

What is the benefit of managed futures?

Here's the thrust of it: reading in The Wall Street Journal about why Markowitz doesn't work anymore, or why mean variance doesn't work anymore, I cringe. One of the things we've learned about the benefits of managed futures as an asset class--we call it an investment class because there's no asset there--is that it's noncorrelated to the rest of the markets; it marches to the beat of its own drummer. Because we stare at this all day long, we know how high the correlations have crept up in the areas that advisors thought were the alternatives. Take style boxes. One day I calculated the correlations between large cap and small, value and growth, and they were all in the nines (meaning 0.9); they have been for some time.

The correlation coefficients have creeped up for so long, that it clearly has impacted portfolios which have been highly impacted in particular on the equity side. And those areas that get a lot of attention, like hedge funds and REITs, have also been creeping up, though not so much hedge funds, which have their own issues. My point is that it should not have been a surprise that portfolios buckled under the pressure of these tectonic changes we saw in the economy last year.

So why did manage futures prosper last year?

It just so happens that managed futures thrive when there are sustained trends in the marketplace. Many managed futures, though not all, trade in a diversified list of markets--currencies, stock indexes, government bonds and other interest rate instruments on the short side, oil and energy in general, all the base and precious metals, agricultural commodities, and they're trolling, using these systematic computer models, for these short-, medium-, and long-term trends that are taking place, and they are capturing snippets of what the buzz word is these days--alpha. They're making profits in such a way that are so unlike everything else, so they're perpetually not correlated to traditional asset classes. In 2008 it was a bellwether year for these systems, and because of these great returns we got in 2008, there's a limelight on managed futures, as if maybe this is the next strategy you should have in your portfolio.

So now people are overweighting managed futures?

Yes. What they miss is that managed futures, like every other asset class, ebbs and flows, but if you look at investors' investment horizons--we hear all the time about long-term investors whose idea of long term is three months!--what they're missing is that if you step back and look at 2008 and what went wrong with the portfolio, if you're talking to a client where there's been a loss of trust, if you're honest with yourself, part of the answer is that we're looking at this with a very short-term investment analysis. Even those buy-and-hold S&P 500 investors...well, we've known for a long time that the longer you hold it, the more stable your returns are in the portfolio. So if you forced investors to stay in a portfolio, there'd be a different discussion than when you have these short-term horizons. What's not as well known is that if you look at a rolling-period analysis, and look at five-year periods, while even in the S&P 500 you can true up those average returns, there's quite a wide dispersion in what those returns are if you compared one 60-month period with another: it swings from minus 8% to a plus 30.

But if you look at other asset classes there's another story. Managed futures with these five-year windows, suddenly become much more stable when it comes to its average return. You'll have similar returns to the S&P of about 10%, but on the rolling five-year period, there are no loss periods. These are not just our funds. The variance on these rolling periods is much Sharper, if I can use the Sharpe ratio analogy. There's a much higher Sharpe ratio in managed futures than in any other alternative that I can find an index for.

So what that translates to is this: Forget what happened in 2008, when managed futures looked great in that particular time frame. If you look at a longer time frame and go back to when these indexes started, say from 1980 on, you'll find that consistently if you hold these for three to five years, you'll have a consistently, relatively stable rate of return compared to other investment choices, including REITs, commodity indexes, and all the versions of equity indexes. The mean return is about the same as equities, but it's more stable--it doesn't swing around.

That's because of the statistical nature of managed futures: these systematic computer models are trolling across 140 or so markets at any time, seeking directional volatility in particular markets. It doesn't matter if the trends are rising or falling, as long as it's a consistent trend.

Managed futures do have an Achilles heel, which is when there's sharp volatility, and you've got a big position and the market swings abruptly, you can get what we call giveback. But risk management is as much a part of these managed futures systems as are the mechanics of when to get in and get out. Look at the returns on a three- to five-year period and you'll see what I'm talking about.

That alone would be a compelling story, but what makes it even more compelling is that the correlation coefficients between managed futures and traditional asset classes are highly stable--they're like a plus or minus 0.2 over a five-year time period. More often than not they're negative, which helps in portfolio diversification.

We service some 1,500 reps, and they get the story, but this investment class stands alone in terms of its unique characteristics. But we can't capture the value of this investment class in 30-second sound bites.

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