October 1, 2010

Managed Futures and Asset Allocation: Asset Class or Investment Strategy?

I have had many conversations with investment professionals regarding asset allocation.  During those chats, I usually refer to managed futures investing as participation in a distinct asset class.  Occasionally, I have been corrected with the comment that “Managed futures is an investment strategy; not an asset class.”

Why is this distinction even important?  Well, an asset class obviously belongs in an asset allocation model whereas an investment strategy may not.

So where do these labels come from? According to the CFA textbook, (Investment Analysis and Portfolio Management, Reilly and Brown, [7th Edition, 2003]), an asset class comprises a group of securities that have similar characteristics, attributes, and risk/return relationships. Traditionally, the three primary asset classes have been stocks, bonds, and cash equivalents.  In recent years, commodities and real estate have been increasingly regarded as standalone asset classes. How, then, to think about alternative investments such as hedge funds and, more specifically, managed futures?

The term “investment strategy” is used very broadly.  Most often, it describes a methodology for selecting investments, usually according to a certain set of criteria. An investment strategy can be very specific and pertain to a particular opportunity or security.  Buying a security based on a matrix of valuation factors combined with market volume indicators is an example of a strategy. It could describe an overall approach to investing.  For example, many investment advisors attempt to deploy an investment strategy focused on diversification when allocating client portfolios.

Is there a correct answer and does it even matter?  As alternative investments go mainstream, I believe it’s time to acknowledge that the broad universe of alternatives is another asset class, alongside stocks, bonds, cash, real estate and commodities.  Within each of those asset classes, there are a myriad of asset class categories and this is precisely where managed futures fits.  Once you have decided to add the alternatives class to your asset allocation model, you will likely want to categorize alternatives across the various underlying disciplines such as long/short, market neutral, event-driven, macro, and managed futures.  You are already doing this for your stock portfolios as you consider large or small caps, value or growth, developed or emerging, and so on.  Therefore, I believe the correct answer to the starting question is actually: “Neither;  managed futures is an asset class category”.

Does it matter? I believe it does, but only if the terminology challenge has somehow resulted in managed futures being left out of your asset allocation models! 

The empirical evidence in circulation about the potential benefits of allocating to Managed futures when constructing a well-diversified portfolio is overwhelming.

"The combined portfolios of stocks (or stocks and bonds) after including judicious investments in leveraged Managed futures accounts show substantially less risk at every possible level of expected return than portfolios of stock (or stocks and bonds) alone." -Dr. John Lintner, The Potential Role of Managed futures Accounts in Portfolios of Stocks and Bonds (1983)

“We found that allocating to Managed futures allows investors to achieve a very substantial degree of overall risk reduction at limited costs.”—Journal Of Investment Management, Vol.2, No. 1 (2004): “Managed futures and Hedge Funds: A Match Made in Heaven."

“For appropriately constructed portfolios, Managed futures are shown to offer unique downside risk control along with the simultaneous potential for upside returns.”  (Ibbotson Associates, 2005): “Managed futures and Asset Allocation”

In 2009 the Chicago Board Options Exchange sponsored a study by EdwardSzado, CFA (“VIX Futures and Options – A Case Study of Portfolio Diversification During the 2008 Financial Crisis”) which explored the impact of the 2008 financial crisis on portfolios.  The study  indicated that managed futures actually became less correlated to stocks as other assets became more correlated during the credit crisis. They stated, “It is clear that, with the exception of bonds and managed futures, (my emphasis) all of the components of the base portfolios performed quite poorly (in a similar fashion to equities) over both the entire period, and the late 2008 period.”

Note the dates.  Dr. Lintner wrote his piece in 1983 and the CBOE in 2009! Their findings, and those of many other researchers in the interim, are essentially telling the same story: that the lack of correlation between managed futures investing and any other asset class category, or traditional asset class, has helped portfolios achieve better risk-adjusted returns than portfolios without managed futures. 

Of course, correlations may change over time and there is no guarantee that these historical relationships will hold in the future. (Note that “better” can translate into less risk for the same return or more return for the same level of risk.) This non-correlation plays out over investment cycles, and in future columns I will look at this phenomenon in more detail.  A preview of that discussion is that “non-correlation” is not the same as “negative correlation,” and positive correlation is sometimes a good thing, especially when stocks are going up!

Next question: how much to allocate to managed futures? Let’s leave that one for another day (and column), too.

In the meantime I promise to refer to managed futures investing as an “asset class category” from here on out.  I encourage you to review your investment strategies and your asset allocation models and make sure that managed futures is being considered. 

The views expressed by the author are his own, and do not constitute an opinion or analysis of Altegris Advisors, LLC or its affiliates. The risk of loss in trading futures can be substantial.  You can lose all or a substantial amount of your investment and should only invest risk capital. Past performance is not necessarily indicative of future results.

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