Remember 2008? To paraphrase Dickens, it was the best of times for managed futures funds and the worst of times for almost every other strategy. Managed futures posted a 15.4% gain that year versus the S&P 500’s stomach-wrenching 38% decline. But a closer look reveals a more complicated story, one that is just as relevant in 2013 as it was in 2008. This so-called performance dispersion was so great that more than 20% of commodity trading advisors dissolved their businesses that year. In other words, while managed futures was a winning strategy in 2008, plenty of managed futures funds lost money and disappeared altogether.
Performance dispersion measures the range of performance results of funds or managers within a sector and can vary enormously among asset classes. Traditional, long-only mutual funds that are in the same investment style category tend to display relatively little performance dispersion. Their results may be tightly clustered because they primarily “hug the index.”
By contrast, hedge funds, managed futures and other alternative investments typically exhibit much greater performance dispersion, not only among the various strategies but within those strategies. Among the different hedge fund strategies in 2012, those specializing in mortgage-backed securities were up an average 16%, while short-selling funds were down 17%. Alternative investment fund managers consciously try not to replicate indexes and generally rely on manager skill, or “alpha,” to produce superior returns.
Take a look at Figure 1. It compares the range of the top and bottom quartiles for the average rates of return of large-cap value mutual funds (as tracked by Morningstar) with managed futures funds (as tracked by the Altegris 40 Index) through November 2012. The distance between the returns of the best- and worst-performing large-cap value mutual funds is relatively small compared with the distance between the returns of the top- and bottom-performing managed futures funds. It is important to note that mutual funds may be subject to different investment restrictions and regulations that impact their performance.
How do you avoid investing with the bottom quartile? I’ve talked about the art and science of selecting managers in an earlier column. It involves a lot of factors, performance being just one of them and by no means the most important. We delve into how managers achieved their returns and how much risk they took to get there. We want to know how long they’ve been in business and if a manager’s interests are aligned with those of the clients. We want funds with large assets that have lived through various market cycles.
In our experience with alternatives and managed futures funds, the size of the fund or its years of existence do not guarantee success. We have seen big performance dispersion even among the largest managed futures fund managers. To reduce the risk of picking a poorly-performing outlier, we think it’s more prudent to use a multi-manager approach over a single-manager approach.
Large performance dispersion does not mean investors should avoid managed futures or alternative investment funds. Because they have a low correlation with traditional stocks and bonds, these funds can play an important role in a diversified portfolio while offering the potential for positive returns. However, even those pursuing the same strategy can achieve widely divergent results. Performance disparity elevates the importance of selecting best-of-breed managers, especially in managed futures funds.