In defense of managed-futures funds
As we look back at the past decade — and look forward to the next — we recognize that despite recent opinion, asset allocation and portfolio diversification are as important as ever.
As we look back at the past decade — and look forward to the next — we recognize that despite recent opinion, asset allocation and portfolio diversification are as important as ever.
What’s different now is that asset allocation through traditional investments no longer appears to be pulling its weight, nor is it giving advisers and their clients the results they are expecting. To be truly diversified — and to reap the potential benefits of asset allocation — portfolios must be constructed with investments that behave differently under the same market conditions.
Throughout the last decade, volatility was king. The heavy losses experienced by the stock market in the early going were seemingly reversed between 2003 and 2007. But like turkeys in the days before Thanksgiving, most of us never saw the pain that would come in 2008.
Advisers relying on asset allocation strategies to protect and increase their clients’ money were baffled. Simply put, it didn’t seem to work.
In truth, asset allocation never stopped working. What happened was, people forgot, or never realized, why it was a winning strategy to begin with. In order for an asset allocation strategy to deliver the benefits of diversification, the assets combined must be non-correlated. In theory, non-correlated assets behave differently from one another so as to reduce portfolio volatility while delivering more-balanced returns. This is fundamental to the strategy, but how many people looked at their portfolio and thought about correlation?
To explain correlation, take two investments that behave the exact same way. When one goes up, so does the other. This represents a correlation of 1-to-1. They move in sync with each other, despite market conditions. To achieve the desired objective, a portfolio should combine investments with low correlation coefficients — close to 0 — relative to one another.
If we look at the early 1990s, the correlation of international stocks, real estate investment trusts and high-yield bonds to the S&P 500 was low. Thus, asset allocation strategies that included these asset classes worked. In 2008, the correlations of these three investment classes relative to the S&P 500 pushed toward a correlation value of 1. The result: When one class began to suffer losses, the rest shortly followed.
Going relatively unnoticed during this time were managed futures. This strategy uses futures contracts based on various financial instruments and commodities that historically have experienced low correlation levels to other investments.
Using the same time frame above for comparison, managed futures had correlations ranging from under 0 to slightly above, i.e., plus or minus 0.2. How did this level of non-correlation help? When the S&P 500 fell a staggering 38% in 2008, managed futures were up more than 14% as measured by the Barclay CTA Index. Suddenly, people took notice and began to funnel money into managed-futures funds at an extraordinary rate. But when managed-futures funds lost 0.1% in 2009, people immediately asked why the strategy no longer worked.
But it does. Managed-futures funds historically have performed well when sustained price trends are evident in the marketplace. The systematic computer models used by most trading advisers troll for short-, medium- and long-term trends. As these are identified, they capture snippets of profit in both rising and falling markets. This method of capturing profits may be counterintuitive compared with other investments, yet it’s this behavior that allows managed futures to remain non-correlated to them.
There’s no getting around it: Managed futures are not a short-term investment approach designed for rapid gains. When new money followed high returns, it was for the wrong reasons. It’s an investment strategy that’s meant to be carried out over the long term, with five years being the suggested minimum period. Looking back at the Barclay CTA Index over the past three decades, managed futures have exhibited a relatively stable rate of return compared with other investments, with the long-term average return being similar to equities without the wild swings experienced by stocks and other widely followed asset classes.
Approaching asset allocation with low-correlation principles in mind will help define success. It always has, but recently, the investing public’s eye came off the ball. It’s time to make the fundamentals of asset allocation and diversification fundamental again.
Ken Steben is the president and founder of Steben & Co. Inc., an investment firm which specializes in managed-futures funds.
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