A Primer on Managed Futures - Part 2
Potential Return
One of the major arguments for diversifying into managed futures is their potential to lower portfolio risk. Many academic studies1 support this argument. The studies show that combining traditional, asset classes with alternative investments such as managed futures, lowers risk.
As an alternative-investment class, managed-futures produced, in the decade before 2005, a compound average annual return of 6.9%. Based on the S&P 500 total return index, U.S. stocks returned 9.3% and U.S. Treasury bonds returned 9.5%. In terms of risk-adjusted returns, managed futures had the smaller drawdown (an historical measure between high and low equity value) among the three groups between Jan 1980 and May 2003. During this period, managed futures had a -15.7% drawdown, while the Nasdaq Composite Index had a -75% drawdown and the S&P 500 stock index, a -44.7% drawdown.
An additional benefit of investing in managed futures includes risk reduction through portfolio diversification. As an asset class, managed futures are largely inversely correlated with stocks and bonds. For example, during periods of inflationary pressure, investing in managed futures that track the metals markets (e.g. gold and silver) or foreign currency can provide a substantial hedge against inflation. In other words, if stocks and bonds underperform because of rising inflation concerns, investing in the appropriate managed futures asset could offset the lack of performance in stocks and bonds. Hence, combining managed futures with these other asset groups could optimize your allocation of investment capital.
1 See Dr John Lintner, Harvard University.CTA Evaluation
Before investing in any asset class, or with an individual money manager for that matter, you should make some important assessments. The first thing to assess is the CTA's disclosure document. CTAs must provide for you disclosure documents upon request. The disclosure document will contain important information about the CTA's trading plan and fees (which can vary substantially between CTAs, but generally are 2% for management and 20% for performance incentive). It will also include three important pieces of investment information related to the CTA's trading plan. These are portfolio drawdown, the annualized rate of return, and the risk-adjusted, rate of return. In order to have this conversation with a prospective CTA, you need a fundamental understanding of what the documentation means and how the non-standard aspects address your concerns regarding affordability, risk, and your investment goals.
During this conversation with a prospective CTA, the trading plan should also be discussed. Like the documentation, discussing a trading plan requires a fundamental understanding on your part. You need to be able to discuss the plan with your CTA on a knowledgeable level to ensure you understand where your money is going, how it will achieve your investment goals, and what the associated risks are. The first step in this process is to understand the elements of a trading plan. Although you need to and will learn more about trading plans, for now let's look at what is outlined here. After that, let's look a bit more closely at portfolio drawdown, the annualized rate of return, and the risk-adjusted, rate of return.
