How can an investor protect his wealth against possible future adverse events? We propose three basic approaches and variants therein.
Features Of Futures Markets
The managed futures category has significant advantages over traditional assets. Futures markets are some of the most liquid in the world, providing exposure to currencies, bonds, equity indexes and commodities. These instruments are readily traded, even during severe market turbulence. Importantly, the investor can go long or short without barriers typically associated with shorting stocks and bonds—no borrowing needed or searching for assets to borrow, or inverse ETFs. These markets also are exchange traded, easily valued and marked to market daily.
Second, leverage in a futures market differs from traditional leverage. An investment via futures does not require direct capital; rather, trades are designated by reference to two distinct "accounts." The investor's core capital is placed in a margin account, which is the depository for daily profits and losses from the futures positions. For individual investors, the margin account consists of risk-free assets such as one-year T-bills. In contrast, it is relatively easy for an institutional investor to maintain margin capital in risk-bearing liquid assets such as equities and bonds. The performance of the margin account can play a significant element in managed futures.
The second "account" tracks the return of the futures positions. Performance depends upon the characteristics of the underlying instrument—currencies, bonds, equity index or commodities. Futures markets are overseen by regulated exchanges; thus, largely avoiding counterparty risks.1 Exchanges require marked-to-market settlement daily. Also, the exchanges can alter the margin requirements depending upon current market conditions. For instance, the margin requirement will increase when volatility in the underlying instrument expands greatly.
Since futures markets are liquid, an investor can apply dynamic asset allocation models and strategies without incurring large market impact costs. For instance, the investor can implement drawdown constraints over short time periods [Mulvey et al. 2011]. Likewise, rebalancing gains can be exploited by resetting the asset mix to predetermined target proportions. In these cases, liquidity provides a distinct advantage since it plays a role in improving portfolio performance.
Sources Of Alpha In Commodities Markets
The commodities segment of the managed futures domain can provide exceptional diversification from equities and fixed income. Commodities futures markets are among the oldest organized exchanges in the world, such as the Dojima rice futures market, which began in 1710 in Osaka, Japan; and the Chicago Board of Trade, which opened in 1848.
In recent years, investors have turned to owning commodities and other real assets to protect themselves against long-term risks. First, as the world population approaches 7 billion people, the demand for basic commodities bumps against limited supply constraints for land, energy supplies and agricultural products, and so on, possibly resulting in pricing disruptions. Even safe drinking water is becoming a scarce commodity in many parts of the world.
A related risk is inflation. Many countries are experiencing extraordinarily low nominal interest rates2 and massive deficit spending plans in order to overcome the fallout from the 2008-09 crash. There is the temptation for these countries to inflate themselves out of their current monetary problems, especially if the local constituents do not understand the importance of fiscal discipline to ensure long-term financial stability. Further, the current level of negative real-interest rates in a number of countries likely will contribute to future increased inflation.
Political risks, such as disruptions caused by oil embargos, wars and terrorist attacks, present another concern. Owning raw materials can be profitable during turbulent periods caused by political factors. Further, it's likely that equities will drop very quickly when a political crisis erupts. The 1973 oil embargo, for example, precipitated a substantial increase in energy prices, accompanied with higher inflation.
Last, there is a small, but still significant, risk due to weather and catastrophic shocks such as crop freezes, hurricanes and tsunamis. Many commodities prices will spike when these events are present.
Investing in commodities promises to reduce the aforementioned risks. However, it's difficult for most investors to own raw materials outright due to storage and insurance costs, depreciation and related issues. Instead, investors have turned to futures and forward markets in the commodities domain. In addition, there are several other paths for investing in commodities, including single-commodity exchange-traded funds (ETFs), long-only commodities ETFs (matching indexes such as the S&P GSCI3), and commodities-only hedge funds such as Clive Capital4 for high-net-worth individuals and institutions.
There has been considerable research into the characteristics of commodities prices over extended time periods. Studies have shown the presence of trends and regime changes in commodities markets [e.g., Erb et al. 2006; Miffre et al. 2007; and Shen et al. 2007]. These patterns are due to multiple causes, including the gradual diffusion of information, inventory conditions, the impact of weather, and political risks. In many cases, prices follow patterns consistent with trend-following and momentum.5 These relationships can be traced to several theories including diffusion of information and noisy traders [Chan et al. 1996; De Bondt et al. 1987; George et al. 2004; Hong et al. 1999; and Rouwenhorst 1998]. For instance, if a farmer hedges against adverse events one year and is successful, he may be inclined to hedge the next year. Likewise, neighboring farmers will often follow the successful hedger. Gradually, since commodities are employed for consumption, either final or intermediate, consumers and producers have to render hedging decisions on an ongoing basis as a function of their core businesses. Likewise, speculators will often watch the market for underlying patterns and take action in concert with these patterns. The basis for many commodities-trading strategies is sustained price swings—either positive or negative.
A second source of alpha relates to the shape of the futures curve. In most commodities, the price of a futures contract is not determined by arbitrage arguments. Supply and demand considerations are paramount. Thus, for example, backwardation occurs when inventories are low and spikes in demand are present. Tactics based on the shape of the futures curve can lead to positive performance [Gorton et al. 2008; and Brennan et al. 1997].
There is some controversy as to whether alpha is present in managed futures funds. For instance, the study at Yale University [Bhardwaj et al. 2008] indicates that CTAs rarely earn much more than the risk-free rate. This study was completed before the 2008 crash in which managed futures funds outperformed other hedge fund categories by a wide margin.
A Relative-Value Commodities Index
A fundamental lesson emerging from the 2008-09 economic crash is that only a few strategies provide meaningful diversification from equities when severe contagion strikes. Standard risk management suffers accordingly, with substantial portfolio losses.
Even absolute-return hedge funds purporting to provide positive returns failed to protect investor capital—although losses here generally were much less than the 50-plus percent plunge that occurred in equity markets. This situation led to a substantial loss of investor wealth, a reduced chance to attain investment goals (and for pension plans, to meet legal liabilities) and a wake-up call for investors who have been applying traditional portfolio models based on a relatively static framework such as the Markowitz portfolio model. Instead, a dynamic asset allocation approach would have been much better [Mulvey et al. 2006, 2008].
This paper discusses the advantages of commodities futures, and managed futures in general, as bona fide stand-alone investments and as meaningful diversifiers within a portfolio of traditional assets. The managed futures category of hedge funds performed particularly well during the 2008-09 crash periods; in fact, it was the sole hedge fund category with positive performance in 2008-09.
We have seen similar results in previous crash periods including the Asian currency crisis in 1997-98; the Russian debt debacle and LTCM in 1998-99; and the technology bubble and crash and the 9/11 disaster in 2001-03. The positive performance can be attributed to several factors: 1) the ready ability to go long or short depending upon economic and other circumstances; 2) the availability of deep liquidity allowing for dynamic asset allocation; and 3) the opportunity to take advantage of volatility via rebalancing gains and regime changes. Each element provides a small advantage. When combined, however, a portfolio of commodities tactics can substantially improve overall investment performance, especially when traditional assets are doing poorly.
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1 Recent problems occurred with MF Global.
2 Interest rates on 10-Year U.S. government bonds have dropped from 15.84 percent in September 1981 to less than 2 percent recently.
3 The S&P GSCI is the most popular commodities index product, with over $100 billion tracking the index.
4 Clive Capital has been a successful hedge fund investing in commodities markets.
5 Trend-following and momentum tactics are based on differing rules and underlying philosophy.
6 A dynamic long-only commodities index was created by SummerHaven, with an investable ETF whose symbol is USCI. The SummerHaven approach is long-only and employs tactics that are somewhat different than the ones described in this paper, although we suspect the motivations are similar in spirit.
7 Most commodities tactics do not depend upon a relative value approach; for example, trend followers will go long a commodity when the current price exceeds a moving average of past prices.
8 The Ulcer Index measures both the length and depth of drawdown over time.
9 In an early study, Lintner  showed the advantages of commodities funds for improving performance in conjunction with traditional assets.