Articles

The Role Of Managed Futures And Commodities Funds
By John Mulvey

Related ETFs: GSG

How can an investor protect his wealth against possible future adverse events? We propose three basic approaches and variants therein.

First, the investor can choose ultraconservative funds, including cash management accounts and Treasury bills, as his primary investment vehicle. While protecting nominal wealth, short-term fixed-income securities will inevitably lead to low returns, especially under the current close-to-zero interest rate environment throughout much of the world.

Safe short-term cashlike instruments fail as a hedge against inflation risks. For long-term investors such as pension plans, low asset return performance will result in the need for relatively high contributions over time, which can be an expensive approach for achieving short-term protection over extended periods.

A second approach to wealth preservation is to attempt to anticipate turbulent periods. Here, the investor lowers risk dynamically by moving from risk-bearing assets such as stocks to safe investments such as short-term government bonds. Such a flight-to-quality approach can be difficult to implement for large institutional investors, however, due to their size, organizational structure and shift to illiquid alternative investments [Swensen 2000]. Also, dynamic asset allocation can be expensive due to market impact costs, false positive indicators and time delays.

A third approach is to invest in assets and strategies that are likely to perform well during turbulent crash periods. There are two primary variants: a) tail risk strategies; and b) strategies or asset categories that have done well historically during turbulent periods. The former is designed to pay off during a crash, whereas the latter is not guaranteed but may be less expensive to implement.

As we discuss in this paper, managed futures strategies in general, and commodities futures strategies in particular, fall under the third approach and accordingly should be considered an important component of a long-term investor's portfolio.

Managed futures encompass four general asset categories: commodities (agricultural markets, energy products and metals); currencies; bonds; and equity indexes. In each of these cases, a futures (or forward) market is established by participants to either hedge or speculate on the underlying instrument. At any given time, a futures pricing curve can be constructed by plotting the prices of futures contracts expiring across the expiration spectrum.

There can be some confusion in futures/commodities nomenclature due to historical circumstances and regulatory issues. In the United States, the Commodity Futures Trading Commission and the National Futures Association regulate futures markets and their participants. The first futures markets were commodities markets such as grains, softs (e.g., cotton) and metals; energy products then followed. Eventually, futures markets have expanded significantly to include currencies, fixed-income instruments and equity indexes. Today, professional money managers who trade primarily futures are designated as commodities trading advisors (CTAs), regardless of which sectors they trade. In this report, we differentiate the broader managed futures area from the original commodities futures markets.

Commodities investments have gained in interest by individual and institutional investors over the past decade. For example, trading volume in exchange-traded commodities has increased dramatically. Furthermore, assets under management more than doubled between 2008 and 2010 to nearly $380 billion (Figure 1); and commodities prices have increased. Market participants attribute the recent price increases in commodities to increased demand for consumer goods, particularly from the populous countries of India and China. In contrast, the size of the world stock market was estimated at about $46.8 trillion at the end of March 2010.

Managed Funds Industry Assets

As we show, for traditionally diversified investors, an allocation to a fund that invests exclusively in commodities markets offers not only a hedge against inflation but also effective diversification because of its low correlation with traditional asset classes. In the long run, commodities investment funds show equitylike returns, but are accompanied by lower volatility and shortfall risk.

Where's The Diversification?
Fundamental flaws in traditional portfolio models became apparent during the severe 2008-09 banking, real estate and general economic crash. Among other problems, many investors had assumed that correlations in rates of return among asset categories would approximate historical values going forward. Under this assumption, the investor would be adequately and safely diversified to "protect" her capital during a crash.

Unfortunately, most asset categories suffered together and lost substantial value. The extreme level of contagion occurring during this crisis can be attributed to several factors. First, market risk soared to unprecedented levels; for example, the implied volatility of U.S. stocks exceeded 70 percent annualized value, and correlation among asset categories trended toward an absolute value of 1.0. As we know from asset pricing, the "fair value" of a security depends upon risk-adjusted discounting of future cash flows, or upon risk-neutral valuation (arbitrage-free pricing). In both cases, if the risks increase along with much higher volatility, prices will plunge. As the 2008-09 crash showed, the financial sector is critical to the health of the overall economy; hence, the spreading of extreme contagion throughout the equity, fixed-income and other asset categories. The U.S. real estate crisis and a sharp drop in confidence accompanied the crisis in the financial sector. Finally, liquidity considerations caused many markets and strategies to become unstable since investors could not sell their assets in response to severe turbulence; market liquidity evaporated for many securities.

Most asset allocation and asset liability management models assume that the correlations among asset returns are relatively constant. Figure 2, for example, depicts the assumed correlation matrix for a $140-plus billion California pension plan [Collier et al. 2010]. Note in particular that the correlation between equities and bonds is assumed to be close to zero. As shown in Figure 3, however, the rolling correlation between stocks and government bond returns takes on a distinctive pattern—positive during normal business conditions, and negative during recessions and crashes. These charts show the existence of distinct economic regimes. Including these more realistic conditions in an asset allocation study will improve investor performance.

Estimated Correlation Matrix For Asset Returns

12-Mo Rolling Correlation, S&P 500 Vs. 10-YrGovemment

Even absolute-performance hedge funds failed to protect investor capital during 2008-09 (Figures 4-6). Figure 4 shows the weekly correlations of the returns of hedge fund categories to FTSE U.S. equity 500 returns during September 2005 to August 2011. As evident, several hedge fund categories—emerging markets, multistrategy, long-short equity, distressed, fixed-income arbitrage and risk arbitrage—had a higher correlation to the FTSE 500 returns than the other categories. Two categories—dedicated short bias and managed futures—stand out with very low correlation to the FTSE 500. The orange colors depict hedge fund categories with negative returns over the target period; categories in blue have positive returns.

Correlations Between FTSE U.S. 500 And Major Hedge

Figure 5 shows cross connections among the hedge fund categories. Most funds had relatively high cross correlations, with a few exceptions, and most had positive performance during 2005-11. Here again, managed futures and dedicated short bias strategies stand out, with relatively low or uncorrelated performance to the other hedge fund categories.

Correlations Among Major HEdge Fund Categories

Figure 6 examines the recent crash period. Here we see that the correlation matrix becomes almost completely covered with 1's. Of particular note: 1) most hedge-fund categories lost money during this period (even dedicated short bias funds); and 2) the precipitous drop of 51.4 percent in the GSCI over the specified year, which includes a maximum 75-plus percent drawdown within the one-year period. This clearly calls into question the efficacy of a long-only approach to commodities as a value-added asset. The managed futures category was the sole category with positive performance.

Correlations Among Major Hedge Fund Categories

Most investors who thought they were adequately diversified learned the hard way that this simply wasn't the case. Even top university endowments—Harvard, Yale and Princeton universities—experienced losses of 25 percent to over 30 percent. This level of loss of capital usually has critical consequences for achieving the goals of long-term investors.

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
Passive indexing strategies have become well established over the past 30 years. These strategies are designed to match a well-defined market segment with a low-cost (and possibly tax-efficient) approach to investing. There is considerable evidence that passive indexing strategies are especially pertinent for large institutional investors, due to their low cost and low fees, as well as their transparency. Passive funds typically have lower turnover than active funds.

Long-only commodities indexes have done well over extended periods of time. Figure 7 shows the FTSE 500 alongside a popular commodities index—the S&P GSCI. The S&P GSCI is an index of long-only investments in the most actively traded commodities and is a popular benchmark for many institutional investors.

Time Series Of GSCI And FTSE 500 Indexes

There are several evident observations. First, the overall price patterns of the S&P GSCI and FTSE 500 are roughly similar. The S&P GSCI outperformed the FTSE 500 and similar equity indexes over the entire 1999-2011 time period in terms of returns, with associated higher volatility and drawdown values. Second, the S&P GSCI experienced severe losses during the crash period of 2008-09, partially due to the sharp correction in oil and other energy-based commodities.

Figure 8 shows that spot prices of commodities rose along with equities in early 2009 until early April 2011. However, the iShares S&P GSCI Commodity-Indexed Trust (NYSE Arca: GSG), which tracks the well-known commodities index, achieved much lower performance during the same period. The underperformance is largely due to the presence of contango in many commodities markets, especially energy products, over the selected time periods. The commodities prices in contango lowered returns since the index is long-only.

Time Series Of GSCI Spot Indez And Investable 'Tracking' Fund (GSG)

To address the problems with long-only commodities investments—primarily large drawdowns and losses due to contango—we developed a relative-value commodities index using the following four subtactics: long momentum; short momentum; long futures curve; and short futures curve.⁶ Each of these tactics is based on a relative ranking of the commodities under study.⁷ Briefly, the four tactics are designed to capture alpha embedded in commodities markets, while carefully balancing the long and short positions in the portfolio—in order to minimize drawdowns and produce positive returns with excellent diversification characteristics (as compared with traditional assets). Recall that managed futures investments can be designed as an overlay strategy—providing additive performance to standard assets.

Figure 9 depicts the performance of the relative long- and short-momentum tactics. Note that the relative long-momentum tactic outperforms the relative short-momentum tactic over most of the entire span. However, during crash periods—2001-02 and 2008-09—the short-momentum tactic did much better than its long-only counterpart. The two tactics combine to provide a more stable return pattern.

DPT Capital Management LLC

A similar characteristic occurs with the long and short futures curve tactics (Figure 10). Here, the long futures tactic has the better long-term return as compared with the short-futures tactic, but does suffer from sharp drawdowns. Again, the combined long-short tactic has superior return/risk characteristics.

DPT Capital Management LLC

Figure 11 depicts the performance of the long-short relative-value commodities strategy, along with the market-neutral version during 1999-2011. The relative value approach applies regimes for determining the tilting of long and short positions. Figure 12 shows the results of the relative value index. In addition, we provide the empirical results of a regime detection system for U.S. equities [Guidolin et al. 2007; and Mulvey et al. 2011].

Combining Long And Short Futures Curve Tactics

Combining Relative Value Commodities And Regine-Detecting Equity Tactics

Since we can gain exposure to commodities via the futures markets, we can enhance the returns of traditional assets. In this example, we couple commodities with a regime-identifying equity model [Mulvey et al. 2011]. The overall performance is excellent. In particular, we focus on the ratio of return to risks wherein risk is measured by the Ulcer Index⁸—downside risks relative to drawdown. The combination of commodities and a careful, regime-based equity strategy is clearly attractive and has low correlation with the FTSE 500.⁹

Conclusions
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.

References
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De Bondt, W.F.M. et al. (1987). "Further evidence on investor overreaction and stock market seasonality," The Journal of Finance. 42(3), 557-581.
Collier, N.J. et al. (2010). "CalSTRS teachers' retirement board regular meeting." February 5.
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Guidolin, M. et al. (2007). "Asset allocation under multivariate regime switching," Journal of Economic Dynamics and Control. 31, 3503-3544.
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Endnotes
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 [1983] showed the advantages of commodities funds for improving performance in conjunction with traditional assets.