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Why isn't diversification within Managed Futures working?
November 2, 2009
Many of us have heard the paraphrased phrase: ‘even the best laid plans’, which seems to mean when said with the proper tone that even the best of plans can have problems.
This must be what many managed futures investors are experiencing thus far in 2009. Despite sound portfolio building logic and portfolios of non correlated Commodity Trading Advisors (CTAs), many managed futures investors are struggling through painful drawdown periods right now.
Programs from Attains recommended list currently in significant drawdowns include Clarke Capital, APA, Hoffman, NDX, Mesirow, Dighton, and DMH. The fact that so many programs are included on that list isn’t as surprising as the different types of programs on that list. A spread trader focusing on the Hog market (NDX), mutli-market systematic programs (Hoffman, Clarke, APA), and discretionary traders (Mesirow, DMH) are all included – showing the tough 2009 for managed futures hasn’t been too picky about who it picks on.
They say misery loves company; but how can such varied trading strategies all enter drawdown phases at the same time? Shouldn’t some of these non-correlated investments be zigging while the others zag; rising while others are falling, and generally being non-correlated.
The easy answer is yes – a portfolio of non correlated investments should see some of what golf tournament partners call “ham and egging”, with one picking up the slack when another is struggling. The more involved answer is that even though it should behave a certain way, that doesn’t mean a non correlated portfolio will always exhibit the zig while you zag, up while you’re down, the ham to your egg, picking up the slack performance. While this isn’t what many investors who believe in making changes when things aren’t going well want to hear, the truth is that many managed futures portfolios designed to be non correlated actually have remained non correlated this year. Their problem isn’t that the portfolio’s correlation increased – the problem is that the components just aren’t seeing profits in the current environment.
Consider the following popular portfolio at Attain, comprised of 5 different managed futures programs spanning 5 different managers, dozens of markets, and 5 different strategy types. What we consider a very nice portfolio comprised of both statistically non correlated and fundamentally non correlated programs.
- Mesirow Absolute Return (a short term discretionary trader using long options and futures)
- Clarke Global Basic (a systematic multi-market program focusing on shorter term trends)
- Paskewitz 3x (a systematic single market specialty manager)
- NDX Shadrach (a single market sector specialty manager specializing in spread trading Hogs)
- Dighton Capital (a longer term discretionary multi-market trader)
Heading into 2009, given this portfolio’s spread between managers and strategy types; we expected it to do quite well. The thinking being even if volatility declines and choppy conditions show up which would hurt systematic programs like Clarke, the shorter term discretionary Mesirow could navigate it well enough and provide some up to Clarke’s down. Or thinking that even if some nice trends emerge which would hurt counter trend strategies employed by Paskewitz and Dighton, Clarke would benefit. And finally, adding NDX, whose hog spread trading strategy doesn’t much care whether we’re trending or not, volatile or choppy.
Unfortunately, even the best laid plans don’t always come to fruition; and for this portfolio – despite trying to add protection against declining volatility and choppy conditions – 2009 has brought losses and a new max drawdown not seen in the portfolio’s historical record.
Now, many people have been quick to blame this poor 2009 performance across different programs on an increase in correlation between different managed futures strategy types. But we’ve run the numbers and just can’t find proof of that happening.
Consider the table below, which compares the all time correlation between the five programs in our example portfolio as of December 31, 2008 with the correlation across the 10 months in 2009. You will see that the 2009 average correlation for each program is actually LESS than the correlation investors went into this portfolio expecting. That should mean better portfolio performance, but it isn’t working out that way so far this year.
That’s the funny (or frustrating) thing about correlation and diversification – non correlated does not mean negatively correlated. These are two separate mathematical concepts, yet many people mistakenly expect non correlated investments to behave like negatively correlated investments.
Negatively correlated means one investment will do the opposite of another; while non correlated means they will do whatever they will do with no regard for what the other program is doing. Over time, that may appear as negative correlation, or “ham and egging”, where one program picks up the slack for another. But non correlated investments can just as easy move in tandem once in a while. What we appear to be seeing for this example portfolio in 2009 is not a case of the portfolio components becoming unexpectedly correlated and ruining our diversification, but rather a case of what Nassim Taleb calls being fooled by randomness (or more correctly in this case – surprised by randomness). Two perfectly non correlated investments (a correlation of 0.00) will effectively post random returns in relation to one another; but those randomly posted returns will not necessarily be in the opposite direction most of the time. And that is what surprises us. In the same way, we know a coin flip to be random, but still act surprised to see 10 or 15 ‘heads’ flips in a row. It’s random, meaning anything can happen.
More non correlated conundrums:
Beyond building a portfolio with statistically non correlated investments, Attain urges investors to look at what we call fundamentally non correlated investments as well. Fundamental non correlation is achieved by diversifying amongst different strategy types, such as adding an option seller with a trend follower, a systematic program with a discretionary one, and so on. The whole point of this type of non correlation is that the same catalysts are unlikely to cause losses in two fundamentally non correlated investments. A surprise announcement that the Fed is buying billions in US Treasuries should not affect the spread price of Hogs directly, for example – meaning a Fed event which could make or break a month’s performance for a program like Clarke should have no affect on NDX.
Now, you can read between the lines there, and realize that neither fundamental nor statistical non correlation can give you 100% protection against unrelated catalysts causing losses in different programs. And that is what I believe we’re seeing some of in 2009. It is not that programs are becoming more correlated and losing money because they are doing the same thing or incorrectly betting on the same market moves. It is not even that they are losing money on the same day or even same month. What is mainly happening is that several different strategy types are just having below average years thus far. What is increasing is not the correlation between programs, but the losing trade percentage across programs.
For example, in our 5 CTA portfolio mentioned above; 4 out of the 5 programs are down on the year. No matter how non correlated those 5 programs are – it is near impossible for that portfolio to be profitable in that case.
To drive this point home, imagine the following fictitious example of three investments. These investments are statistically non correlated, with each either winning while the others lose, or losing significantly less/more when they both lose. However, despite their being non correlated - all three ended up at the same place at the end of 3 months, down -7%.
We seem to expect non correlated investments to not generate the same returns over any quarterly, annual, or other specific time period we look at; but the math doesn’t quite work that way. It is more than possible (and more likely to happen the shorter the time frame you are looking at) to be down (or up) for the quarter or year across several non correlated investments even though they happen to win when the other loses and vice versa on a monthly basis.
So what do people facing situations similar to the one above do? What do you do when non correlated investments are ending up with the same results as if they had been all in a single program? Are their portfolios broken? Should they scrap their portfolios and start anew? Should they abandon managed futures altogether?
The answers are NO, NO, and NO.
Just because your portfolio is currently losing money does not mean that combination of managed futures programs is broken in our opinion; even if the portfolio is hitting new all time max DDs for that specific combination of programs. That is especially true of portfolio in which none of the components are past their individual past max DD levels. If you have a nice mixture of statistically non correlated and fundamentally non correlated programs – you should feel confident in the long term prospects of your portfolio. We’ve shown some evidence that correlations are not rising among managed futures programs; and have run more tests across dozens of programs showing the same.
What we seem to be seeing is nothing more than some bad trading due to a unique environment following the largest and swiftest market selloff (in no t just stocks, but also commodities) since the Great Depression. That unique environment has included a very smooth, V-Shaped recovery off of the March bottom which caused volatility to fall over 75%. With most managed futures programs being long volatility models – that has definitely been a headwind for nearly all managers and portfolios to overcome. This poor environment has not caused programs to become more correlated, but rather caused them to become less profitable over the short term.
You can see in chart below detailing what percent of the programs in our 5 CTA portfolio were profitable each month going back three years that roughly 3 out of 5 programs were profitable each month, on average, between 2006 and the end of 2008. Since the beginning of this year, that trend has reversed with only 2 out of 5 programs now profitable each month.
Past Performance is Not Necessarily Indicative of Future Results
It is this slight move to more programs in your portfolio losing each month than are winning which is causing portfolio level drawdowns, not an increase in correlation. And many clients are calling us asking if the way to cure this is to drop programs from their portfolios which are losing.
Our answer is that one of the worst things you could do at this point, in our opinion; is scrap a portfolio currently under water and start anew. The portfolio you move to will undoubtedly include a few programs currently at or near equity highs – which means you could be in the same boat in 6-18 months – wondering why your portfolio of today’s front runners are not the front runners of tomorrow. We urge you to not panic or do anything rash. We would like to see investors break the buy at the top, sell at the bottom cycle by actually staying in here at what we feel has to be a bottom for managed futures as a whole and programs like Clarke and APA on an individual basis.
But just in case this isn’t the bottom, every managed futures investor should review their own rules for living through a drawdown. If you don’t have drawdown rules, get some. View our past newsletter on Living through Drawdowns here. Drawdowns are not new to this type of investment, and believe it or not we’ve gone through them before (and we will again, guaranteed). You can’t make money without risking money, and managed futures way of making you risk money comes in the form of a drawdown. It is a high stakes game of chicken, where the drawdown tries to make you flinch and get out; while the CTA wants you to stay in as they are confident their program will eventually get back to equity highs.
The problem, of course, is that we don’t know when or if a specific program or set of programs will get back to equity highs. If we did, this would be easy, and we would have no problem risking as much as possible to get to those levels. But in reality it is a delicate balancing act each investor must walk between risking enough to get to the other side and cutting losses before they get larger. We encourage you to not try that balancing act blind, and not to try it when emotional. Bring some tools with you. Set stop trade levels for each component of your portfolio before you start trading, and set goals for how long you’re going to give your managed futures investment. With these numbers down on paper, and tough decisions on when and if to cut a program will be that much easier.
IMPORTANT RISK DISCLOSURE
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Market conditions moved into more of a mixed state during October as some market sectors started to roll over somewhat. Economic reports were again construed as improving as several releases pointed to renewed manufacturing and building growth especially in Asia, although numbers in the U.S. and U.K. were a bit softer than early estimates. Results of the monthly FOMC were more of the same with the Fed governors again indicating that some of the recent stimulus programs will be slowed to a minimum due to ideas the programs are no longer needed. Some sectors of the marketplace continued to be fixated on the potential for inflation as several rounds of stimulus injection not only by the U.S. government, but abroad have led to large moves in several commodities, although the biggest boost from inflationary ideas has been in play with the metal and energy sectors. Energy prices were again buoyed by talk from China that the government plans to continue to build a larger stockpile which furthered upside enthusiasm. For the month RBOB Gasoline futures ended +11.00%, followed by Crude Oil futures +8.53% and Heating Oil futures+7.86%. Natural Gas futures -11.09% were hampered by another round of reports indicating plentiful supply.
The metals sector continued to benefit from news of Chinese stock building along with ideas that governmental stimulus will give inflation a boost in the future. October numbers had Palladium +7.45% leading the rally followed by Copper +4.84%, Gold +3.08% and Platinum +2.15%. Silver -2.42% was under pressure from profit taking and news of slowing cash purchases.
The Food and Ag sectors were mostly last firm month as the pro growth inflation rage came to the forefront again along with weather issues popping up all over the globe. Activity in the grains saw Wheat +8.05% on planting delay worries with Corn +6.40% and Soybeans +4.61% finding support from harvest delays prompted by heavy moisture events in the U.S. Midwest. The livestock sector saw Lean Hogs +14.31% finding support from improved demand after the recent sharp break and Live Cattle -0.52% continued to be hampered by lagging domestic seasonal demand. Soft commodities mostly featured rallies with OJ +21.69%, Cotton +7.64%, Coffee +6.03% and Cocoa +5.00% finding a bid from weather worries and Chinese stocks building. Sugar -10.16% was again under pressure from ideas that recent crop worries have subsided for the time being.
U.S. stock indices and their corresponding futures markets ended in a mixed to lower state as the marketplace had a battle going on between a stronger earnings season and mixed economic reports. Pressure also stemmed from profit taking after the strong 6+ month performance the sector has put up. The S&P Midcap 400 futures -4.61% led the way down followed by the Russell 2000 futures -2.83%, NASDAQ 100 futures -2.03% and S&P 500 futures -1.89 %. The Dow Jones 30 futures +0.11% was slightly higher for the month due to better sector earnings.
Currency markets were again mixed as the U.S. Dollar Index declined by - 0.51% for the month and the Japanese Yen lost -0.46% on worries of further job market deterioration. The biggest increase against the U.S. Dollar was the British Pound up + 2.96% for the month as support stemmed from strong commodity prices. The Swiss Franc +0.92% and Euro + .53% followed the Pound higher.
Bond markets posted a mixed month as weak results from some longer term auctions pressure the 30-Year Bonds finishing the up -0.88 % and the 10-Year Notes up + 0.08% were supported from yield curve trade.
Diversified Option Trading Managers led all managers for October with returns ranging from approximately +2% to + 8%. For many investors this is in sharp contrast to 2008 where the bulk of option traders were playing defense from the falling stock market knife…this year Diversified Managers are cheering the falling US Dollar. The top performer was FCI OSS which returned an estimated 7.75% on the month thanks to several well timed trades in Crude, Gold, and several foreign currencies. OSS is now ahead approximately 29.10% for the year and for investors invested since mid 2008 this month’s return puts the program within a small fraction (1-5% depending on the account start date) of a new equity high. With a little help from the markets we are hopeful that official new highs will be recorded by the year end. FCI CPP was also ahead for the month earning an estimated +1.31%. Finally, in the Diversified Option space, HB Capital earned an estimated +2.13% and is ahead 14.08% for the year and Oak Investment Group was ahead an estimated 2.89% for October.
Financial Option Traders did not fare as well in October as the final 3 days of the month sent Volatility levels skyrocketing. Their estimates were as follows: ACE Investment Strategists -3.17%, Cervino Diversified Options -1.19%, Cervino 2x -3.87%, Crescent Bay PSI -1.07%, Crescent Bay BVP -5.48%, and Raithel Investments -2.49%.
Specialty Managers were mixed for the month with Emil Van Essen’s Spread Trading Program leading the way ahead +1.47%. Van Essen is ahead an estimated +18.39% for 2009 and +23.35% over the past 12 months. For investors looking for some silver lining over the past 12 months Van Essen truly offers a one of a kind trading style worth looking into. Agriculture Specialty Managers struggled to find their footing over the past 2 months as many of the typical fundamental market trends that occur this time of year have been overshadowed by the falling dollar and rising commodity prices. The estimates are as follows: NDX Abednego -0.17%, NDX Shadrach -2.82%, and Rosetta -5.70%.
October proved to be another tough month for most multi market programs. Shorter term managers did have some success trading in commodities, currencies, and stock indexes. The top performing program was Futures Truth SAM 101 which was up an estimated +5.05% in October. Dominion Capital Management Sapphire +2.14% est. also had a nice month as well. Elsewhere, Sequential Capital Management +0.68%, and GT Capital +0.43% est. rounded out the short term sector.
Medium term trend follower Quantum Leap Capital posted a strong estimate of +2.75%. Shorter term stock index trader Paskewitz Asset Management Contrarian 3X St. Index was up approximately +0.43% for the month. Finally, Dighton Capital USA Aggressive Futures +0.81% est. also was profitable in October.
Last week was a tough week for many multi market traders as a late week sell-off in stocks and commodities hurt quite a few programs. Those that took losses include Mesirow Financial Commodities Low Volatility -0.59%, Mesirow Financial Commodities Absolute Return -0.64%, DMH -0.76% est., APA Strategic Diversification -2.07% est., Robinson-Langley -2.30% est., APA Modified -3.25% est., Hoffman Asset -4.72% est., Integrated Managed Futures Global Concentrated -5.09%, Clarke Global Basic -12.45% est., Pere Trading Group -12.47% est., and Clarke Global Magnum -14.80% est.
Trading systems had higher overall performance in October, with a select group of programs in both the day and swing sector generating enough winning trades to hold up the rest of the group. Volatility picked up considerably in the second half of the month, an increase of nearly 50 % from the lowest close on Oct 22nd to the end of the month as equities started to experience downward pressure. The increased volatility could be a positive sign for the trading environment in the final two months of the year.
In the day trading space, Compass SP was in a class of its own in October +$4,164.47. The next best program was Rayo Plus Dax +€1,365 thanks to a big winning trade on the last day of the month. Upper Hand ES traded just once a week on average for the month of October but was able to tack on +$560.41. Clipper ERL took a while to get into a rhythm last month but came out ahead by +$670. BetaCon 4/1 ESX ramped up its trading towards the end of the month with four trades in the last three trading days alone and finished the month +€330. ATB Trendy Balance Dax was fairly quiet for the month and finished up a modest + €115.
On the losing side, BounceMOC ERL was down -$80, BounceMOC EMD -$190, Freedom ES -$462.50, Waugh ERL - $919.34 and PSI! ERL -$1,100.
Moving on to the swing systems, Strategic SP and BAM ES made up the top two spots up +$4,075 and +$2,540 respectively. Bounce ERL was the only other swing system to finish above water +$130 for the month.
The majority of the remaining swing systems escaped the month with moderate losses. Those systems included Jaws US 60 -$153.75, Bounce EMD -$190, Jaws US 400 -$840, Polaris ES -$907.50, Ultramini ES -$1,035, Strategic ES -$1,237.50 and Waugh Swing ES -$1,360.
IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.
Past performance is not necessarily indicative of future results. The performance data for the various Commodity Trading Advisor ("CTA") and Managed Forex programs listed above are compiled from various sources, including Barclay Hedge, Attain Capital Management, LLC's ("Attain") own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.
The dollar based performance data for the various trading systems listed above represent the actual profits and losses achieved on a single contract basis in client accounts, and are inclusive of a $50 per round turn commission ($30 per e-mini contracts). Except where noted, the gains/losses are for closed out trades. The actual percentage gains/losses experienced by investors will vary depending on many factors, including, but not limited to: starting account balances, market behavior, the duration and extent of investor's participation (whether or not all signals are taken) in the specified system and money management techniques. Because of this, actual percentage gains/losses experienced by investors may be materially different than the percentage gains/losses as presented on this website.
Please read carefully the CFTC required disclaimer regarding hypothetical results below.
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.