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Managed Futures Portfolio Rebalancing
March 1, 2010
Portfolio Rebalancing, Re-aligning, Re-Tooling:
Despite some programs moving higher in February, managed futures haven’t bounced back yet in 2010 as most in the industry expect them too; with many popular programs still down for the year and lower than they were 12 months ago.
This poor performance has led many investors to ask questions such as: ‘When is the right time to drop a CTA or system from your portfolio and replace with another one?’ and…‘ Is there a less painful way than waiting for the statistical line in the sand to be crossed?’
There are also those who have seen great success in the past year [past performance is not necessarily indicative of future results] trading option selling programs (and those looking at their stock market performance in their overall portfolio) who are asking similar, yet opposite questions: ‘What should I do with profits and programs at equity highs?’ ‘Should I keep trading and letting them compound, or take profits off the table?’
These are great questions, and the answers can be found in the conversation on when should you look to rebalance and realign you portfolio of managed futures programs and trading systems; and when (and how) you should rebalance your overall portfolio of stocks, bonds, real estate, hedge funds, and so on.
What is re-balancing / re-aligning?
Rebalancing your portfolio is doing just what it sounds like – it is changing allocation levels within the portfolio to get it back in balance. Now, balance for one person may mean 80% alternative investments and 20% stocks, while for another it may mean 50% T-Bills, 20% stocks, and 30% managed futures; so getting it back in balance really means getting it back to your personal target allocation levels.
Rebalancing and keeping target allocations is relatively easy outside of the managed futures space, as you can easily add another $1,000 to your stock allocation by buying more shares of an index tracking exchange traded fund like the SPY or QQQQ.
But it is difficult, if not impossible; to increase your target allocation to managed futures by $1,000 or even $10,000 – given the minimum investment amounts for most managed futures programs range from $100,000 to multi-millions. And it can also be difficult within your managed futures portfolio to make an increase or decrease of $5,000 to the discretionary trader portion of your managed futures portfolio, for example.
Given these constraints on rebalancing within managed futures – most investors are really doing more of a re-alignment of their portfolios through outright adding and dropping of programs rather than incremental additional investments or decreases in the investment.
They, therefore; have a different set of requirements and concerns centered on the question of when you should stop trading a managed futures program which is underperforming.
Overall Portfolio Re-Balancing
We’ll start the conversation by looking at what rebalancing means for your overall portfolio.
Say you came into 2007 with the optimum portfolio mix outlined on the CME website at the time, with an investment split of 40% stocks, 40% bonds, and 20% managed futures – and go through a period of over performance for one sector (like 2007 and 2008 when managed futures were heads and tails above equities). All of a sudden, due to managed futures great performance and the terrible performance of stocks, you would be coming into 2009 with managed futures closer to 25% of your portfolio, and stocks down to about 25%. That means you would be well off your target levels, which would cause underperformance for the total portfolio should stocks rebound (which they did).
Rebalancing a portfolio gets you back in line with your target allocation numbers – and keeps you at the target risk/reward levels you have set up. It is, in a way, a method to sort of force you to buy into drawdowns and book profits from assets at equity highs, which in turn smoothes out the equity curve. Just consider 2009 – where you could have booked profits in your managed futures programs and put that money into a stock allocation – and you can see the benefit of rebalancing. If reading this is causing you to ask – what should my target allocation to managed futures be, read our past newsletter: How much should you allocate to managed futures? (click here to read)
There are several methods of rebalancing used by investors. These include: 1. rebalancing as soon as your allocation percentage drops a set number below your target level (say if you move from 40% to 35%). 2. Rebalancing on a set schedule such as annually, quarterly, or monthly. And 3. Rebalancing when you feel like it, based on market conditions, a hunch, a fear, and so on.
Unfortunately – most people rebalance their portfolios per the third method (when they feel like it); and they do it in reverse (decreasing the underperforming asset and increasing the over performing asset). This is why the grand majority of investors are caught in the unfortunate ‘invest at the highs, get out at the lows’ pattern.
To escape this pattern – consider rebalancing your portfolio annually back to your target allocation levels, which means adding to the underperforming assets and taking away from the over performing ones. This doesn’t take a great deal of sophistication or mathematical prowess, and will make you feel a lot more in control of your investment decisions. You would be less apt to make quick, emotionally charged decisions, for example – knowing that you’ll be making changes at the end of the year anyway. And it will force you into taking the longer term view on your investments (year of year instead of minute by minute)
What about the problem of the large managed futures minimums making it difficult to make incremental changes to your managed futures allocation? Having more money helps. A $50,000 block is about as low as you can go to have an increase mean anything in managed futures (anything less and the manager would be unlikely to have enough to increase trading levels to a point where you would see extra performance in dollar terms – which is what you’re after when increasing an allocation level).
You can also use notional funding and leverage to increase/decrease your allocation. If you are to increase your managed futures exposure by $20K per your rebalancing – you could invest that $20K in a $100K minimum program, for example, using 5 to 1 leverage and notionally funding the additional $80K. [Disclaimer: the additional leverage caused by notional funding can cause a substantially greater risk of loss]
One last item is to consider increasing/decreasing your managed futures allocation percentage with trading systems. They will have lower minimums, allowing you to move in and out in smaller blocks, yet can retain the long volatility/crisis period performance your likely after with your managed futures allocation.
Re-aligning within your Managed Futures Portfolio:
As mentioned above, when it comes to rebalancing within your managed futures portfolio – what you are usually doing is more of a realignment than the rebalancing you’ll do in your overall portfolio. This is because it will be hard to add $5,000 worth of a program here, and decrease by $10,000 there, and so on.
This inability to trade $5,000 more of a managed futures program is due to a combination of managers only risking a small portion of your account on each trade and the lack of granularity in futures contracts. If a manager trades 1 contract per $100,000 in a certain market, for example, he can’t trade 1.2 contracts upon you adding $20,000. There is no such thing as a fraction of a contract, so this manager would require you to add and decrease your exposure in $100,000 “blocks”.
But this issue doesn’t remove the need for rebalancing within your managed futures portfolio. In fact, your managed futures portfolio will probably need rebalancing within it more so than any other asset class – given how non correlated different programs can be within the managed futures asset class. It is rare for the Nasdaq to post large gains for the year while the S&P 500 sees losses, for example; but will be quite common for one of the managed futures programs in your portfolio to be much further ahead or behind another program in your portfolio.
So we return to the question of how, and when, to rebalance within your managed futures portfolio. First the how – which on its surface seems pretty simple, but can get complex in a hurry.
We believe that investors should start down the rebalancing path as simply as possible – and get into more complex variations as the need arises. The simple method is to keep adding different strategy types as you see gains, and to make sure you are not left with just a single strategy type when reducing.
For example, say you started in managed futures with a program like FCI (an option seller) in 2009 and were lucky enough to see success. We recommend rebalancing by taking the gains from the FCI program and adding another strategy type such as NDX Capital’s Shadrach program and its spread trading of Hog futures. From there, if you again see success in 2010, we would recommend rebalancing by taking the profits from the other programs and adding a multi-market systematic system around the same minimum investment amount or a discretionary trader. This rebalancing keeps you from getting overexposed to any one strategy type, which in our opinion will give you a better chance of success.
If you are lucky enough to have a large portfolio of programs which cover every strategy type, the next step is to rebalance within each strategy type. So your multi-market systematic allocation, for example; could be split between programs with a long term and short term views.
This simplistic rebalancing approach doesn’t cover the intricacies of different minimum investment amounts, volatilities, drawdown risks, and so on – but we don’t think that invalidates it. And it is definitely better, in our opinion, than doing no rebalancing.
The more complex version (perhaps to be covered in a future newsletter), is to rebalance the portfolio in such a way that each strategy type would have the same annualized expected volatility – not by the simple number of programs in that strategy type. This would mean you might have $200K in one strategy type, $800K in another, and just $100K in a third – but that they each have the same expected volatility.
What about the downside?
This simple method of adding strategy types also ignores the issue most investors are asking about in the current environment……what about the downside? It’s much easier to make rebalancing decisions when you’re playing with the house’s money – but what do you do when one or more strategies (or the entire portfolio) is losing money?
The first step towards knowing what to do on the downside is knowing when to do it, and we believe managed futures portfolios should be rebalanced annually (especially if they contain option selling programs). As with an annual rebalancing of your overall portfolio on a set schedule – doing so once a year can solve a lot of issues by focusing your decisions on that time period and removing the urge to do something sooner.
When the annual rebalancing time comes, put any programs which underperformed during the past year under the microscope (or call Attain and ask us to do it – we probably already have). Once under the microscope – ask tough questions. Did the program do what it was designed to do? Did it perform in line with its peers? Did it underperform managed futures in general? Is it non-correlated with other programs in my portfolio? Just because a program is down for the year doesn’t mean it needs to be jettisoned from the portfolio (it probably has the best chance of success in the following year – in sort of a Dogs of the Dow phenomenon).
But if it fails any of the tests under the microscope, then it may need to be jettisoned. If you find that programs doing similar strategies were up, and it was down (a trend follower losing money in 2008 or option seller losing money in 2009, for example); or if it was down big when the managed futures index was up, or if it not only lost money, but proved to lose money in many of the same trades and market environments as another program in your portfolio – it’s a prime candidate for the rebalancing axe.
You may also receive information from Attain that there were layoffs at the company, the manager’s main assistant left, they have grown 500% in Assets under management, and so on which can shape a decision to rebalance. Those types of items shouldn’t be the main source of your decision in our opinion, but if you are on the fence with what to do – they can be good supporting documentation, so to speak.
Say a program does get jettisoned out of your portfolio because it was well below its historical averages, had worse 12 and 24 month Sharpe ratios than the managed futures index, and per Attain was sloppy in its backoffice operations – then what?
This is the important part of rebalancing and what most people do incorrectly. It is all too easy to kick one program out because of poor performance and replace it with one of the top performers from the past year, no matter the strategy type. But that can lead to an imbalance in your portfolio. The better method is to fill the void you just made in your portfolio with the same type of strategy, just a better performer from that strategy type.
It seems like nothing more than semantics, but it is important to think of it as replacing the program, not the strategy type. The program underperformed, not the strategy type – and the best way to go about rebalancing the portfolio is to choose a best of breed program in the same strategy type as the program which was stopped. This will keep your portfolio well balanced and ready for whatever the market might throw at it.
Finally – there may be times when you need to rebalance before the year end, and that will be when a program crosses your pre-set line in the sand. We recommend setting lines in the sand (stop trade points) at the following levels depending on the history of the program. The more history, the less likely a program will go substantially beyond its historical Max DD. The less history a program has, the more likely they will have a new max DD in the future which is well above the historical DD.
Length of Track Record Stop Trade/Line in the Sand
10+ years 1.5 times historical Max DD
5 years 2.0 times historical Max DD
3 years 3.0 times historical Max DD
1 year 5 to 10 times historical Max DD
It is important to remember that those levels are for both the drawdown magnitude (how big it is) and drawdown duration (how long it is). Many times a program is within its tested parameters and hasn’t lost anywhere close to 1.5 times its past Max DD, but the length of the DD is twice what it was in the past.
As with the annual rebalancing, if you are forced to rebalance because of a program eclipsing its line in the sand, don’t rebalance away from the strategy type altogether. Try and get a best of breed program in the same strategy type to take its place.
Setting a rebalancing schedule and sticking with it is a great way to get out of the insanity creating ‘invest at the highs, get out at the lows’ pattern 90% of all investors are stuck in. The rebalancing will force you to add strategy types which lost money the past year, take profits off the table from programs like option sellers which could give it all back tomorrow, and generally make you feel a lot more in control of what is happening.
If you haven’t taken a look at your portfolio, either the managed futures portion of the entire thing, with a rebalancing eye – there’s no better time like the present. Rebalancing now could force you to take profits on stocks in your overall portfolio (which have come quite far, quite fast) and option selling programs in your managed futures portfolio; and get into some quality programs at lower levels while they are in drawdowns.
If you do rebalance regularly, make sure not to get emotional and thrown a rogue rebalance in there in the middle of the year because you don’t like that a program didn’t exit a short position or didn’t go long Gold, or the like. Set your line in the sand and forget it.
One of the hardest things is having the guts to stick through a drawdown when your right in the middle of it. Our natural tendency is to get away from something which is causing us pain (losses), and so our natural inclination is to quit a program when it is in a drawdown because it just doesn't feel right. To stick through a drawdown, you need to overcome this natural tendency by making it all about the statistics. Set a line in the sand based off the historical parameters, and don't flinch until that line is crossed. That takes away the daily mental battle of whether you should stick with the program or dump it. It gives you intestinal fortitude, even if you don't really have it.
IMPORTANT RISK DISCLOSURE
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Market action in February was fairly firm in most sectors as another month of positive economic data and a surprise discount rate increase by the Federal Reserve sparked investor optimism that growth in the U.S. has finally taken hold. Investor confidence found added fuel from testimony by Fed Chairman Bernanke that interest rates will remain low for the foreseeable future despite the move in the discount rate. The U.S. greenback also continued the run higher with a third consecutive month of appreciation giving further credence to U.S. economic conditions. The Chinese central bank was also in the news with another round of increasing bank reserve requirements to help put the brakes on the large increase seen in real estate prices recently. European countries remained on alert from credit problems for the Greek government, although there has been a unified movement within the European Union to aid Greece as long as they drastically cut spending. Despite the worries in Europe the overall market tone seemed to reflect that world growth as a whole is still satisfying investor appetite. The Energy complex was one sector that reflected the sentiment Crude Oil futures +8.60% leading the way followed by RBOB Gasoline futures +8.25% and heating Oil futures +6.04%. Natural Gas futures -6.00% continue to reflect a heavy supply scenario.
U.S. stock index futures posted their best monthly performance since November as economic data most of February showed overall growth happened at a better rate than previously expected. Mid-Cap 400 futures +5.19% led the rally followed by NASDAQ 100 futures +4.56%, Russell 2000 futures +4.48%, S&P 500 futures +3.08% and Dow Jones futures +2.94%.
The Metals complex posted a decent rally across the board last month with better economic growth in the U.S. aiding larger prices increases for the industrial sector. Copper +7.08% had the biggest leap followed by Palladium +5.02%, Gold +3.24%, Platinum +2.19% and Silver +1.91%.
The Food and Ag sectors were a mixed bag during February with supply/demand issues a controlling factor in most cases. Activity in the grains saw Wheat add +6.35%, Corn +5.82% and Soybeans +3.94% on weather concerns regarding harvest in South America and planting intentions in North America. The livestock sector was supported by better foreign demand as indicated by the USDA with Lean Hogs +5.88% and Live Cattle +2.79%. Soft commodities were fractured as heavy pressure in Sugar -17.48%, Cocoa -9.66% and Coffee -1.80% came on ideas that recent supply shortages will be offset by better crops in the Southern Hemisphere. Cotton +16.75% posted a strong rally on USDA indications that stronger exports will lower ending stocks below the comfort zone heading into the new crop year.
Market activity in currency futures for February was all about the continued issues involving the sovereign debt of Greece and how the EU will come to its aid to thwart a possible bankruptcy situation. These worries led investors out of the British Pound -4.68%, Euro -1.63% and Swiss Franc -1.17% and into Japanese Yen +1.43% and the U.S. Dollar index +0.99%.
February price activity in the Bond markets was firm as indications by the Federal Reserve that rates will continue to remain low led to support in this sector. 10-Year Notes ended +0.81 and 30-Year Bonds finished +0.10%.
Option Trading managers continued their impressive run into February as uncertain market conditions has kept volatility high. Financial Commodity Investments (FCI) OSS program led all Option Traders with an estimated +3.9% return for the month following a +5.21% gain in January – great start to the year after returning 38.91% with a max drawdown of 7.78% in 2009!
Other Option Trading estimates for February are as follows: ACE SIPC +3.56%, ACE DCP +0.06%, Cervino Diversified Options +0.35%, Cervino Diversified 2x +0.69%, Crescent Bay PSI +2.58%, Crescent Bay BVP +1.96%, FCI CPP +1.08%, and HB Capital +1.91%. Please note that HB Capital has raised his minimum investment from $90,000 to $200,000 after reaching their target $50 Million in assets under management.
Specialty managers posted mixed results for the month with the most diverse of the group (Emil Van Essen Spread Program) reporting strong gains while managers concentrating on the agriculture and grain markets (Rosetta and NDX) found February more challenging. Emil Van Essen posted an estimated gain of +2.58% as several new positions in the energy markets began to materialize late in the month. On the agriculture and grain only side; NDX Abednego and Shadrach both saw small gains of +0.56% and 0.12% respectively while Rosetta gave back approximately -0.77%. Historically NDX has focused on the Lean Hog Market with limited exposure to grains while Rosetta tends to focus on Live Cattle and a variety of grains (Corn, Wheat, and Soybeans). Finally, 2100 Xenon Fixed Income Program +1.69% is a new product in this category that we are looking forward to following along with!
February was an improved month for multi-market managers. Shorter-term traders had the most success as trading ranges expanded across commodities, currencies, and stock indexes. Trend followers also found success trading in the treasuries, softs, and energies. The top overall performer was Dominion Capital Sapphire at +3.22% est. Dominion is a short-term momentum trader and commodity market conditions were tailor made for this type of trading in February. In second place is Covenant Capital Management Aggressive, which was up +2.49% est. Covenant is an ultra-long term trader, who has found several market trends to their liking in 2010. Finally, in third place is GT Capital CTA Dynamic Trading, which was up +2.00% est.
Other profitable multi-market managers in February include Accela Capital Management Global Diversified +1.66% est., 2100 Xenon Managed Futures (2X) Program +1.59% est., Dighton Capital USA Aggressive Futures Trading +1.30% est., Mesirow Financial Commodities Absolute Return +0.41% est., Integrated Managed Futures Global Concentrated +0.25% est., and Mesirow Financial Commodities Low Volatility +0.14% est.
Multi-market managers in the red in February include DMH -0.63%, Hoffman Asset -0.70% est., Clarke Capital Global Magnum -1.25% est., Futures Truth MS4 -1.92% est., APA Strategic Diversification -2.53% est., Clarke Capital Global Basic -2.64% est., Futures Truth SAM 101 -2.88% est., Quantum Leap Capital Management -2.90% est., Clarke Capital Worldwide -5.17% est., APA Modified -6.02% est., and Robinson-Langley -8.75% est.
Short-term term index traders had a decent month in February, as market conditions were conducive to short-term trend and short-term countertrend trading. Paskewitz Asset Management Contrarian 3X St. Index led all managers at +3.80% est. Next in line is Pere Trading Group at +1.92%, followed by Sequential Capital Management -0.09% est.
February was a tough month on trading systems with only 9 out of the 26 systems we actively trade posting positive return numbers. Leading the way was bond swing trader JAWS US 60 at +$1627.50 (hypothetical), which took advantage of range bound conditions in the US 30 Year Bonds. Right behind JAWS 60 was TurningPoint X2 ES +1095.00, and TurningPoint ES +$1095.00, both of which are short term ES trend traders. Other systems in the black include Polaris ES +$1287.50, PSI! ERL +$1060, Upper Hand ES +$917.50, Waugh Swing ES +$327.50, Bounce ERL +$140.00, and Bounce MOC ERL +$137.50.
Unfortunately, there were plenty of systems in the red including MoneyMaker ES -$35.00, Clipper ERL -$110.00, JAWS US Daily -$120.00, Bounce EMD -$300.00, Bounce EMD -$310.00, Strategic NQ -$320.00, Strategic ES -$402.50 Waugh ERL -$700.0, Waugh CTO -$890.00, BetaCon 4/1 ESX -$1060.00, Ultramini ES -$1502.50, Money Beans -$1717.08, AG Mechwarrior ES -$1855.00, Strategic SP -$2100.00, BAM 90 Single Contract -$2289.10, BAM 90 ES -$2625.00, RayoPlus DAX -$2870.00, Compass SP -$3250.00, and ATB TrendyBalance V2 DAX -$3888.01.
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.