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Has the Bear Market Resumed? Protect your Portfolio.

August 16, 2004

 

When the dust settled last week on another poor week for US equities, the major US stock indices stood at their lowest levels of the year, with the Dow down 12.3%, the S&P down 6%, and the Nasdaq down 4.2% so far this year. No sooner had the lows of the year been put in than the media started asking if we're headed back down to the post 9/11 lows. Has the bear market resumed?

Whether or not this recent down move in US equities is a brief sell off before the rally resumes OR a return to the bear market down move begun in March of 2000 remains to be seen. For my two cents, (and despite today's large rally) I think we'll see the 2003 lows a lot sooner than we see the 2000 highs. But the wise investor needs to be prepared no matter what happens, and therefore must have a plan for protecting her portfolio during a bear market or sudden crises such as a 9/11 type terrorist attack on US soil.

While several popular managed futures programs have suffered so far this year, history shows us that managed futures is the place to be during bear markets and crises situations. Futures based investments are often viewed as a way to generate oversized returns due to the leverage built into futures contracts and potential for large moves, but it is their low correlation with traditional markets which causes managed futures investments to be volatility reducers and portfolio diversifiers during the bad times.

But what does low correlation really mean to an individual investor. Saying lowly correlated investments are better than highly correlated ones is fine, but how does it play out in real hard earned money. To tackle this question, we set out to show what low correlation looks like in your portfolio.

We first show how the asset class managed futures reacts to different stress periods, then show the average return of managed futures during both boom and bust times in the stock market, and finally show the size of the average losing month for a portfolio of stocks alone versus a portfolio containing managed futures.

To measure managed futures returns, we chose the Credit Suisse First Boston/Tremont Advisors Managed Futures Index, which is comprised of 164 advisors controlling more than 6.5 Billion is assets (as of June 2002). The CSFB/Tremont index is a calculated index which is asset weighted, meaning larger CTAs have a larger impact on the index performance. Like any index, care must be given in relying on the data given because of inherent problems such as self reporting and survivorship bias.

Because the old saying, "the only thing which rises in a market crash is correlation", seems to bear fruit more often than not, it is helpful to examine any lowly correlated investment during periods of market stress. To accomplish this, we compared the performance of the CSFB/Tremont managed futures index versus that of the S&P 500 during the following four market crisis periods:

1. 1994 - the surprise Fed rate hike in February 1994 sent stocks reeling, and caused the S&L crisis, Orange County bankruptcy, and Mexican Peso devaluation

2. 1998 - This year saw post-Communist Russia default on its debt, causing widening credit spreads across the globe. The widening spreads caused severe losses for several hedge funds, including Long Term Capital Management, which was eventually bailed out by a consortium of banks fearing a LTCM default would result in a severe shock to financial markets.

3. 2000, 2001, 2002 - The much ballyhooed Internet bubble burst - tech crash, which began in March of 2000, and depending on who you speak to either ended in 2002 or remains unfinished.

4. September 2001 - The 9/11 tragedy saw US markets closed several days, with major liquidity and backup fears realized instantly, sending global markets to fresh lows once markets reopened.

The stress period analysis starts to show a clearer picture of what low correlation actually looks like. The lowly correlated managed futures index performed very well during periods of overall market stress, showing positive performance in all four incidences, and averaging over 9% higher performance than the S&P 500 stock index across those periods.

The reason for this is that the drivers of managed futures returns are not the same drivers as those for the stock markets. In fact, they are often opposite, as a bull market in energy prices, for example, can have a negative impact on corporate growth and therefore stock prices while adding to the returns of a trend following managed futures program.

One worry present in a defensive investment is how it reacts during the good times. If the positives are offset by larger or more frequent negatives when the stock market is in rally mode, then the defensive investment serves little purpose. To test this, we looked at the average annual return of the CSFB/Tremont managed futures index and S&P 500 over the boom period of 1995 to 1999, and compared those results to the same indices returns over the bust period lasting from 2000 to 2002.

The table below shows that while an underperformer during the boom period, managed futures still exhibited a positive average annual return. The bust period, in contrast, shows just how powerful diversification into managed futures can be, with the managed futures index averaging positive 8.6% per year versus a negative average annual return of -14.36% for the stock market as measured by the S&P 500. This again shows that low correlation can mean positive performance while your main investments are underperforming.

The last analysis we did was to test a hypothetical portfolio with a 12% allocation to the managed futures index and a 88% allocation to the S&P 500. We often read and hear how beneficial allocating a portion of your assets to a managed futures investment is because of its low correlation, but are rarely shown how this low correlation protects our portfolio.

The table below compares different statistics over the period 1994 through July of this year for two portfolios, one with a 100% allocation to the S&P 500, and a second with an 88% allocation to the S&P 500 index and a 12% allocation to the CSFB/Tremont Managed Futures Index.

The tests show that the portfolio containing the managed futures allocation improves the portfolio across every statistic. The portfolio containing a managed futures allocation has a higher average annual return, (5.0% vs 4.7%), a lower standard deviation (12.1 vs 14.0), and a lower Drawdown (53.0% vs 64.3%). The most telling statistic, and one which should lend credence to the view of managed futures as bear market/crisis protection is the reduction of the average losing month from -3.63% in the portfolio of stocks alone to just -3.09% in the portfolio of stocks and managed futures.

On an annualized basis, this represents 6.48% in bear market protection. This number finally gives us a feeling of what the real benefit of low correlation is. In this case, the benefit is about a 6% higher annual return during a bear market, or the difference between being down 10% for the year during a bad year for stocks or being down just 4%.

Of course, the benefit of managed futures on your portfolio will vary depending on what allocation you decide to give it. The table above shows a 12% allocation to managed futures, and actual allocations run between 0% and 50% of investor's overall assets. It is also important to note that the statistics and graphs above were run using indices, which are difficult and expensive to replicate.

The numbers within the index do come from actual advisors trading actual customers money, however, making the benefits a reality. If looking to managed futures for some of the volatility reducing characteristics outlined above, it is important to find a managed futures investment which exhibits similar characteristics and low correlation to the overall stock market.

Many investors look to a managed futures investment to provide bear market protection without testing the strategy to see if it provides the needed benefit. As a general rule of thumb, the more markets a managed futures program trades, the more like the managed futures index it will be, and the more benefit gained. Those programs or managers specializing in one market or sector - such as an S&P day trading system or CTA specializing in currencies only - may have good looking performance but lack the low correlation and bear market protection characteristics of a more commodities based program which trades multiple markets.

So don't just focus on the possible oversized returns of managed futures and potential high risks that come with those; managed futures offer unique characteristics which can reduce the volatility in your portfolio and add real benefits in times of a market crisis or extended bear market.

- Jeff Malec

**Managed Futures Index data courtesy of Credit Suisse First Boston/Tremont Index LLC. All rights reserved.