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Managed Futures as Bear Market Protection

March 31, 2008

 

We wrote about using managed futures as bear market protection last February in this newsletter, when the stock market was at new all time highs (and all time lows in volatility were pointing to a market “event”), and hope our readers paid heed to that advice, as a market event surely has unfurled and sent stock portfolios reeling lower.

For those who didn’t think to protect their stock portfolios at the highs, it’s never too late to add some bear market protection to your portfolio. Most investors only pay attention to stock market alternatives when they can see and feel the pain of a bear market, unfortunately, and that painful time appears to be now.

While we may not technically be in bear market territory yet, there is no debate that stock investors are feeling the pain so far in 2008. As can be seen in the charts below, stocks have actually been heading lower since October of last year, as investors try and make it through this latest round of market turmoil brought about the credit woes seen in the news daily.

And it isn’t just US stocks suffering from the US housing market issues. Stocks around the world are getting hit, with non-US markets actually feeling the pain even more than their US counterparts. You can see in the chart below that 15 out of the 17 major global markets are down so far this year, and that 10 of those are down double digits. If ever there was a time to think about diversifying your portfolio and adding some bear market protection, this would appear to be it.

Be Prepared for times of Market Stress:

The wise investor needs to be prepared no matter what happens in the future – good times or bad, and therefore must have a plan for protecting her portfolio during a bear market or sudden crisis such as a 9/11 type terrorist attack on US soil.

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 diversifies during the bad times.

But what does low correlation really mean to an individual investor. Saying non 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 over 50 funds run by professional Commodity Trading Advisors controlling Billions of dollars in assets. 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 supposedly 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 five market crisis periods. You’ll notice the last one is the current crisis we’re in, the credit crisis.

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.

5. Credit Crunch, Liquidity Crisis – The current market crisis brought on by a dip in housing prices and collapse in the sub prime mortgage market, , has seen hedge fund failures, bank collapses, unprecendented action by the US Fed, and a global stock sell off.

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 five incidences, and averaging over 11% higher performance than the S&P 500 stock index across those periods.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS

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 increases in commodity 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.

But what about the good times……

Ok, so managed futures do well when the market is tanking, but what about when the market is running higher? A legit worry for any defensive investment is how it reacts during the good times. If the money you make in the bad times is 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 periods of 1995 to 1999 and 2003 - 2007 and compared those results to the same indices returns over the bust periods lasting from 2000 to 2002, and Oct. 2007 to Feb 2008.

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 9.2% per year versus a negative average annual return of -13.91% 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.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS

The last analysis we did was to test a hypothetical portfolio with a 20% allocation to the managed futures index and a 80% 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.

Smoothing the portfolio

The table below compares different statistics over the period 1994 through the end of February, 2008, one with a 100% allocation to the S&P 500, and a second with an 80% allocation to the S&P 500 index and a 20% allocation to the CSFB/Tremont Managed Futures Index.

The tests show that the portfolio containing the managed futures allocation improves the portfolio across nearly every statistic. The portfolio containing a managed futures allocation has a marginally lower average annual return, (10.2% vs 9.7%), but there is less volatility with a lower standard deviation (11.2 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 -3.51% in the portfolio of stocks alone to just -2.56% in the portfolio of stocks and managed futures.

On an annualized basis, this represents 11.40% 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 11% 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 about even...that sounds good to me…..

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS

 

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 20% 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 are mere examples using broad based indices, which are difficult and expensive to replicate.

The numbers within the managed futures 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 to the managed futures index, and of course, a 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.

How can you get involved in a managed futures program? Attain works with several professional Commodity Trading Advisors (CTAs) who run managed futures programs, and can match your capital and risk/reward preferences with the right advisor.

- Jeff Malec, Chartered Alternative Investment Analyst (www.caia.org)

**Managed Futures Index data courtesy of Credit Suisse First Boston/Tremont Index LLC. S&P 500 data courtesy of Barra/S&P. All rights reserved.

***The above discussion if for informational purposes only. It does not represent trading in actual accounts. Many factors, including the ability to meet margin calls, withstand program losses, and more, could negatively affect the performance of the outlined methods and cause losses more than the principal amount. All futures trading contains the risk of substantial losses.***