Constructing a managed futures portfolio

From the Issue of Managed Futures Today
The basics of allocating to multiple managed futures programs follows the golden rules of investing: Know your risk tolerance, diversify, and perform the necessary due diligence.

Once you have decided to add managed futures to your investment portfolio, the next step is to build a sub-portfolio of CTA (commodity trading advisor) programs. There are more than 1,000 CTA programs available, and selecting the right mix of CTAs is necessary to achieve your investment objectives. At this stage it is very important to work with an experienced managed futures portfolio advisor.

We spoke with numerous portfolio managers and there was consensus on the basic steps to integrating managed futures into a portfolio. All agreed the first step is to set realistic objectives for the role of managed futures in the portfolio.

“The primary objective is to provide a return stream that is uncorrelated to traditional asset classes such as equities and fixed income,” says John FitzGibbon, managing director of Lighthouse Partners, a fund-of-funds manager with $4.5 billion under management. “When you think about periods like 1998, 2002, and 2008 (see Figure 1) — the most stressful periods in the markets — managed futures provided positive returns and dampened volatility in investors portfolios.”

Figure 1: Barclay CTA Index vs. S&P 500 (Through July 2010)

Portfolio managers emphasize that investors need to view managed futures as a long-term investment. “The returns in managed futures can come in short bursts, and then there are often extended periods of sideways movement or even a drawdown, so an investor needs to be patient,” says Matt Osborne, managing director of Altegris Advisors, an alternative investment advisor with $2.7 billion under advisement. “Investors need to view managed futures on a minimum three-year time frame.”

“Managed futures are about where the investment portfolio is going to be three to five years from now,” says Walter Gallwas, president of Attain Capital Management, a firm specializing in managed futures through individually managed accounts. “It’s not about where corn is going to be after the next corn export report.”

Just as the purpose of managed futures is to diversify an investment portfolio, the CTA programs chosen must be diversified within the asset class. Portfolio managers highlight four criteria of managed futures programs necessary to get the right mix of CTA trading programs.

The first level of diversification is to invest in CTA programs that trade different markets. Futures offer exposure to a wide range of markets, such as energy, grains, foodstuffs, currencies, interest rates, and equity indexes. “The different markets give you some diversification right off the bat because they don’t necessarily move in tandem with each other or other assets,” FitzGibbon says.

The second level of diversification is to combine trend following and non-trend following CTAs. Trend followers try to profit from long-term trends in the markets, such as the natural gas downtrend in Figure 2. Note that trend followers, like all CTAs, can be either long (profit in rising markets) or short (profit in declining markets). As previously mentioned, managed futures are a long-term investment: The sizable trends in natural gas occurred on average every 67 weeks and lasted for an average of 38 weeks. It is also interesting to note that large trends in natural gas and many other commodity markets occurred in 2008-2009 when the equity markets lost nearly one-half their value.

Figure 2: Long-term Trends in Natural Gas

“The non-correlation benefit of managed futures (to equities and fixed income) is primarily driven by the trend-following managers,” Osborne says. “That’s not to say that non-trend strategies aren’t great and can’t be integrated into a portfolio. We believe they should be, but the predominance is trend following.”

Non-trend following CTAs include short-term traders, fundamental traders, spread trading and individual market specialists. Short-term traders often try to profit from brief reversals of the long-term trend or trading off the news and events of the day or week. Fundamental traders use the traditional supply and demand for a commodity as a predictor of its future price. Spread traders exploit differentials between markets such as corn vs. wheat or between different delivery months of the same commodity. Individual market specialists are CTAs who focus on a specific market segment such as grains, energies or interest rates. “Typically the non-trend-following segments are non-correlated with each other and non-correlated with the trend-following component,” Osborne says.

The third level of diversification is the time frame on which a CTA trades. The time frame is basically the average length of time the CTA is in a trade. Trading time frames are either short-term (10 days or less), medium-term (11 to 30 days) or long-term (more than 30 days), although it is common for long-term trend followers to hold a position for six months to a year or more. By investing with CTAs using different time frames you have the potential to take advantage of short, medium and long-term market moves. For example, short-term traders tend to outperform long-term traders in choppy, sideways markets but long-term traders can capture huge moves when markets go into long-term trends.

Investors should work with their advisor to choose CTAs that diversify the managed futures allocation across markets, trading styles, and time frames. “You could achieve diversification with as few as seven or eight managers, or as many as 30,” FitzGibbon says. “Our Lighthouse Managed Futures Program currently has 23 CTA managers diversified across trend-following programs, short-term trading programs and fundamentally based programs. The fundamentally based programs are predominantly specialists in their markets such as metals, energy, grains, livestock equity indexes and financial futures.

Risk level
It is an old adage in futures trading that rewards and risks are always balanced. If a CTA is producing large percentage gains, it is probably also incurring large drawdowns (the percentage of the portfolio lost before it regains its former peak value). A managed futures portfolio advisor will have measures of CTAs’ risk-adjusted returns, such as the Sharpe Ratio and Sortino Ratio, that will help investors chose a portfolio of CTAs with risk-reward ratios commensurate with an investor’s risk tolerance. (See “Looking beyond return” in Managed Futures Today, May 2010.)

“The first conversation we like to have with a client is about risk,” Gallwas says. “If a client says he’s comfortable with 20-percent risk, we’ll look at managers who have a 10-percent drawdown, where we’ve given the program room to exceed its historical risk.”

Due diligence
As with all trading, it is imperative for an investor to do his homework. Working with a portfolio advisor can make this process easier.

“A typical mistake investors make is to be wooed by the return profile of a CTA without doing full and complete due diligence on the manager,” Osborne says. “Investors overweight a performance assessment instead of looking at the experience of the people involved and their process in terms of running a business. We’ve seen many great traders whose businesses failed because of lack of operational discipline and infrastructure.”

“Our due diligence process can take six to nine months,” Gallwas says. “We try to quantify operational risk as much as possible. Is it a one-man band out of his basement? Is he building an infrastructure? There are a lot of times we like the performance of a CTA but operationally he just doesn’t know what he’s doing, and we’re not willing to take that risk on any manager.”

However, the biggest mistake investors make, according to the portfolio advisors we spoke with, is chasing the hot, new CTA. “It’s human nature to assume that what happened in the past will persist into the future,” FitzGibbon says. “But when it comes to allocating to trend-following managers, it’s not uncommon that their best-performing periods are followed by their steepest drawdowns.”

Using the example of natural gas from Figure 2, a trend-following CTA probably would have had stellar profits through the first half of 2006, been flat or down for the remainder of 2006 and all of 2007, and experienced renewed profitability from the large uptrend in the first half of 2008 and the huge downtrend for the rest of 2008 and the first three quarters of 2009. (Remember, CTAs can profit from both rising and falling markets, so profitability is determined by the size and breadth of the trend, not its direction.)

According to FitzGibbon, a common error is “to invest in a trend-following program very late in the cycle and then watch the program go into a significant drawdown. [Investors] buy the top and effectively sell the bottom.” He adds: “It’s probably easier to know when to get on the train than it is to know when to get off.”

While there are myriad details in constructing a managed futures portfolio, the basics are pretty simple: Set realistic objectives and know your risk tolerance. Think long-term. Diversify you CTA portfolio in terms of markets traded, trading styles, and time frames. Do as much due diligence on how a CTA runs his business as you do on his returns. Don’t chase the hot, new CTA. Finally, work with an experienced managed futures portfolio advisor.