More markets means less risk
Investors are routinely advised to diversify as a means of risk reduction. At its core, diversification is simply a way to mitigate the risk of having all your eggs in a single basket: Any single stock, futures market, currency, or option can suffer a unique shock that could devastate returns. By holding multiple uncorrelated assets — i.e., those that are unlikely to move similarly most of the time — you gain protection against single-asset shocks. The trade-off is you also give up the big gains that can occur when a particular instrument outperforms the rest of the market, but that’s a compromise prudent investors are willing to make.
Although most investors are more familiar with the diversification principles advocated for stock holdings — spreading risk across multiple industry sectors and groups, as well as different capitalizations — diversification is also a key risk-control mechanism in futures investing. Many people may think of futures as a single asset class, but they represent a collection of distinct markets that offer great possibilities for capturing returns through diversification. In fact, it is by creating diversified portfolios of futures contracts that managed futures firms can offer investors a true “asset class” that is uncorrelated to the stock market and other investments.
Because each futures market is different (although, of course, many in the same sector, such as crude oil and heating oil, resemble each other quite closely), one market might be losing money when another might be making money. Blending markets allows futures managers to take advantage of the overlapping cycles in different instruments to produce more consistent returns with lower volatility.
To show how this works, let’s analyze how a basic trend-following system — a commonly applied approach in managed futures — performs across three different futures markets: corn (C), crude oil (CL), and Euro FX (EC). Professional futures managers typically trade larger portfolios (e.g., dozens of markets), but this group will serve to illustrate the principles at hand.
Apply the investment strategy
The strategy we will use on this mini portfolio is a 42-day breakout system: It buys when price breaks out above the highest price of the past 42 trading days (approximately two months); it sells when price breaks down below the lowest low of the past 42 trading days. This is simply a representative technique; breakout trend-following strategies provide the basis of many managed futures trading programs, but professional traders employ other tools (and other systems), including money management formulas, that play a large part in determining final performance. Here, we are not concerned with the system’s performance, aside from what it tells us about the differences between our three markets.
This system is what is known as “stop-and-reverse”: When it exits long trades it simultaneously goes short, and it covers short trades at the same time it buys. As a result, the system is always in the market, either long or short. The principle behind it is that a market is likely to sustain its momentum in a given direction when it exceeds a price high of a certain magnitude (42 days in this case). The advantage of a trend-trading strategy that is always in the market is that it will never miss a price move it is designed to catch.
The drawback of the approach is that markets form extended price trends far less often than they move randomly. This accounts for the hallmark of all trend-following systems: They have fewer (often significantly fewer) winning trades than losing trades, but the large profits generated by the smaller number of winning trades that develop when a market trends more than offset these losses.
Trend-following systems are popular with professional futures money managers because they are not based on forecasting the development of trends, but rather on simply following trends when they have established themselves. However, longer-term trend-following strategies also typically require patience on the part of managers (and investors) to capture the profits these systems can produce. A single trend-following system applied to a single market may go many months — even more than a year — losing money or treading water if the market fails to establish a trend.
Figure 1 illustrates a typical trend-following state of affairs in corn futures. The blue up arrows designate long trades (and short-trade exits), while the red down arrows represent short trades (and long-trade exits). The signals are from the 42-day breakout system. There are two notable trends in this chart: a downtrend in late 2008 and an uptrend in the second half of 2010 that extended into 2011. These two moves were separated by more than one-and-a-half years of mostly trendless, up-and-down trading. A large profitable short trade captured much of the initial downtrend, only to be followed by a small losing long trade, a small winning short trade, a small winning long trade, a small winning short trade and (in July 2010), a long trade that was exited with a large profit in March 2011. The final completed trade in the chart was a losing short trade exited in April 2011. (The long trade initiated in April was still open as of May 15, but was in the red as the corn market reversed to the downside.)
Table 1 summarizes the trades for this period, based on trading two contracts per signal. If this were the system’s entire history in this market instead of a small sample, the high winning percentage — six of eight trades, or 75% — would be quite atypical of a trend-following system, but the fact that three trades accounted for 90% of the gross profits is not. The “Drawdown” column shows that despite the overall profitability for this period, the final trade represented an 18.45% loss of equity from the previous equity peak. Figure 2 shows the system’s equity growth in corn for the trades in Table 1; the stagnant period between the second and third large winning trades is notable.
Table 2 shows the system’s trades in crude oil over roughly the same period, trading one contract per signal. The performance here is much different than in corn. After three winning trades — including one monster profit — the next 10 trades include only a single winner, as the system entered an 18-month losing phase (with losing streaks of four and five trades). By the end of the period, the system had given back nearly 54% of the profits it had gained by December 2009. Figure 3 shows the system equity curve for crude oil.
Table 3 summarizes the system’s trades in the Euro FX, trading one contract. Here, the results resemble those in corn to a certain degree, in that there was a high percentage of winners (67%). However, the profits were a little more consistent in size, and the two-trade losing streak in 2009 erased more than 56% of the profits from the December 2008 equity peak.
Figure 4 shows what happens when these three markets are traded as a portfolio. This combined equity curve (Figure 5) shows how the profitability of the corn and (especially) Euro markets in the latter half of the analysis period more than offset crude oil’s huge drawdown, and instead of the prolonged stagnant period evident in the corn equity curve, the middle of the combined equity curve shows the effect of more trades creating a steadier stream of returns.
Table 4 lists the combined trades and shows that instead of two drawdowns larger than 50% for the individual markets, the maximum drawdown for the mini portfolio was 42%. Similarly, the four- and five-trade losing streaks from crude oil were shortened to two streaks of three losing trades in the combined portfolio.
The strength of simple concepts
The example here illustrates how simply diversifying among markets — without employing any other risk-control rules — can play an important role not just in boosting profits but in naturally reducing risk and creating a more consistent stream of returns. The not-insignificant improvements in this example only hint at the benefits that can come from a widely diversified futures portfolio.
