Upload
doankhanh
View
220
Download
4
Embed Size (px)
Citation preview
The Role of Managed Futuresand Commodity Funds:Protecting Wealth during Turbulent PeriodsProfessor John M. MulveyDepartment of Operations Research and Financial EngineeringBendheim Center for FinancePrinceton UniversityChairman, DPT Capital Management, LLC
February 2012
W H I T E P A P E R
Role of Commodities_Whitepaper_US_21_2_Whitepaper 24/02/2012 09:21 Page 1
Abstract
Often, investors are willing to accept short-term risks
in order to achieve long-term portfolio gains. A form
of this tradeoff has led to a movement away from
traditional equity and fixed-income investments and
towards illiquid alternative categories – private equity and
venture capital, real assets, and hedge funds. Leading
university endowments, many public pension plans, and
wealthy individual investors have embraced the shift to
illiquid investments.
The nature of illiquid alternative investments poses severe
challenges for protecting investor wealth during crash
periods and for achieving rebalancing gains. In this paper,
we discuss the advantages of highly liquid investments –
such as in the managed futures domain – for protecting
capital and for dynamic asset allocation.
The Role of Managed Futures and Commodity Funds Page 2
Role of Commodities_Whitepaper_US_21_2_Whitepaper 24/02/2012 09:21 Page 2
The Role of Managed Futures and Commodity Funds Page 3
How can an investor protect his wealth against possible future
adverse events? We propose three basic approaches and
variants therein.
First, the investor can choose ultra conservative funds, including
cash management accounts and treasury bills, as his primary
investment vehicle. While protecting nominal wealth, short-term
fixed-income securities will inevitably lead to low returns,
especially under the current close-to-zero interest rate
environment throughout much of the world.
Safe short-term cash-like instruments fail as a hedge against
inflation risks. For longterm investors such as pension plans,
low asset return performance will result in the need for
relatively high contributions over time – which can be an
expensive approach for achieving short-term protection over
extended periods.
A second approach to wealth preservation is by anticipating
turbulent periods. Here, the investor lowers risk dynamically by
moving from risk bearing assets such as stocks to safe
investments such as short-term government bonds. Such a
flight-to-quality approach can be difficult to implement for large
institutional investors, however, due to their size, organizational
structure, and shift to illiquid alternative investments (Swensen
2000). Also, dynamic asset allocation can be expensive due to
market impact costs, false positive indicators, and time delays.
A third approach is to invest in assets and strategies that are
likely to perform well during
turbulent crash periods. There are two primary variants: a) tail
risk strategies; and b) strategies or asset categories that have
done well historically during turbulent periods. The former is
designed to pay off during a crash, whereas the latter is not
guaranteed but may be less expensive to implement.
As we discuss in this paper, managed futures in general, and
commodity futures in particular, fits the third approach and
accordingly should be considered an important component of a
long-term investor’s portfolio.
Managed futures encompass four general asset categories:
commodities (agricultural markets, energy products, and
metals); currencies; bonds; and equity indices. In each of these
cases, a futures (or forward) market is established by
participants to either hedge or speculate on the underlying
instrument. At any given time, a futures pricing curve can be
constructed by plotting the prices of futures contracts expiring
across the expiration spectrum.
There can be some confusion in futures/commodity
nomenclature due to historical circumstances and regulatory
issues. In the United States, the Commodity Trading Futures
Commission (CTFC) and National Futures Association (NFA)
regulate futures markets and their participants. The first futures
markets were commodities markets such as grains, softs (e.g.
cotton) and metals; energy products then followed.
1. Introduction
2010 20
1119
8019
8119
8219
83 1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999 20
0020
0120
0220
0320
0420
0520
0620
07 2008
2009
$0
$70
$140
$210
$280
$350
Asse
ts U
nder
Man
agem
ent (
$bn)
0 0 1 1 1 1 2 4 6 7 11 15 19 26 25 23 24 33 36 41 38 41 51
87
132131
170
268
Series1, 320
YTD
207 206 214
Exhibit 1Growth of managed futures and commodity markets
Role of Commodities_Whitepaper_US_21_2_Whitepaper 24/02/2012 09:21 Page 3
The Role of Managed Futures and Commodity Funds Page 4
Eventually, futures markets have expanded significantly to
include currencies, fixed income instruments and equity
indices. Today, professional money managers who trade
primarily futures are designated as commodity trading
advisors (CTAs), regardless of which sectors they trade. In this
report, we differentiate the broader managed futures area
from the original commodity futures markets.
Commodity investments have gained in interest by individual
and institutional investors over the past decade. For example,
trading volume in exchange traded commodities has
increased dramatically. Furthermore, assets under
management more than doubled between 2008 and 2010 to
nearly $380 billion (Exhibit 1). And commodity prices have
increased. Market participants attribute the recent price
increases in commodities to increased demand for consumer
goods, particularly from the populous countries of India and
China. In contrast, the size of the world stock market was
estimated at about $46.8 trillion at the end of March 2010.
As we show, for traditionally diversified investors, an
allocation to a fund that invests exclusively in commodity
markets offers not only a hedge against inflation, but also
effective diversification because of its low correlation with
traditional asset classes. In the long run, commodity
investment funds show equity-like returns, but are
accompanied by lower volatility and shortfall risk.
Role of Commodities_Whitepaper_US_21_2_Whitepaper 24/02/2012 09:21 Page 4
The Role of Managed Futures and Commodity Funds Page 5
Fundamental flaws in traditional portfolio models became
apparent during the severe 2008/09 banking, real estate, and
general economic crash. Among other problems, many investors
had assumed that correlations in rates of return among asset
categories would approximate historical values going forward.
Under this assumption, the investor would be adequately and
safely diversified to “protect” his capital during a crash.
Unfortunately, most asset categories suffered together and lost
substantial value. The extreme level of contagion occurring
during this crisis can be attributed to several factors. First,
market risk soared to unprecedented levels; for example, the
implied volatility of U.S. stocks exceeded 70% annualized value
and correlation among asset categories trended towards 1.0 or
-1.0. As we know from asset pricing, the “fair value” of a
security depends upon risk adjusted discounting of future cash
flows, or via risk neutral valuation (arbitrage free pricing). In
both cases, if the risks increase along with much higher
volatility, prices will plunge. As this crash showed, the financial
sector is critical to the health of the overall economy, hence the
spreading of extreme contagion throughout the equity, fixed-
income, and other asset categories. The U.S. real estate crisis
and a sharp drop in confidence accompanied the crisis in the
financial sector.
Finally, liquidity considerations caused many markets and
strategies to become unstable since investors could not sell their
asset in response to severe turbulence; market liquidity
evaporated for many securities.
Most asset allocation and asset-liability management (ALM)
models assume that the
2. Where’s the Diversification?
Exhibit 2Portfolio models often assume fixed-correlation betweenasset returns
Estimated Correlation Matrix for Asset Returns from a ALM Study for a
Large Public Pension Plan
These results do not properly Model Contagion during Market Crashes
CORRELATION MATRIX
Class Liquidity Fixed Income Real Estate Global Equity Absolute Equity Private Equity
Liquidity 1.00
Fixed Income 0.30 1.00
Real Estate 0.25 0.40 1.00
Global Equity 0.10 0.01 0.40 1.00
Absolute Return 0.00 0.60 0.30 0.35 1.00
Private Equity 0.15 -0.10 0.50 0.80 0.10 1.00
Exhibit 3Correlation between equities and government bond returns changes over time based on economic conditions(normal versus crash) – weekly time steps
Jan-19
60
Jan-20
00-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
Jan-19
80
Jan-19
90
Jan-19
70
Jan-20
09
Jan-19
65
Jan-20
05
Jan-19
85
Jan-19
95
Jan-19
75
Jun-20
09
Source: Global Financial Database, S&P500.
Role of Commodities_Whitepaper_US_21_2_Whitepaper 24/02/2012 09:21 Page 5
The Role of Managed Futures and Commodity Funds Page 6
correlations among asset returns are relatively constant. Exhibit
2, for example, depicts the assumed correlation matrix for a
$140+ billion California pension plan (Collier and Olleman,
2010). Note in particular, the correlation between equities and
bonds is assumed to be close to zero. As shown in Exhibit 3,
however, the rolling correlation between stocks and
government bond returns takes on a distinctive pattern –
positive during normal business conditions, and negative during
recessions and crashes.
These charts show the existence of distinct economic regimes.
Including these more realistic conditions in an asset allocation
study will improve investor performance.
Even absolute performance hedge funds failed to protect
investor capital during 2008/9 (Exhibits 4, 5 and 6). Exhibit 4
shows the weekly correlations of the returns of hedge fund
categories to FTSE U.S. equity 500 returns over the span
September 2005 to August 2011. As evident, several hedge
fund categories – emerging markets, multi-strategy, long-short
equity, distressed, fixed-income arbitrage, and risk arbitrage --
had a higher correlation to the FTSE 500 returns than the other
categories. Two categories – dedicated short bias and managed
futures – stand out with very low correlation to the FTSE 500.
The orange colors depict hedge-fund categories with negative
returns over the target period; categories in blue have positive
returns.
Exhibit 5 shows cross connections among the hedge fund
categories. Most funds had relatively high cross correlations,
with a couple of exceptions, and most had positive performance
over 2005-11. Here again, managed futures and dedicated
short stand out with relatively low or uncorrelated performance
to the other hedge fund categories.
Exhibit 4Correlations between FTSE U.S. 500 and Major HedgeFund Categories – 2005 to 2011(heavy line = correlation > .5; light line = correlationbetween .2 and .5; no line = correlation < .2)
GSCI(6.15%)
FTSE U.S. 5002.09%
Event DrivenDistressed
5.33%
Long/ShortEquity0.71%
Event DrivenMulti-Strategy
6.48%
Event Driven4.08%
Event DrivenRisk Arbitrage
5.04%
Equity MarketNeutral(3.23%)
Global Macro1.99%
DedicatedShort Bias(4.39%)
ManagedFutures7.12%
Fixed IncomeArbitrage(4.62%)
ConvertibleArbitrage
1.60%
Multi-Strategy1.26%
EmergingMarkets3.75%
Exhibit 5Correlations among Major Hedge Fund Categories –2005 to 2011(heavy line = correlation > .5; light line = correlationbetween .2 and .5; no line = correlation < .2)
GSCI(6.15%)
FTSE U.S. 5002.09%
Event DrivenDistressed
5.33%
Long/ShortEquity0.71%
Event DrivenMulti-Strategy
6.48%
Event Driven4.08%
Event DrivenRisk Arbitrage
5.04%
Equity MarketNeutral(3.23%)
Global Macro1.99%
DedicatedShort Bias(4.39%)
ManagedFutures7.12%
Fixed IncomeArbitrage(4.62%)
ConvertibleArbitrage
1.60%
Multi-Strategy1.26%
EmergingMarkets3.75%
Role of Commodities_Whitepaper_US_21_2_Whitepaper 24/02/2012 09:21 Page 6
The Role of Managed Futures and Commodity Funds Page 7
Exhibit 6 examines the recent crash period. Here we see that
the correlation matrixbecomes almost completely covered with
ones. Of particular note: 1) most hedge-fund categories lost
money during this period (even dedicated short bias funds); and
2) the precipitous drop of 51.4% in the Goldman Sachs
Commodity Index (GSCI) over the specified year which includes
a maximum 75+% drawdown within the one-year period. This
clearly calls into question the efficacy of a long-only approach
to commodities as a value-added asset. The managed futures
category was the sole category with positive performance.
Most investors who thought they were adequately diversified
learned the hard way that this simply wasn’t the case. Even top
university endowments – Harvard, Yale, and Princeton
Universities – experienced losses of 25% to over 30%. This level
of loss of capital usually has critical consequences for achieving
the goals of long-term investors.
Exhibit 6Correlations among Major Hedge Fund Categories –Feb 2008 to Feb 2009(heavy line = correlation > .5; light line = correlationbetween .2 and .5; no line = correlation < .2)
GSCI(51.40%)
EmergingMarkets(42.95%)
Multi-Strategy(29.45%)
ConvertibleArbitrage(38.20%)
Fixed IncomeArbitrage(36.20%)
ManagedFutures15.30%
DedicatedShort Bias(5.23%)
Event DrivenRisk Arbitrage
(1.98%)
Event Driven(14.87%)
Event DrivenMulti-Strategy
(12.57%)
Long/ShortEquity
(22.99%)
Event DrivenDistressed(18.72%)
FTSE U.S. 500(42.57%)
Global Macro(23.37%)
Equity MarketNeutral
(22.82%)
Role of Commodities_Whitepaper_US_21_2_Whitepaper 24/02/2012 09:21 Page 7
The Role of Managed Futures and Commodity Funds Page 8
The managed futures category has significant advantages over
traditional assets. Futures markets are some of the most liquid
in the world, providing exposure to currencies, bonds, equity
indices, and commodities. These instruments are readily traded,
even during severe market turbulence. Importantly, the investor
can go long or short without barriers typically associated with
shorting stocks and bonds – no borrowing needed or searching
for assets to borrow, or inverse ETFs. These markets also are
exchange-traded, easily valued, and marked-to-market daily.
Second, leverage in a futures market differs from traditional
leverage. An investment via futures does not require direct
capital; rather, trades are designated by reference to two
distinct “accounts”. The investor’s core capital is placed in a
margin account, which is the depository for daily profits and
losses from the futures positions. For individual investors, the
margin account consists of risk-free assets such as 1-year T-bills.
In contrast, it is relatively easy for an institutional investor to
maintain margin capital in risk bearing liquid assets such as
equities and bonds. The performance of the margin account
can play a significant element in managed futures.
The second “account” tracks the return of the futures positions.
Performance depends upon the characteristics of the underlying
instrument – currencies, bonds, equity index, or commodities.
Futures markets are overseen by regulated exchanges, thus
largely avoiding counterparty risks1. Exchanges require marked-
to-market settlement daily. Also, the exchanges can alter the
margin requirements depending upon current market
conditions. For instance, the margin requirement will increase
when volatility in the underlying instrument expands greatly.
Since futures markets are liquid, an investor can apply dynamic
asset allocation models and strategies without incurring large
market impact costs. For instance, the investor can implement
drawdown constraints over short time periods (Mulvey, et al.
2011). Likewise, rebalancing gains can be exploited by resetting
the asset mix to pre-determined target proportions. In these
cases, liquidity provides a distinct advantage since it plays a role
in improving portfolio performance.
3. Features of Futures Markets
1 Recent problems occurred with MF Global.
Role of Commodities_Whitepaper_US_21_2_Whitepaper 24/02/2012 09:21 Page 8
The Role of Managed Futures and Commodity Funds Page 9
The commodity segment of the managed futures domain can
provide exceptional diversification from equities and fixed
income. Commodity futures markets are among the oldest
organized exchanges in the world, such as the Dojima rice
futures market, which began in 1710 in Osaka Japan, and the
Chicago Board of Trade, which opened in 1848.
In recent years, investors have turned to owning commodities
and other real assets to protect themselves against long-term
risks. First, as the world population approaches seven billion
people, the demand for basic commodities bumps against
limited supply constraints for land, energy supplies, and
agricultural products, and so on possibly resulting in pricing
disruptions. Even safe drinking water is becoming a scarce
commodity in many parts of the world.
A related risk is inflation. Many countries are experiencing
extraordinarily low nominal interest rates2 and massive deficit
spending plans in order to overcome the fallout from the
2008/09 crash. For these countries, there is the temptation to
inflate themselves out of their current monetary problems,
especially if the local constituents do not understand the
importance of fiscal discipline to ensure long-term financial
stability. Further, the current level of negative real interest rates
in a number of countries likely will contribute to future
increased inflation.
Political risks, such as disruptions caused by oil embargos, wars,
and terrorist attacks, present another concern. Owning raw
materials can be profitable during turbulent periods caused by
political factors. Further, it’s likely that equities will drop very
quickly when a political crisis erupts. The 1973 oil embargo, for
example, precipitated a substantial increase in energy prices,
accompanied with higher inflation.
Last, there is a small, but still significant risk due to weather and
catastrophic shocks such as crop freezes, hurricanes, and
tsunamis. Many commodity prices will spike up when these
events are present.
Investing in commodities promises to reduce the
aforementioned risks. However, it’s difficult for most investors to
own raw materials outright due to storage and insurance costs,
depreciation, and related issues. Instead, investors have turned
to futures and forward markets in the commodity domain. In
addition, there are several other paths for investing in
commodities, including single commodity exchange traded
funds (ETFs), long-only commodity ETFs (matching indices such
as the Goldman Sachs Commodity Index3), and commodity only
hedge funds such as Clive Capital4 for high net worth
individuals and institutions.
There has been considerable research into the characteristics of
commodity prices over extended time periods. Studies have
shown the presence of trends and regime changes in
commodity markets (e.g. Erb and Harvey 2006; Miffre et al.
2007; and Shen et al. 2007). These patterns are due to multiple
causes, including the gradual diffusion of information, inventory
conditions, the impact of weather, and political risks. In many
cases, prices follow patterns consistent with trend following and
momentum5. These relationships can be traced to several
theories including diffusion of information and noisy traders
(Chan et al. 1996; DeBondt and Thaler 1987; George and
Hwang 2004; Hong and Stein 1999; and Rouwenhorst 1998).
For instance, if a farmer hedges against adverse events one year
and is successful, he may be inclined to hedge the next year.
Likewise, neighboring farmers will often follow the successful
hedger. Gradually, since commodities are employed for
consumption - either final or intermediate, consumers and
producers have to render hedging decisions on an ongoing
basis as a function of their core businesses. Likewise,
speculators will often watch the market for underlying patterns
and take action in concert with these patterns. The basis for
many commodity-trading strategies is sustained price swings –
either positive or negative.
A second source of alpha relates to the shape of the futures
curve. In most commodities,
4. Sources of Alpha in Commodity Markets
2 Interest rates on 10-Year U.S. government bonds have dropped from 15.84% in September 1981 to less than 2% recently.3 The GSCI is the most popular commodity index product, with over $100 Billion tracking the index.4 Clive capital has been a successful hedge fund investing in commodity markets.5 Trend following and momentum tactics are based on differing rules and underlying philosophy.
Role of Commodities_Whitepaper_US_21_2_Whitepaper 24/02/2012 09:21 Page 9
The Role of Managed Futures and Commodity Funds Page 10
the price of a futures contract is not determined by arbitrage
arguments. Supply and demand considerations are paramount.
Thus, for example, backwardation occurs when inventories are
low and spikes in demand are present. Tactics based on the
shape of the futures curve can lead to positive performance
(Gorton et al. 2008; and Brennan et al. 1997).
There is some controversy as to whether alpha is present in
managed futures funds. For instance, the study at Yale
University (Bhardwaj et al. 2008) indicates that commodity
trading advisors (CTAs) rarely earn much more than the risk free
rate. This study was completed before the 2008 crash in which
managed futures funds outperformed other hedge fund
categories by a wide margin.
Role of Commodities_Whitepaper_US_21_2_Whitepaper 24/02/2012 09:21 Page 10
The Role of Managed Futures and Commodity Funds Page 11
Passive indexing strategies have become well established over
the past thirty years. These strategies are designed to match a
well-defined market segment with a low cost (and possibly tax
efficient) approach to investing. There is considerable evidence
that passive indexing strategies are especially pertinent for large
institutional investors, due to their low cost and fees as well as
transparency. Passive funds typically have lower turnover than
active funds.
Long-only commodity indices have done well over extended
periods of time. Exhibit 7 shows the FTSE 500 alongside a
popular commodity index – the Goldman Sachs Commodity
Index (GSCI). The GSCI is an index of long-only investments in
the most actively traded commodities and is a popular
benchmark for many institutional investors.
There are several evident observations. First, the overall price
patterns of the GSCI and FTSE 500 are roughly similar. The GSCI
outperformed the FTSE 500 and related equity indices over the
entire 1999 to 2011 time period in terms of returns, with
associated higher volatility and drawdown values. Second, the
GSCI experienced severe losses during the crash period
2008/09, partially due to the sharp correction in oil and other
energy based commodities.
Exhibit 8 shows that spot prices of commodities rose along with
equities in early 2009 until early April 2011. However, the
investible version of the GSCI (an exchange traded fund with
the symbol GSG) achieved much lower performance during the
same period. The under performance is largely due to the
presence of contango in many commodity markets, especially
energy products, over the selected time periods. The commodity
prices in contango lowered returns since the index is long-only.
5. A Relative-Value Commodity Index
Exhibit 7Time Series of GSCI and FTSE 500 indices
GSCI Total Return FTSE 500 Total ReturnJul
-1999
Jul-20
070
1000
2000
3000
4000
5000
6000
Jul-20
03
Jul-20
05
Jul-20
01
Jul-20
09
Jul-20
11
Exhibit 8Time Series of GSCI spot index and investible “tracking”fund (GSG) – source Bloomberg
GSCI Spot Index Investible “Tracking” Fund (GSG)
2006
2010
0
50
100
150
200
2008
2009
2007
2011
Role of Commodities_Whitepaper_US_21_2_Whitepaper 24/02/2012 09:21 Page 11
The Role of Managed Futures and Commodity Funds Page 12
To address the problems with long-only commodity investments
– primarily large drawdowns and losses due to contango, we
developed a relative-value commodity index using the following
four sub-tactics: long momentum, short momentum, long
futures curve, and short futures curve6. Each of these tactics is
based on a relative ranking of the commodities under study7.
Briefly, the four tactics are designed to capture alpha embedded
in commodity markets, while carefully balancing the long and
short positions in the portfolio – in order to minimize
drawdowns and produce positive returns with excellent
diversification characteristics (as compared with traditional
assets). Recall that managed futures investments can be
designed as an overlay strategy – providing additive
performance to standard assets.
Exhibit 9 depicts the performance of our relative long and short
momentum tactics. Note that the relative long-momentum
tactic outperforms the relative short momentum over most of
the entire span. However, during crash periods – 2001/02 and
2008/09 the short momentum tactic did much better than its
long-only counterpart. The two tactics combine to provide a
more stable return pattern.
A similar characteristic occurs with the long and short futures
curve tactics (Exhibit 10). Here, the long futures tactic has the
better long-term return as compared with the shortfutures
tactic, but does suffer from sharp drawdowns. Again, the
combined long-short tactic has superior return/risk
characteristics.
Momentum Long Only
Jan-19
99
Jan-20
0702468
1012141618
Jan-20
03
Jan-20
05
Jan-20
01
Jan-20
10
Jan-20
09
Jan-20
00
Jan-20
08
Jan-20
04
Jan-20
06
Jan-20
02
Jan-20
11
Momentum Short Only
Jan-19
99
Jan-20
070.00.20.40.60.81.01.21.41.61.8
Jan-20
03
Jan-20
05
Jan-20
01
Jan-20
10
Jan-20
09
Jan-20
00
Jan-20
08
Jan-20
04
Jan-20
06
Jan-20
02
Jan-20
11
Momentum Market Neutral
Jan-19
99
Jan-20
070.00.51.01.52.02.53.03.54.04.5
Jan-20
03
Jan-20
05
Jan-20
01
Jan-20
10
Jan-20
09
Jan-20
00
Jan-20
08
Jan-20
04
Jan-20
06
Jan-20
02
Jan-20
11
Futures Curve Short Only
Jan-19
99
Jan-20
070.00.20.40.60.81.01.21.41.6
Jan-20
03
Jan-20
05
Jan-20
01
Jan-20
10
Jan-20
09
Jan-20
00
Jan-20
08
Jan-20
04
Jan-20
06
Jan-20
02
Jan-20
11
Futures Curve Market Neutral
Jan-19
99
Jan-20
070
1
2
3
4
5
6
7
Jan-20
03
Jan-20
05
Jan-20
01
Jan-20
10
Jan-20
09
Jan-20
00
Jan-20
08
Jan-20
04
Jan-20
06
Jan-20
02
Jan-20
11
Futures Curve Long Only
Jan-19
99
Jan-20
070
5
10
15
20
25
Jan-20
03
Jan-20
05
Jan-20
01
Jan-20
10
Jan-20
09
Jan-20
00
Jan-20
08
Jan-20
04
Jan-20
06
Jan-20
02
Jan-20
11
6 A dynamic long-only commodity index was created by Summerhaven, with an investible ETF whose symbol is USCI. The Summerhaven approach is long-only and employs tactics that are somewhat different than the ones describedin this paper, although we suspect the motivations are similar in spirit.
7 Most commodity tactics do not depend upon a relative value approach. For example, trend followers will go long a commodity when the current price exceeds a moving average of past prices
Exhibit 9Momentum tactics (long and short) and market neutralcombination -1999 to 2011
Exhibit 10Futures curve tactics (long and short) and marketneutral combination – 1999 to 2011
Role of Commodities_Whitepaper_US_21_2_Whitepaper 24/02/2012 09:21 Page 12
The Role of Managed Futures and Commodity Funds Page 13
Exhibit 11 depicts the performance of the long-short relative-
value commodity strategy, along with market neutral version
over the period 1999 to 2011. The relative value approach
applies regimes for determining the tilting of long and short
positions. Exhibit 12 shows the results of the relative value
index. In addition, we provide the empirical results of a regime
detection system for U.S. equities (Guidolin and Timmermann
2007; and Mulvey et al. 2011).
Since we can gain exposure to commodities via the futures
markets, we can enhance the returns of traditional assets. In this
example, we couple commodities with a regime identifying
equity model (Mulvey et al. 2011). The overall performance is
excellent. In particular, we focus on the ratio of return to risks
wherein risk is measured by the Ulcer Index8 – downside risks
relative to drawdown. The combination of commodities and a
careful, regime bases equity strategy is clearly attractive and has
low correlation with the FTSE 5009.
8 The Ulcer index measures both the length and depth of drawdown over time.9 In an early study, Lintner (1983) showed the advantages of commodity funds for improving performance in conjunction with traditional assets.
Exhibit 11Combining long and short momentum and futures curve tactics: Relative value versus market neutral – 1999 to 2011
DPT Target Relative Value Market Neutral
Jan-19
99
Jan-20
070
1
2
3
4
5
6
7
8
9
Jan-20
03
Jan-20
05
Jan-20
01
Jan-20
10
Jan-20
09
Jan-20
00
Jan-20
08
Jan-20
04
Jan-20
06
Jan-20
02
Jan-20
11
Exhibit 12Combining relative value commodity and regime detecting equity tactics versus FTSE US 500 Index
JULY 1, 1999 TO DECEMBER 31, 2011
Jul 1999-Dec 2011 FTSE500 Equity-regimes + Commodities Commodities only Equity only – regimes60% commodities 40% equities 40% 60% 30% 60%
Geo. Return 1.18% 10.70% 5.23% 7.89% 1.96% 3.89%
Volatility 21.39% 6.26% 3.49% 5.24% 2.59% 5.19%
Sharpe ratio** -0.08 1.23 0.64 0.93 -0.40 0.17
Drawdown 54.73% 7.27% 4.77% 7.13% 3.27% 6.50%
Ret/Drawdown 0.02 1.47 1.10 1.11 0.60 0.60
Ulcer Index 22.44% 2.25% 1.48% 2.22% 1.17% 2.33%
UPI -0.08 3.42 1.51 2.20 -0.89 0.38
Corr w/ FTSE500 1.00 -0.018 -0.019 -0.019 -0.005 -0.005
2% fee 2% fee 2% fee no fees no fees
**3% risk free rate
*Data is back-tested only. All investors should be aware that future results may not be the same as historical performance.
Role of Commodities_Whitepaper_US_21_2_Whitepaper 24/02/2012 09:21 Page 13
The Role of Managed Futures and Commodity Funds Page 14
A fundamental lesson emerging from the 2008/09 economic-
crash is that only a few strategies provide meaningful
diversification from equities when severe contagion strikes.
Standard risk management suffers accordingly, with substantial
portfolio losses.
Even absolute return hedge funds purporting to provide positive
returns failed to protect investor capital -- although losses here
generally were much less than the 50+ percent plunge that
occurred in equity markets. This situation led to a substantial
loss of investor wealth, a reduced chance to attain investment
goals (and for pension plans, to meet legal liabilities), and a
wakeup call for investors who have been applying traditional
portfolio models based on a relatively static framework such as
the Markowitz portfolio model. Instead, a dynamic asset
allocation approach would have been much better (Mulvey et
al. 2006 and 2008).
This paper discusses the advantages of commodity futures, and
managed futures in general, as bona fide standalone
investments and as meaningful diversifiers within a portfolio of
traditional assets. The managed futures category of hedge
funds performed particularly well during the 2008/9 crash
periods. In fact, it was the sole hedge fund category with
positive performance in 2008/9.
We have seen similar results in previous crash periods including
the Asian currency crisis in 1997-98, the Russian debt debacle
and LTCM in 1998-99, and the technology bubble and crash and
the 9/11 disaster in 2001-03. The positive performance can be
attributed to several factors: 1) the ready ability to go long or
short depending upon economic and other circumstances; 2) the
availability of deep liquidity allowing for dynamic asset allocation;
and 3) the opportunity to take advantage of volatility via
rebalancing gains and regime changes. Each element provides a
small advantage. When combined, however, a portfolio of
commodity tactics can substantially improve overall investment
performance, especially when traditional assets are doing poorly.
6. Conclusions
Role of Commodities_Whitepaper_US_21_2_Whitepaper 24/02/2012 09:21 Page 14
The Role of Managed Futures and Commodity Funds Page 15
The performance of a portfolio of managed futures tactics in a
fund can be subdivided into three components. The first
element involves return on the capital set aside for providing
the margin for the futures securities. In many cases, especially
for individual investors, their margin funds must be placed in
risk free and highly liquid funds such as 1-year T-bills. Today,
these investments are likely to remain close-to-zero
performance, given the ultra-low level of interest rates across
the globe. Institutional investors are allowed to post other liquid
assets in their margin accounts, such as equities and
fixedincome securities, with the possibility of sizeable returns
(with greater risks naturally).
Second, the return of individual tactics as standalone
investments is a primary component. For example, we might
construct a trend following rule for investing in gold futures.
The geometric mean of an index based on this tactic provides
attribution of this component – about 2-4% per year over the
past thirty years.
The third component involves portfolio determinatives.
Accordingly, a fund that employs the fixed proportional
investment rule, such as, 60% equity and 40% bonds will,
in many cases, outperform a buy-and-hold (do nothing) rule.
This excess return is called rebalancing gains, which can be
substantial for highly volatile markets and tactics such as we
have seen in the commodity arena. In other cases, the
rebalancing gains will depend upon more complex rules and
models such as via financial optimization models. Any excess
(or shortfall) return of this dynamic portfolio over the buy-and-
hold rule falls into this component. Luenberger (1998), and
Mulvey and Kim (2008) provide further discussion. More recent
studies in other areas have confirmed these empirical tests
(e.g. Mulvey et al. 2007, and the Rydex equal weighted version
of the S&P 500).
Appendix: Performance Attribution
ReferencesBhardwaj. G., G.B. Gorton, and K.G. Rouwenhorst (2008). Fooling some of thepeople all of the time: the inefficient performance and persistence of commoditytrading advisors, Yale ICF working paper 8(21).
Bodie, Z. and V.I. Rosansky (1980). Risk and return in commodity futures.Financial Analysts Journal. 36, 27-39.
Brennan, D., J. Williams and B.D. Wright (1997). Convenience yield without theconvenience: A spatial-temporal interpretation of storage under backwardation.Economic Journal. 107, 1009-1022.
Chan, L.K.C., N. Jegadeesh and J. Lakonishok (1996). Momentum strategies. TheJournal of Finance. 51(5), 1681-1713.
De Bondt, W.F.M. and R. Thaler (1987). Further evidence on investor overreactionand stock market seasonality. The Journal of Finance. 42(3), 557-581.
Collier, N.J. and M.C. Olleman (2010). CalSTRS teachers’ retirement board regularmeeting. February 5.
Erb, C. B., CFA, and C. R. Harvey (2006). The strategic and tactical value ofcommodity futures. Financial Analysts Journal. 62(2), 69-97.
George, T.J. and C. Hwang (2004). The 52-week high and momentum investing.The Journal of Finance. 59(5), 2145-2176.
Gorton, G, B. and K.G. Rouwenhorst (2006). Facts and fantasies aboutcommodity futures. Financial Analysts Journal. 62(2), 47-68.
Gorton, G B, F. Hayashi, and K.G. Rouwenhorst (2008). The fundamentals ofcommodity futures returns. Yale University working paper.
Greer, R.J. (2000). The nature of commodity index returns. The Journal ofAlternative Investments. 3, 45-52.
Guidolin, M., and A. Timmermann (2007). Asset allocation under multivariateregime switching. Journal of Economic Dynamics and Control. 31, 3503-3544.
Hong, H. and J. Stein (1999). A unified theory of underreaction, momentumtrading, and overreaction in asset markets. The Journal of Finance. 54(6), 2143-2184.
Jeanneret, P., P. Monnin, and S. Scholz (2011). Protection potential of commodityhedge funds. Journal of Alternative Investments. 13(3), 43-52.
Lintner, J. (1983). The potential role of managed commodity-financial futuresaccounts (and/or funds) in portfolio of stocks and bonds. Harvard Universityworking paper.
Luenberger, D. (1998). Investment Science. Oxford University Press, New York, NY.
Miffre, J., and G. Rallis (2007). Momentum in commodity futures markets. Journalof Banking and Finance, 31(6), 1863-1886.
Mulvey, J.M., K. Simsek, Z. Zhang (2006). Improving investment performance forpension plans. Journal of Asset Management. 7, 93-108.
Mulvey J.M., C. Ural and Z. Zhang (2007). Improving performance for long-terminvestors: wide diversification, leverage and overlay strategies. QuantitativeFinance. 7(2), 1-13.
Mulvey, J.M., W.C. Kim (2008). Constantly rebalanced portfolio – Is meanreversion necessary? Encyclopedia of Quantitative Finance. John Wiley and Sons,U.K., 2, 714-7.
Mulvey, J.M., K. Simsek, Z. Zhang and F. Fabozzi (2008). Assisting defined-benefitpension plans. Operations Research. 56, 1066-1078.
Mulvey, J.M., W.C. Kim (2011). Multi-stage financial planning: Integratingstochastic programs and policy simulators. In Stochastic Programming: The Stateof the Art, editor (ed. G. Infanger), 257-276.
Mulvey, J.M., M. Bilgili, and T. Vural (2011). A dynamic portfolio of investmentstrategies: applying capital growth with drawdown penalties. In The Kelly CapitalGrowth Criterion: Theory and Practice, (eds L. MacLean, E. Thorp, and W.Ziemba).
Rouwenhorst, K.G. (1998). International momentum strategies. The Journal ofFinance. 53(1), 267-284.
Shen Q., A. Szakmary, and S. Sharma (2007). An examination of momentumstrategies in commodity futures markets. Journal of Futures Markets. 26(3), 227-256.
Swensen, D. (2000). Pioneering Portfolio Management: An UnconventionalApproach to Institutional Investment. Free Press.
Role of Commodities_Whitepaper_US_21_2_Whitepaper 24/02/2012 09:21 Page 15
This publication does not constitute an offer or invitation to buy or sell any investment or participate in any investment activity, nor any advice concerning the acquisition or disposal of securities. This publication has not been approved by a
person authorised under the Financial Services and Markets Act 2000 (“FSMA”) for the purposes of section 21 of FSMA. Accordingly this publication and the information contained within it is only made to, and for the use of, persons whom
FTSE believes to be investment professionals within the meaning of article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 or U.S. institutional investors and major U.S. institutional investors, as provided
by Rule 15a-6 under the U.S. Securities Exchange Act of 1934. This publication and the information contained within should not be relied upon by anyone else. All information is provided for information purposes only and is derived from historical
data and information deemed to be reliable and generally available to the public in its primary form. Nothing in this publication constitutes financial or investment advice, nor any advice concerning the acquisition or disposal of securities. You
should exercise your discretion in your use of the information contained within this publication and if you do not have the relevant professional expertise in relation to investments of the kind referred to in this publication, before using the
information you should consult an investment professional who does for advice. FTSE makes no claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the results to be obtained from the use of the information
contained within this publication or the fitness or suitability of such information for any particular purpose to which it might be put. No responsibility or liability can be accepted by FTSE for any errors or for any loss from the use of this publication.
All figures and graphical representations in these slides refer to past performance and are sourced by FTSE. Past performance is not a reliable indicator of future results. “FTSE®” is a trade mark of the London Stock Exchange Group companies
and is used by FTSE under licence. This publication is not intended for dissemination to the public or distribution by subscription and recipients of this publication shall not disseminate or distribute it in any way. No part of this publication may
be reproduced, stored in a retrieval system or transmitted by any other form or means whether electronic, mechanical, photocopying, recording or otherwise without the prior permission of FTSE.
Role of Commodities_Whitepaper_US_21_2_Whitepaper 24/02/2012 09:21 Page 16