Managed Futures can be an integral part of your investment allocation

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Since 2001 I have recommended that clients strongly consider adding a managed futures component to their investment allocation.

Not all my clients have managed futures (for different reasons) but for those that are growth oriented investors, I always try and add managed futures to the mix.

During the very lean years, in the early 2000’s, when most equities were getting taken behind the woodshed, it was the managed futures portion of my client allocations that were a bright light in the darkness.

I credit managed futures for keeping more than one client from experiencing the overwhelming emotions that may have lead to selling near a market bottom (at the time). Adding managed futures to your portfolio acts much like adding high quality shock absorbers to your car.

From my experiences, managed futures help smooth out market volatility and provide a more comfortable ride for investors, therefore keeping clients emotionally hydrated and focused on the long term planning goals.

Here are 5 reasons why I believe managed futures can be a beneficial component to your allocation:

1- Diversification - Managed futures give you exposure to far away markets that you otherwise wouldn’t be able to invest in. The establishment of global futures exchanges allow managed futures managers to diversify their holdings into markets all over the world.

These include currencies, stock indices, financials, agricultural products, precious metals, and energy products. On any given Sunday, a managed futures manager may be long the Japanese Yen and short US Dollars or vice versa.

2- Performance- In addition to improving overall portfolio returns, managed futures have the ability to perform well in a variety of economic climates, including inflationary periods and periods of down stock markets, like the ones I described up above.

One reason for this is that managed futures trading advisors have the ability to take advantage of price trends in either direction, much like hedge funds. Most traditional mutual funds have to be long the market and don’t have the flexibility afforded alternative investments, such as managed futures.

Value of an Initial $10,000 Portfolio with a 10% Allocation to Managed Futures vs. a Traditional Stock and Bond Portfolio
(Jan. 1980 - Mar. 2004)

3- Non-Correlation- Managed futures have historically performed independently of traditional investments, such as stocks and bonds. This is referred to as non-correlation, or the potential for managed futures to perform well, regardless of whether traditional markets such as stocks and bonds are rising or falling.

Managed futures are often negatively correlated to U.S. stocks. For example, if one stock has a 30% correlation to another stock, then they generally move in the same direction 30% of the time. If managed futures are negatively correlated, then they have the ability to move up, even when US stocks are down.

4- Modern Portfolio Theory (MPT)- I think because many people don’t understand managed futures there’s a common misconception that futures are highly volatile and risky and you will lose all your money.

When in fact MPT shows otherwise (below). By adding managed futures as a component to a diversified investment portfolio, you may actually decrease volatility and increase returns as a whole.

The Effect of Diversifying a Traditional Portfolio into Managed Futures
(Jan. 1980 - Dec. 2003)

5- Professional Money Managers- You may know something about picking individual stocks or bonds but I highly recommend leaving this portion of your allocation in the hands of the pros. I outsource this portion of client allocations to professional money managers that have a long track record in the managed futures business.

A complete 180

The irony for me with the whole situation is that I constantly rail about controlling costs when it comes to choosing your investments. Half this blog has been about screening for cost efficient mutual funds and building ETF based portfolios. I always say, “all you can ever do is control your costs, the performance will come.”

Well when it comes to managed futures I do a complete 180. When it comes to internal costs there’s nothing more costly (on average) then a managed futures fund. It’s not unusual for a managed futures fund to have expenses in the neighborhood of 8-10%. 10% that’s crazy right? Well, it may seem so on the surface.

Non correlated diversification trumps fund fees in this case

I’ve said it before, if you can give me a valid reason why an investment makes sense, then we can override the way we NORMALLY evaluate the situation. I’ve sighted an example in the past, of a friend of mine in the financial services business, that recommends mutual funds that have had good performance with half the market volatility of the benchmark index.

I can see how that approach makes sense. The performance is competitive (regardless of fees) and the investing journey is unusually smooth, which is great for the clients. That to me is a valid enough reason for someone to discount the overriding importance of a mutual funds fees in the decision making process.

Managed Futures are the exception to my normal approach

Such is the case with managed futures. The performance, in these portfolios (net of fees) has been excellent over the longterm and the non correlated diversification (that acts as a portfolio shock absorber) is priceless; it trumps my normal approach.

Managed Futures Funds pay me a 3% trail

In the interest of full disclosure, part of the reason internal fees are so high is because advisors are paid handsomely. In my case, the managed futures family I use pays me a 3% trail, a lot more than the normal 1% I charge clients for the rest of the allocation.

Don’t get me wrong this is a very nice thing (for me), but I recommend managed futures because it’s right for the client (for all the reasons I’ve pointed out). If I thought it was doing more harm than good and I was the only one benefiting, than I’d get rid of it tomorrow.

In conclusion

The key to long term investing success is a smooth journey, because it keeps the human emotions in check. The key to a smooth journey is owning solidly diversified investments that are not overly correlated to one another. For my money, managed futures are a perfect fit for that description…

(Here’s an article that sheds some more light on the diversification managed futures provide.)

If you’ve had experience with managed futures or want to know more, drop me a comment…

Carnivals

• This post was featured in the Carnival of Personal Finance #130 hosted by Money Smart Life. For more information please visit the Carnival of Personal Finance.

Tags: Managed Futures, managed futures funds