Recently Jim wrote about the benefits of investing like an endowment, something that is finally becoming possible for investors like you and me. This week we are going to focus on managed futures, a component of the endowment model in the alternative asset class.
What are futures?
Quite simply, a futures contract is a legal obligation to buy or sell a certain amount of something, whether it be corn, gold, oil, or government bonds. Futures trading in the US started in 1848 in Chicago, as a way for producers and companies (consumers) to hedge their risk.
Imagine you are Kellogg's and you are planning your Corn Flakes production. You feel that today's corn prices are good enough for you to make a tidy profit, but you are worried that they may go up. You could buy corn futures contracts for the amount of corn you plan on buying and lock in today's price. If the price of corn goes up, your hedge makes money, so you can still make a profit. If prices go down, you get to buy corn from farmers at the lower price, but your futures contracts lost money. Even after that loss, you are purchasing corn at the price you first expected.
In addition to the hedgers, there are speculators who bet that the contracts will go up or down. In the last example, there may be a person who does fundamental analysis and feels corn will go up. He buys a futures contract hoping corn gets more expensive. If it does, he makes money. If not, he loses.
There are six major categories of futures: agricultures, energy, metals, currencies, interest rates (like government bonds), and equity indices (like the S&P 500). Under these categories there are over 150 contracts traded, in markets all over the world. Trading futures happens 24/7.
Who Trades Futures?
Both individuals and professionals trade futures. Most individuals who trade futures lose money - I have heard about 85% of retail accounts lose most of their money.
However, there is a professional class of trader called a Commodity Trading Advisor (CTA). CTA's are regulated, routinely audited, and usually trend followers. We at Camelback Wealth Management use these types of traders for our clients' portfolios.
There are different ways of accessing CTAs. One way is through a mutual fund, that either trades the markets directly or hires CTAs under the mutual fund umbrella. It is also possible to invest in CTAs directly, but the minimums are fairly high.
Aren't futures risky? Why would I want futures in my portfolio?
When professionally managed, the risk for owning managed futures is greatly mitigated. In fact, adding managed futures to your portfolio actually decreases the risk as measured by standard deviation. That is exactly why you would want them in your portfolio.
For the last 11 years, managed futures (the CISDM CTA Asset Weighted Index) has returned 6.7% per year with only 8% standard deviation. In comparison, the S&P 500 made 0.6% and had standard deviation of 16.3%. But the best part is the lack of correlation between the two - in fact, the correlation is -0.11 (low correlation means the two investments move independently of each other, lowering risk of the portfolio).
The following graph shows the performance of managed futures during months in which stocks advanced dramatically over the last 31 years. In the 64 months in which the S&P 500 was up 5% or more in a month, managed futures were up 39 times, or 61%.
