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Managed Futures: still the Better Diversifier?

October 7th, 2012 · 4 Comments · Equities, Futures, Trend Following

StdDev vs MF+HF  Rollinger

A decade ago, Cass Business School Professor Harry M. Kat wrote a paper entitled Managed Futures and Hedge Funds: A Match Made in Heaven. In the paper Kat studied the impact of adding managed futures to traditional bond/stock portfolio allocations.
In comparison to hedge funds, Kat found that:

Apart from their lower expected returns, managed futures appear to be more effective diversifiers than hedge funds.

This is obviously an interesting paper but it starts to date; and blog reader Tom Rollinger from Sunrise Capital had the good idea to update the numbers in his paper entitled Revisiting Kat’s Managed Futures and Hedge Funds: A Match Made in Heaven.

Quite a lot has happened since 2002. In the markets in general and the alternative investment space in particular. So checking how Kat’s findings have held up was an obviously interesting follow-up. A sort of “out-of-sample” testing.

In the paper, Rollinger applies the same methodology used by Kat to measure the effect of adding managed futures to the traditional portfolios, then combining hedge funds and managed futures, and finally the effect of adding both hedge funds and managed futures to the traditional portfolios.

First: a Managed Futures Definition

Trend followers, CTAs and managed futures are terms usually used inter-changeably, and Rollinger establishes this (emphasis mine):

Managed futures traders are commonly referred to as “Commodity Trading Advisors” or “CTAs” […]
somewhat misleading since CTAs are not restricted to trading only commodity futures. […]
Moreover many investors generically say “managed futures” or “CTAs” when they more precisely mean “systematic CTAs who employ trend following strategies”. This paper focuses on CTAs utilizing systematic trend following strategies.

The index used by Rollinger for Managed Futures is the Barclay Systematic Traders Index. The other asset classes are represented by:
– Bonds: Barclays U.S. Aggregate Bond Index
– Stocks: S&P 500 Total Return Index
– Hedge Funds: HFRI Fund Weighted Composite Index

This is different from Kat’s data/choice of indices but Rollinger shows in his Appendix B that for the period covered by Kat (June 1994–May 2001), the results “closely resemble” the original when using these different indexes.

Results of the “out-of-sample” test, a decade after Kat

Both papers simulate different portfolio allocations between the “traditional” 50/50 Bond/Stock portfolio and the “alternatives”, either Managed Futures, Hedge Funds or combination of both. The impact on the return distribution can then be observed.

It seems that the findings have stayed very similar since Kat published his paper. Adding managed futures to stocks and bonds helps more and quicker than do hedge funds, and do not bring on the negative side effect from hedge funds – increased tail risk.

From Rollinger’s paper (emphasis on Kat’s quote mine):

Managed futures have continued to be very valuable diversifiers. Throughout our analysis, and similar to Kat, we found that adding managed futures to portfolios of stocks and bonds reduced portfolio standard deviation to a greater degree and more quickly than did hedge funds alone, and without the undesirable side effects on skewness and kurtosis.
As the contribution to alternatives increases, all four moments of the return distribution benefit:
1) Mean return increases
2) Standard deviation decreases
3) Skewness increases
4) Kurtosis decreases

Overall, our analysis is best summarized by the following quote from Dr. Kat (regarding his own findings almost 10 years ago): “Investing in managed futures can improve the overall risk profile of a portfolio far beyond what can be achieved with hedge funds alone“.

The Papers

Here is a link to Kat’s original paper on SSRN:
Managed Futures and Hedge Funds: A Match Made in Heaven
Its abstract:

In this paper we study the possible role of managed futures in portfolios of stocks, bonds and hedge funds. We find that allocating to managed futures allow investors to achieve a very substantial degree of overall risk reduction at limited costs. Apart from their lower expected return, managed futures appear to be more effective diversifiers than hedge funds. Adding managed futures to a portfolio of stocks and bonds will reduce that portfolio’s standard deviation more and quicker than hedge funds will, and without the undesirable side-effects on skewness and kurtosis. Overall portfolio standard deviation can be reduced further by combining both hedge funds and managed futures with stocks and bonds. As long as at least 45-50% of the alternatives allocation is allocated to managed futures, this again will not have any negative side-effects on skewness and kurtosis.

And here is the link to Rollinger’s paper:
Revisiting Kat’s Managed Futures and Hedge Funds: A Match Made in Heaven

In November 2002, Cass Business School Professor Harry M. Kat, Ph.D. began to circulate a Working Paper entitled Managed Futures and Hedge Funds: A Match Made in Heaven. The Journal of Investment Management subsequently published the paper in the First Quarter of 2004. In the paper, Kat noted that while adding hedge fund exposure to traditional portfolios of stocks and bonds increased returns and reduced volatility, it also produced an undesired side effect — increased tail risk (lower skew and higher kurtosis). He went on to analyze the effects of adding managed futures to the traditional portfolios, and then of combining hedge funds and managed futures, and finally the effect of adding both hedge funds and managed futures to the traditional portfolios. He found that managed futures were better diversifiers than hedge funds; that they reduced the portfolio’s volatility to a greater degree and more quickly than did hedge funds, and without the undesirable side effects. He concluded that the most desirable results were obtained by combining both managed futures and hedge funds with the traditional portfolios. Kat’s original period of study was June 1994–May 2001. In this paper, we revisit and update Kat’s original work. Using similar data for the period June 2001–December 2011, we find that his observations continue to hold true more than 10 years later. During the subsequent 101⁄2 years, a highly volatile period that included separate stock market drawdowns of 36% and 56%, managed futures have continued to provide more effective and more valuable diversification for portfolios of stocks and bonds than have hedge funds.

I have just noticed Attain have also written up a piece comparing both papers. You can read more on their site:
Between kat and rollinger: blending managed futures and hedge funds

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4 Comments so far ↓

  • Michael Harris

    Hi Jez,

    Thanks for the report. I have seen the original paper in the past and I had some reservations as to whether its results are realistic. There are some issues that are not even mentioned, like for example the fact that the S&P 500 index can be traded – in the past through futures or a basket of stocks and recently with ETFs – whereas the other indices cannot be traded so they reflect arbitrary choices of constituents in practice. In addition, is there selection and/or survivorship bias involved in the CTA index? These are serious issues IMO. The positive skew may be an artifact of some bias in the CTA index. Also, the period of the test reflects a bad time for stocks, specifically after the 2000 drop. How would the results be affected if another secular bull market in stocks were to start? There are some other issues also but these are a few to start with.

  • Nicolas Granja

    Hello Michael,

    I think that if there is another super bull market like 1982-1999 the effects of the diversification would seem less attractive, but that makes a lot of sense, Systematic Trend Followers tend to do very well in very bad periods for Stocks while being uncorrelated most of the time, which is exactly what you want for stock portfolio diversifier. Whether stocks have done well or not is irrelevant, what matters is that the combination of both investments is much better than holding traditional assets.

    Regarding survivorship bias, the SP 500 also has that problem, so from a data perspective I don’t think is that important (or at least it is not a problem that we can solve). Regarding the the fact that the CTA index is not investable, you are totally right but with some research in the space I think it is very easy to pick a portfolio of managers that would mimic the index. I actually think that it is relatively easy to find one portfolio of Trend Followers that would beat the CTA index easily but I understand that it sounds polemic to some.

  • Michael Harris

    Hi Nicolas,

    Thanks for the reply. While I agree with you about the first part I disagree with your comment that “it is very easy to pick a portfolio of managers that would mimic the index.” This is equivalent to discovering a profitable trading system because the CAR of the index is currently at 8.69% since 1987. Using this index to make investment decisions, including allocation, amounts to hindsight, as the churn rate of advisers that comprise it is very high. I think the whole study Jez was kind enough to provide information about is a nasty statistical fluke. Otherwise, everyone with an excel tool to build an index that tracks some CTA index based on past data would be rich. Things are not that simple. I have high appreciation for trend-following and futures managed accounts but I disagree with claims they represent an asset class that can provide diversification benefits to specific portfolios due to the problems I mentioned. Again, any such claims are based on statistical averages that are non significant due to high churn rates, reporting problems, liquidity issues, etc.

  • Nicolas Granja

    Hi Michael,

    I have been invested in several Trend Followers for the last couple of years, the portfolio correlates a lot with the Trend Followers Wizards performance and with the State of Trend Following and by derivation with the CTA Index, although I would say that it has better performance. In any case I must admit that is no proof and there is no way to prove it even if I am successful in 10 years since that can be caused by sheer luck.

    Therefore I will try to give a different argument from a fundamental point of view. Trend Followers are a good diversifier to traditional portfolios because they tend to be long volatility investments, they perform very well in crisis because of this. Also, when there are stock markets crashes, financial crisis or something like that, there tend to be a lot of trends developing: everything moves a lot, this is precisely the time when you need performance and it is the time when TF delivers. I would say that even if you pick TF programs or funds that haven’t performed in the last 5 years on an absolute basis, they still add a lot of value by virtue of their performance in 2007-2008.

    Lastly, I don’t consider Managed Futures or Trend Following as an asset class and to me that classification is meaningless anyway. I think they represent a strategy that has a return profile like Long/short equity, equity short biased or spread trading and as such add good diversification to traditional portfolios.


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