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