Commodities, Managed Futures and Diversification

Carlton Chin, CFA submits: As gold has continued to rally to all-time highs, there has been increased interest in gold, commodities, and managed futures as “diversification plays.” Indeed, these “assets” have been receiving increasing attention as true “asset classes” that offer good risk/returns and diversification benefits – for a traditional portfolio of stocks and bonds. The Rise of the Commodities Index Although commodities futures have been around for decades, the use of commodities indices became more popular when Goldman Sachs came out with the GSCI (Goldman Sachs Commodities Index, now the S&P GSCI). As large endowments and other institutional investors began to allocate assets to commodities, additional commodities indices were rolled out. Several of the indices have taken advantage of the “roll yield” in the energy sector. Index creators point to worldwide production and consumption with respect to the high energy sector allocation. Additional factors include the energy sector’s historical “roll yield” (based on contango/backwardation) leading to good “buy and hold” performance – as well as correlation benefits. The Rogers International Commodities Index (“RICI”) and Dow Jones Commodity Indices are other well-known commodities indices with strong allocations to the energy sector. Based on our asset allocation and fund management work, we have studied various commodities indices over the years, with an emphasis on characteristics such as liquidity, hedge-ability, diversification, and correlations with traditional assets. More specifically, we have developed a “liquid commodities index” that, since 1998, has a 0.3 correlation with the S&P 500 and a generally positive risk/return relationship, similar to other commodities indices. Liquid Commodities Index The chart shows that commodities have been a generally good investment over the years, although 2008 was difficult for “buy and hold” commodities investors. 2008 saw the collapse of financial assets, along with crude oil and many other commodities prices. Although statistics show that commodities offer diversification, no asset class will help all of the time. Please note that the performance of the index and managed futures programs in this article have not been traded and are hypothetical in nature. Managed Futures A “buy and hold” commodities approach has proven to be a solid diversifier over the years. However, just like “buy and hold” stock strategies have come under fire, the 2008 decline in commodities has led some investors towards actively “managed futures” as a good alternative investment. “Managed futures” strategies trade futures contracts and can potentially profit from both up and down movements in markets such as commodities, interest rates, and currencies. During the 2008 financial crisis, many managed futures programs were able to profit from the extreme moves, with the Barclays CTA Index posting a +14.1% return. The actively-managed component of a managed futures strategy offers additional diversification for a typical portfolio. To obtain an apples-to-apples comparison, we used the same portfolio allocations as our “liquid commodities index” – and applied a managed futures trading strategy. Below are the correlations from 1998 to the present. Correlations: Commodities, Managed Futures & S&P (1998 to Present) Liquid Commodities Index Managed Futures (Active Commodities) Combo (Index + Managed Futures) S&P 500 Liq. Commod Index 1.00 0.09 0.85 0.33 Managed Futures 0.09 1.00 0.60 -0.23 Combo 0.85 0.60 1.00 0.14 S&P 500 0.33 -0.23 0.14 1.00 Semi-Correl (S&P) 0.45 -0.32 0.20 1.00 Note how all of the commodities programs (buy and hold index, active managed futures, combination) offer diversification benefits, based on their correlations with the S&P 500. Over this time period, the index had a relatively low correlation of 0.33 to the S&P, while managed futures had an even better -0.23 correlation. “True” Diversification: Semi-Correlation Semi-deviation and semi-correlation are downside measures of risk and correlation that study results when assets decline. If you study the chart above, the bottom line shows the semi-correlation of each asset class with the S&P 500. Note how the active commodities managed futures program achieves a -0.32 semi-correlation with stocks, suggesting that when the stock market declines, the diversification benefits of managed futures potentially increase. Managed Futures Strategies: Positively Skewed Performance Trading strategies that work best for managed futures often create desirable return patterns that achieve “fat-tails” and “positive skew.” This means that losses are cut short, while profits are allowed to accumulate. Return distributions become skewed to the positive side: a good thing. Good managed futures traders typically apply robust systematic approaches that have been carefully researched – using statistical methods, to maximize forward information and minimize data-mining. Post-modern portfolio theory is increasingly embracing improved risk measures in order to better understand these trading strategies. Various sources have shown that managed futures programs offer good diversification benefits during times of crisis, and our downside risk measures suggest this to be true. Summary Using the best practices from institutional investing and hedge fund strategies – and applying a mathematical and scientific approach to develop investment strategies and improve risk management – can maximize the use of information. It is useful to apply theoretical approaches in a sensible manner to ensure practical and robust results in our pragmatic world. The numbers show that commodities and managed futures have a place in well-diversified portfolios. Correlation studies suggest that both buy-and-hold commodities and managed futures strategies can help smooth out the pattern of returns for a portfolio by potentially “zigging” when other assets are “zagging.” Complete Story »