June 11, 2012

By Louis P. Stanasolovich, CFP^®, CCO, CEO, Founder and President of Legend Financial Advisors, Inc.^® and EmergingWealth Investment Management, Inc.

Alternative Investments, such as managed futures, offer the potential to enhance returns and reduce volatility of traditional investment portfolios. Managed futures represent an important strategy used by investors to attempt to achieve non-correlated diversification in their portfolios.

A managed futures fund is a pool (generally a partnership, separate account or mutual fund) of investment dollars traded in the futures markets by a Commodities Trading Advisor, or (CTA). As an asset class, managed futures can potentially enhance the returns and lower the volatility of traditional investment portfolios through exposure to the world's commodity, interest rate, bonds as well as stock and currency markets. Investors then have opportunity to generate positive returns during periods of poor equity market performance.

Diversify Risk With Managed Futures:

Historically, advisors and investors have attempted to obtain diversification by investing among different asset classes including equities, fixed income and cash. In recent years, equities in both the U.S. and abroad have become increasingly correlated, thereby mitigating this thought process.

Investment decisions to invest utilizing region, sector and capitalization strategies can fail. Adding a managed futures investment to a portfolio provides investors with an additional tool in the tool box). Numerous academic research studies demonstrate that the inclusion of a managed futures component can help reduce overall portfolio risk while "enhancing portfolio returns in economic environments in which traditional stock and bond investments offer limited opportunities. Of course there is no guarantee that any strategy will be profitable or avoid losses or that the addition of managed futures to a portfolio will lower volatility or reduce risk.

Potential for Profit in Any Economic Environment:

The beauty of managed futures is that CTAs (managers of managed future programs) have the flexibility to position assets for profit, independent of market direction. Managed futures trading advisors can take advantage of price trends by purchasing futures positions in anticipation of a rising market, or by selling futures positions if they anticipate a falling market. During deflationary trends, futures provide an opportunity to profit by selling into a declining market with the expectation of buying, or closing out the position, at a lower price. Managed futures programs are often considered to be a "long volatility" strategy, so they can take advantage of rapidly changing trends in the marketplace. Trading advisors can even use strategies employing options on futures contracts that allow for profit potential in flat or neutral markets.

Practically 24/6 Global Diversification:

Managed futures investments have the potential to help diversify a portfolio across different sectors of the market and geographies. Commodity Trading Advisors (CTAs) and managed futures funds can participate in approximately 150 different markets (asset classes) worldwide on 35 plus exchanges 24 hours per day (Because the exchanges are global it is in effect six days per week.), including stock indices, financial instruments, agricultural and tropical products, precious and industrial metals, currencies, and energy products. Furthermore, they can go long or short on each of those positions. Through an investment in managed futures, investors can participate in global markets and potentially diversify their portfolios without having to monitor numerous complex international markets. Once again, there is no guarantee that any strategy will be profitable or avoid losses or that the addition of managed futures to a portfolio will lower volatility or reduce risk. All one can do is look at what has happened in the past. Managed futures have worked very well in the past.

Creating Low Correlation with Traditional Investments Reduces Portfolio Volatility:

A primary benefit of adding a managed futures component to a diversified investment portfolio is the potential to decrease portfolio volatility. This potentially lower volatility is a direct result of managed futures' historically low to slightly negative correlation with traditional investments, including equities and bonds.

In part, low correlation results from the fact that managed futures programs can profit from both upward and downward directional moves in the assets underlying portfolio contracts. These programs also enhance diversity by providing exposure to global markets and non-traditional market segments, like agriculture or financial futures.

Shooting for Desired Returns with Less Risk:

The addition of managed futures to a portfolio creates the possibility to reduce downside risk in times of crisis in traditional markets. Research has found that, historically, many managed futures programs have exhibited low or even negative correlations with equity indices during months when equity returns have been negative and positive correlations during months when equity returns have been positive.

In terms of risk-adjusted returns, managed futures have had significantly smaller drawdowns (The maximum peak-to-valley drop in an investment's performance history) since 1980.

Long-Only Commodities Does Not Equal Managed Futures:

Managed Futures Investments invest client assets on a discretionary basis using global futures markets as an investment medium. They may participate in diverse markets—agriculture, currencies, financial instruments, securities, and others—throughout the world, buying and selling futures contracts in anticipation of pricing trends. When compared with long-only index investing in commodity futures, such as energy or precious metals, managed futures have distinct investment characteristics. Managed futures programs, which in most cases are considered "trend followers" can take advantage of price trends, both up and down, in a variety of markets.

CTAs and Managed Futures investment programs (partnerships) and even mutual funds, generally manage their clients' assets using a proprietary trading system, or a discretionary method. Usually, these involved highly sophisticated computer programed mathematical algorithms with trades executed within a few minutes of new trading information being obtained from live market trades on exchanges.

Lower Risk:

Due to the fact that managed futures have a negative correlation as well as possessing corresponding risk reduction, they offer potentially more profit opportunities and are an excellent diversification tool.

Source: This article was originally printed as "Benefits of Managed Futures in a Balanced Portfolio", by Louis P. Stanasolovich, CFP^®, Legend Financial Advisors, Inc.^® (Risk-Controlled Investing Newsletter, November, 2008).

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