Please address all correspondence to:
Harry M. Kat
The University of Reading
Reading RG6 6BA
* Associate Professor of Finance, ISMA Centre, University of Reading. The author
would like to thank Daniel Stark (Daniel B. Stark & Co.) and Sol Waksman (The
Barclay Group) for helpful comments as well as providing the managed futures index
return series used.
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.
For longer-term investors the additional negative
skewness that arises when hedge funds are introduced in a portfolio
of stocks and bonds forms a major risk as one large negative return
can destroy years of careful compounding. To hedge this risk, investors
will have to expand their horizon beyond just stocks and bonds. In Kat
(2002a) it was shown how stock index put options can be used to hedge
against the unwanted skewness effect of hedge funds. In Kat (2002b)
it was shown that put options on (baskets of) hedge funds can perform
a similar task.
Of course, the list of possible remedies does not end here. Any asset
or asset class that has suitable (co-)skewness characteristics can be
used. One obvious candidate is managed futures. Managed futures programs
are often trend following in nature. In essence, what these programs do
is somewhat similar to what option traders will do to hedge a short call
position. When the market moves up, they increase exposure and the other
way around. By moving out of the market when it comes down, managed futures
programs avoid being pulled in, like hedge funds are. As a result, the
(co-)skewness characteristics of managed futures can be expected to be
more or less opposite to those of hedge funds.
In this paper we investigate how managed futures
mix with stocks, bonds and hedge funds and how they can be used to control
the undesirable skewness effects that arise when adding hedge funds
to portfolios of stocks and bonds. We find that managed futures combine
extremely well with stocks and bonds as well as hedge funds and that
the combination allows investors to significantly improve the overall
risk characteristics of their portfolio without giving up much in terms
of expected return.
2. MANAGED FUTURES
The asset class 'managed futures' refers to professional
money managers known as commodity trading advisors or CTAs who manage
assets using the global futures and options markets as their investment
universe. Managed futures have been available for investment since 1948
when the first public futures fund started trading. The industry did
not take off until the late 1970s though. Since then the sector has
seen a fair amount of growth with currently an estimated $40-45 billion
under management. There are 3 ways in which investors can get into managed
futures. First, investors can buy shares in a public commodity fund,
in much the same way as they would invest in a stock or bond mutual
funds. Second, investors can place funds privately with a commodity
pool operator (CPO) who pools investors. money and employs one or more
CTAs to manage the pooled funds. Third, investors can retain one or
more CTAs directly to manage their money on an individual basis or hire
a manager of managers (MOM) to select CTAs for them. The minimum investment
required by funds, pools and CTAs varies considerably, with the direct
CTA route open only to investors that want to make a substantial investment.
CTAs charge management and incentive fees comparable to those charged
by hedge funds, i.e. 2% management fee plus 20% incentive fee. Similar
to funds of hedge funds, funds and pools charge an additional fee on
top of that.
Initially, CTAs were limited to trading commodity
futures (which explains terms such as public commodity fund, CTA and
CPO). With the introduction of futures on currencies, interest rates,
bonds and stock indices in the 1980s, however, the trading spectrum
widened substantially. Nowadays CTAs trade both commodity and financial
futures. Many take a very technical, systematic approach to trading,
but others opt for a more fundamental, discretionary approach. Some
concentrate on particular futures markets, such as agricultural, currencies,
or metals, but most diversify over different types of markets.
For our purposes, one of the most important features
of managed futures is their trend following nature. That CTA returns
have a strong trend following component can be shown by calculating
the correlation between managed futures returns and the returns on a
purely mechanical trend following strategy. One such strategy is the
one underlying the Mount Lucas Management (MLM) index. The latter reflects
the results of a purely mechanical, moving average based, trading strategy
in 25 different, commodity and financial, futures markets. Estimates
of the correlation between the MLM index and CTA returns are typically
positive and highly significant.
We distinguish between four different asset classes: stocks, bonds, hedge
funds and managed futures. Stocks are represented by the S&P 500 index,
bonds by the 10-year Salomon Brothers Government Bond index and hedge
funds by the median equally weighted portfolio of 20 different individual
funds. All three were used earlier in Kat (2002a, 2002b). Managed futures
are represented by the Stark 300 index. This asset weighted index is compiled
using the top 300 trading programs from the Daniel B. Stark & Co. database.
The top 300 trading programs are determined quarterly based on assets
under management. When a trading program closes down, the index does not
get adjusted backwards, which takes care of survivorship bias issues.
All 300 of the CTAs in the index are classified by their trading approach
and market category. Currently, the index contains 248 systematic and
52 discretionary traders, which split up in 169 diversified, 111 financial
only, 9 financial & metals, and 11 non-financial trading programs.
Throughout we use monthly return data over the period
June 1994 - May 2001. For bonds, hedge funds and managed futures we
use the sample mean as our estimate of the expected future return. For
stocks, however, we assume an expected return of 1% per month as we
feel it would be unrealistic to assume an immediate repeat of the 1990s
bull market. Under these assumptions, the basic return statistics for
our four asset classes are shown in table 1. The table shows that managed
futures returns have a lower mean and a higher standard deviation than
hedge fund returns. However, managed futures also exhibit positive instead
of negative skewness and much lower kurtosis. From the correlation matrix
we see that the correlation of managed futures with especially stocks
and hedge funds is extremely low. This means that, as long as there
are no negative side effects such as lower skewness or higher kurtosis
for example, managed futures will make very good diversifiers. This
is what we investigate in more detail next.
4. STOCKS, BONDS, PLUS HEDGE FUNDS OR MANAGED
We study the impact of hedge funds and managed futures for two different
types of investors. The first are what we will refer to as '50/50 investors.'
These are investors that always invest an equal amount in stocks and bonds.
When adding hedge funds and/or managed futures to their portfolio, 50/50
investors will reduce their stock and bond holdings by the same amount.
This gives rise to portfolios like 45% stocks, 45% bonds and 10% hedge
funds or 40% stocks, 40% bonds and 20% managed futures. The second type
of investors is what we will call '33/66 investors.' These investors always
divide the money invested in stocks and bonds in such a way that 1/3 is
invested in stocks and 2/3 is invested in bonds
The first step in our analysis is to see whether there are any significant
differences in the way in which hedge funds and managed futures combine
with stocks and bonds. We therefore formed portfolios of stocks, bonds
and hedge funds, as well as stocks bonds and managed futures. Table 2
shows the basic return statistics for 50/50 investors. Table 3 shows the
same for 33/66 investors. From table 2 we see once again that if the hedge
fund allocation increases both the standard deviation and the skewness
of the portfolio return distribution drop substantially, while at the
same time the return distribution's kurtosis increases. A similar picture
emerges from table 3 for 33/66 investors. With managed futures things
are different, however. If the managed futures allocation increases, the
standard deviation drops faster than with hedge funds. More remarkably,
skewness rises instead of drops while the reverse is true for kurtosis.
Although hedge funds offer a somewhat higher expected return, from an
overall risk perspective managed futures clearly are better diversifiers
than hedge funds.
5. HEDGE FUNDS PLUS MANAGED FUTURES
The next step is to study how hedge funds and managed futures combine
with each other. This is shown in table 4. Adding managed futures to a
hedge fund portfolio will put some downward pressure on the portfolio's
expected return as the expected return on managed futures is lower than
that of hedge funds. However, from a risk perspective the benefits of
managed futures are again very substantial. From the table we see that
adding managed futures to a portfolio of hedge funds will lead to a very
significant drop in the portfolio return's standard deviation. With 40-45%
invested in managed futures the standard deviation comes down from 2.44%
to 1.74%. Skewness rises quickly as well; from .0.47 without to 0.39 when
50% is invested in managed futures. In addition, kurtosis exhibits a strong
drop; from 2.67 without to .0.17 when 45% is invested in managed futures.
Giving up 10-15 basis points per month in expected return does not seem
an unrealistic price to pay for such a substantial improvement in overall
6. STOCKS, BONDS, HEDGE FUNDS AND MANAGED FUTURES
The final step in our analysis is to bring all four asset classes together
in one portfolio. We do so in two steps. First, we combine hedge funds
and managed futures into what we will call the .alternatives portfolio..
Second, we combine the alternatives portfolio with stocks and bonds. We
varied the managed futures allocation in the alternatives portfolio as
well as the alternatives allocation in the overall portfolio from 0% to
100% in 5% steps. For 50/50 as well as 33/66 investors, the results are
displayed in figure 1-8. From figure 1 and 2 we see that without managed
futures increasing the alternatives allocation will significantly raise
the expected return, while the expected return drops when the managed
futures allocation increases. This simply follows from the assumption
that the expected return on hedge funds is 0.99% but only 0.7% on managed
futures. A more interesting picture emerges from figure 3 and 4. These
graphs clearly show that investing in alternatives can substantially reduce
the overall portfolio return's standard deviation. The drop, however,
is heavily dependent on the percentage of managed futures in the alternatives
portfolio. Surprisingly, for allocations to alternatives between 0% and
20% the lowest standard deviations are obtained without hedge funds, i.e.
when 100% is invested in managed futures. For higher alternatives allocations
it pays to also include some hedge funds in the alternatives portfolio
though. This makes sense as for the alternatives portfolio itself the
lowest standard deviation is found when 40-45% is invested in managed
futures. We saw that before in table 4.
Figure 5 and 6 show the skewness results for 50/50
and 33/66 investors respectively. From these graphs we see once more
that without managed futures increasing the alternatives allocation
will lead to a substantial reduction in skewness. The higher the managed
futures allocation, however, the more this effect is neutralized. When
more than 50% is invested in managed futures the skewness effect of
hedge funds is (more than) fully eliminated and the skewness of the
overall portfolio return actually rises when alternatives are introduced.
Finally, figure 7 and 8 show the results on kurtosis. With 0% allocated
to managed futures, kurtosis rises substantially when the alternatives
allocation is increased. With a sizeable managed futures allocation,
however, this is no longer the case and kurtosis actually drops when
more weight is given to alternatives.
In sum, figure 1-8 show that investing in managed
futures can improve the overall risk profile of a portfolio far beyond
what can be achieved with hedge funds alone. Making an allocation to
managed futures not only neutralizes the unwanted side effects of hedge
funds but also leads to further risk reduction. Since managed futures
offer an acceptable expected return, all of this comes at quite a low
price in terms of expected return foregone.
To make sure that the above findings have general
validity, i.e. are not simply due to the particular choice of index,
we repeated the above procedure with a number of other CTA indices,
including various indices calculated by The Barclay Group. In all cases
the results were very similar to what we found above, meaning that our
results are robust with respect to the choice of managed futures index.
7. SKEWNESS REDUCTION WITH MANAGED FUTURES
The above leads us to the question what the exact costs are of using managed
futures to eliminate the negative skewness effects of introducing hedge
funds in a traditional portfolio of stocks and bonds. To answer this question
we follow the same procedure as in Kat (2002a). First, we determine the
managed futures allocation required to bring the overall portfolio skewness
back to its level before the addition of hedge funds (-0.33 for 50/50
investors and 0.03 for 33/66 investors). Subsequently, we leverage (assuming
4% interest) the resulting portfolio to restore the standard deviation.
The resulting overall portfolio allocations and the accompanying changes
in expected return (on a per annum basis) and kurtosis are shown in table
5 and 6. From the latter we see that the optimal portfolios are quite
straightforward. In essence, the bulk of the managed futures holdings
is financed by borrowing, without changing much about the stock, bond
and hedge fund allocations. It is interesting to see that for smaller
initial hedge fund allocations the optimal hedge fund and managed futures
allocation are more or less equal. This is true for 50/50 as well as 33/66
Looking at the change in expected return, we see that as a result of the
addition of managed futures and the subsequent leverage the expected return
actually increases instead of drops. From the last column we also see
that this rise in expected return is accompanied by a significant drop
in kurtosis. This compares very favourably with the results in Kat (2002a,
2002b) where it was shown that the costs of skewness reduction through
stock index or hedge fund puts can be quite significant.
In this paper we have studied the possible role
of managed futures in portfolios of stocks, bonds and hedge funds. We
found that allocating to managed futures allows 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. This does not mean that hedge
funds are superfluous though. 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. Assuming that on
average hedge funds will continue to provide higher returns than managed
futures, the inclusion of hedge funds will also boost the portfolio's
expected return somewhat.
Kat, H (2002a), Taking the Sting Out of Hedge Funds, Working Paper ISMA
Centre, University of Reading.
Kat, H (2002b), In Search of the Optimal Fund of Hedge Funds, Working
Paper ISMA Centre, University of Reading.
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