BMFR 2nd Qtr 1999

A Perspective on Risk

"Behold the turtle- he never makes progress until he sticks his neck out."

- James Bryant Conant

Sound investment policy is really about intelligent risk management. There is no such thing as a risk free investment. Even an investment in cash exposes the investor to the risk that his buying power will erode through inflation. The real issue is not whether you want to take risk, but which risks and how many of them you are willing to accept. To make intelligent decisions as to how much of a particular risk is right for you, and how to blend risks properly to lower overall portfolio risk, you must have accurate measurements about how much risk each sector of your portfolio is exposing you to. Some investors rely on conventional wisdom (or lack thereof) to dictate their asset allocation. Others rely upon outdated statistics. The wise investor continues to study the facts. Change is inevitable.

There is a widespread conception that managed futures investments are far riskier than equities. There have been several academic studies showing that inclusion of managed futures investments into a traditional diversified portfolio (i.e. stocks and bonds) can actually reduce overall portfolio volatility due to the low correlation with equities and bonds. However, there has been little research done that compares the outright volatility of equities with that of managed futures. The following comparison of the volatility of managed futures returns versus the volatility of returns for various equities indices may offer a surprising perspective on the issue.

Using the standard deviation of monthly returns as a reasonable proxy for risk, we compared the rolling monthly standard deviation (on a 12-month basis) for the Barclay CTA Index with that of the Standard & Poors 500, the Morgan Stanley Capital Index (EAFE) and the NASDAQ Composite Index. (Figure 1) Based on these comparisons, several significant differences are observed.

Figure 1

The most dramatic differences were observed in the comparison between the NASDAQ and Barclay. During the entire decade of the nineties managed futures have been less volatile than the NASDAQ. At times the disparity was shocking. During the last three years the NASDAQ has been twice to three times as volatile as the Barclay CTA Index.

While managed futures were generally more volatile than the S&P in the decade of the eighties, the risks were much more comparable during the nineties. During the past two years, the volatility of the Barclay CTA Index was roughly half the volatility of the S&P, and during 1998 managed futures were roughly one-third as volatile as the S&P.

The volatility of managed futures during the 1990s was significantly less than that of international equities, as represented by EAFE. There were spikes ('90 - '91, '93 - '94, and '97 - '98) in the volatility of EAFE during which time managed futures were approximately one third as volatile as EAFE. Coupling this with the fact that the correlation between managed futures and the S&P is much lower than that between the S&P and EAFE (0.03 versus 0.48) leads one to ask whether managed futures may be a much better diversifier for an equity portfolio than international stocks.

Please keep in mind that the volatility of individual CTAs is likely to be greater than the volatility of the Barclay CTA Index. Please also keep in mind that individual stocks are likely to be more volatile than the stock indices used to measure market performance.

We have seen that recent managed futures returns, as measured by the performance of the Barclay CTA Index, have had lower standard deviations than traditional equity investments. What would we find if we looked a bit closer and distinguished upside volatility from downside volatility? Following up on an idea postulated first by Randy Warsager and Sol Waksman, we calculated the standard deviation of profitable months as well as the standard deviation of losing months for each of the indexes being examined. The comparison of these values is found in Table 1.

Table 1

Table 1 shows that managed futures have greater upside volatility and less downside volatility than any of the other indexes examined. In addition, if we look at the ratio of upside to downside volatility, again managed futures is the clear winner. This does not mean that managed futures are safer than stocks. What it does show is that different investment sectors behave differently. The question of how to take advantage of these differences is being left to you.

The stock market tends to climb a wall of worry. It edges up little by little, month after month, providing consistent profits until some surprise knocks the props from under the market and then it suddenly plunges 15% or 30% as in August 1998 or October 19, 1987. Since most stock investors are usually long, these market declines spell losses for them.

Most, if not all, of the CTAs in the Barclay universe trade the markets from both the long and short side. Therefore, they can make (or lose) money whether the markets are rising or falling. In addition, a significant portion of CTAs are trend followers; thus they tend to exit losing trades very quickly, so that a precipitous market reversal will often trigger a stop causing a small loss. On the other hand when a market moves in the trader's direction, CTAs tend to stay with profitable trades for quite some time. Therefore there is a tendency for CTAs to lose money slowly resulting from a series of small losses over time, but with low volatility. When trend followers do well, they tend to make their money in short explosive spurts (thus high upside volatility).

What are we to conclude from all of this? We conclude that while there is risk in managed futures, the risk is probably exaggerated in most peoples' minds. When compared with mainstream investments, the volatility of managed futures during the last decade has been in the same relative range as other investments (less than some), and during recent years has actually been significantly lower. This is partially due to the fact that the volatility in equities is increasing, and partly because CTA volatility has been decreasing. The gradual decrease in CTA volatility may be due to the greater emphasis on risk control among CTAs. Many of the larger CTAs have diversified among many more markets, and have developed multiple models to spread the risk among several different strategies, thus taking less risk on any particular trade. CTA volatility has been decreasing for over a decade, yet many investors are judging risk using stale statistics.

This does not mean that managed futures have become less risky than equities, but it may mean that the exaggerated risk in peoples' minds is largely a result of the far distant past in the case of managed futures. The misconception is also largely due to a confusion between managed futures and unmanaged futures as practiced by many individuals trading their own accounts. Potential investors still need to be educated that managed futures make sense in a portfolio because of the potential to make money during those times when traditional investments may be doing poorly, such as August 1998.

Jim Little is executive vice president at Campbell & Co., Inc., a CTA firm established in 1972 and currently managing approximately $1.5 billion for individual and institutional clients worldwide.

RISK DISCLOSURE WHEN CONSIDERING ALTERNATIVE INVESTMENTS YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS USE LEVERAGE AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. WITH RESPECT TO ALTERNATIVE INVESTMENTS IN GENERAL, YOU SHOULD BE AWARE THAT: RETURNS FROM SOME ALTERNATIVE INVESTMENTS CAN BE VOLATILE. YOU MAY LOSE ALL OR PORTION OF YOUR INVESTMENT. WITH RESPECT TO SINGLE MANAGER PRODUCTS THE MANAGER HAS TOTAL TRADING AUTHORITY. THE USE OF A SINGLE MANAGER COULD MEAN A LACK OF DIVERSIFICATION AND HIGHER RISK. MANY ALTERNATIVE INVESTMENTS ARE SUBJECT TO SUBSTANTIAL EXPENSES THAT MUST BE OFFSET BY TRADING PROFITS AND OTHER INCOME. A PORTION OF THOSE FEES IS PAID TO CAPITAL MANAGEMENT PARTNERS, INC. TRADING MAY TAKE PLACE ON FOREIGN EXCHANGES THAT MAY NOT OFFER THE SAME REGULATORY PROTECTION AS US EXCHANGES. WITH RESPECT TO AN INVESTMENT IN A FUND, YOU SHOULD BE AWARE THAT: THERE IS OFTEN A LACK OF TRANSPARENCY AS TO THE FUND'S UNDERLYING INVESTMENTS. AS TO FUND OF FUNDS, THE FUND'S MANAGER HAS COMPLETE DISCRETION TO INVEST IN VARIOUS SUB-FUNDS WITHOUT DISCLOSURE THEREOF TO YOU OR TO US.  BECAUSE OF THIS LACK OF TRANSPARENCY, THERE IS NO WAY FOR YOU TO MONITOR THE SPECIFIC INVESTMENTS MADE BY THE FUND OR TO KNOW WHETHER THE SUB-FUND INVESTMENTS ARE CONSISTENT WITH THE FUND'S HISTORIC INVESTMENT PHILOSOPHY OR RISK LEVELS. A FUND OF FUNDS INVESTS IN OTHER FUNDS AND FEES ARE CHARGED AT BOTH THE FUND AND SUB-FUND LEVEL.  THUS THE OVERALL FEES YOU WILL PAY WILL BE HIGHER THAT YOU WOULD PAY BY INVESTING DIRECTLY IN THE SUB-FUNDS.  IN ADDITION, EACH SUB-FUND CHARGES AN INCENTIVE FEE ON NEW PROFITS REGARDLESS OF WHETHER THE OVERALL OPERATIONS OF THE FUND ARE PROFITABLE. THERE IS NO SECONDARY MARKET FOR FUND INTERESTS.  TRANSFERS OF INTERESTS ARE SUBJECT TO LIMITATIONS.  THE FUND'S MANAGER MAY DENY A REQUEST TO TRANSFER IF IT DETERMINES THAT THE TRANSFER MAY RESULT IN ADVERSE LEGAL OR TAX CONSEQUENCES FOR THE FUND. A FUND'S OFFERING MATERIALS OR A MANAGER'S DISCLOSURE DOCUMENT DESCRIBES THE VARIOUS RISKS AND CONFLICTS OF INTEREST RELATING TO AN INVESTMENT AND TO ITS OPERATIONS.  YOU SHOULD READ THOSE DOCUMENTS CAREFULLY TO DETERMINE WHETHER AN INVESTMENT IS SUITABLE FOR YOU IN LIGHT OF, AMONG OTHER THINGS, YOUR FINANCIAL SITUATION, NEED FOR LIQUIDITY, TAX SITUATION, AND OTHER INVESTMENTS. KEEP IN MIND THAT THE PAST PERFORMANCE OF ANY INVESTMENT IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.  YOU SHOULD ONLY COMMIT RISK CAPITAL TO A FUND INVESTMENT.  ALTERNATIVE INVESTMENT PRODUCTS, INCLUDING HEDGE FUNDS, ARE NOT FOR EVERYONE AND ENTAIL RISKS THAT ARE DIFFERENT FROM MORE TRADITIONAL INVESTMENTS.  YOU SHOULD OBTAIN INVESTMENT AND TAX ADVICE FROM YOUR ADVISERS BEFORE DECIDING TO INVEST. CAPITAL MANAGEMENT PARTNERS, INC. (CMP) HAS ENTERED INTO SELLING AGREEMENTS WITH SOME OF THE FUNDS DESCRIBED ON THIS WEBSITE, PURSUANT TO WHICH IT IS PAID FEES BY THE FUND OR ITS MANAGER IN CONNECTION WITH FUND SALES MADE BY CMP. IN ADDITION, CMP MAY ACT AS AN INTRODUCING BROKER FOR INDIVIDUALLY MANAGED FUTURES ACCOUNTS AND TO SOME OF THE FUNDS AND AS SUCH, MAY RECEIVE A PORTION OF THE COMMODITY BROKERAGE COMMISSIONS THEY PAY IN CONNECTION WITH THEIR FUTURES TRADING OR RECEIVE A PORTION OF THE INTEREST INCOME (IF ANY) EARNED ON AN ACCOUNT'S ASSETS.  CERTAIN CTAS MAY ALSO PAY CMP A PORTION OF THE FEES THEY RECEIVE FROM ACCOUNTS INTRODUCED TO THEM BY CMP.  BEFORE SEEKING ANY ADVISOR'S SERVICES OR MAKING AN INVESTMENT IN A FUND, INVESTORS MUST READ AND EXAMINE THOROUGHLY THE RESPECTIVE DISCLOSURE DOCUMENT OR OFFERING MEMORANDUM. 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