High-Performance Managed Futures Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States With offices in North America, Europe, Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more For a list of available titles, visit our web site at www.WileyFinance.com High-Performance Managed Futures The New Way to Diversify Your Portfolio MARK H MELIN John Wiley & Sons, Inc Copyright C 2010 by Mark H Melin All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the web at www.copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages Designations used by companies to distinguish their products are often claimed as trademarks In all instances where John Wiley & Sons, Inc is aware of a claim, the product names appear in initial capital or all capital letters Readers, however, should contact the appropriate companies for more complete information regarding trademarks and registration For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002 Wiley also publishes its books in a variety of electronic formats Some content that appears in print may not be available in electronic books For more information about Wiley products, visit our web site at www.wiley.com Library of Congress Cataloging-in-Publication Data: Melin, Mark H High-performance managed futures : the new way to diversify your portfolio / Mark H Melin p cm – (Wiley finance series ; 598) Includes index ISBN 978-0-470-63793-7 (cloth); ISBN 978-0-470-88667-0 (ebk); ISBN 978-0-470-88684-7 (ebk); ISBN 978-0-470-88685-4 (ebk) Portfolio management Investments Risk I Title HG4529.5.M45 2010 332.64 52–dc22 2010012326 Printed in the United States of America 10 Contents Preface ix Acknowledgments xiii Disclaimer xv CHAPTER Understand It: The Truth about Risk and Misunderstood Investments What Is This “Managed Futures” I’ve Never Heard About? Stock Market “Safety” and Other Myths Invest with Stock Market Neutral Programs The Stock Market Is Not “Safe” or “Conservative” and Does Not Offer True Diversification It Works in Practice but Does It Work in Theory? Wall Street’s Motivation for Keeping Managed Futures a Secret CHAPTER Define It: Establish Performance and Risk Targets The Simple Managed Futures Definition Target Risk/Reward Profiles CHAPTER Work With It: Build Basic Portfolios Using Targets Portfolio Diversification versus Individual Manager Selection Individual CTA Analysis and Portfolio Considerations 14 16 25 27 28 41 43 52 CHAPTER Realize It: The Old Way versus High Performance 69 The Fastest-Growing Asset Class? This Unique and Very Special Asset Class Managed Futures Defined Decoding the D Doc 69 70 72 85 v vi CONTENTS CHAPTER Don’t Be a Victim: Leverage Managed Futures Regulation and Account Structure to Avoid Hedge Fund Fraud Managed Futures Regulation, Account Structure, and Protection Transparency: The Ability to See and Understand an Investment Auditing Performance and Money Flow Tight Regulatory Control: Meet the NFA and CFTC CHAPTER Recognize It: Volatility + Volatility and Lintner’s Message Volatility Used to Reduce Volatility All Volatility Is Risky To Different Degrees Standard Deviation as Measure of Volatility CHAPTER Use It: Reward-Adjusted Deviation (RAD) Considers Past Probability and Rewards Success Study 1: Exploring RAD with Math The Test of Success Study 2: Average Drawdown: RAD versus STD When Actual Risk Improves Study 3: Where CTAs Fall Based on RAD Risk “Indicators” Don’t Indicate Risk CHAPTER Protect it: Principal-Protected, Conservative, and Risky Investments Don’t Be Fooled Four Steps to Creating Principal-Protected Products Strategies to Maximize Return CHAPTER Use All of It: Overlooked Points of Correlation Is Managed Futures the World’s Most Noncorrelated Asset? Balance Risk and Return: Managed Futures Cushion during Stock Turbulence Correlation Study: Major Indexes Managed Futures Noncorrelation Is Not an Accident 89 90 91 95 98 101 103 103 117 119 120 122 124 127 131 133 134 137 139 147 149 150 152 154 Contents Traditional Returns-Based Correlation Logic Is Faulty Noncorrelation with Stocks Could Be the Investor’s Best Friend CHAPTER 10 Build It: CTA Evaluation and Portfolio Construction Translating Investor Goals into Portfolio Design Strategy What Is the Best Method to Identify Successful CTAs? Portfolio Building with Volatility Skewing High-Performance Managed Futures PortfolioBuilding Exercise Why Investors Must Look Past Simple Average Return Headlines The Hidden Risk in Uneven Returns Distribution Don’t Judge by Looks Alone CHAPTER 11 Understand It: The Naked Truth Behind Managed Futures Risk The Simple Way to Look at Risk Management: Choke Points Leverage Can Magnify Wins as Well as Losses; Just Ask a Banker Exploring Individual Manager Risk Fraud Risk CHAPTER 12 Don’t Sit Back: Active Management of Risky Investments Are the Biggest Risks Those That Are Unknown? A Graphical Look at the Managed Futures Account Individual Manager Risk The Future of Managed Futures can be Found in its History Conclusion vii 160 167 169 171 173 176 178 191 193 194 199 201 203 209 212 217 219 221 228 230 236 Appendix A: HPFM Strategy Benchmark Performance Study 239 Appendix B: Twelve Questions Investors Should Ask of Themselves 242 Appendix C: Selecting a Commodity Trading Advisor 244 Appendix D: Identifying True Risk and Utilizing the Best Managed Futures Performance Measure 253 viii CONTENTS Appendix E: Regulated versus Unregulated Entities 268 Appendix F: Markowitz and Lintner: A “Modern” Investment Method Half a Century Old 271 Notes 281 About the Author 297 Index 299 Preface his book reveals a unique method of investing independent of stocks and the economy—a method that studies have shown has outperformed the stock market for the past 27 years, judging success by the major indexes, their drawdown statistics, recovery time, and total returns The investment method is derived from a Nobel Prize–winning theory that was later revised by a legendary Harvard University professor But what is most amazing is that many investors and even financial professionals are not aware of the asset class, or they misunderstand the investing method T WELCOME TO HIGH-PERFORMANCE MANAGED FUTURES This book is divided into two sections: The fundamental section from Chapters 1–5 contains information that might surprise even the most experienced investor Here performance is discussed—and performance can be both positive and negative The book then reveals managed futures portfolio-building fundamentals, showing how risk targets are established and basic portfolios built After these headlines have been discussed, the book dives into the structure of the asset class and industry regulation, including performance auditing Upon completing Chapter readers should posses a basic understanding of the managed futures asset class, at which point sophisticated investors are encouraged to move to the second section of the book, Chapters 6–12, where unique portfolios are built, traditional academic thought is challenged, and most importantly, risk and risk management are discussed in frank detail, a topic for all investors IT’S NOT FOR EVERYONE Some investors might consider the book’s ideas exciting and cutting edge with significant potential; call this group the optimists Others, the traditionalists, might be less receptive to changing their fundamental belief system ix x PREFACE and will complain and nitpick Still others, call them the intelligent risk managers, might say “there is no free lunch,” as my father always told me Everything is a matter of understanding true risk and reward While realistic optimists are welcome, this book is written for sophisticated, intelligent risk managers This book is appropriate for intelligent, qualified investors who desire higher performance and consider acceptable risk an intelligent concession to appropriate reward, and recognize some risks simply deserve a polite “no thank you.” It is written for investors who use only risk capital to diversify investments with the goal of not becoming entirely dependent on the stock market or the economy at large; for those who understand performance measures are tools that measure past performance and not indicate future results For that matter, they recognize no one has a magical crystal ball or can predict the future; future projections are based on logical thought process and making intelligent connections, but any projection into the future is nothing more than opinion—pure conjecture If this describes you, then read on and discover a truly interesting investing method This book provides insight into what for many is a very different concept: a new world; indeed, the world of High-Performance Managed Futures It will be new for those who live their lives in the confines of a stock-centric world The reason for this starts in the educational system that all but ignores futures and options, with a few exceptions, and mirrors societal values and dictates the source of investing power is centered on the stock market and a little island in New York This book indeed leads a stock-centric world on a journey of discovery A HIGHLY REGULATED INDUSTRY Managed futures is a highly regulated investment The tight industry regulation can be a major benefit to investors, particularly when it comes to audited returns performance and specific intelligent regulations regarding transparency and how client investment capital cannot be directly manipulated by the investment manager under the limited protection of account segregation These investor protections should be used as an international template when considering prevention of hedge fund fraud Communication with potential investors is highly regulated While this book is considered free speech, anyone regulated in this industry is required to provide a reasonably balanced view of risk and reward Facts must be supported by reality and anything deceptive is considered fraud, plain and simple While it may be annoying, in this regulated environment participants are also required to consistently point out that past performance is not 288 NOTES and current cash equity balance To the extent that the equity in your account is at any time less than the nominal account size you should be aware of the following: (1) Although your gains and losses, fees and commissions measured in dollars will be the same, they will be greater when expressed as a percentage of account equity (2) You may receive more frequent and larger margin calls (3) The conversion chart below may be used to convert actual rates of return (RORs) to the corresponding RORs for particular funding levels Rate of Return 100% funded 75% funded 50% funded 25% funded −20% −10% −5% 0% 5% −20% −10% −5% 0% 5% −30% −15% −7.5% 0% 7.5% −40% −20% −10% 0% 10% −80% −40% −20% 0% 20% Additions or withdrawals will materially affect RORs of notionally funded accounts This is because the advisor will continue to trade the account at the agreed trading level without taking into consideration additions or withdrawals, and thus any additions or withdrawals of actual funds will not result in a corresponding proportional increase or decrease in the nominal funding of an account For example, assume that a client opens an account with an actual funding level of $100,000, and instructs the advisor to trade the account at a nominal level of $200,000 If the client withdraws $50,000 of actual funds from the account, the advisor will continue to trade the account at a nominal level of $200,000 Before the withdrawal, the account would be traded at a 50 percent funding level, but after the withdrawal the account would be traded at a 25 percent funding level If the trading program were to experience a −5 percent rate of return, then if that performance occurred before the withdrawal the actual performance would be a −10 percent return but if that performance occurred after the withdrawal the actual performance would be −20 percent Please note that the increased leverage resulting from notional funding may lead to more frequent and larger margin calls in the event of a drawdown in an account Hypothetical Risk Disclosure: This composite performance record listed is hypothetical and these trading advisors have not traded together in the manner shown in the composite Hypothetical performance results have many inherent limitations, some of which are described below No representation is being made that any multiadvisor managed account or pool will or is likely to achieve a composite performance record similar to that shown In fact, there are frequently sharp differences between a hypothetical composite performance record and the actual record subsequently achieved One of the limitations of a hypothetical composite performance record is that decisions relating to the selection of trading advisors and the allocation of assets among those trading advisors were made with the 289 Notes benefit of hindsight based on the historical rates of return of the selected trading advisors Therefore, composite performance records invariably show positive rates of return Another inherent limitation on these results is that the allocation decisions reflected in the performance records were not made under actual market conditions and, therefore, cannot completely account for the impact of financial risk in actual trading Furthermore, the composite performance record may be distorted because the allocation of assets changes from time to time and these adjustments are not reflected in the composite CFTC Risk Disclosure: The risk of trading commodity futures, options, and foreign exchange (forex) is substantial The high degree of leverage associated with commodity futures, options, and forex can work against you as well as for you This high degree of leverage can have the effect of substantially magnifying potential losses as well as gains You should carefully consider whether commodity futures, options, and forex are suitable for you in light of your financial condition If you are unsure you should seek professional advice Past performance does not guarantee future success In some cases managed accounts are charged substantial commissions and advisory fees Those accounts subject to these charges may need to make substantial trading profits just to avoid depletion of their assets Each CTA is required by the Commodity Futures Trading Commission (CFTC) to issue to prospective clients a risk disclosure document outlining these fees, conflicts of interest, and other associated risks Hard copies of these risk disclosure documents are readily available by clicking on each CTA’s “request disclosure document” button The full risk of commodity futures, options, and forex trading cannot be addressed in this risk disclosure statement No consideration to invest should be made without thoroughly reading the disclosure document of each of the CTAs in which you may have an interest Requesting a disclosure document places you under no obligation and each document is provided at no cost The CFTC has not passed on the merits of participating in any of the following programs nor on the adequacy or accuracy of the disclosure documents Other disclosure statements are required to be provided to you before an account may be opened for you Past performance is not necessarily indicative of future results Prospective clients should not base their decision to invest in these trading programs solely on the past performance presented Additionally, in making an investment decision, prospective clients must also rely on their own examination of the person or entity making the trading decisions and the terms of the advisory agreement, including the merits and risks involved CHAPTER Realize It Source: CME Group: Managed Futures, Portfolio Diversification Opportunities Barclay Alternative Asset MAP Database; as of this writing, historical assets under management information can be downloaded without charge www barclayhedge.com/research/indices/cta/mum/CTA Fund Industry.html Source for mutual fund comment: www.investopedia.com/terms/m/managed futuresaccount.asp “What Does Managed Futures Account Mean? An account 290 NOTES that is like a mutual fund, except that positions in government securities, futures contracts, and options on futures contracts are used to manage the portfolio Note that the comparison here is only relative to the concept that investment decisions made by a mutual fund are done through an individual investment manager who is skilled in the markets in which they invest There are obvious significant differences between a stock mutual fund and managed futures, including the markets traded, the risk factors, leverage, margin, and other variables.” Barclay Alternative Asset MAP Database; see Appendix A for details Ibid Ibid CHAPTER Don’t Be a Victim CFTC Regulations require FCMs to maintain separate accounts, funds, and assets to satisfy all of its current obligations to customers trading futures, and options on futures on foreign commodity exchanges FCMs may not commingle set-aside funds with their own or their proprietary or noncustomer funds or accounts www.cftc.gov; www.ccftc.gov/files/tm/tmclearingcorpphase1part 190.pdf; www.nfa.futures.org; www.nfa.futures.org/news/newsComment.asp? ArticleID=334 Penalties can be severe for not adhering to account segregation rules: www futuresmag.com/News/2009/9/Pages/CFTC-sanctions-JP-Morgan-.aspx Based on interviews and e-mails that took place between the author and Patricia Cushing, Director of Compliance at the National Futures Association, and Larry Dyekman, Director of Communications and Education for the National Futures Association, over the summer of 2009 Ibid Ibid NFA President Roth testifies before Congress: http://banking.senate.gov/public/ files/roth.pdf The “wild west road show” comments are those of the author See note CHAPTER Recognize It The 2007 Berkshire Hathaway Annual Meeting Top 20 Questions The full quote was: “The measurement of volatility: it’s nice, it’s mathematical, and wrong Volatility is not risk Those who have written about risk don’t know how to measure risk Past volatility does not measure risk When farm prices crashed, [farm price] volatility went up, but a farm priced at $600 per acre that was formerly $2,000 per acre isn’t riskier because it’s more volatile [Measures like] beta let people who teach finance use the math they’ve learned That’s nonsense Risk comes from not knowing what you’re doing Dexter Shoes was a terrible mistake—I was wrong about the business, but not because shoe prices were volatile If you understand the business you own, you’re not taking risk 291 Notes Volatility is useful for people who want a career in teaching I cannot recall a case where we lost a lot of money due to volatility The whole concept of volatility as a measure of risk has developed in my lifetime and isn’t any use to us.” www.jvbruni.com/Berkshire%202007annualmeeting.pdf Barclay Alternative Asset MAP Database Study identified the CTAs with the highest standard deviation, worst drawdown and longest average recovery time, isolated the 20 highest “worst” CTAs in each category, then averaged the results Barclay Alternative Asset MAP Database, study conducted January 2010 Study identified the CTAs with the highest worst drawdown, isolated the 20 highest, and then averaged the results After this a standard returns-based correlation analysis was conducted and identified the eight most uncorrelated CTAs These CTAs were placed in a portfolio using equal weighting for all CTAs to illustrate a mathematical concept Barclay Alternative Asset MAP Database Study identified the CTAs with the highest standard deviation, isolated the 20 highest, and then averaged the results After this a standard returns-based correlation analysis was conducted and identified the eight most noncorrelated CTAs These CTAs were placed in a portfolio using equal weighting for all CTAs to illustrate a mathematical concept CHAPTER Use It This study is a simple mathematical study and the study and the RAD formula are available in Excel spreadsheet format on the book’s web site This study is not indicative of performance of any asset or investment but rather a mathematical illustration Barclay Alternative Asset MAP Database To accomplish this, a rules-based filtering process was utilized based on the author’s opinions on “credibility.” First, the entire database of CTAs was culled Second, a search eliminated CTAs who possessed a track record less than six years, reported under $20 million under management, compounded annual return of less than 15 percent, and positive up/down deviation ratio of less than 1.5 Barclay Alternative Asset MAP Database To accomplish this, a rules-based filtering process was utilized First, the entire database of CTAs was culled Second, a search eliminated CTAs who possessed a track record less than six years, reported under $20 million under management, compounded annual return greater than 15 percent, and positive up/down deviation ratio greater than 1.5 Note that the establishment of the control group is not as significant as the fact that the risk measures change and how it impacts that control group Barclay Alternative Asset MAP Database To accomplish this, the total results from the study control of 41 CTAs were downloaded into an Excel spreadsheet along with key risk statistics The study then organized this group of 41 by a variety of risk measures, including average drawdown Barclay Alternative Asset MAP Database To accomplish this, the total results from the study control of 41 CTAs were downloaded into an Excel spreadsheet along with key risk statistics 292 NOTES Barclay Alternative Asset MAP Database To accomplish this, the total results from the study control of 41 CTAs were downloaded into an Excel spreadsheet along with key risk statistics Barclay Alternative Asset MAP Database To accomplish this, the total results from the study control of 41 CTAs were downloaded into an Excel spreadsheet along with key risk statistics Barclay Alternative Asset MAP Database To accomplish this, a rules-based filtering process was utilized First, the entire database of CTAs was culled The study then organized this group of 41 by a variety of risk measures, including CTAs in this group with compounded annual returns in excess of 30 percent The study then organized this group of 188 CTAs by a variety of risk measures, in this case based on the top 10 drawdowns This Excel spreadsheet is available on the book’s web site with screen shots of software used in the study Barclay Alternative Asset MAP Database The study then organized this group of 188 CTAs by a variety of risk measures, in this case based on the top 10 drawdowns CHAPTER Protect it: Principal-Protected, Conservative, and Risky Investments These numbers are chosen to illustrate a concept and are not representative of any investment There exist a variety of methods to calculate interest, all dependent on the product For the purpose of illustration, the value of the investment the two components are broken down into separate calculations The Protection VAMI starts with the initial amount, which is multiplied by the interest rate each month This interest rate amount is added to the yearly value This new yearly value is then multiplied by the interest rate to obtain the next year’s VAMI The Excel spreadsheet is available on the book’s web site With principal protection there is no absolute guarantee principal is protected The principal protection concept works best when interest rates are high and the source of protection can generate an appropriate return The interest rates and returns used in this chapter are for mathematical illustration and are not based on any specific investment In fact, the interest rates quoted on a compounded basis are significantly higher than interest rates as of this writing, but the point is to illustrate the protection concept under ideal circumstances This point bears repeating as it is mentioned in the text When the protection amount is used as margin, it is not “protected” because a margin call could reduce the protection amount to an undefined level This point is outlined in the CME publication, “Why Managed Futures?” CMEGroup, 2008, John W Labuszewski, Research and Product Development, available for download on the book’s web site Ibid Ibid 293 Notes CHAPTER Use All of It This statement is based on the author’s opinion that the futures and options derivative contract structure enables spread trades across various time frames and markets and using different futures and options strategies that can easily go long, short, or even neutral to the underlying market movements to a degree More to the point, the core strategies available to managed futures managers, unique to the futures markets, are behind the author’s assertion In this chapter, the strategies are outlined that are often based on unique contract structures available only in futures and option derivative markets To provide examples of a few commodity trading advisor (CTA) strategies that are not necessarily correlated to the up or down price movement of any market, a CTA could buy the July contract and sell the November contract of the same product This strategy is not necessarily dependent on the up or down price movement of the underlying product, but the price differential between the July and November contract, which could be influenced by different factors that would influence the up and down price movement of a market Another example is an option premium collection CTA who sells options on both sides of the market This option strategy can be profitable regardless of market direction to varying degrees depending on the volatility of the market and how far the market moves out of a trading range, not necessarily the direction in which the market moves This contract structure is unique to futures and options and thus drives the lack of correlation, in the author’s opinion Managed Futures: Portfolio Diversification Opportunities, Chicago Mercantile Exchange (September 2008) An interesting story, some might consider it an urban legend, about the movie “Trading Places” and Richard Dennis is located on the book’s web site Richard Dennis is a turtle trader who some credit as popularizing trend trading See Michael Covel, The Complete Turtle Trader: The Legend, the Lessons and the Results (New York: HarperBusiness, October 2007) The source of information on this CTA was the Barclay MAP database This is entirely a hypothetical example and is not based on any actual CTA trades or strategy but an illustration based on the author’s conceptual knowledge of various CTA strategies The shorter the track record, the less applicable the correlation analysis Barclay Alternative MAP Database, using all-period correlation and started from the point of the shortest index track record, October 2006, until September 2009 Updated results are on the book’s web site along with screen shots of the study methodology The shorter the track record, the less applicable the correlation analysis CHAPTER 10 Build It Hypothetical Risk Disclosure: This composite performance record listed is hypothetical and these trading advisors have not traded together in the manner shown 294 NOTES in the composite Hypothetical performance results have many inherent limitations, some of which are described below No representation is being made that any multiadvisor-managed account or pool will or is likely to achieve a composite performance record similar to that shown In fact, there are frequently sharp differences between a hypothetical composite performance record and the actual record subsequently achieved One of the limitations of a hypothetical composite performance record is that decisions relating to the selection of trading advisors and the allocation of assets among those trading advisors were made with the benefit of hindsight based on the historical rates of return of the selected trading advisors Therefore, composite performance records invariably show positive rates of return Another inherent limitation of these results is that the allocation decisions reflected in the performance records were not made under actualmarket conditions and, therefore, cannot completely account for the impact of financial risk in actual trading Furthermore, the composite performance record may be distorted because the allocation of assets changes from time to time and these adjustments are not reflected in the composite Investing in a CTA on a drawdown is a sophisticated method for qualified investors and is a risky, highly speculative investment strategy and as outlined in the book there is no guarantee at which point an investor could exit a program or that a margin call will stop losses This is not recommended for all CTAs and only risk capital should be used The concept was addressed in the book Managed Trading: Myths and Truths by Jack D Schwager (New York: John Wiley & Sons, 1996) and was also studied in the Attain Managed Futures Newsletter dated April 26, 2010 in the article “Should You Buy, Hold, or Fold a Drawdown in Managed Futures?” Both studies are well researched, in the author’s opinion On the book’s web site we also offer a professional download of the white paper study on the topic CHAPTER 11 Understand It Study conducted with BarclayHedge over the summer of 2009 BarclayHedge sent one e-mail to all those reporting to the managed futures index This yielded responses from 75 CTAs who answered several questions, including the question: How many times has your CTA strategy received a margin call where fully funded customers were required to deposit additional funds? There were six total questions asked, each of which confirmed the basic findings The reporting of this information was entirely voluntary and participation was a smaller percentage of the overall universe of CTAs This information and the accuracy of the information provided was not confirmed by the book, the author or BarclayHedge This study is limited in scope and should not be construed as a definitive study on the matter, but rather it highlights a study topic that should receive more academic attention There is significant risk of loss when investing in managed futures and no attempt is being made to diminish the potential for a CTA to experience a margin call Complete screen shots from the study are available on the book’s web site This study should not be used or construed in any manner that would Notes 295 diminish the risk potential in managed futures Past performance is not indicative of future results “Why Managed Futures?” CMEGroup, 2008, John W Labuszewski, Research and Product Development On p 11, first column, the official expresses the opinion that a managed futures investment falling to zero might be considered an “unlikely probability.” The entire sentence is as follows: “If, for example, the managed futures investment declines to zero (an unlikely probability), the underfunded guarantee portion will advance to a level which falls short of 100 percent of par.” Past performance is not indicative of future results There is significant risk of loss in managed futures and margin calls can and happen regardless of past behavior High-Performance Managed Futures: The New Way to Diversify Your Portfolio by Mark H Melin Copyright © 2010 Mark H Melin About the Author ark H Melin has written/edited three books, including the industrystandard textbook The Chicago Board of Trade’s Handbook of Futures and Options (McGraw-Hill, 2006) Melin has worked extensively in the futures and options industry as a consultant for organizations such as the Chicago Board of Trade and OneChicago, the single stock futures exchange, as well as several futures commission merchants (FCMs) and broker-dealers (BDs) He is currently a division director at one of the largest non-clearing FCMs, where he works with financial professionals and qualified investors to integrate managed futures into investment portfolios Melin’s interests include educating investors and financial professionals on an amazing asset class that can no longer be ignored as well as surfing, skiing, ice boating, hockey, and mountain biking, all of which are almost as invigorating as managed futures For more information visit www.wiley.com/go/managedfutures M 297 High-Performance Managed Futures: The New Way to Diversify Your Portfolio by Mark H Melin Copyright © 2010 Mark H Melin Index Account cash balance (ACB), 220 Account structure decisions CPO/fund of funds, 83–84 direct account diversified portfolio, 84 mutual fund or ETF, 84–85 regulation and protection, 90 single CTA, 83 Active portfolio management, yellow/red flags in, 229–230 Advisor background disclosure, 77, 86 Aggressive managed futures program, 37–39, 64–65 investing after drawdown, 39 investment minimums, 43–44 performance targets for, 42 problems issues with, 38–39 Aggressive returns, 26 Agricultural traders and markets, 157–159 AIG, 134 Alpha, 10 Arbitrage trading, 80 Asset under management (AUM), 261–262 Audit reports, 96 Auditing and money flow, 95–97, 213 Average drawdown, 260–261 Average drawdown recovery time, 259–262 Balanced portfolio, Balarie, Emanuel, Barclay Alternative Database, 42 Barclay CTA index, 19, 165 Benchmarks, 173, 239–241 Beta, 10–11 Black swan event, 55, 82 Blue chip investments, 218 Brinson, Gary, 11 Broker-dealers (BDs), 17 Brokerage arrangements, 86–87 Brorsen, B Wade, 13 Buffett, Warren, 103 Buy and hold strategy, 4, 17, 217 Calmar ratio, 265 Catastrophic market risk strategies, 163–164 Certification method, 14 Chicago Mercantile Exchange (CME), 1, 11, 150 CME Portfolio Diversification Opportunities, 277 Commission, 87 Commodities, 6, 74–75 Commodities for Every Portfolio (Balarie), Commodity brokers, 77–78 Commodity Exchange Act, 93 Commodity fund operator, 77 Commodity Futures Trading Commission (CFTC), 92, 98–100, 212, 268 Commodity pool operator (CPO), 27, 42, 83–84, 136, 144 Commodity trading advisor (CTA), 5, 13–14, 19, 25, 74–75 See also Individual CTA analysis analysis of factors for, 49–52 chasing performance, 251 commodity broker vs., 77–78 hidden risk, 64–66 individual CTA analysis, 52–55, 254–255 investing after a drawdown, 39 investing client capital, 80–93 leverage adjustment, 49–51 market timing, 251–252 methods to identify successful, 173–176 oversight of, 92–95 portfolio diversification and “miracle on ice effect,” 51 recovery time, 51 risk-focused criteria, 246–247 selection of, 244–252 299 300 Commodity trading advisor (CTA) (Continued ) short-term results and hidden information, 248–250 trend trader, 52–55 understanding strategies, 245–246 volatility diversification, 52 “CTA Sustainability Study,” 169–171, 173–174 Compounded annual return, 255–256 Conflicts of interest, 86–87 Conservative managed futures program, 29–32 investment minimums, 43–44 moderate-conservative mix, 44–46 performance targets of, 42 volatility and, 32 Conservative returns, 26 Correlation, 71, 147–149 correlation planning, 159 major indexes study, 152–154 market traded correlation, 165–167 price correlation, 161–163 returns-based correlation as faulty, 160–167 stocks, bonds, and managed futures, 151 strategy correlation, 164–165 time frame correlation, 167 volatility correlation, 167 Correlation matrix, 151–152 Counter trend strategy, 60–62 Cushing, Patricia, 96 Dennis, Richard, 155 Derivatives, 233–234 Direct account diversified portfolio, 84 Direct CTA investments, 27 Direct managed futures account, transparency of, 90–95 Directional strategy, 58 Disclosure document (D Doc), 85–87 advisor background, 86 brokerage arrangements, 86–87 conflicts of interest, 86–87 fee structure, 86–87 opening pages, 86 past performance, 87 principal risk factors, 86 INDEX signature documents, 87–88 trading strategy, 86 “Disclosure Documents: a Guide for CTAs and CPOs,” 86 Discretionary volatility trader, 58–60 Diversification, 11–13 asset diversification, 4, 237 as investment goal, managed futures and, 11–13, 18–19 risk and, 5, 103, 273–274 stock diversification, 10–11 systematic risk and, 10 volatility diversification, 52, 103 Downside deviation, 264 Drawdown(s), 39–41, 106–108 buying on drawdown, 39, 195–197 worst drawdowns, 108–112 Drawdown recovery time, 8–9, 117 as investment factor, 51 Due diligence, 170, 188–191 correlation, 190 past risk measures, 189–190 probability, 190 returns, 190–191 Dyekman, Larry, 97, 100 Exchange-traded fund (ETF), 84–85 Fee structure, 86–87 Fees and performance reporting, 97–98 Fidelity Investments, 71 Filtering process, 177 Financial Industry Regulatory Authority (FINRA), 98 FINRA Ten Tips for 2010, Force of probability, 266–267 Foreign government bonds, 138 Fraud risk, 200, 202, 212–214 Friedman, Milton, 272 Fund of funds, 83–84 Future delivery, 73 Futures commission merchant (FCM), 77, 83, 92–94, 206, 269 Futures contracts, 75, 79 Futures market, 79 Goldman Sachs, 138 Government regulation, 90, 231–233 Gregoriou, Greg, 13 Guarantee/guarantor, 138–139 Index Hedge account, 228–229 Hedge funds fraud schemes, 89, 93 long/short funds, 156 risk and, Hedging strategy, 79 High-performance managed futures (HPMF) index, 188–189 High-performance managed futures (HPMF) portfolio-building exercise, 178–191 benchmarks, 188 diversification goals, 179 drawdown recovery time filter, 183 due diligence, 188–191 investing on drawdown, 179 money under management, 181–183 past probability/positive performance variance filter, 185–187 portfolio structure, 179 return filters, 187–188 risk, probability, and returns, 183 track record, 180–181 universal filtering, 179–180 High-Performance Managed Futures (HPMF) web site, 14, 16, 22–23 Illiquidity, 137–138 Incentive fee, 87, 97 Individual CTA analysis, 52–55 counter trend, 60–62 discretionary vol trader, 58–60 experience, strategy, risk management, 52–55 leverage usage, 57–58 positive win/loss size ratio, 54–55 win strategy and strategy, 55–57 Individual manager risk, 200, 202, 209–212, 228–230 Introducing broker (IB), 77, 83, 94, 269 Investment indexes performance, worst drawdowns, Investment minimums, 137 Investors risk self-questionnaire, 5, 242–243 Johnson, Ned, 71 Length of track record, 257 Leverage, 203–204 Leverage adjustment, 49, 57–58 Leverage risk, 219 301 Lintner, John, 3, 6, 11, 15, 102–104, 117, 276–280 Liquidation value (LV), 220 Liquidity, 95 Lockup periods, 95, 137–138 Loeb, Gerald, 83, 276–277 Long/short hedge funds, 156 Madoff Ponzi scheme, 89–91, 93, 98, 202 Managed futures See also High-performance managed futures (HPMF) portfolio-building exercise 2009 “Waterloo” performance, 19–20 agricultural traders and markets, 157–159 characteristics of, 1–3, 70–72, 236–237 definition, 27–28, 72–74 diversification and, 11–13, 18–19, 43 as fastest-growing asset class, 69–70 as noncorrelated major asset class, 1, 3, 11, 148–150, 154–157, 167, 237 as paradigm shift in investing, 21–22 performance comparison (1980–2008), risk and, 3, 6, 11, 13 safe harbor effect of, 168 successful portfolios, characteristics of, 169–171 target for returns, 26, 41–42 technical definition, 73–74 three-way oversight of, 92–95 timing of investment, 195–197 trend-following strategy, 20–21 volatility/returns/drawdown insight, 39–41 Wall Street’s views on, 16–19 Managed futures account, 220–221 graphical look at, 221–228 investment minimums, 43 margin-to-equity management, 225 margin usage, 225–227 profit analysis, 222 profit/loss momentum, 223–224 share of profit/loss, 222–223 strategy diversification, 224–225 Managed futures indexes, 12 differences in indexes, 13–14 Managed futures industry needs of, 230–231 regulation of, 90, 231–234 Managed futures risk, 199–200 CTAs strategy and, 201 risk of, empirical studies of, 13 302 Managed futures risk (Continued ) fraud risk, 200, 202, 212–214 individual manager risk, 200, 202, 209–212 margin and leverage risk, 200, 202–209 planning for, 214–215 worst-case scenario, 214 Managed Futures Strategy Benchmark Performance Study, 239–241 Managed Trading: Myths and Truths (Schwager), 39, 196 Management fees, 87, 97 Manager of mangers, 77 Margin, 143–145, 204–205, 219 Margin calls, 57, 204–205 Margin interest income, 78 Margin levels, 206 Margin and leverage risk, 200, 202–209 Margin-to-equity ratio, 207–209, 225 Margin usage, 225 Market-neutral managed futures, Market risk, strategies for, 163–164 Market traded correlation, 165–167 Market value (MV), 220 Markowitz, Harry and Modern Portfolio Theory (MPT), 6, 9–10, 15, 102, 119, 271–277 Merrill, Charles, 71 Merrill Lynch, 71 Moderate managed futures program, 33–35 diversification options, 46–49 hypothetical results of, 46 investment minimums, 43–44 performance targets for, 42 Moderate returns, 26 Modern Portfolio Theory, (MPT), 6, 9–10, 15, 102, 119, 271–277 Morningstar, 5, 22 Mutual fund, 71, 84–85 National Futures Association (NFA), 5, 39, 54, 68, 70, 78, 85–86, 92, 98–100, 206, 213, 268 Negative returns, 7–8, 120, 131 Noncorrelated asset class, 1, 3, 11, 148–150, 154–157, 167, 237 Notional funding, 58, 204 O’Donnell, Tom, 15–16, 23 Options/market neutral, 81 INDEX Papagiannis, Nadia, 5, 22 Performance auditing, 95–97 audit reports, 96–97 disclosure documents, 87 fees and, 97–98 frequency of, 96 validity of returns, 96 Performance-risk measures, 255–259 asset under management (AUM), 261–262 average drawdown, 260–261 average drawdown recovery time, 259–260 Calmar ratio, 265 compounded annual return, 255–256 downside deviation, 264 length of track record, 257 returns distribution, 264 Sharpe ratio, 258 Sortino ratio, 262–263 standard deviation of returns, 256–257 Sterling ratio, 265 upside/downside deviation, 263–264 worst drawdown, 256–257 Peters, Carl, 277 Ponzi scheme, 89, 202 Portfolio design strategy See also High-performance managed futures portfolio-building exercise asset allocation, 172 diversification, 176–177 establishing goals, 172–173 flexible systems, 177–178 investor goals and, 171–173 risk tolerances, 172 risk/reward profile, 172 specific objectives/correlation needs, 172 stated objectives, 171 time frame/access to capital, 172 volatility skewing and, 176–178 Portfolio developer bias, 60 Portfolio diversification individual manager selection vs., 43–52 Lintner’s work on, 277–279 “miracle on ice effect,” 51 multimanager vs top-returning CTA, 43–44 risk management and, 44 volatility diversification, 52 Portfolio manager bias, 197–198 Price correlation, 161–163 Index Principal-protected note, 137 Principal-protection product, 133–134 amount of protection, 139–140 50 percent of protection used as margin, 143–145 guarantor for, 138–139 high-risk assets and, 140 how it works, 135–136 investment minimums, 137 largest factor impacting returns, 140–142 lockup period and illiquidity, 137–138 perception and math of, 134–135 returns generator, 136 source/term of protection, 135–136, 140 steps to creating, 137–139 strategies to maximize return, 139–145 Probability of success/size of win, 265 Proprietary track record, 60 Recovery time, 51 REFCO bankruptcy, 94 Registered Investment Advisors (RIAs), 83 Registered securities broker, 84 Regulated vs unregulated entities, 268–269 Regulatory control, 98–100 Returns-based correlation analysis, 148 faulty logic of, 160–167 Returns distribution, 264 Reward-adjusted deviation (RAD), 119–120 average drawdown, 124–127 CTAs risk/reward analysis, 127–130 downside/upside deviations, 121 mathematical demonstration of, 120–122 negative return as ultimate risk, 131 standard deviation vs., 123–124 test of success, 122–124 as widened performance measure, 130–131 Risk See also Managed futures risk; Reward-adjusted deviation (RAD) account structure decisions, 83–85 diversification and, 5, 103, 273–274 hidden risk, 64–66 investment portfolio and, myths of, 3–4 negative return performance, 131 stock market and, 3–4 uneven returns distribution, 193–194 Risk benchmarks, 173 Risk disclosure, 26, 86, 105 303 Risk management margin and leverage, 209 margin-to-equity ratio, 207–209 planning and, 214–215 worst-case scenario, 214 Risk quadrants, 274 Risk-reward tradeoff, 6, force of probability, 266–267 investor’s goals for, 26 investors self-questionnaire, 242–243 managed futures and stock turbulence, 150–152 probabilitly of success/size of win, 265 size of win/loss, 266 win/loss percentage, 266 Risky assets, principal-protection product, 133 Roth, Daniel J., 99 Rouah, Fabrice, 13 Safe harbor effect, 168 Schneeweis, Thomas, 13 Schwab, Charles, 71 Schwager, Jack, 39, 195 Securities and Exchange Commission (SEC), 98 Segregated account, 93–94, 212 limited protection of, 92–95 Sharpe, William, 10–11, 15–16, 35 Sharpe ratio, 35, 66, 118, 173, 258 definition of, 36–37 Short volatility programs, 175–176 Signature documents, 87–88 Single CTA, 83 Size of win/loss, 266 Sortino ratio, 126, 131, 262–263 Spread (arbitrage) trading, 80–81 Spurgin, Richard, 13 Standard deviation, 101, 103, 256–257 reward-adjusted deviation (RAD), 123–124 as risk measure, 9–10, 120 Statistical risk measures, 178 Sterling ratio, 265 Stock diversification, 10–11 Stock market correlations of, 71, 150 managed futures and, 150–152 noncorrelated assets and, 167 risk and, 6, 234–235 304 Stock market neutral programs, 5–6 Strategy correlation, 164–165 Strategy drift, 225 Structured notes, 133 Survivorship bias, 14 Systematic risk, 10–11 Systemic market risk, 160 Target risk/reward profiles, 28–41 aggressive programs, 37–39 conservative programs, 29–33 moderate programs, 33–35 Time frame correlation, 167 Townsend, John, 13 Trading, gambling, or investing, 76 Trading strategy, disclosure documents, 86 Trading system, 77–78 Transactional commission, 78 Transparency, 90–95, 213, 231–232 Trend following strategy, 20, 159, 174–175 Trend trader/trading, 52–55, 62–64, 82–83, 155, 174–175 U.S government-back debt, 138–139 Unsystematic risk, 10 Upside/downside deviation, 263–264 INDEX Volatility, 5, 101, 133 “bad” volatility, 118 conservative managed futures investments and, 32 drawdown and, 106–108 Lintner’s work, 104 managed futures, 39–41 positive/negative returns and, 102 riskiness of, 103–104 standard deviation, 117–118 to reduce volatility, 103 worst drawdown, 108–112 Volatility correlation, 167 Volatility diversification, 52 Volatility skewing, 176 Volatility tolerance, 101 Waksman, Sol, 14 Warwick, Ben, 271 Win percentage, 174 Win/loss percentage, 266 Worst drawdown, 256–257 Written documents, 213 Zero-sum game, 74 ... understand the risk issues or is generally uncomfortable with the investment they should not invest in managed futures E xv High-Performance Managed Futures: The New Way to Diversify Your Portfolio. .. the managed futures index is added to the stock and bond portfolio While the returns when adding managed futures are higher, the significant benefit comes with lowered portfolio volatility in the. .. feet 16 HIGH-PERFORMANCE MANAGED FUTURES wet in managed futures, they started to feed the data into their computerized asset allocation models And here is where they ran into problems The numbers