The 2008 and 2009 global financial crisis left many investors disappointed with the high volatility and negative performance of their portfolios and leading them to re-evaluate the risk reducing ability of asset allocation.
They were surprised to find that many of the historically non-correlated asset classes had become highly correlated during the crisis, rendering asset allocation less effective at diversifying returns and lowering risk. As such, it is no coincidence that many investors are now implementing hedging strategies (such as short futures contracts), in conjunction with their asset allocation strategy, in an effort to better manage portfolio volatility, avoid large losses during substantial market declines, and create a smoother overall investment experience.
As asset managers increasingly focus on risk management, it is imperative that they develop strategies to combat both individual and systemic risks, which can be detrimental to investors' ability to generate wealth and maintain prosperity in retirement.
Historically, the common answer to overcoming portfolio volatility and large portfolio losses has been to stay invested in the market; continue saving and investing in your portfolio across all market conditions; when the market goes down, ride out the storm-eventually growth will return and the damage to a portfolio will be repaired. When the damage is as devastating to portfolios as the most recent crisis, the recovery time may be longer than investors heading toward retirement can afford.
If nothing else that crisis stressed the importance of non-correlated diversification and risk management, two of the primary benefits to including managed futures in an investor's portfolio. Utilizing futures contracts within a hedging strategy provides an inversely correlated asset class that is tailored to perform best during periods of volatility and financial crisis. The equity market has a tendency to fall sharply during periods of high volatility and rise slowly during periods of low volatility, making managed futures important simply for the diversification benefits they offer.
Managed futures traders participate in more than 150 markets around the world that deal in currencies, energy, minerals, and commodities, among others. They also have the ability to realize profits from positive and negative developments in multiple markets at the same time by practicing both long and short trading strategies as conditions dictate.
Now that managed futures are available in a mutual fund wrapper retail investors have access in a highly cost effective manner that maintains liquidity. Previously, hedging strategies using futures were accessed through cumbersome limited partnerships, which required a K-1. The bulk of managed futures funds use multi-managers that have access to, and employ, a number of underlying commodity trading advisors, which creates another layer of fees and could be a potential downside to these types of funds. The high expenses are a factor of the fact that these funds engage in a tremendous amount of trading and there is almost always a market open somewhere in the world. One of the things that expensive trading brings to investors is downside risk management. The investor also must bear the expense of the fund manager, but paying for a manager to manage the allocation and monitor the risk and performance of managers specializing in specific futures can be well worth the incremental cost to reduce risk and to get the diversification benefits.
Below are some additional facts investors should know about futures contracts:
- Are agreements to trade cash back and forth with the exchange at the end of each trading day based on market movements
- Are based on broad market indices, both domestic (S&P 500, Russell 2000, etc) and international (EAFE, MSCI Emerging Markets, FTSE, Nikkei, etc.)
- Have leveraging power of 12 to 1 (i.e. the upfront cash needed to invest in $100 of futures notional contracts is about $8)
- Enable the strategy to operate based upon a small cash position of typically 3% to 5% of portfolio assets
- Have virtually no counterparty risk, as any changes in their values are settled in cash at the end of every day
If investors really want to move the needle in their portfolios, managed futures should be 5% to 10% of the total portfolio. Managed futures will reduce overall volatility because of their non-correlated nature to other holdings within the portfolio. By lowering your portfolio volatility, if you'd like to invest more in a certain sector of the market, managed futures can allow you the confidence to do just that.
As more risk management strategies hit the marketplace, it will be imperative the advisors and investors "look under the hoods" of each method. It is likely that those strategies continuing to manage portfolio volatility via asset allocation will still be exposed to periods of systemic risk, in which asset allocation will be rendered ineffective. Identifying those strategies that address both types of risk are likely to provide a better overall investment result.
Andrew Rogers is Chief Executive Officer of Gemini Fund Services, LLC, which provides comprehensive, pooled investment solutions as an engaged partner to independent advisors.