Your clients may balk when they hear "futures" - accusing you of straying into a fantasy of an asset class that solves all our problems. Yet finance professionals have used managed futures for decades to boost the performance of stock and bond portfolios. Futures are a rich tool for diversification, offering more than 150 global markets, from grains and gold to currencies. This asset class is uncorrelated to all others, including real estate and private equity, as well as U.S. stocks and bonds, says Robert Lindner of Lindner Capital Advisors in Marietta, Ga.
Many investors diversify further by using more than one trader, each with a distinct approach. Called commodity trading advisors-a name left over from the days when they focused on commodities-their performance varies greatly. But grouped together, commodity trading advisors have a long and healthy record: From January 1980 through November 2010, the Barclay CTA Index had an average annual return of 11.5%, compared with 7.9% for the S&P 500. The correlation? Just 0.01. The CTA Index is also less volatile than stocks.
The idea of using futures to diversify got a boost in 1983 when John Lintner, a professor at Harvard Business School, wrote: "the combined portfolios of stocks (or stocks and bonds) after including judicious investments ... in leveraged managed futures accounts show substantially less risk at every possible level of expected return than portfolios of stocks (or stocks and bonds) alone." He was preparing to report this conclusion at a conference of the Financial Analysts Federation, a predecessor of the CFA Institute, when he died of a heart attack.
"When Lintner did his research, there were 22 commodity trading advisors and he had about 26 months of data. Now we have 2,200 traders and 27 years of data," Lindner says. At the time, Lintner was trading currencies, bonds, metals and pork bellies, and represented 30% of the market himself. Today, computers generate activity based on algorithms, and commodity trading advisors have many more types of futures to trade.
From January 1994 through October 2010, putting 40% of a portfolio in the DJ/Credit Suisse Managed Futures Index would have cut the volatility of a portfolio split between 60% world stocks and 40% global government bonds by about 2.5 percentage points, while boosting the return 1.25 percentage points (see chart).
Advisors can buy managed futures for high-net-worth accredited investors under SEC rules through a structured note from Deutsche Bank or the Equinox Fund from Mutual Hedge, which also offers a family of Frontier Funds for smaller investors. Lindner expects to see a plethora of new managed futures mutual funds by next year.
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