Lintner Revisited: The Benefits of Managed Futures 25 Years Later
- Ryan Abrams
Investment Analyst
AlphaMetrix Alternative
Investment Advisors, LLC
- Ranjan Bhaduri, PhD, CFA, CAIA
Managing Director– Head of Research
AlphaMetrix Alternative Investment Advisors, LLC
- Elizabeth Flores, CAIA
Director– Interest Rate Products
CME Group
Introduction
In this paper we attempt to update
Professor Lintner’s work by demonstrating
that the beneficial correlative properties
of managed futures presented in his
research persist today
Dr. John Lintner, a Harvard Professor, presented the seminal paper
entitled “The Potential Role of Managed Commodity – Financial
Futures Accounts (and/or Funds) in Portfolios of Stocks and Bonds”
at the annual conference of the Financial Analysts Federation
in Toronto in May 1983. The findings of his work, namely that
portfolios of equities and fixed income exhibit substantially less
variance at every possible level of expected return when combined
with managed futures, remain as true as ever more than 25 years
later. In this brief paper, we attempt to update Professor Lintner’s
work by demonstrating that the beneficial correlative properties
of managed futures presented in his research persist today. We
also reintroduce managed futures as a diverse collection of liquid,
transparent hedge fund strategies that tend to perform well in
environments that are often difficult for traditional and other
alternative investments.
While many casual observers most closely associate managed
futures and Commodity Trading Advisors with trend following,
the reality is that the strategies and approaches within managed
futures vary tremendously, and that the one common unifying
theme is that these managers trade highly liquid, exchange-traded
instruments and deep foreign exchange markets. As a result, the
terms many fund managers choose to implement, including lockups, gates, side pockets, and penalties for early redemptions, rarely
apply to investments in managed futures.
Liquidity and transparency also simplify risk management, and
investing via separately managed accounts, a common practice
among managed futures investors, mitigates the risk of fraud since
investors retain custody of assets.
Trend following has demonstrated performance persistence
over the more than 30 years since the first “turtle” strategies
began trading, and many of the largest and best known CTAs
employ variations of diversified trend following systems. These
strategies should play a role in all well-diversified institutional
portfolios, but they account for only one of many varieties of
managed futures strategies, the vast majority of which exhibit no
statistical relationship whatsoever with trend following programs.
Counter-trend strategies attempt to capitalize on the often rapid
and dramatic reversals that take place at the end of trends. Some
quantitative traders employ econometric analysis of fundamental
factors to develop trading systems. Others use advanced
quantitative techniques such as signal processing, neural networks,
genetic algorithms, and other methods borrowed and applied from
the sciences.
Recent advances in computing power and technology as well as
the increased availability of data have resulted in the proliferation
of short-term trading strategies. These employ statistical pattern
recognition, market psychology and other techniques designed
to exploit persistent biases in high frequency data. The countless
combinations and permutations of portfolio holdings that these
trading managers may hold over a limited period of time also tend
to result in returns that are not correlated to any other investment,
including other short-term traders.
The countless combinations and permutations of the portfolio
holdings of these managers over a limited period of time also
tend to result in returns that are not correlated to any other
investment.
A useful analogy for different managed
futures trading programs and styles, as well
as for alternative investments in general,
consists of thinking of each trading style
or program as different radio receivers,
each of which tunes into different market
frequencies. Simply put, some strategies or
styles tend to perform better or “tune in” to
different market environments. The diverse
and uncorrelated investments offered by
managed futures allow institutional investors
to access an entire universe of liquid
transparent hedge fund strategies to add to
their portfolios.
Exhibit 1
Distribution of Pair-Wise Correlations Among Constituents in
the AlternativeEdge Short-Term Traders index, January 2003 – October 2008.
Exhibit 2
Correlation Matrix of Traditional and Alternative investment Benchmarks
Sources: AlphaMetrix Alternative investment Advisors, Bloomberg, LPX GmbH. All statistics calculated to maximize number of observations, as such number of observations used for calculations varies
(BTOP 50 - Jan 1987, S&P 500 - Jan 1980, MSCI World - Jan 1988, Lehman Bond Composite US index - Sep 1997, Lehman Bond Composite Global index - Feb 1980, GSCI Tr - Jan 1980, dJ AiG Commodity
index - Feb 1991, HFr Fund Weighted index - 1990, HFr Equity Hedge index - Jan 1990, LPX Buyout index - Jan 1998, S&P/Citigroup World REIT TR index - Jan 1990). All statistics calculated through Sep
2008 with the exception of the Lehman Bond indices, which are calculated through Aug 2008. The AlternativeEdge STTI begins in January 2003 and assumes equal weightings to 23 short-term traders,
the constituents, defined as futures traders with an average holding period of less than 10 days. The constituents’ returns are actual, but the index returns are proforma. in instances where the track
record for a program or programs had not yet commenced, its weighting is divided on a pro-rata basis among all other constituents.
The long-term correlations among equities,
fixed income and managed futures remain low even 25 years after Lintner’s study, suggesting its continuing relevance to investors
interested in attaining the “free” benefits of diversification. Exhibit 2 illustrates the low and occasionally negative correlations among
managed futures and other investments.
Studying the potential role of managed futures in traditional
portfolios of stocks with the Omega lens for risk-adjusted
performance takes a modern approach to the Lintner study.
Lintner did not have the benefit of the Omega tool during the time
he conducted his work, and the Omega function encodes all the
higher statistical moments and distinguishes between upside and
downside volatility, whereas the Sharpe ratio does not.
Exhibit 3
Correlation Matrix of Traditional and Alternative investment Benchmarks
Source: AlphaMetrix Alternative Investment Advisors. Bloomberg data. Note that the Lehman Bond Composite Global Index cease reporting
after August 2008 and therefore return information does not exist for September 2008.
Exhibit 3 indicates that for low thresholds, the combination of
managed futures and a traditional portfolio is best, and for higher
thresholds a portfolio of managed futures is dominant. Moreover, a
traditional portfolio of stocks and bonds combined with managed
futures is superior at every meaningful threshold (i.e., where any
of the graphs have an Omega score of at least 1.0).
These Omega results yield a very compelling argument for the
inclusion of managed futures in an institutional portfolio. For a
review of Omega graphical analysis, please refer to [Bhaduri &
Kaneshige, 2005].
Managed futures are not and should not be viewed as a portfolio
hedge, but rather as a source of liquid transparent return that
is typically not correlated to traditional or other alternative
investments.
Although managed futures has often produced outstanding
returns during dislocation and crisis events, it must be
emphasized that managed futures are not and should not be
viewed as a portfolio hedge, but rather as a source of liquid
transparent return that is typically not correlated to traditional or
other alternative investments. Some of the different approaches
taken by managed futures managers tend to exploit the sustained
capital flows across asset classes that typically take place as
markets move back into equilibrium after prolonged imbalances.
Others thrive on the volatility and choppy price action which
tend to accompany these flows. Others still do not exhibit
sensitivity to highly volatile market environments and appear
to generate returns independent of the prevailing economic or
volatility regime. Exhibits 4 – 7 illustrate the performance of the
BTOP 50 Index during periods that have historically been difficult
for both the S&P 500 Index and most hedge fund strategies.
Exhibit 4:
BToP 50 vs. S&P 500 during S&P 500’s Worst Five drawdowns Since 1987
Exhibit 5:
Performance of the BTOP 50 Index during 15 Worst Quarters of S&P 500 index Performance
Exhibit 6:
BTOP 50 vs. HFRI Fund Weighted Index During HFRI Fund Weighted Index's Worst Five drawdowns Since 1990
Exhibit 7:
Performance of the BTOP 50 Index During Worst Ten Quarters of HFRI Fund Weighted Index Performance
Conclusion
Managed futures present very real risks for investors just like
any other hedge fund style. Investors can potentially experience
volatility and substantial drawdowns, especially if the trading
manager has set a higher return objective and is taking more risk
to try to obtain it. Investors should always conduct thorough due
diligence to properly understand the potential risks and weaknesses
of trading programs before investing. This is especially important
because the trading methodologies employed by CTAs, the level of
risk and return that is targeted, and the quality of the operational
infrastructure of trading managers may vary tremendously across
the space. As such, it is critical that the investor takes the time
to properly understand the nuances of the trading manager’s
investment strategy, risk management, as well as the domain of
instruments traded and potential concentration risks. The investor
should also be acutely aware of operational risks and should make
every effort to understand the relationship between the trading
manager, associated entities, patterns in personnel turnover,
trade execution and order flow, and compliance and operational
policies and procedures. The investor should also take care to
read and understand any disclosure documents, prospectuses,
and offering memoranda prior to investing in a manager’s fund
in order to understand additional risks and relevant disclosures.
It is also important to make sure that proper governance and
separation of duties exists within the trading manager as well as
among the trading manager, its fund, and service providers. Only
by conducting proper due diligence and vetting of the trading
methodology and manager’s credentials can the investor determine
the suitability and potential risks of the investment.
Managed futures offer institutional investors actively managed
exposure to a truly global and diversified array of liquid,
transparent instruments. The returns of many managed futures
funds do not display correlation to traditional or alternative
investments, nor to one another. Institutional investors should
view managed futures not only as a means to enhance portfolio
diversification, but also as liquid absolute return vehicles with
intuitive risk management.
Sadly, Litner died shortly after presenting his treatise on the role
of managed futures in institutional portfolios. It is remarkable
just how solid his argument has remained over the past 25 years.
The inclusion of managed futures in an institutional portfolio
leads to a better risk-adjusted performance (either through the
mean-variance framework, or through the more modern Omega
analysis). The results are so compelling that the board of any
institution, along with the portfolio manager, should be forced to
articulate in writing their justification in not having a substantial
allocation to the liquid alpha space of managed futures.
It is also fitting that during the silver anniversary of Dr. Lintner’s
fine work, it survived the ultimate litmus test through the historic
financial meltdown of 2008. Managed futures have been one of
the very few bright spots for investments (both alternative and
traditional) during this recent crisis in the economy.
Indeed, one might argue that Dr. Lintner saved his very best work
for last.
The results are so compelling that the board of any institution, along with the portfolio manager, should be forced to articulate in writing
their justification in not having a substantial allocation to the liquid alpha space of managed futures.
Authors & References
To contact the authors:
References:
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Benefits and Pensions Monitor, December 2005.
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Funds.” Alternative Investment Quarterly, Second Quarter, 2008.
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Journal of Alternative Investments, Winter 2007.
- Bhaduri, Ranjan and Niall Whelan. “The Value of Liquidity” Wilmott Magazine, January 2008.
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AlternativeEdge Research Note. Newedge Group, June 9, 2008.
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Hedgeworld’s InsideEdge. November 20, 2007.
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Bonds.” The Handbook of Managed Futures: Performance, Evaluation & Analysis. Ed. Peters, Carl C. and Ben Warwick. McGrawHill Professional, 1996. 99-137.
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* All charts, graphs, statistics, and calculations were generated using data from Bloomberg, the Barclays Capital Alternative
Investment Database, LPX GmbH, and Manager Reported Returns.