Tuesday, September 28, 2010

Melin, High-Performance Managed Futures

Mark H. Melin’s High-Performance Managed Futures: The New Way to Diversity Your Portfolio (Wiley, 2010) goes far beyond the standard asset allocation book. It not only makes the case for managed futures but does so from the perspective of risk. It is thorough and well documented, yet at the same time eminently practical. Both high net worth individual investors and financial advisors could profit from it.

The most compelling reason to invest in managed futures is that they are not correlated to the equity market. For instance, managed futures had positive returns in nine of the past ten stock market declines. One caveat: these returns are based on the performance of indexes such as the Barclay CTA index and the CASAM CISDM index in which no one can invest. Instead, the investor’s return depends on the performance of individual commodity trading advisors (CTAs) who pursue a variety of strategies. There is no generic CTA, just as there is no generic hedge fund.

Investors often think that they can mimic managed futures with ETFs. They have access to a broad spectrum of commodity ETFs, from agriculture to metals to energy. Although Melin doesn’t take on ETFs directly, he nonetheless defends his turf, explaining that managed futures generally show little correlation not only to stocks or hedge funds but “even the markets in which the CTAs trade.” (p. 148) CTAs can spread trade with different delivery months or slightly different products (such as feeder cattle and live cattle), they can hedge commodity futures with single stock futures, and they can pursue various option strategies.

Since non-correlation is the key selling point of managed futures, Melin spends some time discussing proper correlation analysis. The traditional price correlation matrix, he contends, is faulty. As it relates to managed futures, “price correlation does not consider the CTA strategy or markets traded, which can be critical points of correlation in managed futures that are often not visible in traditional returns correlation.” As an example he cites the naked S&P option-selling strategy, which before the fall of 2008 had a 0.05 correlation to the S&P 500. It looked “almost perfectly uncorrelated to the S&P but in fact the strategy was correlated and still is correlated to a catastrophic stock market collapse.” (p. 161) Melin maintains that the best correlation methodology includes five key ingredients: returns/price, strategy, market, time frame, and volatility.

What would a well-diversified managed futures portfolio look like? It would include allocations to various strategies—for instance, 30% trend following, 10% countertrend, 20% volatility, 20% discretionary, 20% spread. Melin provides filters for choosing CTAs, starting with an average drawdown recovery time filter.

I’ve just scratched the surface of this compelling book. Readers can also go to a website that has an assortment of data, reports, and academic studies as well as information on how to invest and financial advisor/introducing broker recommendations.

A grammatical footnote: “managed futures” normally takes a singular verb, as in “What is managed futures?". I couldn’t bring myself to follow this convention.

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