October 2007 marked the start of one of the most dramatic declines in the history of the American stock market. Surpassed only by the Great Depression of 1929 and regardless of what you are now being told, we may not have hit bottom yet. This break resulted in a drop in the value of the average stock and bond portfolio of over 40%. Sadly, it seems that investors have learned little in the last 80 years on how to protect themselves during times of economic stress. I place the blame squarely on the shoulders of the “experts” or financial pundits. While you will constantly hear them recommending that investors diversify their stock portfolio, that strategy is nearly worthless in protecting your portfolio. 75% of all stocks move in the same direction as the indexes and in stress condition that percentage jumps to nearly 100%. To be fair financial pundits on TV, publications and brokers at the investment banking firms do recommend alternative investments. That is, investments that have a low correlation to the standard stock and bond portfolio. The problem lies in the alternative investments which are recommended by these pundits. In general, the recommended alternative investments offered for all but the wealthiest investors and institutional investors include only convertible arbitrage, emerging markets, distressed securities, relative value and event driven trading schemes. Unfortunately, these approaches show an increase in correlation during periods when market conditions deteriorate. In other words, they lose their effectiveness at precisely the moment when they need it most. Hedge funds tend to use all these approaches but the average hedge fund lost in excess of 21% last year. Makes you wonder what they were hedging. The single asset class to make any appreciable money last year was managed futures. Managed futures as an asset class actually made an impressive 14% during 2008. This is not surprising. In the 12 worst months on the stock exchange going back to 1987, managed futures have been profitable 11 times. Managed futures on whole have a zero correlation to the standard stock and bond portfolio. Although the performance of managed futures year in and year out has out performed the standard stock portfolio, the real value of this asset class may be in the fact that historically there is a substantial negative correlation to stocks during periods of economic stress. As you can see, historically, Managed Futures has been a wonderful addition to the traditional stock portfolio during times of economic stress. This type of investment gives investors the opportunity to actually lower volatility (risk) in your portfolio as well as increase profitability.
Ok, if managed futures are so successful why is it not more widely recommended by financial pundits and investment banking houses? The answer lies in the high volatility that is common in this type of investment. Commodity futures are highly leveraged. So, inherently, this type of investment takes on more risk but they promise more reward by definition. Although there is significant volatility, it is “good volatility”. Investors that are unduly worried about the volatility of managed futures may be missing the opportunity to reduce overall risk in their investment portfolio. This may seem counterintuitive until you study how these programs work. Over 70% of managed money is trend following in nature. Because of the leverage they try to capture outsized returns. Central to this approach is to “cut loses short and let profits run.” By their very nature they tend to produce more big winners than big losers. In our study of volatility in managed futures we need to look at the distribution of monthly returns. We rapidly see that the returns have a more positive skew than the classic normal distribution. In other words, managed futures tend to produce a larger than expected number of extreme returns, and the extreme returns are more likely to be positive than negative. With all the “good” volatility in managed futures, the simple volatility measure greatly exaggerates risk of loss.
The low correlation and high levels of “good volatility characteristic of managed futures allow for a major impact on the standard sock and bond portfolio with only a modest allocation. Historically, 40% stocks, 40% bonds and 20 % managed futures would have generated higher yields, less down side volatility and a substantially higher Sharpe Ratio compared to the traditional stock and bond portfolio from 1987 to present.
Finally, in today's volatile global economy I feel that it is important that you further diversify your invest portfolio by putting some of your capital in something other than the U.S Dollar. Because it is difficult to tell which currency is going to do well going forward, I would suggest putting some of your funds in Gold. This is very easy to do for a commodities based investment such as I have outlined above. Simply go long the Comex Gold. Wait until the contract matures and take delivery. It is a 100 ounce contract so you will be charged about $98,000 at today's price level. Your gold will be placed in an insured bank depository. You will receive weekly updates on the value of your gold. It is extremely liquid and will only cost you a $50 commission to sell it. The really great part is that most clearing firms will allow you use up to 80% of the value of the Gold for margin on futures trades.
Good luck and good trading,
An investment in futures contracts is speculative, involves a high degree of risk and is suitable only for persons who can assume the risk of loss in excess of their margin deposits. You should carefully consider whether futures trading is appropriate for you in light of your investment experience, trading objectives, financial resources, and other relevant circumstances. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.