The Missing Piece of the Portfolio Puzzle

As alternative investments, managed futures values have a low or negative correlation to traditional investments and can fortify portfolios against the kind of market events that we experienced in 2008.

Only recently have managed futures become accessible to individual investors. These assets—investments whose value varies with changes in market indexes, interest rates, currency exchange rates and commodity prices–have long been used by foundations and other institutional investors to diversify traditional portfolios of stocks and bonds.

Now investors who have total portfolios of $500,000 to $5 million can benefit from managed futures. These investments are often viewed as being a bit risky for individual investors, and it’s true that they’re not for the faint of heart.

Unlike many traditional investments, managed futures aren’t suited to long-term, buy-and-hold strategies; they must be closely monitored and managed. But when added to well-diversified portfolios of stocks and bonds and properly managed, they may help to protect individual investors against market declines.

As alternative investments, their values have a low or negative correlation to traditional investments. Accordingly, managed futures can be the missing piece of the puzzle needed to fortify portfolios against the kind of market events that we experienced in 2008.

Managed futures accessible to individual investors had been available only about a year when the stock and bond markets tanked in 2008. Having added managed futures to your portfolios prior to the meltdown could have eased some of your pain. For the calendar year 2008, the Altegris 40 Index, which tracks the performance of 40 managed-futures programs, collectively returned 15.47%. Of course, low or negative correlation is a double-edged sword; this index was at minus 7.53% for the 12 months that ended in August of this year.

Ironically, the risks of managed futures in good stock and bond markets are a good thing when they’re used properly as a diversifier. Otherwise, investors couldn’t rely on their upside when stocks and bonds are down. And sometimes, managed futures provide more upside than downside. From 2008 to mid-2009, their downside relative to good equity performance was exceeded by their upside relative to poor equity performance.

Managed futures’ lack of performance correlation with equities has been historically consistent. In the 19 full calendar years between 1990 and 2008, there was not a single year when both the Altegris 20 Index and the S&P 500 Total Return Index registered negative numbers. During that period, the worst single-month performance for managed futures was minus 6.16% (January, 1992), while the comparable decline for the S&P was minus 16.79% (October, 2008).

The effectiveness of managed futures in smoothing out performance declines that traditional portfolios encounter was predicted decades ago, when this type of investment was relatively new and access was limited to large institutions.

Their usefulness was foreseen by Harvard Business School professor John Lintner. In 1983, Lintner presented a now-classic paper on the subject, “The Potential Role of Managed-Commodity and Financial Futures Accounts (and/or Funds) in Portfolios of Stocks and Bonds.” Regrettably, Lintner died shortly thereafter in a car accident.

The paper turned out to be truly visionary. It demonstrated that incorporating managed futures into a stock and bond portfolio would tend to increase its returns relative to measurable risk. Adding the right measure of managed futures to a portfolio of stocks and bonds can reduce risk, Lintner reasoned, because their low performance correlation to these more traditional markets protects against volatility -- the bane of consistent investment returns.

Lintner’s insights into the effects of managed futures on traditional portfolios have proved accurate. Since then, many large institutional investors have benefited from his findings.

At the time, there were no managed futures indexes that retail investors could track. But this has changed now that a small number of firms are providing the complex back-office management of managed futures accounts — active management that’s too specialized for most financial planners and wealth managers.

Individual investors are able to take advantage of this investment by working with a planner or wealth manager who has an arrangement with one of these specialists. The effective use of managed futures requires careful day-to-day attention, so planners should choose these advisors carefully and communicate with them on a regular basis.

While an overall portfolio too heavy in managed futures may be inadvisable for individual investors, one that’s too light lacks a sufficient hedge against disastrous markets like the 2008 meltdown.

Robert J. Lindner, CEO, is founder of Lindner Capital Advisors, an advisory firm in Marietta, Georgia that provides turn-key investment solutions to clients of financial planners, wealth managers and a select group of broker/dealer representatives.