Embracing DiversityWhy Managed Futures? While there are an unlimited number of publications covering the advantages of portfolio diversification, until recently, few of them explore the possibilities of trading commodities along with typical stock, bond and real estate investments. Although investment and fund managers are very aware of the importance of diversity, speculators often mistakenly overlook its value. A consistent managed futures program can potentially reduce the overall risk of a well diversified portfolio. As all commodity traders know, the futures market can be a great way to hedge the economic risk of a pool of investments. Research provided by the Chicago Board of Trade has even suggested that the Efficient Frontier’s optimal portfolio is actually shifted outward by including commodities. The CBOT writing titled “Portfolio Diversification Opportunities” (Click Here to Read) implies that adding managed futures to a stock and bond portfolio has the potential to reduce the overall risk of the portfolio as well as increase long term returns. According to Dr. Harry M. Markowitz’ definition of the Efficient Frontier, this means that for each additional unit of risk a higher return is attainable; thus a shift outward in the curve. Additionally, studies conducted by Harvard University Professor John V. Lintner in 1983 suggested that the risk vs. reward ratio of a portfolio containing managed futures is higher than that of a well diversified stock and bond portfolio. Once again, if this assumption is in fact true there may be increased efficiency by adding managed futures as a means of diversification. Because markets are often driven by human emotion and unforeseen events, it is impossible to predict future prices. Consequently it is important to have a truly diversified portfolio of investment strategies. The ability to profit in any market without regard to its direction is a priceless advantage over buying stocks. Investors should be willing to sacrifice some of the upside potential of a pure equity portfolio in order to preserve capital in times of a declining stock market. William F. Sharpe, pioneer of modern portfolio theory and Nobel Prize winner, defined the secret to successful investing as the ability to manage risk on a broad based level. Sharpe developed a mathematical formula, the Sharpe Ratio, to put numerical value to the ever-popular theory of risk and return. The ratio determines the excess return for each additional unit of risk, or standard deviation. In other words, Sharpe Ratio tells us whether profitable investments come from a well-planned portfolio, or the acceptance of excessive risk. While most investors recognize this risk reward relationship, many are focusing on the wrong component of the equation. Paying attention to risk, as opposed to return, creates a more fruitful investment environment. A famous sports strategist, Branch Ricky, once pointed out that “Luck is the residue of design”. The same is true in the world of investments. Constructing a portfolio capable of weathering all types of macro economic and political conditions is the key to successful trading. Properly diversifying a portfolio will reduce the amount of risk an investor is exposed to and allow for less volatile returns. The concept of diversification is based on the pursuit of negatively correlated investments. Correlation refers to the tendency to profits and losses of one investment to move in unison with another. Therefore, negatively correlated ventures will produce opposite results. Due to the prospective ability to capitalize on both up and down price movements in the futures market, the trading arena seems like a likely vehicle to produce results that are not necessarily correlated to more traditional holdings such as stocks, bonds and real estate. How we may be able to Help There is a catch to adding a mix of options and futures into a typical stock and bond holding; diversifying a portfolio by simply opening a self directed commodity trading account probably isn’t enough. Most retail traders lose money overall, regardless of the length of time that they manage to “stay in the game”. According to many publications, including the infamous book Mind over Markets written by James F. Dalton, Eric T. Jones and Robert Bevan Dalton, an estimated 80% of all traders lose money. As brokers, we have had the opportunity to witness the carnage first hand. The average market participant simply doesn’t have the experience, training, psycological stability and time that it takes to yield profits in such highly leveraged and treacherous markets. Although there are no guarantees that any managed futures program, will yield positive results; Commodity Trading Advisors are hired by clients to utilize the skills acquired throughout their experience in an attempt to return consistent profits. We feel that close proximity to the options and futures markets, trial and error and experience have lead us to a keen understanding of the trading game. It is our opinion that we have attained a basket of knowledge and skills that are imperative to being financially successful in this game. Although these skills don't ensure success we do feel that they will point you in the right direction. Our familiarity with the markets could potentially be of value to those looking to participate in a managed futures program. |
