As the US debt downgrade infects the stock market – an issue that could provide significant headwinds for stock investors over the next decade – it might be appropriate to recognize the value in building a truly defensive portfolio of diverse returns streams. To this end, it is useful to define the investment from a perspective not often considered: the performance drivers.

Our society is conditioned to invest by “buying” something, owning it and holding these investments in hopes the price moves higher. As you will see, a long only investment has several underlying correlation factors at the performance driver level that tie them together. It is common for financial professionals to discuss “diversification” with a stock market portfolio of different market sectors and geographic regions. But is such “diversification” really true? Nobel Prize winners have clearly stated that diversification with stocks is impossible due to systematic risk. Why is this?

It is commonly reported that the value of stocks, real estate and commodities are influenced by economic supply and demand. When the economy is prosperous, or the perception of economic growth is present, the resulting consumer demand and business spending tends to propel prices higher. Thus, to varying degrees, a significant performance driver that causes the value of stocks, real estate and commodity investments to rise or fall is economic supply and demand. This fact was graphically evidenced during 2008.

Due to this, the correlation discussion should be advanced by giving more serious consideration to the core performance drivers that underlay all investments, drawing the conclusion that it does not matter if the investment is in stocks from around the world in different market sectors, real estate in different geographic regions or commodities with a variety of different uses, these investments are hinged to economic supply and demand at the performance driver level to varying degrees.

What contributes to managed futures general lack of correlation to the stock market and other assets is the primary strategy performance driver is not necessarily hinged to economic supply and demand. From an asset correlation standpoint, this is reasonably unique and it is these core strategic performance drivers that should be given consideration when developing modern portfolios.

Understanding Managed Futures Performance Drivers

Understanding investment performance drivers is critical to understanding how the managed futures asset class integrates into a diversified portfolio. To achieve understanding, recognize that managed futures can go both long and short a basket of the four major asset classes, including equities, commodities, currencies and interest rates. As a result, in managed futures the performance of the primary trading strategies is often driven by the “market environment,” or more simply put the general price activity of an asset such as stocks or commodities. As you consider the example of market environments I’m about to describe, think about how the core performance drivers in managed futures differ from the other asset classes.

A stock might have a history consistently trading in what is known as a price “range” from $50 to $80, seldom moving out of this range. This “market environment” is commonly referred to as a “range bound” or “trendless” market. Conversely, if the price activity were to break out of the $50 to $80 price range and continue with momentum in a consistent direction either higher or lower, it would be considered a “trending” market environment. These market environments are factors that often influence performance of a managed futures strategy. In managed futures a strategy is the primary method used to determine how and when an investment manager executes trades. While fundamental traders exist, the majority of managed futures strategies are technical in nature.

The most popular technical strategy is trend following. The market environment most often influencing a trend following trading strategy is price persistence, which is the characteristic for the price of an asset to “trend” or continue in one direction. At a basic level, trend following programs work when they identify a valid price trend and then buy or sell in the direction of the trend, a strategy that most often benefits when the price of the asset continues in that direction of the trend. The direction of the price trend, higher or lower, is not as influential as the persistence and momentum behind the price trend. When markets are “trending” these trend following strategies, by definition, tend to prosper; conversely, when markets are “range bound” and inconsistent in regards to price trends, investors might expect these strategies to experience varying performance. Normally, in this environment markets are identified as choppy and volatile.

There are other strategies that determine how and when trades are executed. Within trend following there are various sub-strategies including counter trend trading, where the trader attempts to anticipate when a trend is ending.  There are spread arbitrage programs, where buying one product and selling a related product makes this strategy’s performance driver temporary price dislocation and mean reversion. When the price of one product, such as gasoline, is dislocated out of line with historical price norms of another product, such as oil, the managed futures spread trader would typically sell the higher priced item and buy the low priced item in hopes that the prices would revert back to the mean, or the historical norms of their price relationships. Options strategies are often based on market volatility, with long options programs buying options, hence long volatility, and short options programs selling volatility, a strategy that can benefit from “range bound” market environments.

The key take away is that unlike many asset classes, managed futures is one of the few investments available that operate to the beat of a different drummer. The primary performance driver of the strategies is based on the market environment and price activity – factors not tied to any market moving higher in price or economic supply and demand, which is reasonably unique among major investments. This helps explain why managed futures correlation numbers and performance during stock market crisis or prolonged bear markets have, in the past, generally been so attractive and points to how advisors can differentiate themselves by offering truly asset diversified portfolios. Of course, past performance is no guarantee of future results.

When developing a modern portfolio, it is this lack of asset correlation at the performance driver level that is critical to successful implementation of an investment portfolio that has opportunity to perform in both bull and bear market environments. In later articles we examine the managed futures strategies in more detail and how managed futures performance drivers integrate into a balanced modern portfolio.

Explaining Correlation

When speaking of performance drivers we are talking on a strategic level, and now we will switch to mathematical analysis of correlation.

Managed futures have historically displayed lower or zero-correlation with other asset classes. Correlation is a statistical measure of how returns of two strategies move together over time: A correlation of 1 indicates the two returns move perfectly together, a correlation of 0 indicates common price movements are random or uncorrelated; and -1 indicates opposite movement.

As you would expect, managed futures is highly uncorrelated to the performance of the stock market, real estate and commodities, but here are a few interesting facts. Managed futures is also uncorrelated to the performance of general hedge funds and even the markets in which the managed futures programs invest. Consider two examples to understand just how uncorrelated managed futures is by looking at how agricultural managed futures traders are uncorrelated to the performance of the agricultural markets they trade, and how a managed futures program trading single stock futures is so very uncorrelated to the performance of the general stock market. In chapter nine of the book High Performance Managed Futures we point out a correlation chart that shows the Barclay Agricultural CTA Index exhibits a correlation of just 0.29 to the CRB Index, a common measure of the price of various commodities.

The key point is to understand that which is behind these numbers. The strategic reasons for managed futures lack of correlation to the stock market and even the markets in which the CTAs trade is that they can go long and short the markets and have different underlying performance drivers than most investments. The next step in this process is considering how this lack of correlation works to integrate this investment into a well balanced portfolio and the implications of doing so.

How Managed Futures Integrates into a Modern Portfolio

The diversification characteristics of managed futures is supported by research from Professor John E. Lintner of Harvard University, who demonstrated that it is desirable to invest in multiple asset classes with little correlation to one another. The performance driver concept takes this a few steps further, and points to how and why managed futures fits within a traditional stock and bond portfolio. This true asset diversification with uncorrelated investments is the goal of a theory known as “Modern Portfolio Theory,” developed by Harry Markowitz, who won a Nobel Prize for his efforts.

When developing a modern portfolio, it is this lack of asset correlation at the performance driver level is critical to successful implementation of an investment portfolio that has opportunity to perform in both bull and bear market environments.

This is a critical message that investors should understand, particularly as the largess of US Government debt becomes apparent to the marketplace.

About the Author: Mark Melin is author of three books, including High Performance Managed Futures, and has taught managed futures at Northwestern University in Chicago. Mr. Melin consults with pension funds, family offices and high net worth investors on developing uncorrelated managed futures portfolios.  For further information visit his web site at www.Go2ManagedFutures.com or via e-mail at info@Go2ManagedFutures.com. All contents copyright (C) 2011 Mark H. Melin’

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CONTENT DISCLOSURE

This article and related communication substantially represent the opinions of the author and are not reflective of the opinions of any exchange, regulatory body, trading firm or brokerage firm. The opinions of the author may not be appropriate for all investors and there is no warrantee relative to the accuracy or completeness of same.

RISK DISCLOSURE

PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.

THE RISK OF LOSS IN TRADING COMMODITIES CAN BE SUBSTANTIAL. YOU SHOULD THEREFORE CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR FINANCIAL CONDITION. THE HIGH DEGREE OF LEVERAGE THAT IS OFTEN OBTAINABLE IN COMMODITY TRADING CAN WORK AGAINST YOU AS WELL AS FOR YOU. THE USE OF LEVERAGE CAN LEAD TO LARGE LOSSES AS WELL AS GAINS. YOU COULD LOOSE ALL OF YOUR INVESTMENT OR MORE THAN YOU INITIALLY INVEST. IN SOME CASES, MANAGED COMMODITY ACCOUNTS ARE SUBJECT TO SUBSTANTIAL CHARGES FOR MANAGEMENT AND ADVISORY FEES. IT MAY BE NECESSARY FOR THOSE ACCOUNTS THAT ARE SUBJECT TO THESE CHARGES TO MAKE SUBSTANTIAL TRADING PROFITS TO AVOID DEPLETION OR EXHAUSTION OF THEIR ASSETS.

THE DISCLOSURE DOCUMENT CONTAINS A COMPLETE DESCRIPTION OF THE PRINCIPAL RISK FACTORS AND EACH FEE TO BE CHARGED TO YOUR ACCOUNT BY THE COMMODITY TRADING ADVISOR (“CTA”). THE REGULATIONS OF THE COMMODITY FUTURES TRADING COMMISSION (“CFTC”) REQUIRE THAT PROSPECTIVE CUSTOMERS OF A CTA RECEIVE A DISCLOSURE DOCUMENT WHEN THEY ARE SOLICITED TO ENTER INTO AN AGREEMENT WHEREBY THE CTA WILL DIRECT OR GUIDE THE CLIENT’S COMMODITY INTEREST TRADING AND THAT CERTAIN RISK FACTORS BE HIGHLIGHTED. THIS DOCUMENT IS READILY ACCESSIBLE AT THIS SITE. THIS BRIEF STATEMENT CANNOT DISCLOSE ALL OF THE RISKS AND OTHER SIGNIFICANT ASPECTS OF THE COMMODITY MARKETS. THEREFORE, YOU SHOULD PROCEED DIRECTLY TO THE DISCLOSURE DOCUMENT AND STUDY IT CAREFULLY TO DETERMINE WHETHER SUCH TRADING IS APPROPRIATE FOR YOU IN LIGHT OF YOUR FINANCIAL CONDITION.

YOU ARE ENCOURAGED TO ACCESS THE DISCLOSURE DOCUMENT. YOU WILL NOT INCUR ANY ADDITIONAL CHARGES BY ACCESSING THE DISCLOSURE DOCUMENT. YOU MAY ALSO REQUEST DELIVERY OF A HARD COPY OF THE DISCLOSURE DOCUMENT, WHICH WILL ALSO BE PROVIDED TO YOU AT NO ADDITIONAL COST.

PFG BEST DOES NOT HAVE AN OWNERSHIP STAKE IN ANY OF THE CTAS WE RECOMMEND OR UPON WHICH WE PROVIDE RESEARCH. MUCH OF THE DATA CONTAINED IN THIS REPORT IS TAKEN FROM SOURCES WHICH COULD DEPEND ON THE CTA TO SELF REPORT THEIR INFORMATION AND OR PERFORMANCE. AS SUCH, WHILE THE INFORMATION IN THIS REPORT AND REGARDING ALL CTA COMMUNICATION IS BELIEVED TO BE RELIABLE AND ACCURATE, PFG BEST CAN MAKE NO GUARANTEE RELATIVE TO SAME. THE AUTHOR IS A REGISTERED ASSOCIATED PERSON AT PFG BEST.

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