In my many conversations with investment professionals about asset allocation, I usually refer to managed-futures investing as participating in a distinct asset class. I'm corrected occasionally with the comment: “Managed futures is an investment strategy, not an asset class.”
Why is this distinction important? An asset class obviously belongs in an asset allocation model, whereas an investment strategy may not.
According to the certified financial adviser textbook, an asset class is a group of securities with similar characteristics, attributes and risk-return relationships. The three primary asset classes traditionally have been defined as stocks, bonds and cash equivalents.
In recent years, commodities and real estate have been regarded as stand-alone asset classes. How, then, to think about alternative investments such as hedge funds and, more specifically, managed futures?
The term “investment strategy” is used broadly. Most often, it describes a methodology for selecting investments, usually according to a set of criteria. An investment strategy can be highly specific and pertain to a particular opportunity or security, or it can describe an approach to investing. For example, many investment advisers attempt to deploy a strategy focused on diversification when allocating portfolios.
Is there a correct answer to the asset-class-versus-investment-strategy question, and is it relevant? As alternative investments go mainstream, it's time to acknowledge that the broad universe of alternatives is another asset class, alongside stocks, bonds, cash, real estate and commodities. Each of those asset classes comprise myriad categories, and that is precisely where managed futures fits.
Once you decide to add the alternatives class to your asset allocation model, you probably will want to categorize alternatives across the underlying disciplines, including long/short, market-neutral, event-driven, macro and managed futures. You already are doing this for your stock portfolios as you consider large- or small-caps, value or growth and developed or emerging.
Thus, the correct answer to the first question is that managed futures is neither an asset class nor an investment strategy but an asset class category.
And it matters only if the terminology challenge somehow has resulted in managed futures' being left out of your asset allocation models.
The empirical evidence is overwhelming about the potential benefits of allocating to managed futures when building a well-diversified portfolio:
“The combined portfolios of stocks (or stocks and bonds) after including judicious investments in leveraged managed-futures accounts show substantially less risk at every possible level of expected return than portfolios of stock (or stocks and bonds) alone.”
— John Lintner, “The Potential Role of Managed Futures Accounts in Portfolios of Stocks and Bonds,” 1983
“Allocating to managed futures allows investors to achieve a very substantial degree of overall risk reduction at limited costs.”
— Journal of Investment Management, Vol. 2, No. 1, “Managed Futures and Hedge Funds: A Match Made in Heaven,” 2004
“For appropriately constructed portfolios, managed futures are shown to offer unique downside risk control, along with the simultaneous potential for upside returns.”
—Ibbotson Associates Inc., “Managed Futures and Asset Allocation,” 2005
In 2009, the Chicago Board Options Exchange sponsored a study exploring the 2008 financial crisis' effect on investment portfolios. The research indicated that managed futures became less correlated to stocks during the crisis as other assets became more so.
“It is clear that, with the exception of bonds and managed futures, all of the components of the base portfolios performed quite poorly (in a similar fashion to equities) over both the entire period and the late-2008 period,” the study found.
Note the dates of Mr. Lintner's and the CBOE's pieces. Their findings essentially tell the same story: The lack of correlation between managed-futures investing and any other asset class category or traditional asset class during certain periods has helped portfolios with managed futures achieve better risk-adjusted returns than those without them.
Correlations may change, of course. This noncorrelation plays out over investment cycles. It's not the same as negative correlation, while positive correlation is sometimes a good thing, especially when stocks are going up.
Jon Sundt is president and chief executive of Altegris Investments Inc.