[Editor's Note: This is a guest post from Donald Wieczorek who manages a futures fund (both commodities and other types) and is married to an emergency medicine resident. Although Mr. Wieczorek would obviously love for you to invest with him at Purple Valley Capital, I felt the educational value of the post was sufficiently worthwhile to publish. Larry Swedroe is the most famous advocate for commodities (via collateralized commodity futures -CCF funds) among Boglehead authors and he and Rick Ferri have had some epic debates on the subject worth reading. I don't hold commodities or any other type of futures in my portfolio but I don't think it is unreasonable to dedicate some small portion of your portfolio to the asset class. I am also not a fan of any type of technical analysis such as “trend-following” much less “trading” of any kind, much less derivative trading. Donald and I have no financial relationship and you should not take publication of this post here as any kind of endorsement.

By way of introduction, I thought it would be useful to define the concept of a “future” for WCI readers. Investopedia gives a nice summary:

A financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash. The futures markets are characterized by the ability to use very high leverage relative to stock markets.

Donald Wieczorek

Donald Wieczorek

Futures can be used either to hedge or to speculate on the price movement of the underlying asset. For example, a producer of corn could use futures to lock in a certain price and reduce risk (hedge). On the other hand, anybody could speculate on the price movement of corn by going long or short using futures.

Now, onto the post itself.]

If there is one subject in finance that everyone agrees on, it is that diversification can increase returns while also decreasing volatility and limiting portfolio-wide drawdowns. My wife is an emergency medicine resident, and I wish to share with readers how we diversify our own personal investment portfolio with a managed futures trading program that I created and have been trading for over six years. Many investors think they are diversified because they own equities in different industries or countries, some bonds, and perhaps even have exposure to real estate, but true diversification should reach well beyond this standard portfolio. True diversification includes not only spreading capital across different asset classes, but time frames and methods of investing as well.

Like many readers of The White Coat Investor, my wife and I choose to own low cost passive index funds for our equity and bond exposure. Unfortunately, as great as these index funds are over the long run, they do run into periods of extremely poor performance every so often and seemingly with increased frequency. For example, in the financial crisis of 2008, the S&P 500 dropped over 50% from its peak. Such collapses can be financially and psychologically devastating. For diversification purposes, ideally, we wanted to have an investment that grants access to totally different asset classes, time periods, and even type of strategy. The strategy we use that incorporates all of these aspects of true diversification is known as trend following managed futures, and it has been around for decades, though few have heard of it, and even fewer have exposure to it.


Trend Following Managed Futures

Trend following managed futures is not peddled by Wall Street brokers because it doesn’t generate high enough commissions, and it isn’t showcased on CNBC nor written about in the Wall Street Journal because the strategy is simple, reactive (not predictive in any way), and goes against what is taught in finance classes since it is entirely based upon simple mathematical concepts as opposed to fundamental analysis. The goal of trend following managed futures is to catch and ride large price trends (both up and down) whenever and wherever they develop in the futures marketplace. Such strategies trade with the trend (i.e. buying breakouts, or selling breakdowns), cut losers quickly, ride winners, and utilize stringent risk management. The reason such an investment can be a fantastic diversifier is because it implements all three pillars of true diversification in one investment: different asset classes, different holding periods, and different method of attempting to make money.

First, the assets included in the managed futures complex could not be more different than equities and bonds. For example, the futures strategy that we utilize monitors and trades approximately 40 uncorrelated world futures markets including corn, lumber, cotton, orange juice, Australian Dollar, cattle, crude oil, gold, coffee, and copper, among many more. The point of the asset selection within this strategy is to include as many different and uncorrelated markets as possible. It is important to note that this is not a simple passive index that always holds positions in all markets. Instead, it is actively managed such that the portfolio only holds positions in markets that are trending or moving in large ways, either up or down. And unlike the S&P 500 which simply reduces its weighting to losing equities within the index due to its market-cap weighting structure, trend following futures programs cut losing positions entirely. Our strategy, for instance, on average holds about ten positions at any one time.

Second, trend following managed futures is a great diversifier because it trades across different time frames. While my wife and I will hold the S&P 500 and total bond fund indexes indefinitely, trend following managed futures strategies often hold winning positions for an average of four to six months, and losing positions for as little as one day. While the S&P 500 and bond fund add or drop positions infrequently, managed futures strategies make approximately one or two trades per week. Including such a strategy that uses different time frames will smooth an equity curve and offer greater diversification for a portfolio.

Third, and perhaps most importantly, managed futures help diversify a portfolio by adding a different type of strategy by being able to short, or profit from, falling markets. Unlike the S&P 500 and total bond fund which are both long-only investments, trend following managed futures strategies initiate long positions in rising markets and short positions in falling markets. I cannot stress enough the importance of having the capability to short markets at times, especially during recessions or financial crises. Trend following managed futures strategies had one of their most profitable years in history in 2008 due to being short equity markets, energies, grains, and carry currencies, while simultaneously being long the US Dollar, Yen, and Treasuries. Investing in a strategy that does well when almost everything else collapses is a fantastic way to diversify. When you combine the fact that managed futures strategies trade entirely different asset classes, trade over varying time frames, and have the ability to trade both long and short, it is no wonder they are uncorrelated to traditional investments. For example, the managed futures strategy we use has a -0.10 correlation to the S&P 500 and a -0.15 correlation to the Vanguard total bond fund. Such uncorrelation proves just how advantageous having an allocation to managed futures can be for a portfolio in terms of achieving true diversification.


Risks of Managed Futures 

Although this strategy can be a fantastic diversifier if used properly, there certainly are risks in getting involved, and the use of such a strategy is not for everyone. Because this trading system is always positioned in the hottest markets (both up and down), it is volatile and will have wild swings. Although this strategy does well during periods of trending markets (i.e. strong economic growth, crises, inflation, etc…), it performs poorly when markets are range-bound and flat.

For example, the last couple of years have been meager for the trend following industry due to zero interest rate policies (thus few large currency moves), flat economic growth, and minimal inflation. Psychologically, this type of investment can be very difficult as well, because it has frequent small losses in exchange for infrequent but large gains. Drawdowns can be lengthy. Success in futures trading requires an immense amount of psychological fortitude, discipline, and patience.


My Story

In full disclosure, I am a licensed commodity trader (CTA) and have traded client capital, as well as my own, since 2008 when I founded Purple Valley Capital, Inc. I originally just traded my own capital but became legally registered and incorporated when my family, friends, and outside investors began showing interest in my strategy in order to help achieve further diversification within their portfolios. I built my trend following strategy from the ground up, and have seen, along with my investors, the benefits and risks of such a managed futures strategy. I am a mathematically inclined thinker who likes trading, but I am not much of a salesman. This is actually the first time I have ever written about or discussed what I do in an open forum since I started trading professionally over six years ago. But I really respect Dr. Dahle’s website, his goals, and wishes to help those wearing white coats get on the track to financial freedom in order to achieve the good life. I wanted to share how my wife and I, along with my outside investors, go about diversifying our personal investment portfolios with managed futures, and discuss how such a strategy may make sense for individuals if their risk tolerance, psychological make-up, and investment goals are a proper fit for the strategy. Whether it is with managed futures, or some other investment strategy, the idea of trying to achieve true diversification is an extremely important matter. Again, there are many ways to diversify, but this is how we go about doing it.


Our Results with Managed Futures 

I have included a chart and table below which illustrate how adding an uncorrelated investment, such as trend following managed futures, can help increase total returns while also decreasing volatility and drawdowns. Hopefully this article will help others think about diversification slightly differently than they had in the past, and perhaps stimulate an interest in looking for a diversifier that spans different asset classes, time frames and method of trading.


The Disclaimers of Managed Futures 

The above is for illustrative purposes and past results are not necessarily indicative of future results. The data included is that of the S&P 500 Total Return Index, the Vangaurd Total Bond Fund and Purple Valley Capital, Inc.'s trend following trading system from August 1st, 2008 through June 30, 2014. The return of PVC's trading system is net of all fees.


[Editor's Note: Well, there you have it. The case as best he can make it for managed futures as an asset class and for his fund in particular. Clearly Don has had fantastic results the last few years (obviously I haven't audited these results.) Is he lucky, good, or is there something to this as an extremely volatile diversifier? Do you buy the concept of diversifying across “time periods” and “strategies?: Do you invest in futures of any kind? Why or why not? Comment below! Don has promised to thicken up his skin for the inevitable comments a post like this will generate, but let's try to keep this debate about ideas. Ad hominem attacks will be deleted.]