[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
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.
*INVESTING IN FUTURES INVOLVES SUBSTANTIAL RISK AND IS NOT SUITABLE FOR ALL INVESTORS. 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 SHOULD THEREFORE CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR FINANCIAL CONDITION. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
[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.]
1) What’s the expense ratio?
2) What happens to the illustration if you start the chart at January 2011, 2012, or 2013?
Also, what does it look like compared to a 60/40 or 80/20 stock/bond portfolio progressively invested over time? The alternatives for somebody investing in this is not a lump sum investment of 100% bonds or 100% stocks.
I’d also like to see the pure PVC returns since the negative correlation with stocks and bonds may be it’s greatest value to a portfolio. He listed overall correlation data, but it would be nice to have a visual of it over time.
I made an excel spreadsheet that allows you alter the allocations to whatever you’d like, and see how it affects the equity curve and statistics. It’s really interesting and fun to play around with. Just change the values in cells B2-B4. I also included pure PVC trading system returns at the bottom as well. Follow this link to open the excel workbook: http://www.purplevalleycapital.com/Blended_Portfolio.html
Adding to GK’s comment,
What happens to illustration if the chart is started pre-recession i.e. 2004,2005? We will then be able to see how it fared during recession years.
I am all for diversification, and I am also in favor of considering non-traditional asset classes. Thank you for the information.
Interesting article. I appreciate the diversity in topics.
These are great questions; thanks for stimulating a discussion. Expenses in the managed futures industry are typically 2-fold: a yearly management fee based on assets managed (typically 2%) plus an incentive fee (20% of profits). But these fees can range depending on the manager and investor preferences. Such expenses are high relative to other investments, and it is the trader or managers’ job to earn them by offering a product or service that exceeds these fees. I personally charge the typical 2/20 fee structure. Including September’s performance (above chart and figures don’t include it since it’s so new), which was a great month for trend followers due to the massive recent trends in currencies, my company’s trading system has returned an average of 19.36%/year since 2008 for my investors after all fees, including incentive fees. Trading is the quintessential meritocracy. If you perform well, it can be profitable for everybody. If you don’t, you go out of business. I love it. The failure rate is extremely high in futures trading (95% fail within 12 months). Thus, those who trade well can charge fees, and investors will pay them if they want access to the strategy. I understand that everyone may not agree with this. That’s ok. This type of investment is certainly not for everyone.
In terms of the illustration, I included real audited after-fee data from my performance because that is what I know best, and I thought it would hold more weight than talking about hypothetical back-tested data, or other traders’ equity curves. That said, for those looking for actual data on how trend following managed futures strategies performed prior to when I started trading, I’d recommend reading through Appendix B of Michael Covel’s book “Trend Following” where he discloses real historical data from over 20 professional trend followers, several of whom have traded since the 1970’s and 1980’s. John Henry, the owner of the Boston Red Sox, is one of them. You’ll notice that these strategies tend to perform very well during recessions, crises, or market dislocations because during such times, markets tend to move unidirectionally, and become very “trendy” (mostly down). This is especially true in a liquidity crisis like we all experienced in 2008. As an asset class, trend following managed futures were profitable during all of the recessions since the 70’s. This is mostly a function of our ability to short markets and ride large downtrends. But more important than all of the data, or specific performance numbers, are the general concepts of why such strategies are such good diversifiers. They span different asset classes, time frames, and have an ability to trade long and short.
95% failure rate is awfully high. That’s a pretty big risk to take choosing a manager. Overall back-tested data must look terrible, despite the 5% winners out there.
Jim, I completely agree, and it fascinates me! It’s a similar story in all markets (average active investor loses over time…which is why buying indexes is advised). This losing process is simply expedited in futures due to the leverage, which is why that 95% first year failure rate is so high. What’s fascinating to me, and why I began studying this in school, is the idea that those 5% were doing something that the losers weren’t. If their success is purely due to random luck, they’d all have different philosophies and strategies. But they don’t. They all trade very similarly, have the same psychological make up, and put risk management above all else. The biggest key, especially in futures trading because of the inherent leverage, is the ability to admit you’re wrong and take a loss quickly. It’s not about whether you’re right or wrong, but how little you lose when you’re wrong and how much you make when you’re right. Often times, the best traders are only “right” 30-40% of the time, but their winners are massive, and their losers are small. This is very difficult for most to handle psychologically, which is why the majority fail. It’s simply human nature and psychology. Think about it, would you be happy only having a 30-40% success rate with intubations!? I’m guessing not!
Interesting idea. We had a group of us who did a lot of active trading while in school and did really well. But the time it took to monitor everything was defeating. Besides this making a huge return on $100 is easier than when you have a million. Loosing $100 isn’t a big deal, but with bigger numbers it’s all a little more scary. I would like to see the chart like GK said as these charts always seem to be picked for a reason. Maybe start with a chart when it did poorly as that’s what the 2008 start date uses when comparing it to the S&P 500.
I prefer to do it myself, keep expenses low and if I need more money I put in some more hours. That seems to be the quickest way to earn money and it’s guaranteed to work every time!
I have written a longer comment to help answer the above questions, but it is currently “awaiting moderation,” most likely because of its length. Hopefully it will be posted soon! In terms of the chart, I graduated college in June of 2008, and started trading client capital in August through to present day. It is all of the real audited data I have. I wish I traded since the 70’s when inflation roared and trend followers crushed it. But I wasn’t alive. In my longer comment, I discuss where you can find as much data and charts as your heart desires as well as expense ratios. Stay tuned!
[Comments approved now, sorry for the hassle. Just an issue with running a blog.]
I like the post….whether or not this is for me or anyone else can be debated, but I enjoy learning about things I didn’t even know existed.
Thanks for the post.
Thank you John, this is what it’s all about! If there is such a thing as a “Holy Grail” in investing, it is to learn as much as you can about all types of investments and find which fit you personally in terms of your psychology, philosophy, goals and risk tolerance (read: yours, not your advisors!). The point of my guest post was to be informational-–whether it’s with trend following futures, or any other type of investment strategy, look to span assets classes, time frames, and method/strategy if diversification is what you’re after.
These are RFCs qualifying for 1256 treatment? That’s one of the best benefits of actively traded futures.
Having worked with futures traders for many years I’ll say that there are many that can do well for a few years, but i haven’t worked with any that can keep it up.
Yes, futures contracts are treated by the IRS as “1256 contracts” meaning all gains/losses are taxed 60% at long-term and 40% short-term capital gains rates. There are ways to invest in futures or managed futures funds through tax advantaged accounts as well (i.e. self-directed IRAs, etc…) Sorry to hear your path hasn’t crossed yet with the consistent winners, but they are out there. If you need the names, Appendix B in Covel’s book(as noted above) is a great start. I’ve had the pleasure and honor of being mentored by a few of them.
For those interested, AQR offers a managed futures fund in a mutual funds wrapper.
https://funds.aqr.com/our-funds/alternative-investment-funds/managed-futures-strategy-fund
Disclosure: I am an investor in the fund, via Fidelity as an intermediary, but have no other financial relationship with the firm.