The Field Guide to Surviving Volatility

Our friend Jeffrey Dow Jones (yes, that’s his real name) over at the Cognitive Concord Blog was out with the above titled post last week, and it couldn’t be more timely in our opinion.  His four point ‘field guide’ has the following items:

1. Buy Insurance

2. Hold Cash

3. Own things that go up in value when it gets volatile.

4. Size trades based on volatility

Now, we’re biased of course – but we couldn’t help but think managed futures fit perfectly with this approach.  We’ll start with guide item #3, “Own things that go up in value when it gets volatile”. We’ve covered here, and here, and here how managed futures is a ‘long volatility’ investment, meaning it is designed to do well during periods of increased directional volatility. Need some proof… how about plotting the DJCS Managed Futures Index against the S&P 500 over the past 6 market crisis periods.

Crisis Peroid

(Past performance is no necessarily indicative to future results)
Managed Futures = DJCS Managed Futures Index
U.S. Stocks = S&P 500 Total Return *from Jun 1994 to June 2013

How do managed futures do it? They aren’t magic. They do it by entering nearly every breakout to new high or low prices in various markets, losing on 60% to 70% of those as they prove to be false breakouts, and then capturing outlier profits on the remaining 30% to 40% which keep going in a volatile move one way or the other. Sounds like just the kind of “thing” Mr. Dow Jones was thinking of (although he mentions US Treasuries and the Japanese Yen, not managed futures).

As for #1 – buying insurance – we don’t see how that is very much different than #3 – as insurance is something you can own which will go up in value. Of course, you could buy insurance for a lot cheaper than you could invest in something, which is perhaps why Mr. Dow Jones lists them as two separate items.  Our problem with using insurance as a hedge or way to ‘survive’ volatility is that insurance is a wasting asset (it only lasts for a finite time) – versus something you own being with you until you sell it – which will, by definition, result in a loss if the insured event doesn’t come to pass.

And here’s where managed futures as a hedge/diversifier really shines. You see, an investment which goes up during volatility spikes won’t necessarily go down when volatility isn’t spiking. That whole non correlated not equaling negatively correlated thing (see the bottom of this newsletter for more on that). If you take a look at the chart above and focus in on the far right columns – you can see this play out in actual data with managed futures having been that rare type of insurance over the past 19 years, the free kind.  If you plotted S&P 500 puts as insurance in the same manner, the average 12 month performance would be severely negative, but here we have managed futures generating positive returns while also providing protection. Not too shabby. (past performance is not necessarily indicative of future results).

How do managed futures mesh with holding cash?  Well, the bulk of money allocated to a managed futures program is typically held in cash, and the ability of notional funding in futures accounts allows for all sorts of portable alpha plays with your cash allocation (although you start to go away from the purpose of holding cash if your cash isn’t acting like cash.

Finally – Mr. Dow Jones mentions sizing your trades for volatility.

“All you have to do beforehand is derive some kind of formula for how large to size your trades.  Here’s a quick ‘n dirty example that I came up with, based on a somewhat-standard version that the industry uses:

Trade Size (# of shares) =  P * [Portfolio Size / Asset Volatility]  / Share Price

Where P is a constant that determines the baseline percentage the trade should represent for of the total portfolio.

In layman’s terms, all that formula says is that when it gets more volatile, you trade smaller.  But it’s remarkable how few people actually do this…  ”

Volatility based trade sizing! Now you’re really talking the language of managed futures.  The basic building block of most managed futures programs just happens to be adaptive trade sizing based on the initial (volatility based) risk.  This is also part of the reason managed futures can have lumpy returns and do well in times of rising volatility, as they initially size their positions off of low volatility when markets break out of a trading range.

Head on over to Cognitive Concord for the full read, but just remember to read (managed futures) between the lines.

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