Even Bad Diversification Works

Last week, Business Insider unveiled the “Most Important Charts in the World.” If ever there was an outfit with a flair for the dramatic headline, that would be them…but there was one chart that caught our attention entitled, “Diversification Works.” It was from none other than Josh Brown at Ritholtz Wealth Management.

Diversification Works

(Disclaimer: Past performance is not necessarily indicative of future results)
Chart Courtesy: The Reformed Broker

Now if you asked a roomful of random investors what diversification in their portfolio meant to them, chances are all of them would have a slightly different answer. In this particular instance, Brown defines diversification as a portfolio including a 30% allocation to the S&P 500, 30% to foreign stocks, and 40% to bonds. We’ll give you the bonds, but pairing foreign stocks with US stocks doesn’t strike us as all that diversified.  Foreign stocks (MSCI ex US) have a correlation of 0.89 with US stocks over the past 10 years, for example.

And being managed futures folks, we couldn’t help but look at their chart and wonder… what if you had managed futures in the foreign stocks slot instead? Would diversification have “worked” then?

Here’s our chart swapping the 30% foreign stocks allocation with 30% managed futures, per the Newedge CTA Index.

Diversified with Managed Futures

(Disclaimer: Past performance is not necessarily indicative of future results)
(Diversified = 40% Barclays Bond Aggregate Index, 30%  Newedge CTA Index, and 30% SPY)

While Brown was bragging of the diversified portfolio regaining its peak 14 months before a stock-only portfolio, the portfolio containing managed futures regained its peak 35 months prior, or more than twice as fast!  How? Because 30% of the portfolio was positive during the 2008 crisis as managed futures became negatively correlated to stocks during the crisis.  Now that’s some diversification.

Some may concentrate on the far right hand side of both of these charts, where the stock-only portfolio has, after 7 years, eclipsed the total return of the diversified portfolio (whether diversified in other stocks or managed futures), and discount diversification as unimportant or even costly. You would have made more money not being diversified, but that’s not the point for those who want some protection.

The point, as Josh Brown points out, is to have shorter drawdowns. The point is to be able to regain a peak sooner. The point is to be able to not panic at the bottom.  And, of course, the point (for us) is that diversification can “work” even better when you aren’t diversifying with another form of stock market investment (foreign stocks), and instead gaining true diversification with different return drivers.

P.S. – Past Performance is Not Necessarily Indicative of Future Results. The chart should probably be titled – Diversification Worked (past tense), not works (present tense). We noticed a comment summing that up rather nicely, and ask the simple question: Will Simple Beat Complex in the Next 5 Years?

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Top Ten Managed Futures Performers of June

While one month’s performance is no way to judge an investment that has 3 to 5 year cycles, a glance at who’s doing well in the different environments month to month can be a useful data point at times. Here’s the top managed futures performers (by return only) for the month gone by:

Note: These programs are not necessarily recommended by Attain. For a list with much more thought behind it – check our semi-annual rankings. (Be on the lookout for the latest semi-annual rankings in the coming weeks).

 (Disclaimer: past performance is not necessarily indicative of future results. Programs listed consist of those with at least a 3 year track record tracked by Attain Capital Management for investment by clients via managed accounts and do not represent all available programs in the managed futures universe.  The Max DD represents the worst drawdown of all time for the listed programs). 

Top 10 CTA's of June
June ROR
Max DD
Min. Invst.
Paramount Capital (QEP)18.94%-57.77%100,000
Purple Valley Capital -- Diversified Trend11.02%-49.34%1,000,000
JKI Futures -- Etiron 2X Large10.73%-37.27%1,000,000
Dreiss Research Corp. (QEP)9.34%-51.44%1,000,000
Altis Global Futures Portfolio -- Composite (QEP)7.60%-44.00%20,000,000
Northstar Commodity Investment -- TBE Capital (QEP)7.60%-44.27%25,000
Melissinos Trading -- Eupatrid Commodity (QEP)7.25%-22.71%250,000
Global Ag (QEP)7.01%-20.82%1,000,000
M.S. Capital Management -- Gl Diversified 6.99%-35.62%2,000,000
Tellurian Capital -- Ascend6.70%-29.91%500,000

Alternative Investments: Why do we care?

Have you ever gotten into an argument and thought of the perfect ‘come back’ line a days later, or wish you had said something a little different in an interview or on a first date. Well, our CEO Jeff Malec was invited to present at a “Lunch & Learn” (whatever that is…) put on by Advocate Asset Management, proprietor of the EVO volatility strategy, and their partners Aegea Capital this week. Thing is, he wasn’t a huge fan of his spiel, having one of those ‘a ha’ moments on the walk back to the office where you think, I should have approached it this way.

You usually don’t get a chance to say it again (especially on that first date), but when you have your own blog… well, then there might just be a chance. Here’s Jeff’s revised speech, getting into why we’re all worried about this alternative investment stuff in the first place.

I’m a philosophy major, so I’ll begin by asking – what are we all doing here? Ignoring the existential answers to that question and focusing just on the investment world – we’re all here because we have a problem.

The problem is – we’re most all “naturally long” stocks, meaning that even when we don’t have a direct investment in stocks and benefit from share prices rising; we have indirect exposure to the stock market via our jobs, the real estate market, corporate bonds, and even commodity investments tied to how the global economy is doing.  That’s a problem because the stock market is known for some rather big down moves and bouts of scary volatility (see the dot.com bubble and credit crisis as the most recent examples).

The game anyone who worries about such things plays is finding and creating investments which can reduce the risk of these volatility spikes and big down moves. We all want to sleep a little better at night (and get some better performance and earn some fees, it’s not all altruistic). So how can you do that? How do you protect a stock heavy portfolio? The basic options are: Do negatively correlated stuff:

  • Exit stocks all together
  • Buy insurance (puts)
  • Invest in negatively correlated strategies (short bias hedge funds, buy VIX futures)

o   Invest in non correlated stuff

  • Commodities
  • Hedge Funds
  • Managed Futures

Turns out this isn’t that easy of a game, however; as there are issues with both approaches. The problem with investing in negatively correlated stuff (puts, short bias, VIX) is it’s expensive. It will perform when you need it to, in the bad times – but it costs too much during good times, either through paying premiums or missing out on gains or holding a decaying asset; creating a scenario where you have to get the timing just right in order for the economics to work out.

And the problem with non correlated stuff is that it won’t always be a hedge. Many people confuse non correlation with negative correlation. Non correlation means an investment will do something different (on average), that’s all you know. That ‘on average’ part is the killer, as it means the correlation will sometimes be positive and sometimes negative, averaging out to around zero correlation (non correlated).  Problem is, we don’t live in a world of averages. We feel pain in real time, not on a smoothed, average basis – so when our non correlated investment becomes highly correlated over a short period of time, such as we saw in real estate, commodities, and hedge funds in 2008, it’s at best frustrating – and at worst a disaster for the portfolio.

What investors really want in an alternative investment is the best of both worlds. They want negative correlation during down turns, and positive or no correlation the rest of the time. But how do you do that absent a crystal ball allowing you to perfectly time the market. How do you this ‘best of both worlds’ hedge?

The poster child for such a ‘best of both worlds’ hedge has been Managed futures, which have historically been able to make some money during stock market rallies, and make a lot of money during market crisis periods (past performance is not necessarily indicative of future results… which we’ll see in a second).  Managed futures have historically been slightly positively correlated in up markets and negatively correlated in down markets.

How did they do this? It isn’t magic. They mainly use a systematic, “long volatility” approach which goes both long and short upon a market seeing increased volatility and breaking out of its current range, and spread bets over many market sectors such as grains, energies, currencies, bonds, and even stock indices so something they track is always moving. The trick during stock market rallies when there was little to no volatility, was to compensate by extracting volatility breakouts from other sectors.

That all sounds great, but there’s one little problem – it hasn’t been working of late. Fast forward to today, and you can see that it’s not just the VIX and stock market volatility that’s low. It’s prevalent everywhere. We’re seeing the smallest ranges in the 10yr Note in 35 years. The smallest annual move in Crude Oil in 20 years. Currencies in the 5th percentile (95% of cases higher) of historical implied volatility. There is complacency everywhere, and that is has hurt managed futures ability to make money when stocks are rallying (especially the larger programs which trade mostly financials). Traditional managed futures programs backup plan for a low volatility, non crisis period market isn’t contributing as it has in the past.

Which brings us to Advocate and Aegea, who have attempted to design a solution for this problem. They don’t try and beat the slow, low volatility times with multiple market sectors and hopes of volatility being present elsewhere. They do it with market structure. What do they mean by that? In the simplest sense, that there is a defining characteristic to some markets, their structure, where the asset has a built in decay in value or built in curve where nearby prices are higher than further off prices, and so forth.

In the case of short options and short Vix futures, the market structure will, by definition, provide return during periods which aren’t good for a strategy designed to profit when volatility spikes. Of course, this is nothing new – option sellers have been ‘picking up pennies in front of the freight train’ like this for years. The difference here is, they are not just cognizant of the risk of the train coming down the track in the form of a volatility spike, they are planning for it.

They know the risk to being positively correlated to stocks via market structure during low volatility times is you won’t be negatively correlated when the spike comes, and have designed their models to do something about. They try to be net long volatility (yet still able to collect premium) by being short it on the front end and long it on the back end on the securities side,  and being dynamic in their exposure on the VIX futures side, with the ability to switch to long VIX should their indicators signal a rising volatility environment. But enough from me, let’s let them explain just how they do that.

Thanks to the team at Advocate and Aegea for the lunch (and the learn).

Alternative Links: Is this what every Commodity trader looks like?

Commodity Trader“Behold the greatest piece of trading art ever created.  The piece is untitled, undated (likely from early 1970s) and by an unknown artist (Alfred Marshall), yet like the Mona Lisa it can be admired for it’s simplicity, intriguing facial expression and style which reflects upon it’s subject.  I hereby entitle it Smug Trader.” – (Trading Pit Blog)

We found this gem yesterday via Chicago Sean.


Rollinger explains Red Rock Capital Commodity Long Short Program – (Futures Magazine)

Managed futures June Performance – (Attain Capital)


Clearing houses to publish risk models – (Financial Times)


Asness: Why Investors Should Use Momentum Strategies – (Value Walk)

Buying the Managed Futures Drawdown – (Hedge Fund)

Managed Futures Podcast Series – (CME Group)


Mutual Funds Still Favorite Vehicle Of Choice For Alternatives – (Value Walk)

Managed Futures June Performance

After a bumpy start to the year, the average YTD performance of the 4 managed futures indices we track has managed to pull itself into the positive for the first time in 2014 {disclaimer: past performance is not necessarily indicative of future results}. Here’s the month by month performance of Managed Futures for 2014 thus far:

Managed Futures June Performance(Disclaimer: Past performance is not necessarily indicative of future results)
(Only 51% of returns reported to the BarclayHedge CTA Index)

Lessons Learned From 37 Years of Futures Trading

Originally From Attain’s 3/’11 Newsletter:

Managed Futures have come a long way in the past 37 years, and so has Barbara Mueller, who will be retiring at the end of March after nearly four decades dealing with futures trading. Barbara has been working in the industry since 1973, and has been an invaluable asset to Attain Capital since 2006.

In honor of her retirement, we’re taking a break from our traditional analysis this week to pay tribute to Ms. Mueller. It has been an honor to work with someone as knowledgeable, talented and motivated as Barbara, and here she provides us with her (often comical) insight from 37 years of experience in the world of futures trading.

Moving Forward, Looking Back

When Attain asked me to come up with a list of the best things I’ve learned after more than 3 ½ decades in the futures industry, it was pretty daunting.  After all, 37+ years ago, we were in the stone age of trading. We did have the wheel (and telephones), but there were no personal computers, no fax machines, no stock index futures, no US options on futures, no 24 hour markets, and gold was trading at $135 an ounce.  There were no Treasury bond futures or other financial instrument futures. The CFTC and NFA (the futures regulatory agencies) did not exist yet.  We were governed by the CEA -the Commodity Exchange Authority.  And the list goes on.

Typical commissions were $75 to $100 round turn. Account forms were only 1 page!  Some of the prices were still written on blackboards at the Chicago Board of Trade and you could inspect physical grain there as well.   The whole managed futures industry was an still an embryo, with Richard Dennis not teaching his Turtles until 1983 and Paul Tudor Jones still a clerk on the trading floor. S&P futures, the most popular trading system vehicle in the world, wasn’t launched until 1982 (the minis didn’t start trading until 1997!) Options on commodities in the United States weren’t authorized until 1984 and System Writer, the precursor to Trade Station, wasn’t launched until 1989.

As one of the first women brokers in the futures industry, it’s been quite a journey-and an accidental one at that.  I was just waiting for a teaching job to open up in the Chicago Public School System and my Dad suggested I go to work for one of his friends at the Chicago Board of Trade in the interim. Thirty seven years later, I guess I can no longer call this an “interim” job!

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Asset Class Scoreboard – YTD

If Newton were to offer investment advice it might go something like this… “For every investment theory, this is an equal and opposite investment theory” … Or something like that. The old “Sell in May” theory juxtaposed against nearly every asset class seeing gains in May seems to be a perfect case in point:

May Asset Class Scoreboard(Disclaimer: Past performance is not necessarily indicative of future results)

Chart May Asset Class Scoreboard(Disclaimer: past performance is not necessarily indicative of future results.)
Source: All ETF performance data from Morningstar.com
Sources: Managed Futures = Newedge CTA Index, Cash = 13 week T-Bill rate
Bonds = Vanguard Total Bond Market ETF (BND),
Hedge Funds= IQ Hedge Multi-Strategy Tracker ETF (QAI)
Commodities = iShares GSCI ETF (GSG); Real Estate = iShares DJ Real Estate ETF (IYR);
World Stocks = iShares MSCI ACWI ex US Index Fund ETF (ACWX);
US Stocks = SPDR S&P 500 ETF (SPY)

Quick Notes:

1) Managed Futures is finally over the breakeven point on the year.

2) Should Gundlach be worried about his short housing market call?

3) What’s going on with bonds moving in the same direction as stocks?

4) Are these monthly numbers an example of a “complacent market?”