Managed Futures: Is It an Asset Class?

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For those unfamiliar with the term managed futures, it is a niche sector of alternative investments that evolved out of the Commodity Futures Trading Commission Act of 1974, and refers to professionally managed assets in the commodity and financial futures markets. Management is facilitated by either Commodity Trading Advisors (CTAs) or Commodity Pool Operators (CPOs) who are regulated by the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA).

Managed futures is the little kid brother to the hedge fund juggernaut. Even so, its impact upon the industry is writ large in two significant and related ways: first, managed futures unlike its brethren hedge funds operate in a highly regulated environment; second, this same regulated environment which imposes disclosure and reporting requirements lends itself to fomenting lower barriers of entry for new talent to evolve. Interestingly, the institutionalization of alternative investments can be traced back to the development of managed futures performance tracking databases first established around 1979. This data became the basis for an academic body of research on managed futures beginning with the seminal study by Harvard Business School professor, Dr. John E. Lintner.

So is managed futures an asset class? Let’s cut to the chase… in this writer’s humble opinion the answer is no, absolutely not. Well, maybe we would reconsider if managed futures was confined to just commodity interests, but with futures contracts also trading on financials, managed futures is as much an asset class as are registered investment advisers, mutual funds or hedge funds.

Lee, Malek, Nash and Rose (2006), on the other hand, would beg to differ. Their paper The Beta of Managed Futures makes the case that the predominant strategy in this space is trend following, and thus an appropriate benchmark for managed futures is one that mechanically mimics trend following systems. To say the least, it’s an interesting approach, and one which addresses issues related to peer group analysis and indices based on a composite of individual CTA programs. As Lee, Malek, Nash and Rose posit, “CTA indices represent the result of investing in CTAs, not the results of investing like CTAs.”

The weak part of their thesis, however, has to do with the assumption that managed futures essentially represents just trend following strategies. Lee, Malek, Nash and Rose readily admit that CTAs “employ a wide range of methods” and that such methods are “by no means exhaustive,” and include “breakout systems, systems based on moving averages and systems based on pattern recognition”. They attempt to reconcile this issue by creating a “beta benchmark” that “consists of twenty systems trading the world’s most liquid… markets”. According to their study, they found that their benchmark, for the period analyzed, was highly correlated to large CTAs.

That said, a mechanical trading index approach still leaves questions, including the validity of the trading methods utilized and the robustness of the parameters used to supposedly define the “beta of managed futures”. At a more subtle level, questions are raised by a relatively new concept proposed by Lo (2004) called the Adaptive Markets Hypothesis (AMH). AMH is based on an evolutionary approach to economic interactions and builds on the research of Wilson (1975), Lo (1999) and Farmer (2002) in applying the principles of competition, reproduction and natural selection.

In light of AMH, the paper by Lawrence Harris, The Winners and Losers of the Zero-Sum Game: The Origins of Trading Profits, Price Efficiency and Market Liquidity provides an intellectually honest answer as to the true dynamics underlying managed futures.

The following is from the paper’s abstract; written in 1993, it is not something you’d likely see in an academic paper nowadays: “Trading is a zero-sum game when measured relative to underlying fundamental values. No trader can profit without another trader losing. People trade because they obtain external benefits from trading… Three groups of stylized characteristic traders are examined. Winning traders trade for profit. Utilitarian traders trade because their external benefits of trading are greater than their losses. Futile traders expect to profit but for a variety of reasons their expectation are not realized.”

Harris goes on to discuss the obvious but little acknowledged fact that, “Trading performance reflects a combination of skill and luck. Successful traders may be skilled traders or simply lucky unskilled traders. Likewise, unsuccessful traders may be unskilled traders or unlucky skilled traders... We would like to believe that skill accounts for most variation in past performance among traders and managers,” but “from past performance alone, you cannot confidently determine who is skilled and who is lucky.” Therein lies the conundrum and the alternative investment industry's dirty little secret.

From this 20,000 foot level, the paper drills down and “examines the economics that determine who wins and who loses when trading.” Harris considers “the styles of value-motivated traders, inside informed traders, headline traders, event study traders, dealers, market-makers, specialists, scalpers, day traders, upstairs position traders, block facilitators, market data monitors, electronic proprietary traders, quote-matchers, front-runners, technical traders, chartists, momentum traders, contrarians, pure arbitrageurs, statistical arbitrageurs, pairs traders, risk arbitrageurs, bluffers, ‘pure’ traders, noise traders, hedgers, uninformed investors, indexers, pseudo-informed traders, fledglings and gamblers.” The paper goes on to “describe each of these traders, explain how their trading generates profits or losses, and consider how they affect price efficiency and liquidity.”

Because this paper was written in the early 1990s some of the descriptions may admittedly be dated relative to technological and quantitative developments in the field of trading since. Nevertheless, Winner and Losers of the Zero-Sum Game is a little noticed gem of a working paper whose astute observations ring true even today despite the escalating arms race in academic working papers being spun out of the university-industry revolving door.

Then why is managed futures constantly referred to as an asset class? Answer: out of laziness. However, such laziness goes beyond just the financial industry’s responsibility; truth is, half the problem lies with investors themselves—try as one might to delineate sophisticated investment concepts, the most common reaction is investors’ eyes glazing over.

So if managed futures is not an asset class, then what is it? As with many of the acronyms and lingo that the financial industry regularly comes up with, mainly for marketing reasons, the term has become a misnomer. What started out as an investment activity that was defined by regulations is now conventionally considered by many an asset class. C'est la vie…

Winners and Losers of the Zero-Sum Game - Harris

References:
Harris, Lawrence. “The Winners and Losers of the Zero-Sum Game: The Origins of Trading Profits, Price Efficiency and Market Liquidity” School of Business Administration, University of Southern California, Draft 0.911, May 7, 1993.

Lee, Timothy C.; Malek, Marc H.; Nash, Jeffrey T.; and Rose, Jeffrey M. “The Beta of Managed Futures,” Conquest Capital Group LLC, February 2006.

Lintner, John E. “The Potential Role of Managed Commodity—Financial Futures Accounts (and/or Funds) in Portfolios of Stocks and Bonds” Presented at the Annual Conference of the Financial Analysts Federation, May 1983.

Lo, Andrew W. “The Adaptive Markets Hypothesis; Market efficiency from an evolutionary perspective” The Journal of Portfolio Management, 30th Anniversary Issue 2004, pp. 15-29.

Using a Zero-Beta Asset for Measuring Variance

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Numerous research papers on gold begin by establishing that of all the commodities gold is a distinct asset. Anecdotal themes include the idea that human civilization has long been enamored with gold going back to ancient times, as well as the fact that, unlike most other commodities, bullion can be stored almost indefinitely and requires very little maintenance. These attributes are given as the reason gold has throughout history been used as a medium of exchange and maintains its purchasing power. In Research Study No. 22, Gold as a Store of Value, published by the World Gold Council in 1998, author Stephen Harmston relates the oft-heard story that "an ounce of gold bought 350 loaves of bread in the time of Nebuchadnezzar… still buys approximately 350 loaves of bread today." Notwithstanding that we have been unable to identify an archeological or biblical source for this tale,[1] let us assume that this bit of trivia is true, along with other stories involving an ounce of gold buying a nice suit, armor or otherwise.

Assuming gold does have the unique ability to maintain consistent purchasing power over an extended period of time, such asset would seem to fit the definition of a zero-beta asset. This is the conclusion of a paper by McCown and Zimmerman (2006) titled, Is Gold a Zero-Beta Asset? Analysis of the Investment Potential of Precious Metals in which they analyze gold returns using three different frameworks: the Sharp (1964) and Lintner (1965) capital asset pricing model (CAPM); the arbitrage pricing theory (APT) of Ross (1976); and cointegration using a test methodology developed by Elliott, Rothenberg and Stock (1996), and another methodology by Kwiatkowski, Phillips, Schmidt and Shin (1992).

Running a regression analysis from 1970 to 2003 where the "risk-free" rate is the yield on the US T-Bill, McCown and Zimmerman use three different proxies for the market portfolio: MSCI US Index, MSCI World denominated in local currency, and MSCI World denominated in US dollar. Acknowledging that the CAPM is "limited in usefulness as a tool for investment analysis," the authors observe that "all of the estimated beta coefficients for gold are statistically indifferent from zero," and therefore gold does not reflect "much, if any, systematic risk". In their CAPM study the conclusion is that gold effectively behaves as a zero-beta asset, yet it also "has a positive risk premium". The APT methodology and cointegration tests also validate the authors' hypothesis.

The paper concludes that gold shows "the characteristics of zero-beta asset," and that the "mean return is just slightly higher than that of T-Bills". Further, "estimates of CAPM and the APT show that both gold and silver bear virtually no market risk, and their estimated betas are statistically indifferent from zero". All three frameworks showed evidence of inflation-hedging ability when added to an investor’s portfolio. Obviously, McCown and Zimmerman's research doesn’t take into account the rise of gold since 2003, which brings up that "old saw" about how correlation does not imply causation. Given that gold is priced today much higher than in 2003, yet inflation has generally been tame since the millennium, raises a question concerning the underlying perspective of this study. Perhaps a better framework for studying gold is that is acts like a currency proxy?

Over the course of our lifetime we are trained to value assets from a US dollar-centric perspective, and it is hard for US-based investors to think differently. In Europe one views prices from a euro-centric perspective. However, it is also possible to revalue the economy and markets from the perspective of preserving purchasing power. When assets such as stocks are revalued in gold as a unit of account, we gain a completely different outlook on whether or not such assets have risen or fallen, and to what extent. For example, if we were to value the Dow Jones Industrial Average, not in US dollars but in ounces of gold, it would have cost around 30 ounces of gold to buy the Average at 10,000 when the index first crossed over that line in 1998. When it crossed over that line again back in October 2009, it would have cost less than 10 ounces of gold.

In a March 30, 2010 Financial Times article titled, "Will negative swap spreads be our coal mine canaries?" Gillian Tett forces us to rethink what constitutes a "risk-free" rate. In finance classes the rate based on the three-month US T-Bill is almost always assumed as the risk-free proxy for input into the CAPM. But what if, as Tett suggests in her article, that there is no risk-free rate? Black's (1972) zero-beta CAPM provides a solution by supposing a riskless asset does not exist, and that investors hold different risky portfolios all existing on the efficent frontier. In order to calculate the zero-beta CAPM, one simply replaces the "risk-free" rate with a "zero-beta" rate. This is necessary to calculate the mean-variance of the market portfolio.[2]

One of the more interesting aspects of McCown and Zimmerman's research was that gold still reflected characteristics of a "zero-beta" asset when using the 'MSCI World denominated in local currency' as a proxy for the market portfolio. When employing the CAPM, analysts traditionally measure portfolio variance denominated in either the US dollar or in the local currency in which the portfolio's assets are actually denominated. What we are suggesting is that zero-beta also implies the idea of relative valuation when measuring variance based on some unit of account. In other words, a better method for measuring variance when using the zero-beta CAPM necessitates an exchange rate constant which consistently maintains purchasing power over an extremely long time horizon, rather than a floating exchange rate variable which reflexively alters the value of the assets it is suppose to measure.

Footnotes:
[1] Dr. Claude Mariottini, Professor of Old Testament, Northern Baptist Seminary, states that no where in the Old Testament does it say that "in the days of Nebuchadnezzar an ounce of gold bought 350 loaves of bread." Further, Dr. Mariottini logically points out that "one must assume that the ounce, a unit of weight in the avoirdupois system, once used in the United Kingdom and still used in the United States, was also used in Babylon. Since the Babylonians did not use imperial units, this statement is false." Source: Gold and Bread http://tinyurl.com/yjxpn6d

[2] Zhang, Lu. "The Capital Asset Pricing Model" Stephen M. Ross School of Business, University of Michigan (2007).

Is Gold a Zero-Beta Asset? Investment Potential of Precious Metals

References:
Harmston, Stephen. "Gold as a Store of Value" Research Study No. 22, World Gold Council (November 1998).

Mariottini, Claude. "Gold and Bread" http://doctor.claudemariottini.com/ (June 10, 2008).

McCown, James Ross and Zimmerman, John R. "Is Gold a Zero-Beta Asset? Analysis of the Investment Potential of Precious Metals" Meinders School of business, Oklahoma City University (July 24, 2006).

Tett, Gillian. "Will negative swap spreads be our coal mine canaries?" Financial Times (March 30 2010).

Zhang, Lu. "The Capital Asset Pricing Model" Stephen M. Ross School of Business, University of Michigan (2007).