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focuses on managing the assets of institutions and individuals, who would
like to diversify their current and/or potential portfolios into alternative
and complementary asset classes. Before discussing correlation, an important
first step is to define the needs of the investor. It is assumed that the
investor already has a portfolio of traditional assets including stocks
and bonds. His needs are to earn a return large enough to meet the requirements
of the beneficiaries of his portfolio, and to control risk to the lowest
possible levels. In the context of traditional modern portfolio theory, the objectives of the investor are first to use a portfolio on the so-called efficient frontier, commensurate with his return/risk preferences, and second to find ways to shift this efficient frontier towards more return and less risk. The shift in efficient frontier upwards (more return) and to the left (less risk) is accomplished by adding new asset classes with the correct characteristics to the portfolio. Correlation is an important dimension of performance because of the role it plays quantitatively and qualitatively in determining if portfolio enhancement can occur through diversification. Therefore, if there is no significant correlation, a managed futures investment can enhance portfolio performance when its expected return is merely greater than the risk-free rate. Thus, the correlation coefficient is an important determinant of the effectiveness of any asset used for diversification. There are a number of reasons to expect little correlation between managed futures and stocks and bonds. Conditions which are not favorable to stocks and bonds usually are favorable for managed futures. Inflation, deflation and times of economic and political uncertainty can cause major moves in the price of commodities. As an example, when inflation appeared during 1977-1981, the Consumer Price Index (CPI) rose over 60%. Futures funds averaged over 37% over the same five-year period. On the other hand, stocks averaged 14%, while bonds only broke even. Nearly all economic circumstances are reflected somewhere in the commodity markets, and it is probable that the diversity of these forces helps contribute to non-correlation between managed futures and stocks and bonds. Another possible basis for non-correlation between managed futures and stocks and bonds is the diversity of the markets traded. There are at least 40 futures contracts on U.S., CFTC regulated exchanges which qualify for large scale trading. Market categories include agriculturals (wheat, corn, soybeans, soybean meal and oil), livestock (hogs and cattle), foods and fibers (sugar, coffee, cotton, cocoa), petroleum products (crude oil, heating oil, unleaded gasoline), metals (silver, gold, platinum, copper, palladium), currencies (British pound, Australian dollar, Japanese yen, Euro, Swiss franc, Canadian dollar), interest rate instruments (U.S. Treasury Bonds, Bills, Notes, Eurodollar Deposits, Municipal Bond Index), and stock indices (S&P 500, Nasdaq 100). The diversity of markets traded contributes to the non-correlated nature in performance between managed futures and stocks and bonds. Yet another factor contributing to non-correlation is the structure of futures contracts themselves. When a position is taken in a futures contract it can be just as easily long or short. There are no rules making it relatively more difficult to establish short as opposed to long positions as there are in the equity markets. If one has the ability to recognize trends, profits can be made either in rising or falling markets. The capability of profiting from declining markets can provide a significant degree of non-correlation in return patterns. A clear example of the difference between managed futures and other asset management styles is to consider active management in the debt and equity markets. Most traditional investing by institutions is to buy and hold in these markets, and to retreat to cash when weakness occurs. The CTA, on the other hand, can be long or short (or neutral). It is not difficult to see how the latter strategy could be non-correlated with the former. In summary, the performance of managed futures is measured along the following lines: 1.
As a stand-alone investment. |