John Lintner, a Harvard professor, presented the seminal paper “The Potential Role of Managed Commodity Financial Futures Accounts (and/or Funds) in Portfolios of Stocks and Bonds” in May 1983. The findings of his work, namely that portfolios of equities and fixed income exhibit substantially less variance at every possible level of expected return when combined with managed futures, remain as true as ever today.
In this brief paper, we attempt to update Mr. Lintner's work by demonstrating that the beneficial correlative properties of managed futures presented in his research persist today. We also reintroduce managed futures as a diverse collection of liquid, transparent hedge fund strategies that tend to perform well in environments that are often difficult for traditional and other alternative investments.
While many casual observers most closely associate managed futures and Commodity Trading Advisors with trend following, the reality is that the strategies and approaches within managed futures vary tremendously; the one common unifying theme is that these managers trade highly liquid, exchange-traded instruments and deep foreign exchange markets. Counter-trend strategies attempt to capitalize on the often rapid and dramatic reversals that take place at the end of trends. Some quantitative traders employ econometric analysis of fundamental factors to develop trading systems. Others use advanced quantitative techniques such as signal processing, neural networks, genetic algorithms and other methods borrowed and applied from the sciences. Recent advances in computing power and technology as well as the increased availability of data have resulted in the proliferation of short-term trading strategies. These employ statistical pattern recognition, market psychology and other techniques designed to exploit persistent biases in high-frequency data. The countless combinations and permutations of portfolio holdings that these trading managers may hold over a limited period of time also tend to result in returns that are not correlated to any other investment, including other short-term traders.
A useful analogy for different managed futures trading programs and styles, as well as for alternative investments in general, consists of thinking of each trading style or program as different radio receivers, each of which tunes into different market frequencies. Simply put, some strategies or styles tend to perform better or “tune in” to different market environments. The diverse and uncorrelated investments offered by managed futures allow institutional investors to access an entire universe of liquid transparent hedge fund strategies to add to their portfolios.
The long-term correlations among equities, fixed income and managed futures remain low even 25 years after Mr. Lintner's study, suggesting its continuing relevance to investors interested in attaining the “free” benefits of diversification. Exhibit 1 illustrates the low and occasionally negative correlations among managed futures and other investments.
Studying the potential role of managed futures in traditional portfolios of stocks with the Omega lens for risk-adjusted performance takes a modern approach to the Lintner study. Mr. Lintner did not have the benefit of the Omega tool during the time he conducted his work, and the Omega function encodes all the higher statistical moments and distinguishes between upside and downside volatility, whereas the Sharpe ratio does not.
The Omega graph in Exhibit 2 indicates that for low thresholds, the combination of managed futures and a traditional portfolio is best, and for higher thresholds a portfolio of managed futures is dominant. Moreover, a traditional portfolio of stocks and bonds combined with managed futures is superior at every meaningful threshold (i.e. where any of the graphs have an Omega score of at least one).