Alternative Rock and Alternative Investment

Given the recent fears from the overheated real estate market, a record trade deficit and the squeeze put on by historically high energy prices, it’s easy to be concerned about inflation. Commodities have historically been used as a hedge against inflation, and that hasn’t changed. What has changed is how accessible the ability to allocate assets into the commodities markets. It was once that investing in commodities meant perhaps buying gold bullion or purchasing ETFs that specialize in commodities like gold and oil. But now investors are becoming savvier and more interested in control of their portfolios, and new investment vehicles are responding to their interests. And it’s not just Wall Street that’s moving in: according to a Business Week article, as of 2004 Harvard has 13% of its $22.6 billion endowment allocated to commodities.

Alternative investments is a lot like alternative rock, alternative in name but not in public appetite. One of the major alternative investment vehicles are managed futures programs. This industry is comprised of professional money managers known as commodity trading advisors (CTAs) who trade using futures and options. These advisors can trade in multiple asset classes (futures on stocks, bonds, currencies and commodities) and are not limited to long-only trading strategies. In a landmark paper, John Lintner in 1969 demonstrated that managed futures programs can boost return while reducing overall portfolio risk. This work was further developed by researchers such as Thomas Schneeweis of the University of Massachusetts, who laid out the basic framework showing that managed futures can reduce portfolio risk, enhance returns in different market conditions, and participate in financial products not available in traditional investment products.

With macroeconomic factors like accelerating consumption from China and India in place, commodities are rapidly ascending in investor’s interest. Finding and evaluating managed futures programs remains challenging for the individual investor. The key to evaluating programs across different investment methods lies in two basic concepts, risk and return. Investors seek to maximize their returns for a given risk. How to managed futures fare? According to one of the most comprehensive surveys available conducted by Gorton and Rouwenhorst in 2004, from evaluating data from the Commodities Research Bureau and evaluating for long term investing by taking data from 1959-2004, their finding was that a commodity futures index produces returns comparable with stocks with about 80% of the volatility for that period. This suggests, as astonishing as it seems that equities may have more downside risk than commodities.

What does that mean for the individual investor? The key to determining whether managed futures are appropriate is to determine the allocation of their portfolio that can gain the benefits of managed futures programs in order to maximize their portfolio return and reduce risk. Importantly, managed futures must be seen as long term investments, and not limited to current excitement over their importance. The value that diversification adds holds true in all markets. To be an informed investor, be sure to think about the components of a successful portfolio.

Khurram Naik is a derivatives broker at Infinity Futures in Chicago. He is a graduate of Carnegie-Mellon and has worked in research in cognitive science and education at Princeton, Harvard and Carnegie-Mellon University. He is also a former field director for a political campaign. He maintains a blog on literature and cognitive science. He can be reached at [email protected]

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