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Managed Futures And Superior Risk Management

by Marlee-Jo Jacobson-

There are aspects of investment analysis that work well for traditional investments. When applied to managed futures, these long standing traditional procedures unknowingly increase risk. We evaluate a few 'mass beliefs' currently influencing the analysis and selection of managed futures investments.

When erroneous beliefs are identified and released, truth dramatically improves the probability of a positive return because the 'unseen' cause of risk is removed from the environment.

William Sharpe states that:

"Frequently portfolio performance is evaluated over a time interval of at least four years, with returns measured for a number of periods within the interval - typically monthly or quarterly. This provides a fairly adequate sample size for statistical evaluation." 

We believe that managed futures need a more direct thought process for fundamental valuation to have substance. WHY?

1.Rate of return calculations for managed futures incorporate data having no relevance to actual risk taken to receive a specific return.

2.Time weighted, dollar weighted, actual funding and notional funding are four methods of calculating rate of returns. Because multiple methods of calculating returns exist, the possibility of accurately comparing investments using only traditional rate of return calculations is
slim.

3.Quantifying an advisors trading skill using only performance data can be a major cause of unseen risk. WHY?

How performance was achieved is usually overlooked. 

Market conditions relative to skills and strategy may not be considered.

Actual capital at risk relative to realized returns is not considered.

Prudent cost evaluation relative to return is forgotten.

Equity growth relative to return needs to be evaluated.

The perceptions and beliefs of the analyst building your investment is a primary colossal consideration.

Benchmark Portfolios and Relevant Investment Comparisons

To quote Mr. Sharpe again: "The essential idea behind performance evaluation is to compare the returns obtained by the investment manager through active management with returns that could have been obtained for the client if one or more appropriate alternative portfolios had been chosen
for investment. The reason for this comparison is straightforward - performance should be evaluated on a relative basis, not on an absolute basis.

In order to infer whether the manager's performance is superior or inferior, returns of similar portfolios that are either actively or passively managed are needed for comparison. Such comparison portfolios are often referred to as benchmark portfolios.

Selecting benchmark portfolios should prove relevant and feasible, meaning they should represent alternative portfolios that could have been chosen for investment rather than the portfolio being evaluated". 

Benchmark portfolios or indexes according to "what should be" as defined by William Sharpe for managed futures investments do not exist. They can be created, but do not naturally exist. Imitating traditional stock indexes, the managed futures industry creates indexes comprised of advisor performance. Each index contains advisors having similar market sectors or strategies. For example, Energy, Stock Index, Grains, Financial, Inter-Bank, Systematic and Diversified Traders ETC. Indexes can be created for any purpose. These indexes have no relevance to any single investment and cannot prudently be used to compare any single investment.

Superior Risk Management Closes the Gap Between Belief, Truth and Relevance

Industry participants and the media use indexes published by industry professionals as benchmarks for comparison to specific investments, or referring to the pulse of an industry or sector. I receive the Alpha report from Investment Advisor Magazine. It carries the Carr/Barclay
CTA Index and a hedge fund index. The index is published along with the S&P, NASDAQ, Russell 2000, and a myriad of other stock and bond market indexes.

*****Stock and bond market indexes are comprised of closing stock or bond prices at the end of each day. Indexes directly mirror prices of the stocks or bonds in it. If someone developed a grain index and daily prices for all the grain markets were included, then that futures index mirrors the equity indexes and has useful relevance.

If people bought the grain markets reflecting the exact proportions used in the index, then the index serves a useful purpose. If people invested in grain traders based on values of the grain index, they are increasing their risk because there is no relevance between the grain index and the performance of any grain trader! *****

In the scenario above, the gap between 'belief', 'truth' and 'relevance' is wide therefore risk of loss is
increased.

CTA and hedge fund indexes reflect the returns of trading talent applied to markets, whereas debt and equity indexes reflect the market prices of stocks or bonds in each index. I perceive that the industry wide applications of using CTA and Hedge Fund indexes for benchmark and
investment evaluation purposes are 'erroneous.' The 'belief' underlying the application unknowingly
increases risk for many investors.

A Foundation Burdened With Error Will Only Multiply Error ~Nothing Else is Possible

About The Author: Marlee-Jo Jacobson founder of Sanctity Capital Management and SafeMoneyMetrics is 2nd generation in futures. She has over 20 years of experience including floor trading, hedging and major project development for key national and international accounts. Complete professional history can be found at http://www.sanctity.com/why/about.htm 
Website' http://www.alwaysafemoneymetrics.com

 

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