Futures And Superior Risk Management
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
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
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
Actual capital at risk relative to realized returns is not
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
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
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