How Managed Futures Fit into Your Portfolio

01/17/2012 7:00 am EST

Focus: MANAGED FUTURES

Managed futures assets add juice to a portfolio in times of economic stress because they are uncorrelated to the broader markets, explains fund manager Dave Kavanagh. He also details how his fund makes investment decisions, and why he avoids making sector bets.

Kate Stalter: I’m talking with Dave Kavanagh of the Grant Park Fund (GPFAX).

Now Dave, explain to us your investing philosophy and your objective here. I understand that this is managed futures, something a lot of our listeners may not be so familiar with.

Dave Kavanagh: Yes, Dearborn, or the Grant Park Fund, has two products. One is the mutual fund, and one is a public limited partnership that we distribute to the general public through the broker-dealer network.

We found that our penetration rate really sits at around 2% to 3%. So it is getting more interest, but it’s not getting near the interest that we think managed futures should have.

In a nutshell, what managed futures provide is an important non-correlated asset that any serious investor should have in their portfolio. Statistical studies—academic studies—suggest that that should be anywhere from 5% to 15% of a portfolio.

Some people say, “Well, it should be held for three to five years.” I would posit that it should be held as long as you own equities and/or fixed income in a portfolio, because of the diversification effects.

What we’re trying to do is to provide some stability. One of my colleagues likes to suggest that it’s the seatbelt in the portfolio. You get into a car, you’re in a high-performance car, you still want to put a seatbelt on in case there’s an accident.

Historically, this type of a product has performed quite well in times of economic stress, whether it be during the tech bubble in 2000 to 2003, when that popped…and in late 2007 through 2008 and early into 2009, it provided a very good diversifier with positive returns. Our public fund was up 20%-plus in 2008, and I’m sure you and your listeners understand what happened in that time period.

Even this year, we recently launched a mutual fund. We began trading in March of 2011 and through the end of the year, the fund was actually down about 60 basis points, vs. the S&P down 3.8%, the total return during that timeframe.

At the same time, the standard deviation for the fund was only 7%, while the standard deviation of the S&P was almost 17%. But most importantly, the correlation co-efficient of that product vs. the S&P was -0.22.

So you had better returns, negative correlation, less standard deviation. I’m not sure there’s a serious investor out there that wouldn’t want to include a portion of this type of a product into their portfolio.

Kate Stalter: Dave, say a little bit about some of the holdings within the fund. How are these determined?

Dave Kavanagh: Well, it’s a fund of managed-futures funds. At this point in time, there’s five sub-managers that we choose, commodity trading advisors that we choose and monitor on a daily basis.

An example—I’m not saying specifically in this fund, but the types that we have—they might be currency only, they might be discretionary, they might be short-term systematic, long-term systematic, trend following…

The one thing that we do for the most part is: We like a diversified portfolio that gives us exposure on not only on a time-horizon front. The markets that we trade, we want to be well diversified across the entire markets available, and those markets have to be liquid with considerable open interest.

We don’t go out and make a sector bet. I think there are some funds out there, and I’m not saying we’ll never introduce a fund like that, but at this point in time we don’t go out and make sector bets. I can’t tell you what the next big trade of 2012 is going to be. So we want to be well represented.

Let’s call it the six major market sectors. Historically it’s proven the case, you’ll see a number of those sectors take hold and you get good returns from them.

In the interest of full disclosure, 2011—and I’ve been doing this since I started this fund in 1989 and I began trading on the floor of the Board of Trade in 1981—2011, I think, was the hardest year I have ever seen in the managed futures business.

Historically, if you look back, it’s times like this that probably make it the most opportune time to invest, because as you know, there’s been an incredible amount of both fiscal and monetary stimulus into the various markets globally. I don’t think you can have that happen without some profound market events finally occurring.

I think there’s just been an enormous amount of cross currents over the last 12 to 24 months, and once there’s a clarity to the situation out there—which I think will eventually come some time this year—you’re going to get some real great opportunities in the managed funds space.

Kate Stalter: One of the things you were saying there, Dave, led me to wonder about something: How often do you change the asset-allocation mix, given the strength or weakness of various asset classes?

Dave Kavanagh: We won’t change the mix based on the strength or weakness, because what you have to remember is: The two things that are the hallmarks of managed futures is the risk management that’s embedded in it…and also the ability to go short.

So if the manager we employ, if their model—whether they be discretionary or quantitative—suggests that this asset is overpriced at $10. So if widget is A is overpriced at $10 and it starts to decline and then it starts to break through $9, they could very well take a short position on that.

Meanwhile, your corresponding portfolio manager perhaps is still long that widget A, but we’re going to be short. If that trend goes down to $5 or $4 or $3, we’re going to benefit from that.

So we’re looking for sustained movements amongst various asset classes—not movements that only go up. So most of the models that the CTAs [Commodity Trading Advisors] employ are reactive, not predictive, so that the things that they really want to make sure is that they’re in liquid, deep markets, where if there is a sustained trend they’ll be able to put a position on, get in and get out with very little disruption to the market.

Kate Stalter: One last question I had for you today, just with regard to the holdings again. Morningstar has the fund being 67% in cash. I was just wondering whether that was just a function of how the holdings were categorized. Can you explain that?

Dave Kavanagh: Well, they are accurate. Actually it’s about 75 cents on the dollar, kept either in cash or securities or cash equivalents. So our average duration is probably less than a year, AAA investment-grade cash equivalents.

We do that as a methodology for yield enhancement. We don’t do that to make a bet on interest rates. It’s the balance, the other 25 cents on the dollar, which you really have to pay attention to, because that’s where all the activities in the fund take place.

Futures contracts by definition are leveraged. So the ability, that 25 cents on the dollar that’s being deployed to the various exchanges around the world, may actually control anywhere from $1 to $3 of contract or face value in the various six major sectors that we trade in.

Remember that we trade in energies, grains, metals, currencies, equities—both domestic and international—and fixed income—domestic and international. So we’re controlling positions in those six sectors with that 25 cents on the dollar.

If an investor were to give us a dollar to invest, the positions that he would control would be possibly in excess of the dollar that he gave us, even though that 75 cents is part in investment grade securities.

It’s the other 25 cents that is taking the risk in the portfolio. We choose to take 75 cents on the dollar and invest in investment-grade securities, because we want to stick to what we think we have an expertise in.

We could, if we wanted, have the ability to go out and buy equities, buy longer-term bonds. We don’t want to take the interest-rate risk, and we don’t want to take the risk on the equity side either, so we choose to put it in the short-term securities market.