Managed Futures Can Smooth Your Ride
05/07/2012 7:00 am EST
Focus: MANAGED FUTURES
Managed futures funds take advantage of trends in various options, futures, and currency markets to weather choppy markets, writes Dave Kavanagh. He also explains how his managed futures fund-of-funds can also capitalize on both sides of the market, by going long as well as short.
Dave, we spoke back in January, when the first-quarter rally in the equity markets was just beginning to get under way. We’re four months into the year right now. How would you characterize the place of managed futures in a portfolio at this juncture?
Dave Kavanagh: Well, if investors have been patient, they’ll stick with the allocation to managed futures. I think it’s done what it’s supposed to have done in, the sense that when we look at a program, one of the things that we try to insist on, or at least try to capture, in times of economic stress—especially in the equity markets—is that we offer protection.
The first quarter is over. You had 10%-plus returns out of the S&P. The managed futures industry is struggling—plus or minus 1% to 2%, for the most part. So we haven’t added any real alpha to the portfolio, to the upside. But again, I think if you look at it historically, the statistics are irrefutable that the addition of managed futures adds good diversification and positive returns in times of significant stress.
The way we take an approach is kind of a holistic portfolio approach across many sectors. So, there are certainly a number of good trends that we can point to that we’ve made money in. But the choppiness of the markets in the rest of the portfolio really hasn’t led to significant gains.
But I still feel that, and am very confident, having done this for 27 years now and I’ve gone through a number of these cycles: This is a product that I really feel, both from an institutional and retail standpoint, people should be invested in.
Kate Stalter: Now, that leads to something else I was wondering about. It seems that I’m hearing a lot more about managed futures funds in the past several months. Is this an area that you feel retail investors are becoming more open to? Is there more interest, or do people hear the terms futures and options, and they feel a bit wary about that?
Dave Kavanagh: No. I think, in general, people still, despite the run-up—and we’ve had almost 100%-plus run ups since the March 2009 lows of the equity markets—I think 2008 is still in people’s minds.
I think they’re probably looking, especially some of the more astute FAs and RIAs are looking for products, alternative products, that can add diversification, positive returns. Because there’s still a fair amount of, one might argue, storm clouds that are kind of on the horizon there.
Still a lot of uncertainty in Europe. And, you know, you’ve got the upcoming elections, and you’ve got what some people are calling “taxageddon,” with the taxes in the first quarter that come into effect in 2013.
So I think there’s a number of things that are still weighing on the minds of investors, and they’re looking for diversification. And as I said, you’re seeing many FAs and RIAs really looking for other things to invest in. And traditional fixed income and equities—especially with fixed income at the levels there’re at, I think interest-rate risk is perceived to be pretty substantial in a lot of portfolios.
Kate Stalter: I want to shift gears a little bit. The last time we talked, you really emphasize that you don’t make sector bets. Can you speak to the approach of the fund, Dave, and why that is, and how that plays out?
Dave Kavanagh: Well, the fund itself may employ one or two sector-specific traders. But at the end of the day, we want to have a pretty broad diversification of market sectors that we want to invest in. Because as an allocator, we don’t like to prognosticate or forecast what sector is going to be hot.
There were a number of years ago, to use an example, where the most profitable trade in our portfolio was the Mexican peso. At the beginning of the year, I would have never dreamed that that would have been our most profitable trade.
So we won’t concentrate the portfolio in any one sector or any one trader, for that matter, because we just don’t. We’re not smart enough. I’d like to suggest that we know better than what other people don’t. So we just have a diversified approach to all sectors that we can get exposure to.
Kate Stalter: Do you use a sub-advisor model?
Dave Kavanagh: Yes. We don’t trade the money ourselves. We trade it out in the mutual fund. We allocate it out to five different traders.
At the LP [limited partnership] level, we allocate it out to 11 different managers. So, it is a managed futures fund of fund that we allocate out to.
Kate Stalter: One of the popular phrases that I’m hearing more and more these days is “trend following.” You didn’t use that phrase, but it does sound like that is, in a way, what you’re saying: “We follow what these various markets are telling us, not trying to make a guess as to what might happen.” Would that be correct?
Dave Kavanagh: That would be spot on. We’re not predictive in the trades.
For the most part, the sub-advisors that we use, they usually take a quantitative approach. The majority of them, or most all of them, are not predictive in the sense that they don’t sit down and read The Wall Street Journal and say, “Gosh, it looks like oil stocks declined yesterday, so I want to get low on crude oil.”
You know, there’re reacting to a price movement in crude oil to the upside, and then they’ll try to capture part of that trend. They’re predictive in the sense that their model is telling them that the price trend might or should continue, so they’ll take a position. But it’s not based on a fundamental aspect of something they read, or economic data that wants them to get long or short for that matter.
Again, I guess I would emphasize that not only the markets that we trade that give us that diversifying effect, but it’s the ability of the fund to go short and long that also provides substantial diversification from a traditional portfolio.