In November 2002, Cass Business School Professor Harry M. Kat, Ph.D., began to circulate a Working Paper titled “Managed Futures and Hedge Funds: A Match Made in Heaven,” that later (Q1 2004) would be published in the Journal of Investment Management. The paper described how adding (equity-based) hedge fund exposure to traditional portfolios of stocks and bonds increased returns and reduced volatility. It also produced an undesired side effect — increased tail risk (lower skew and higher kurtosis).
Kat went on to analyze the effects of adding managed futures to traditional portfolios and the effect of adding both hedge funds and managed futures to traditional portfolios. He found that managed futures were better diversifiers than hedge funds, and that they reduced the portfolio’s volatility to a greater degree and in a more timely manner than did hedge funds, without the undesirable side effects. He concluded that the most desirable results were obtained by combining both managed futures and hedge funds with traditional portfolios. Kat’s original period of study was June 1994 – May 2001.
In September 2012, Sunrise Capital published a white paper that revisited and updated Kat’s work. We analyzed the out-of-sample period since the end of his study, June 2001 to December 2011, and found that his observations continued to hold up. During the past 10.5 years, a highly volatile period that included separate stock market drawdowns of 36% and 56%, managed futures have continued to provide more effective and more valuable diversification for stock and bond portfolios than have hedge funds.
Skewness and kurtosis
When building portfolios using the Modern Portfolio Theory (MPT) framework, investors focus almost solely on the first two moments of the distribution: Mean and variance. According to a 2011 study by Marc Odo, the typical MPT method of building portfolios appears to work well as long as historical correlations between asset classes remain stable. But in times of crisis, asset classes often move in lock-step and investors who thought they were diversified experience severe “tail risk” events. By only focusing on mean return and variance, investors may not be factoring in important, measurable and robust historical information.
Skewness and kurtosis, the third and fourth moments of the distribution, frequently offer vital information about the real-world return characteristics of asset classes and investment strategies. Skewness and kurtosis are paramount to this study:
- Skewness, a measure of symmetry, compares the length of the two “tails” of a distribution curve.
- Kurtosis is a measure of the peakedness of a distribution — i.e., do the outcomes produce a “tall and skinny” or “short and squat” curve? In other words, is the volatility risk located in the tails of the distribution or clustered in the middle?
To understand how vital these concepts are to the results of this study we revisit Kat’s original work. Kat states that when past returns are extrapolated, and risk is defined as standard deviation, hedge funds do indeed provide investors with the best of both worlds: An expected return similar to equities but with risk similar to bonds. However, Kat showed that during crisis periods, hedge funds also can be expected to produce a more negatively skewed distribution. Kat adds, “The additional negative skewness that arises when hedge funds are introduced [to] a portfolio of stocks and bonds forms a major risk as one large negative return can destroy years of careful compounding.”
Kat’s finding appears to be substantiated in Koulajian and Czkwianianc (2011), which evaluates the risk of disproportionate losses relative to volatility in various hedge fund strategies: “Negatively skewed strategies are only attractive during stable market conditions. During market shocks (i.e., the three largest S&P 500 drawdowns in the past 17 years), low skew strategies display: Outsized losses of –41% (vs. gains of +39% for high skew strategies); increases in correlation to the S&P 500; and increases in correlation to each other.”
Skewness and kurtosis may convey critical information about portfolio risk and return characteristics.
Crunching the numbers
Like Kat, our analysis focuses upon four asset classes: Stocks, represented by the S&P 500 Total Return Index; bonds, represented by the Barclays U.S. Aggregate Bond Index (formerly Lehman Aggregate Bond Index); hedge funds, represented by the HFRI Fund Weighted Composite Index, and managed futures, represented by the Barclay Systematic Traders Index (see “The skinny,” below).
The performance statistics shown in “The skinny” are similar to Kat’s results. Our results show that managed futures have a somewhat lower mean return and a higher standard deviation than hedge funds. However, they exhibit positive instead of negative skewness and much lower kurtosis. This is critical. The lower kurtosis conveys that less of the standard deviation is coming from the tails (lower tail risk), and the positive skewness indicates a tendency for upside surprises, not downside. From the correlation matrix, we see that hedge funds are correlated highly to stocks (0.80), managed futures are somewhat negatively correlated to stocks (–0.15), and the correlation between managed futures and hedge funds is low (0.10).
To study the effect of allocating to hedge funds and managed futures, we form a baseline “traditional” portfolio, 50% stocks 50% bonds and add hedge funds or managed futures in 5% increments (see “Building a portfolio,” below). As in Kat’s paper, when adding in hedge funds or managed futures, the original 50/50 portfolio will reduce its stock and bond holdings proportionally. For example a 10% allocation to hedge funds or managed futures means there is a 45% allocation to both stocks and bonds. (Note: All portfolios are rebalanced monthly.)
Similar to Kat, we studied the differences in how hedge funds and managed futures combine with stocks and bonds. Kat found that adding hedge funds to the 50/50 portfolio lowered the standard deviation, as he hoped. Unfortunately, hedge funds also increased the negative tilt of the distribution. In addition to the portfolios becoming more negatively skewed, the return distribution’s kurtosis increased, indicating fatter tails. However, Kat found that when he increased the managed futures allocation, the standard deviation dropped faster than with hedge funds, the kurtosis was lowered and, most impressively, the skewness actually shifted in a positive direction. Kat noted, “Although hedge funds offer a somewhat higher-than-expected return, from an overall risk perspective, managed futures appear to be better diversifiers than hedge funds.”
Our results show that Kat’s observations have held up. When we increased the hedge fund allocation, the portfolio return went up and the standard deviation went down. However, the previously discussed “negative side effect” of adding hedge funds was present, as the skewness of the portfolio fell and the kurtosis went up.
But when we added managed futures to the traditional portfolio, we observed more impressive diversification characteristics. In fact, managed futures appear to have improved the performance profile more in this period than with Kat’s study. Adding managed futures exposure increased mean return and simultaneously increased the skewness of −0.76 of the traditional portfolio to a positive 0.05 at the 45% allocation level. The standard deviation dropped more and faster than it did with hedge funds, and kurtosis also improved, dropping from 2.23 to –0.21 at the 40% allocation level.
In updating Kat’s study, we have validated its conclusions further. Managed futures continue to offer superior diversification compared to other strategies.Throughout our analysis, and similar to Kat, we found that adding managed futures to portfolios of stocks and bonds reduced standard deviation to a greater degree and more quickly than did hedge funds alone, and without the undesirable side effects on skewness and kurtosis.
The most impressive results were observed when combining both hedge funds and managed futures with portfolios of stocks and bonds. The most desirable levels of mean return, standard deviation, skewness and kurtosis were produced by portfolios with allocations of 70%-90% to alternatives and with a preponderance of the alternatives portfolio allocated to managed futures.
“Mix and match” (below) shows performance statistics for portfolios that combine all four of the asset classes ranging from a 100% traditional portfolio to a 100% alternatives portfolio.
“The efficient frontier” (below) illustrates the benefits of allocating to alternatives with a sizable percentage to managed futures. “Mix and match” demonstrates that as the contribution to alternatives increases, all four components of the return distribution benefit: Mean return increases, standard deviation decreases, skewness increases and kurtosis decreases.
Investing in managed futures can improve the overall risk profile of a portfolio far beyond what can be achieved with hedge funds alone. An allocation to managed futures not only neutralizes the unwanted side effects of hedge funds, as was best illustrated in 2008, but also leads to further risk reduction. With its potential for strong returns, these benefits come at a low price.
Thomas Rollinger, a 16-year veteran of the managed futures industry, is director of new strategies development for Sunrise Capital Partners. Prior to joining Sunrise, Rollinger studied under — and was a portfolio manager for — quantitative hedge fund legend Edward O. Thorp.