With Friends Like These…

There is a saying in our business,”the trend is your friend.” Given the recent downturn in trend following returns, I am reminded of another saying, “with friends like these, who needs enemies.” I was in a meeting recently with a consultant who asked a question we have heard many times over the years. How do you keep clients invested in managed futures in times like these? We know the history, the diversification benefits, the crisis protection, the long volatility profile…but, each time there is an extended period of challenging performance clients look to throw in the towel – because their equity investments are ripping up and managed futures is down. A good question, and the answer, I think, lies in the statement – it is a matter of faith.

Investors in the equity market have faith. They trust, and have been conditioned, that the market goes up over time, corrections are temporary. Participating in the capital formation of companies provides a risk premium to the investor and is an investment in the economic growth of a country.

Managed futures on the other hand is viewed as a trading strategy, it goes long and short, it is typically quantitative based. The perception is…I can’t have faith in a model, it can break. But this perception is misplaced, trend following measures a real economic risk premium in the market, just like equities (see older posts diving deeper on this topic, Portfolio Symmetry, Commodities are not Stocks, Benchmarking Alternative Beta). Investors in this market are rewarded by taking the price risk companies seek to shed. Faith should be in the durability of this premium, just like there is in the equity risk premium. Faith is gained by understanding this risk premium, when it works (periods of volatility and instability), and when it doesn’t (periods of low volatility and stability). Similar to equities, faith should be garnered from the underlying economics of the markets.

MLM Index: Why no equities?

The MLM Index™ (see www.mtlucas.com for a description of the MLM Index™) does not include an allocation to equities. Many of our trend follower competitors do include them, and as a result we get asked all the time the reasons behind excluding them. As we have written about in previous posts (Portfolio Symmetry and Commodities are not Stocks), we believe that commercial markets like commodities, currency and interest rates are fundamentally different than equity markets, and need to be accessed in a different way, matching the economic rationale for the markets existence. Equity markets exist to fund the growth of capitalism and transfer capital from savers to businesses to be invested profitably. That’s a long only rationale in our mind, as the market participants are overwhelmingly one way. We think this is borne out by the tendency of equity earnings and prices to generally rise over time as economies grow. It also means that there isn’t a natural investment pool short the equity markets – no one has a business model that relies upon falling equity prices. One way you can see the differing utility functions is in the options market – implied volatility on puts trade at a premium to calls, as the demand for protection of a long investment book is much greater than the demand for call protection on a big real money short portfolio. Continue reading

Commodities are not Stocks

Apples vs OrangesThe Bloomberg Commodity Index finished July down 12% YTD and 28% over the last 12 months. It is currently 60% off its highs in June 2008 (remember $150 oil?). Several large commodity funds closed in July. Does this asset class make sense? Our answer – absolutely YES – but commodities aren’t stocks so let’s stop benchmarking and investing in them the same way.

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