In my book Jackass Investing: Don't do it. Profit from it., I take on the myth that "Futures Trading is Risky." I do this by first pointing out that it’s not futures that are risky, but the often reckless behavior of individual futures traders. If the proper risk controls are not in place and if leverage is abused, substantial losses will occur. But this reckless behavior is not unique to futures trading, stock investors often routinely and recklessly expose themselves to unnecessary risk (my definition of "Jackass Investing") by hanging on to losing positions. In fact, it's the cornerstone of the "buy-and-hold" mantra. You need only look back over the past decade to see numerous instances where supposedly diversified stock portfolios incurred losses that exceeded 30%. The reality is, with the diversification opportunities that are available in the futures markets, a portfolio of futures, managed properly, should be less risky than a portfolio of stocks. In fact, there is historical evidence of this value. It is presented in the performance of managed futures indexes. Let’s take a look.
A comparison of futures performance
I’ll start by summarizing the returns of the first index (Index #1), which is diversified across fewer trading strategies than the second index. As a result, it incurs substantial risk in relation to its returns.
During the period January 1987 through December 2010, this index produced a 9.5% average annual return. Not bad. But it did so while exposing its followers to high risk. In fact, as shown in Figure 1, the index suffered multiple losing periods in excess of 20%, with one loss actually destroying more than half of the index value.
Now let’s look at the performance of a second index. This one is clearly comprised of traders who employ a more conservative approach. The result is that the index suffered no losing periods of greater than 20%. In addition, despite the substantially lower risk, the second index produced a greater annualized return than did the first index: +9.6% to +9.5%. This favorable combination of greater gains and lesser losses is the ideal goal sought after by most rational investors. However, because of the belief in the myth that futures trading is risky, most people did not benefit from the performance of the second index. For this index tracks the performance of CTAs. Specifically, it represents the returns earned by the Barclays Hedge BTOP 50 managed futures index.
The CTAs included in the BTOP 50 index trade in a diversity of markets and also incorporate a wide variety of trading strategies designed to adapt to changing market conditions. In early 2008 for example, many of these CTAs were long crude oil and many other commodities, as well as short global stock indexes. When the financial crisis hit hard and those commodities fell in price, many of those same CTAs reversed into short commodity positions, garnering healthy profits from both those positions and their short positions in global equities. In stark contrast, the risky first index did not adapt, and as a result suffered extensive losses. Perhaps it is this behavior pattern that has led to the erroneous myth that futures trading is risky. But this argument crashes to earth like a skydiver without a parachute when it is disclosed that the first index isn’t a futures trading index at all. It is the S&P 500 Total Return Index.
A long stock position has historically and persistently been promoted by financial advisors and the mainstream financial media to serve as the core holding for every portfolio created. And this same conventional wisdom has consistently espoused the view that futures trading is risky, certainly too risky to be included in a "conservative" portfolio. But the exact opposite conclusion should be reached. Managed futures, with their superior risk-adjusted returns, should receive a solid allocation in every portfolio. In fact, if it was true, as many financial professional preach, that "risky" investments have no place in a conservative portfolio, then no one would own stocks. They're too risky! While the disclaimer that past performance is not indicative of future performance applies to an investment in managed futures, as the history shown here illustrates, the biggest risk of futures may be that they are excluded from most investors' portfolios.
About the Author
Mike Dever is founder and CEO of Brandywine Asset Management and the author of Jackass Investing: Don’t do it. Profit from it. Copies of Mr. Dever's book (also released under the title Exploiting the Myths: Profiting from Wall Street’s misguided beliefs), are available at Amazon at http://amzn.to/q0Qn6U. Signed copies or bulk orders can be purchased at www.JackassInvesting.com.
