The following is a guest post by Don Wieczorek, who is the president of Purple Valley Capital. Don is a sponsor for this website. The views expressed in this article are solely his own.
In my opinion, if there is one subject in finance that everyone agrees on, it is that diversification can increase returns while also decreasing volatility and limit portfolio-wide drawdowns. Many investors think they are diversified because they own equities in different industries or countries, some bonds, and perhaps even have exposure to real estate, but true diversification should reach well beyond this standard portfolio. True diversification includes not only spreading capital across different asset classes, but time frames and methods of investing as well.
Some investors look to the industry known as “managed futures” to help fill this void. Managed futures is made up of professional money managers who are known as “Commodity Trading Advisors” (CTAs). CTAs are required to become registered with the U.S. government’s Commodity Futures Trading Commission before they can offer themselves to the public as money managers. The industry is large, with over 1,000 registered CTAs, cumulatively managing well over $100 billion.
CTAs generally manage their clients’ assets using a proprietary systematic trading system or discretionary method that may involve going long or short various futures contracts in areas such as metals (gold, silver, copper), energies (crude oil, natural gas), grains (corn, wheat, soybeans), equity indexes (S&P500, Nikkei 225), food//soft commodities (coffee, sugar, cotton, cocoa) as well as foreign currency and U.S. government bond futures. The majority of CTAs employ a trend following approach, which aims to capture the large trends, both up and down, in the various futures markets. By entering markets when they break out to either the upside or downside, systematically cutting losing trades very quickly, and holding onto winners, trend followers aim to skew returns and volatility to the upside. When market prices trend, often the result of trending fundamentals that are accentuated by the various psychological biases of market participants, trend following CTAs can perform well, but when markets are flat and choppy, they will perform poorly. The main advantage of allocating to a CTA is that it can implement all three pillars of true diversification: different asset classes, different holding periods, and different method of attempting to make money.
Although allocating to a CTA can be a fantastic diversifier if used properly, there certainly are risks in getting involved, and the use of such a strategy is not for everyone. First and foremost, CTAs buy and sell futures contracts, which are inherently leveraged products and carry with them a risk of large potential loss. Because trend following CTAs, almost by definition, aim to be positioned in the hottest markets (those hitting new highs or new lows), performance can be volatile and have deep drawdowns as well. Psychologically, this type of investment can be very difficult, because it can produce frequent small losses in exchange for infrequent but large gains. Drawdowns can be lengthy. Although this strategy can perform well during periods of trending markets (i.e. strong economic growth, crises, inflation, etc…), it performs poorly when markets are range-bound and flat. For example, the last couple of years have been meager for the trend following CTA industry due to zero interest rate policies (thus few large currency moves), subdued economic growth, and no inflation. Fortunately for the industry, this is finally starting to change, and many markets have started to trend again, however there is no telling if, or how long, it will last. Managers simply follow the market action and attempt to manage risk at all times. Success in futures trading requires an immense amount of psychological fortitude, discipline, and patience.
In full disclosure, I own and operate Purple Valley Capital, Inc., a CTA that has traded client (and my own) capital for over nine years, having started it in 2008 during my senior year of college. I originally just traded my own capital but became legally registered and incorporated when my family, friends, and outside investors began showing interest in my strategy in order to help them achieve further diversification within their portfolios. I built my trend following strategy from the ground up, and have seen, along with my investors, the benefits and risks of such a managed futures strategy. Whether it is with managed futures, or some other investment strategy, the idea of trying to achieve true diversification is an extremely important matter. Again, there are many ways to diversify, and CTAs are simply one way to try and go about doing so. Hopefully this article will help others think about diversification slightly differently than they had in the past, and perhaps stimulate an interest in looking for a diversifier that spans different asset classes, time frames and method of trading, whether it be with a CTA, or some other vehicle.
Purple Valley Capital, Inc.
FUTURES TRADING IS SPECULATIVE & INVOLVES A HIGH DEGREE OF RISK. IT IS NOT SUITABLE FOR EVERYONE. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS