Reducing risk by adding dynamite

If you’re simply trying to get the highest possible return per dollar, then your best investment is a lottery ticket. At the moment, a winning $1 PowerBall ticket will net you a sweet $90 million.

cattlepitUnfortunately, the odds of winning that $90 million is about the same as meeting a talking giraffe named Lester. And if you take no risk at all, by investing in one-month Treasury bills, you earn nothing at all – less than nothing, if you take inflation into account.

The general idea, then, is to get your maximum return for most acceptable amount of risk. Normally, that means starting with a diversified portfolio of stocks and stirring in other investments that don’t march in lockstep with the New York Stock Exchange.

The other investments are meant to make the ride to your goal less bumpy – not necessarily to make you rich, or even to beat the Standard and Poor’s 500 stock index. The idea is to get a return that won’t have you dreaming about dollar bills with wings flying off into the night.

The traditional diversifiers for a stock portfolio are bonds – which, according to a recent Bankrate.com study, are the most hated investment in America at the moment. Another is cash.

A third is commodities – specifically, managed futures funds —  which sounds a bit like reducing fire hazards with dynamite. But according to a celebrated study by Harvard professor John Lintner in 1983, have a surprisingly calming effect on both stock and bond portfolios. Lintner found that  “the improvements from holding an efficiently-selected portfolio of managed accounts or funds are so large–and the correlation between returns on the futures portfolios and those on the stock and bond portfolio are so surprisingly low (sometimes even negative)–that the return/risk tradeoffs provided by augmented portfolios…clearly dominate the tradeoffs available from portfolio of stocks alone or from portfolios of stocks and bonds.”

A follow-up study by – of course – Managed Futures World—suggested a 7% allocation to managed futures would increase your risk-adjusted return. The results make some intuitive sense. Futures managers typically invest in a wide array of contracts, from beans to precious metals and interest rates. They don’t really care whether the trend is up or down: They just care that it’s a tradable trend. Most modern commodity pools are run by people who don’t care about the forecast for soybeans: They’re technical traders, not fundamental ones.

For a long time, a managed futures account was not for the bootless and unhorsed. These professionally managed accounts are limited partnerships, often with high minimum investments, high fees and limited liquidity. Many have some downside protection in that they will liquidate if losses get beyond a certain point.

In recent years, however, some open-ended funds and exchange-traded funds have dipped their toes into the managed futures arena. Of the four ETFs, only one – First Trust Morningstar Managed Futures Strategy ETF (FMF) – is in the black, up 3.3%. Its expense ratio is 0.95%. (Full disclosure: I write on a freelance basis for Morningstar, which produces the index that this fund follows.)

Among traditional open-ended funds, nearly all available to individuals come with sales charges and hefty annual fees. The largest managed futures fund, the $2.4 billion Nataxis ASG Managed Futures Strategy A, charges 1.7% in annual fees, as well as a maximum 5.75% sales charge. You have to be a firm believer in managed futures to swallow those kinds of fees.

Are they worth it? Currently, none of the funds really have a long enough track record to prove that they are as salubrious as the Lintner studies – and others – claim. And until that happens, and fees go down, it might be best to leave managed futures to those who can afford them.

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