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How to diversify a managed futures program.
The benefits of diversification have been wellestablished since the early work of Markowitz [1952] and the formal proofs of Samuelson [1967]. Modern capital market theory demonstrates that the value of diversification is bounded by the systematic risk of the market as a whole.
In recent years, however, pension and endowment funds are turning to futures markets, looking for reductions in systematic risk. Some strategies involve hedging with market index or other futures contracts. Others involve the establishment of managed futures programs, often employing numerous managers who are called commodity trading advisors or CTAs.
In this article, we examine the benefits and limitations of diversifying across commodity trading advisors. Do such programs benefit investors the way that adding more securities to a portfolio has a diversifying effect?
The answer to this question has important implications for assessing the general effect of diversification on portfolio risk. Beyond that, however, it is important for a significant segment of the investment community.
Exhibit 1 shows the growth of the managed futures industry in the U.S. since 1980 in billions of dollars under management. These figures represent funds placed with CTAs for speculative trading in futures, and do not reflect hedging or trading of overthe-counter derivatives.
The estimated amount for 1994 is $25.6 billion. Although 1994 and 1995 produced two highly publicized cases of institutions terminating their managed futures programs, it seems unlikely that the industry will do anything but continue to grow.1
A managed futures program can take many forms. Investors can allocate a portion of their investable funds to a commodity fund or pool; the former is a public fund and the latter private.2 Commodity funds and pools are generally known to have high cost structures and extremely inconsistent performance.
An alternative and more widely used method by institutional investors is a dedicated, negotiated arrangement in which CTAs are hired and managed by an overseer, usually called a MOM, for "manager of managers." Because the relationship is negotiated, the cost structure is typically much more attractive. Because MOMs also have a strong incentive to provide good performance for their institutional clients, they monitor the CTAs' performance closely and freely hire and fire. This kind of system thus works much better...