The FTC Newsletter for systematic trading | issue: 06/2008

Futures

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Managed Futures: solving the mystery

Do Managed Futures constitute an asset class? Or are we merely talking about a non uniform group of indvidual managers who cannot be lumped together? The answer is not only of theoretical interest if there is the possibility of including Managed Futures as part of an investment portfolio.

Everything was very simple in the early days of portfolio management. Essentially there were only three different classes of assets: stocks, bonds and the rest, which concerned only very few investors - alternative investments, encompassing real estate, private investments in companies not listed on the stock exchange, art, commodities or hedge funds. Even the pure academics, who were busy developing modern portfolio theory during the 1960s and 70s, either made do with the time-honored classes or didn‘t bother with them at all. In his paper „Portfolio Selection“, Markowitz derives a solution which allows the best mix ratio of two or more individual stock. Tobin, creator of the Capital Market Line, and William Sharpe, whose Capital Asset Pricing Model (CAPM) was soon to become a widely accepted market portfolio-based risk model, initially wasted no time on market segmentation. They simply proposed allocating a variable proportion of the market portfolio to a riskless asset so that risk propensity and earnings expectation are in harmony with one another. Sharpe suggested just what this market portfolio might comprise: the sum of all available - not riskless - assets, weighted according to their respective capitalization.
So, for example, an investor would have to own a significant amount of stock in Google, Shell or Toyota, because these instruments are very highly capitalized, but only a negligible amount of Tanzania Tea Packers Ltd stock, because the latter‘s capital stock of around 5 million euro is, to say the least, peanuts. Vietnamese government bonds are not at all included in the market portfolio, because they are not available.

Oil tankers and silver spoons

The CAPM with its market portfolio had far-reaching consequences for what are now popular forms of portfolio construction and for the choice of individual instrument in the context of asset management. One of which is particularly interesting for the purposes of this article: if the market portfolio genuinely comprises ALL available assets (weighted according to capitalization), then it would obviously include not only stocks and bonds, but also currencies, commodities, real estate, silver spoons, stamps, Van Gogh paintings and latterly - given that they are available in the form of appropriate investment products - container ships, oil tankers and aircraft.
Because no investor is capable of putting together such a portfolio, much less sustain one, Sharpe may also be regarded as the incubator of a booming sector of industry: the index branch. Indices are seen as a practical approximation of the overall market they are attempting to reflect. Whereby the rule of thumb is that the broader the index (i.e. the bigger the proportion of the market reflected by the index), the more precise the approximation. And the narrower the index, the easier it is to emulate. Over the years, day-to-day asset management has given rise to several blue-chip indices which are now used by asset and portfolio managers as market portfolio benchmarks. For the stock markets, these would be the S&P 500 (USA), Nikkei 225 (Japan), Stoxx 50 (Europe) or MSCI World (global). As far as bonds are concerned, the JP Morgan Total Return Indices play a similar role. For commodities, the Standard & Poor‘s GSCI Index is a favorite, and even the beloved arts have failed to escape the clutches of the index industry. However, silver spoons are still waiting for a suitable benchmark.

The case of the chaotic DIY store

Why are we so obsessed with categorizing every last outpost of the investment universe? Put simply: imagine you‘re at a DIY store trying to put together a set of essential tools with which to successfully complete your DIY projects. The way things tend to be sectioned throughout the store, it‘s already sheer torture. And now imagine there is no system of categorization at all...
If you have a vivid imagination, you‘re probably already in a state of panic and can sympathize how it would be for any asset manager worth his salt trying to manage without indices and asset classes. Apart from the fact that he is unable to substantiate his success owing to the lack of a benchmark, he would come up against a brick wall in the form of the sheer mass of opportunities on a globalized financial market.
The selection of assets for an overall portfolio nowadays is usually a top-down process: first, asset classes are selected and weighted (represented by their indices), and then the most promising individual positions of the respective classes are selected. Because everyone from the buyers to the sellers of all types of investment product is aware of this, there has been discussion for a fairly long time as to what makes a group of assets a separate class and which of them unquestionably belong in a portfolio.
Whilst it is in the interests of sellers of participations in ships to position and market their products as a separate investment class, asset managers aspire to keep their universe as transparent as possible. They therefore often tend to include all equity holdings apart from exchange-traded stocks in the private equity class.

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