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Managed futures: the ugliest duckling.

Pension fund managers are a very cautious breed. Charged with over-seeing billions of dollars, their task is to invest these funds productively but with an emphasis on safety. Since higher return almost always implies higher risk, their challenge is to grapple with this unavoidable tradeoff.

Investments must be prudent, but what is thought prudent changes with the times. Common stocks were considered too risky for fiduciaries even as late as the 1950s. Real estate was beyond the pale until relatively recently. (Some may wish it had stayed that way.)

Even as fashions change, certain principles don't, and none is so firmly rooted as the need to diversify. Under the Employee Retirement Income Security Act of 1974 (ERISA), diversification is a statutory duty. ERISA is deliberately vague about the anatomy of a prudent investment, but it stands like the Rock of Gibraltar when it comes to diversification.

The Current Wisdom

The State of Virginia Retirement System took this principle to heart. Being on the constant lookout for ways of reducing volatility by diversifying, the trustees were struck by the potential benefits offered by an investment in managed futures. They observed that if a managed futures component had been added to a stock and bond portfolio, even during the bull market of the last decade, overall return would have increased while volatility would have decreased.

After careful study, Virginia decided to take advantage of this opportunity for diversification. They allocated a relatively modest $100 million to managed futures. Important safeguards were put in place. Multiple managers were hired and their investment decisions were subjected to daily review -- literally. No investment could have been undertaken more cautiously or with closer supervision.

It didn't matter. As soon as the media saw the word "futures," they started howling. A Virginia business magazine featured a cover showing the trustees heaving a pair of dice into the Grand Canyon. A newspaper story ranted about the "rape" of the Virginia pensioners. You would think that the trustees had burned the money.

The word "futures" just seems to invite that sort of knee-jerk reaction. The negative reputation of the futures markets is the largest cloud that hovers over the managed futures industry. Many people can't bring themselves to believe that the words "investment" and "futures" belong in the same sentence.

Some of this stems from the unfortunate experience of many small investors who simply don't belong in these markets. Everyone seems to have an Uncle Harry who lost his shirt playing pork bellies. Unlike the securities industry, which has been able to maintain an image of respectability in the face of any number of scandals, the futures industry is stuck with an image problem that it can't seem to shake.

"Hedgers" and "Speculators"

However, this image bears little resemblance to reality. The futures markets are not, as many people think, a glorified gambling casino. The truth is exactly the opposite. The futures markets serve the essential economic function of facilitating the reduction of risk. If you look at the actual working of the futures markets, you begin to understand the source of their impressive investment potential.

Thousands of businesses all over the world utilize the futures markets to hedge their exposure to price change. Wheat farmers sleep better at night because they can lock in the value of a crop while it is still in the field. Food manufacturers can nail down their future costs of production. Importers or exporters can lessen the financial heartburn that comes with currency fluctuations. Endless other examples abound of businesses ready and eager to pay for price insurance.

Investors who willingly trade the other side from these "hedgers" are called "speculators." Although the term "speculator" has become weighed down with negative connotations, it describes the legitimate role played by those who facilitate trade by providing liquidity. The potential for gain inherent in accepting the very risks that the hedgers are trying to avoid, in other words, the premium received for performing this "price insurance" function, is the speculator's well-earned economic reward.

The CTA

Managed futures accounts are overseen by professional commodity managers known as Commodity Trading Advisors or CTAs. Their objective is to capture profits by trading these markets selectively. CTAs are federally regulated and function much like mutual fund managers with a few differences.

While mutual fund managers are usually buyers, CTAs are just as likely to be "short" (i.e. on the selling side) of a futures contract as "long." CTAs also deal in a universe of futures contracts that is far more diverse than the world of stocks. A CTA with positions in cotton, silver, Swiss Francs and soybeans, for example, is unlikely to suffer losses because of any single economic occurrence. Contrast that with a mutual fund manager whose entire stock portfolio -- no matter how skillfully chosen -- may get pounded if interest rates rise, inflation recurs or market psychology simply turns negative.

So is there a down side to managed futures? Of course, but it is the same down side that plagues all investments: the possibility of loss. Although the long-term track record is impressive, managed futures are not always profitable. Nevertheless, investors in managed futures, by carefully choosing their CTAs, easily can avoid exposure to the kind of large losses that people associate with futures. Most CTAs are as risk-averse as other professional money managers, and conservative CTAs are easy to find.

Fear of Futures

So why don't more fiduciaries add managed futures to their portfolios? Modern portfolio theory certainly suggests that they should, but there are a number of recurring objections. Each of these can be met head on.

The most common argument is that futures are too speculative or risky. Despite endless statistics that document the risk-reducing effect of a managed futures component in a diversified portfolio, this notion of high risk has real staying power. The only solution is education.

Another objection is that the futures markets represent a "zero sum game" in which there is no "inherent return." In other words, managed futures are not a real asset. There are several answers to this. First, the acceptance of risk from hedgers commands a legitimate economic return and that return is just as "inherent" as the profit earned by anyone else in the risk-acceptance (i.e. insurance) business.

Second, although a dollar is lost for every dollar gained in the futures markets, hedgers must be willing to allow others to profit in order to have a two-sided market. Hedgers could not enjoy the huge collateral benefits that come with hedging their risks if the speculators didn't make money. Although no one would argue that successful futures trading is easy, the futures markets -- bottom line -- are a win-win proposition for both speculators and hedgers. Otherwise the markets would not exist. A zero sum game is not the same thing as a loser's game.

Finally, an often unspoken objection is that managed futures are simply too new or too different. The plain fact is that few portfolio managers feel comfortable out on a limb. If a portfolio manager unsuccessfully invests $10 million in IBM, lots of other managers will be sitting in the same boat. It's no fun to take a beating, but it doesn't hurt so badly if you have company.

This same portfolio manager won't feel that he or she has much "cover" with an investment in managed futures. That is probably the main reason that managed futures remain the ugliest duckling in the investment world. No other investment, not even junk bonds, produces the same kind of emotional fireworks. The Virginia experience confirms that; dismissing managed futures out of hand is often the path of least resistance.

Fiduciary or Follower

The question pension managers ought to address is whether they are willing to get back to the basics of what being a fiduciary is all about. It's no easy task to overcome the temptation to merely follow the crowd, and hard to get past a "no one's been fired for buying IBM" mentality. However, avoiding that sort of lemming-like mind set is exactly what fiduciaries are paid to do.

Managed futures deserve nothing more or less than to be evaluated on their merits just like any other investment. Because they enhance rather than detract from portfolio diversification, they deserve active consideration by anyone trying to reduce their overall risk. They can and should play the same legitimate role in a diversified portfolio as stocks, bonds, real estate or anything else.

Herb Berkowitz is president of Berkowitz Futures Advisory in Anchorage, which manages commodity futures for individuals, institutions and other investors.
COPYRIGHT 1992 Alaska Business Publishing Company, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Title Annotation:Financial Planning; managing retirement income
Author:Berkowitz, Herb
Publication:Alaska Business Monthly
Date:Nov 1, 1992
Words:1426
Previous Article:Know your customer: a matter of life and death.
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