Portfolio Diversification in an Age of Heightened Uncertainty

Investors are smart: They believe markets don’t throw-up vagaries, but rather brutal concreteness. And they expect their investments to fall-in line.

My personal investment thesis is to presume the unassumed.  Society is changing but pollster’s procedures have not; economies are evolving and the investment methodology of econometricians and analysts are old and dusty. This was proved last year with surprise outcomes of Brexit and the U.S. election – both of which captivated the world and upended global markets.

The S&P 500’s post-election rally rests largely on noise rather than signal versus expectation. Underneath, the chasm between them is cracking. How much higher can an economy at full-capacity possibly run?  We are awash with capital without productivity?  Knowledge is cheap and people are even cheaper?  These questions and others will eventually need to be paid by someone and like all market shifts it will continue to lurk like a thief in the night until it’s too late.  There is no better time to exchange a volatile future for the shape given by an extremely diversified investment portfolio.

We know that markets are lived in forward time, but only understood in backward time.  And we all know there is no greater affliction than people’s faith in their ability to forecast the future. Investors can look to managed futures funds to help reduce their exposure to risk. It is the transparency and liquidity that make active risk management and exposure diversification possible.

Relative to equities, managed futures have exhibited a measurable negative correlation in equity bear markets, particularly during prolonged stressed market environments, and a positive correlation or non-correlation in equity bull markets.

Here are some questions and clarifications to consider about managed futures as a portfolio diversifier:

• Operational rigor – certain funds are simply a sales organization that out-sources its investment return to a third-party.  Immediate questions should include what is the due-diligence process? How much transparency is there in the profit-and-loss of managers, of overnight funds?  Who is performing risk-management or operational functions?  There are some funds that provide institutional access which means the mutual fund investor benefits from a firm who has spent decades of time and millions of dollars meeting the operational and risk-management expectations of some of the most discriminating investors with the highest standards in the world.
• Trading account ownership and fund safety – institutional investors including pension funds and insurance companies typically demand investments with a managed account or an account where all investments and transactions can be seen and also with limited power of attorney.  My immediate thought is if institutional investors demand managed accounts then why should non-institutional investors expect anything less!  Many managed futures mutual funds don’t use managed accounts because established trading managers don’t want the burden of oversight from the managed account and it also requires a great dedication to infrastructure of which may not be a priority to the fund.
• Risk controls and fund security – institutional investors are interested in managed futures funds with comprehensive risk-management systems that can monitor individual manager or sector exposure on an intra-day basis.  Mutual funds allocating to funds without a managed account simply cannot employ the same kind of risk-management protocol.  In addition, nightly “cash-sweeps” assure unneeded funds are taken away from the managers clearing house nightly and placed into custodial fund management.   
• Fees and value vs. cost – to a large degree, managed futures mutual fund fees can be complex and yes, complexity can breed suspicion.  On the contrary, I thoroughly enjoy speaking about any fund fee complexity as the investor eventually learns that many of the fee conventions are skewed towards the investor to buffer against potential drawdown as opposed to lining the pockets of a fund company.  Any fund prospectus will display the “beneath the hood” fees yet those fees are confusing and can swing from what appears overstated in one year to understated in the next.  Instead of focusing on prospectus interpretation,  concentrate fee questioning on important things including what is the “below the line” management fee, is there a claw-back provision to keep traders at-risk with investors, and does the fund itself forgo profits in a drawdown?