Dynamic Duo: Managed Futures and Hedge Funds

By Rollinger, Thomas | Futures (Cedar Falls, IA), December/January 2012 | Go to article overview
Save to active project

Dynamic Duo: Managed Futures and Hedge Funds

Rollinger, Thomas, Futures (Cedar Falls, IA)


Professor Harry Kat put together an impressive 2002 study on portfolio diversification that illustrated the benefits of alternative investments. We carried that work forward to see how it held up.

In November 2002, Cass Business School Professor Harry M. Kat, Ph.D., began to circulate a Working Paper titled "Managed Futures and Hedge Funds: A Match Made in Heaven," that later (Ql 2004) would be published in the Journal of Investment Management. The paper described how adding (equity-based) hedge fund exposure to traditional portfolios of stocks and bonds increased returns and reduced volatility. It also produced an undesired side effect - increased tail risk (lower skew and higher kurtosis).

Kat went on to analyze the effects of adding managed futures to traditional portfolios and the effect of adding both hedge funds and managed futures to traditional portfolios. He found that managed futures were better diversi fiers than hedge funds, and that they reduced the portfolio's volatility to a greater degree and in a more timely manner than did hedge funds, without the undesirable side effects. He concluded that the most desirable results were obtained by combining both managed futures and hedge funds with traditional portfolios. Kat's original period of study was June 1994 -May 2001.

In September 2012, Sunrise Capital published a white paper that revisited and updated Kat's work. We analyzed the out-of-sample period since the end of his study, June 2001 to December 201 1, and found that his observations continued to hold up. During the past 10.5 years, a highly volatile period that included separate stock market drawdowns of 36% and 56%, managed futures have continued to provide more effective and more valuable diversification for stock and bond portfolios than have hedge funds.

Skewness and kurtosis

When building portfolios using the Modern Portfolio Theory (MPT) framework, investors focus almost solely on the first two moments of the distribution: Mean and variance. According to a 20 1 1 study by Marc Odo, the typical MPT method of building portfolios appears to work well as long as historical correlations between asset classes remain stable. But in times of crisis, asset classes often move in lock-step and investors who thought they were diversified experience severe "tail risk" events. By only focusing on mean return and variance, investors may not be factoring in important, measurable and robust historical information.

Skewness and kurtosis, the third and fourth moments of the distribution, frequently offer vital information about the real -world return characteristics of asset classes and investment strategies. Skewness and kurtosis are paramount to this study:

Skewness, a measure of symmetry, compares the length of the two "tails" of a distribution curve.

Kurtosis is a measure of the peakedness of a distribution - i.e., do the outcomes produce a "tall and skinny" or "short and squat" curve? In other words, is the volatility risk located in the tails of the distribution or clustered in the middle?

To understand how vital these concepts are to the results of this study we revisit Kat's original work. Kat states that when past returns are extrapolated, and risk is defined as standard deviation, hedge funds do indeed provide investors with the best of both worlds: An expected return similar to equities but with risk similar to bonds. However, Kat showed that during crisis periods, hedge funds also can be expected to produce a more negatively skewed distribution. Kat adds, "The additional negative skewness that arises when hedge funds are introduced [to] a portfolio of stocks and bonds forms a major risk as one large negative return can destroy years of careful compounding."

Kat's finding appears to be substantiated in Koulajian and Czkwianianc (2011), which evaluates the risk of disproportionate losses relative to volatility in various hedge fund strategies: "Negatively skewed strategies are only attractive during stable market conditions.

The rest of this article is only available to active members of Questia

Sign up now for a free, 1-day trial and receive full access to:

  • Questia's entire collection
  • Automatic bibliography creation
  • More helpful research tools like notes, citations, and highlights
  • Ad-free environment

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
Loading One moment ...
Project items
Cite this article

Cited article

Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

Cited article

Dynamic Duo: Managed Futures and Hedge Funds


Text size Smaller Larger
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

While we understand printed pages are helpful to our users, this limitation is necessary to help protect our publishers' copyrighted material and prevent its unlawful distribution. We are sorry for any inconvenience.
Full screen

matching results for page

Cited passage

Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

Cited passage

Welcome to the new Questia Reader

The Questia Reader has been updated to provide you with an even better online reading experience.  It is now 100% Responsive, which means you can read our books and articles on any sized device you wish.  All of your favorite tools like notes, highlights, and citations are still here, but the way you select text has been updated to be easier to use, especially on touchscreen devices.  Here's how:

1. Click or tap the first word you want to select.
2. Click or tap the last word you want to select.

OK, got it!

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.

Are you sure you want to delete this highlight?