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How Managed Futures Work in a Portfolio

Nadia Papagiannis, CFA

Nadia Papagiannis: Hello, my name is Nadia Papagiannis. I'm an alternative investment strategist here at Morningstar. Today I have with me Brian Hurst and Yao Hua Ooi from AQR Capital Management.

AQR Capital Management was founded in 1998 and currently manages about $24 billion in both traditional and alternative investments. They've recently debuted a new managed futures strategy fund and that's what we're here to talk about today. Thank you for coming and visiting with us today.

Brian Hurst: Thank you.

Papagiannis: Brian, can you please explain what managed futures means and why an investor might include that in their portfolio?

Hurst: Absolutely. Managed futures, by and large, is what we would call trend following. That means buying assets that are going up and selling assets that are going down.

Why is this important? Well, this type of strategy, with its flexibility to go long and short, in many different asset classes, equities, fixed income, currencies, and commodities, gives an investor a lot of diversification to their portfolio. Since most investors are long-only, this is going to give you an alternative way to get access to a strategy that tends to pay off when the rest of your portfolio is not doing as well.

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Papagiannis: It's called managed futures because you're investing in futures contracts?

Hurst: Right, futures and currency forward contracts.

Papagiannis: So, Yao Hua, are we just talking about equities here in managed futures or are we talking about more than equities?

Yao Hua Ooi: We're talking about more than equities in managed futures. Managed futures strategies are generally comprised of equities, commodities, currencies, as well as fixed income futures, and all across global markets. We think it's very important to apply these trend following strategies across multiple markets and multiple asset classes, because that provides great diversification to the strategy and improves its expected performance.

Papagiannis: So, Brian, we're diversifying in this managed futures strategy by going across different asset classes, but also we're going both long and short, correct? How does that help diversify a portfolio?

Hurst: Right. The real power of managed futures strategies is benefiting the portfolio, your overall portfolio, when markets are not doing so well. So it's important to be able to be flexible and go short.

So when we identify a market trending down, we're going to establish short positions in that market. Therefore, if the trend continues, markets keep going down, we will profit from those trends.

Papagiannis: So how is this better than diversifying simply by taking maybe a little bit of a long commodities fund, a little bit of an equities growth, a little bit of equities value, and a little bit of a bond fund? How is this better in terms of diversification, Brian?

Hurst: Great, that's a good example. I think that kind of describes most of our portfolios. We'll have 50% to 80% of our money invested in equities. Equities are volatile. That's going to dominate the risk of our portfolios.

So when we think about diversification, we're thinking about diversifying in terms of what are the bets that you're taking? When you have a lot of money in equities, you're basically making a growth bet.

However, as we know, the economy doesn't always grow, so we want to have something in there that can help benefit, if things start turning around. Managed futures is one example of a strategy that can hopefully take advantage of these types of trends that tend to happen over time, as are staged processes in the markets.

Papagiannis: So this strategy, it's not a new strategy is it, Yao Hua? It's been around for a while?

Ooi: No, in fact, it's a strategy that has been around since the late '70s and the early '80s. It's represents about a fifth of the alternative investment space, so we think that's about $200 billion in the hedge fund universe. But this is the first... in the recent years, that has definitely grown in interest amongst more traditional investors. We think that's why it's more of a topic of interest right now.

Papagiannis: But, generally, when people think of hedge funds, they think of risky. And so is this strategy risky, Brian?

Hurst: Well, I would say all strategies are risky and all holdings are risky. The risk level that we're targeting in this fund is roughly about 10% on average. We also have a risk cap, about 13%, targeted risk.

To give you a sense of what that means, equity risk is on the order of 20%, annualized volatility. Bond risk is maybe on the order of 5% to 10%. So we're talking between equity and bond risk for this fund. More importantly, we're targeting a risk level. So we're going to change and size our positions through time to maintain a consistent level of risk.

Whereas, if you thought about what happened in 2008. If you were holding your portfolio in equities and bonds, market volatility skyrocketed in that fourth quarter. Therefore, your riskiness in your overall portfolio increased. When that happens, we're going to be scaling back our positions naturally, as part of our process, to maintain a consistent amount of conviction, our bet through time, in these strategies.

Papagiannis: How might an investor allocate to this type of strategy?

Hurst: Sure. I think it's a good diversifier, but it is also something new. It's something you need to get comfortable with. We think 5% to 10% allocation can give you pretty substantial benefits in terms of your risk-reward trade-off for your whole portfolio.

Papagiannis: Does that come out of the equity portion, or the fixed income portion, or just out of both, or how does that work?

Hurst: Sure. We think that most people generally will have 50% or more of their capital invested in equities. And given that equities are much more volatile than things like fixed income, or alternatives they might be invested in, that's going to dominate your returns. So to maximize diversification, you're probably best off taking it out of your equity piece.

Papagiannis: Thank you very much.