This article appeared in the AIMA Newsletter, June 2002.
© Alternative Investment Management
Association (AIMA), 2002. Reproduction of all or part of this article prohibited without the express
written permission of AIMA and the author.
Understanding the relationship between risk, reward and
margin/equity ratio in managed futures, and the implications
for assessing their attractiveness as an asset class
By David Harding and Georgia Nakou, Winton Capital Management
Abstract
In order to benefit from managed futures as an asset class within a diversified
portfolio, asset managers must be able to assess the quality of managers and make
estimates of futures returns and risks. We have here highlighted the indissoluble
relationship between return and risk in managed futures investments and have gone
on to suggest how some insights from margined investment can be useful in thinking
about risk in unleveraged portfolios
Recent studies have reinforced the case for including managed futures as a diversifying
tool within a mixed portfolio (Schneeweis and Georgiev 2002; Schneeweis and Spurgin
1999). However, the nature of investment in futures, and in particular the concepts of
margin and leverage, makes them a slippery asset class to conceptualise by traditional
methods. The notion of risk, which is of obvious concern for potential investors, is tied
inextricably to these two concepts. This relationship provides a useful starting point for
discussing the structural differences between managed futures and margined
investments in general, and traditional unleveraged investments. Furthermore, it will
be argued that the reasons behind the perceived level “riskiness” of margined
portfolios lie in the realm of business strategy rather than in any inherent property of a
given investment strategy. This in turn will lead to a discussion of the versatile role of
leverage in the construction of risk-optimised investment vehicles.
Managed futures investment portfolios differ from traditional investment portfolios
(e.g. stock and bond mutual funds) in that they are not limited in any way by the twin
constraints that all asset weights should be positive (all Xi > 0) and that, including cash
as an asset, the sum of the asset weights should equal the value of the portfolio (Σxi =
1). These investment constraints are those that, in a traditional context, given a set of
assets
i and a set of expected returns, risks and correlations, enable, via a procedure
know as Markowitz mean-variance optimisation, the construction of an “optimal”,
“efficient” portfolio, that is portfolio which produces the most reward for a stipulated
level of risk. The absence of these constraints transforms the way we must look at risk
when assessing the attractiveness of an investment in managed futures.
The reason that the asset weights need not sum to the value of the portfolio is that it
is possible to underwrite the price risk of a substantial value of underlying assets with
the downpayment of only a small “margin”; perhaps as little as 1 or 2%. It is thus
possible to take a lot of risk with a little money; however, it is unlikely that any
sensible investment scheme is going to use all its assets as margin at any time. If for
example it did use all the assets as margin for a single futures position in a contract
with a margin requirement of 2% then a decline in the contracts value of only 2% would
lead to a 100% loss in the value of the assets.
Almost all managed futures investments consist, like stock portfolios, of widely
diversified baskets of underlying contracts. Since diversification is the best known
effective risk/reward ratio enhancement strategy, diversified futures portfolios may
employ a reasonably substantial proportion of their assets as margin - though nothing
This article appeared in the AIMA Newsletter, June 2002. © Alternative Investment Management
Association (AIMA), 2002. Reproduction of all or part of this article prohibited without the express
written permission of AIMA and the author.
like 100%. A range for typical managed futures investment would be more likely to be
5–30% (Figure 1). Since these numbers are much less than the (traditionally
understood) “asset constraint” of 100%, it follows that futures fund managers could
always employ more of their clients’ money as trading margin and thus potentially
produce higher returns. What prevents them from doing this? The answer is that they
impose an arbitrary constraint on the level of margin to equity to limit the volatility of
the investment returns to a level which they believe to be appropriate to their
customers. For historical reasons which will be further discussed below, this level has
traditionally been set fairly high in the managed futures industry, giving the
impression, on the face of it, of a risky investment class. In reality, the level of risk
measurable from the track record of a futures fund manager tells us nothing about
the inherent riskiness of the underlying strategy that he is pursuing and everything
about the level of risk that, in running his business, he is choosing to offer the client.
This is important to note in that it is substantially different to other branches of the
investment management business and thus a potent source of potential confusion when
assessing risk for futures fund managers.
100% 50%
Margin
Annualised 30-day Standard Deviation of Returns (rolling daily)
80%
30%
%Total Equity Employed in
60%
Futures Margin
Variance
40%
10%
20%
0% -10%
Jan-98
Apr-98
Jan-99
Apr-99
Jan-00
Apr-00
Jan-01
Apr-01
Jan-02
Apr-02
Oct-97
Jul-98
Oct-98
Jul-99
Oct-99
Jul-00
Oct-00
Jul-01
Oct-01
Figure 1. All the risk you want… at a fraction of the money. Historical
margin/equity and volatility in the returns of a Winton futures fund.
What considerations influence futures fund managers in deciding what level of risk to
operate at? The considerations are numerous, and are related primarily to the
packaging and marketing of investment products. Although no two managers will
necessarily operate exactly alike, a number of distinct approaches can be discerned
from a cursory survey of the industry. Several managers offer multiple different
versions of more or less the same strategy differing only in the percentage of assets
employed as margin. This could be seen as superfluous, given that a higher
margin/equity ratio can easily be achieved by the client retaining part of the allocated
funds under his own control in a reserve account. In other cases, managers will
demonstrate different degrees of risk preference or aversion in the way they run their
businesses or will orient them towards different investor groups and their level of risk
preference (e.g. speculative private client or institutional investor). Also, since
managers are usually remunerated through a mixture of management and performance
fees there is a complicated relationship between the mix of these fees the client is
likely to incur and the level of margin. A higher margin account will pay a
proportionately greater percentage of its fees in terms of performance fees, a lower
margin account, a greater proportion of management fees. A further factor affecting
the level of margin employed by a manager may be his confidence level in the strategy
he is employing. As stated before, the higher the margin the greater the level of
returns that will be generated by a successful strategy; however if the manager’s
This article appeared in the AIMA Newsletter, June 2002. © Alternative Investment Management
Association (AIMA), 2002. Reproduction of all or part of this article prohibited without the express
written permission of AIMA and the author.
objective is to maximise the compound growth rate of the assets under management
over many years he cannot afford to lose 100% (or even 70, 80, 90%) at any time. There
is thus a risk constraint introduced which will limit the level of margin he will be
willing to routinely employ.
Indeed, if the manager and his investors have unbiased utility preference functions
(i.e. the attraction of a 1% wealth gain exactly equals in magnitude the aversion shown
to a 1% wealth loss), and their objective is to maximise the compound rate of growth of
his assets over the long term, then there is an optimal level of leverage calculated
according to what is know as the “Kelly Criterion”. This establishes the optimal
percentage of one’s investment to commit (or borrow to over-commit in the form of
leverage) as a function of the forecast return distribution (assuming normal return
forecast) of the investment.
From the investors point of view, therefore, it is especially important in assessing
futures fund managers to look at the reward to risk ratio (Sharpe, Sortino or similar) in
order to asses the quality of the strategy rather than estimating risk with simple
dispersion measures. These ratios remain substantially unchanged even by large
changes in leverage, and therefore provide an independent measure of the
effectiveness of the underlying investment strategy. Having evaluated the most
desirable reward to risk ratio investment, the risk can be tailored by the investor to
any level desired by agreement with the manager. Most managers if asked will be very
happy to operate accounts for major investors on any level of margin stipulated. A
secondary issue to take account of is the level of fees, particularly management fees,
which are usually calculated with reference to an account size (which may well be
nominal), which is related to some standardised level of margin. Ideally, a half
leveraged account would be levied half the management fee and vice versa.
Performance fees, on the other hand should tend to be lower on a higher leveraged
account as the value of the optionality contained within them from the point of view of
the manager is higher.
This sort of analysis also suggests a fairer method of comparing managed futures funds
with other risky investments. Portfolios of stocks for example over the long run have
quite high risks both measured by monthly variance or by peak to trough drawdown.
Major stock indices can be expected from time to time to decline 50–75% in value and
yet to produce a long-term return of only 3–7% in excess of the risk free rate. Individual
stocks have a lower return to risk expectation than this. By these standards the return
to risk ratio of the better-managed futures managers is attractive and can be seen to
represent a desirable diversification to long-term investment portfolios (Table 1).
Furthermore, although there is only really a documented history of managed futures
investment over the last 30 years there are good logical reasons why the inclusion of
managed futures would help institutional managers to reduce the risk of long term
asset liability mismatch, given that managed futures investments can prosper during
periods of sustained risks in interest rates or commodity prices, or currency instability.
<Insert Table 1>
Table 1∗. Comparative return/risk statistics for two sets of simulated returns
generated by the Winton Capital Management trading system at different levels of
∗
In compliance with AIMA editorial policy, we present here simulated rather than
actual returns. WCM Simulated Returns represent purely hypothetical performance
figures, generated by applying the Winton trading system to market prices from the
last 20 years. The following assumptions were also made:
• Account size: $50 million;
• Risk-free rate of return: 3-month T-Bill rate;
This article appeared in the AIMA Newsletter, June 2002. © Alternative Investment Management
Association (AIMA), 2002. Reproduction of all or part of this article prohibited without the express
written permission of AIMA and the author.
leverage, managed futures and hedge fund indices, major stock indices and individual
stocks over the past 20 years.
The concepts of margin and leverage provide us with a useful handle for grasping the
essential differences between managed futures (and other types of margined
investment) and traditional non-margined assets. At the same time, they suggest an
avenue for assessing these different types of assets classes side by side on a return/risk
basis. Most importantly, they provide a method for tailoring leveraged investments to
individual investors’ risk tolerance. It is suggested here that measures of return/risk
should comprise the initial step in assessing the suitability of an underlying managed
futures strategy; thereafter, the investor should be free to adjust the leverage to suit
their risk requirements.
References
Lintner, J. (1983). The Potential Role of Managed Commodity-Financial Futures Accounts in
Portfolios of Stocks and Bonds. Annual Conference of the Financial Analysts Federation, Toronto,
Canada, 1983.
Schneeweis, T. and G. Georgiev (2002). The Benefits of Managed Futures. CISDM/ISOM Working
Paper.
Schneeweis, T. and R. Spurgin (1999). Quantitative Analysis of Hedge Fund and Managed Futures
Return and Risk Characteristics. In: R. Lake (ed.), Evaluating and Implementing Hedge Fund
Strategies.
Further analysis of the effects of variable leverage can be found at
www.wintoncapital.com/leverage.htm
• Commission on trades: $10 per round turn.
WCM Simulation 1 also used the following specifications:
• Average margin/equity: 20%;
• Fees: Management 1% (monthly); Performance 20% (quarterly).
WCM Simulation 2 also used the following specifications:
• Average margin/equity: 5%;
• Fees: Management 0.25% (monthly); Performance 20% (quarterly).
This article appeared in the AIMA Newsletter, June 2002. © Alternative Investment Management Association (AIMA), 2002. Reproduction of all or part of this article
prohibited without the express written permission of AIMA and the author.
Average Annual Returns Annualised Standard Deviation Sharpe Ratio Maximum Monthly Drawdown
3 years 10 Years 20 Years 3 years 10 Years 20 Years 3 years 10 Years 20 Years 3 years 10 Years 20 Years
WCM Simulated Returns*
WCM Simulation 1 - 20% M/E 20.00% 45.59% 54.75% 26.99 26.49 25.76 0.7 1.4 1.7 26.76% 26.76% 26.76%
WCM Simulation 2 - 5% M/E 7.95% 13.30% 16.06% 6.84 6.7 6.58 0.7 1.4 1.6 6.95% 6.95% 6.95%
Fund Indices
Zurich CTA Index 3.95% 9.84% 11.82% 7.80 8.97 15.19 -0.1 0.8 0.7 5.82% 10.69% 20.39%
CSFB/Tremont Managed Futures 0.48% 11.05 -0.4 14.23%
CSFB/Tremont Hedge Fund 10.56% 8.31 0.8 9.36%
Equity Indices
S&P 500 -2.53% 13.26% 15.70% 16.64 14.01 15.28 -0.5 0.8 1.0 30.49% 30.49% 30.49%
FTSE 100 -5.74% 8.01% 13.76 13.86 -0.8 0.4 29.25% 29.25%
NASDAQ Composite -9.16% 11.82% 40.48 27.26 -0.4 0.4 68.09% 68.09%
MSCI World Equity -5.46% 15.59 -0.7 35.39%
Stocks
Citigroup Inc 17.09% 31.39% 32.27% 31.24 31.88 32.27 0.4 1.0 0.6 -29.87% -44.26% -64.89%
General Electric Co. 1.35% 19.78% 18.34% 28.39 21.90 22.45 -0.1 0.9 0.8 -36.83% -36.83% -36.83%
AOL Time Warner Inc -31.48% 69.62% 64.69 64.49 -0.7 1.1 -68.83% -68.83%
Berkshire Hathaway Inc -0.14% 23.03% 28.14 25.10 -0.2 0.9 -43.81% -43.81%
BP Plc 5.48% 17.23% 25.89 23.20 0.0 0.7 -22.64% -49.87%
Microsoft Corp. -12.37% 28.43% 54.10 40.27 -0.4 0.7 -62.84% -62.84%
Vodafone Group Plc -17.54% 19.71% 33.76 31.70 -0.7 0.6 -63.35% -63.35%
Risk-free Investment
T-Bill (3 months) 4.48% 4.52% 6.04% 0.41 0.32 0.60 n/a n/a n/a n/a n/a n/a
$ LIBOR (3 months) 5.07% 5.11% 6.93% 0.49 0.36 0.72 n/a n/a n/a n/a n/a n/a
Gold -1.65% -4.49% -4.43% 13.01 10.11 9.93 -0.5 -2.3 n/a -70.42% -70.42% -70.42%
