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Sometimes
being fundamentally correct can be monetarily wrong. Too many advisors today
espouse their economic views, while disregarding the idea that trends often
ignore fundamentals and can last far longer than fundamentals may dictate. By
stubbornly holding on to a certain view on the market, investors and/or
advisors can either miss out on potential gains or may even give back some of
their accumulated profits.
The
most glaring example of this has occurred most recently with the US real
estate market. First, I believe that real estate prices should not rise in a
recessionary environment. Furthermore, with the burst of the dotcom/tech
bubble, one would assume that investors would not have the excess equity to
upgrade to a bigger home or buy a second home. Nonetheless, the obvious boom
in real estate has resulted in tremendous capital appreciation for many real
estate investors. This trend has lasted for several years, soaring in the
face of fundamental reasoning.
Of
course, some would argue that home prices have risen because of artificially
low interest rates and interest only loans. I do not disagree with this
analysis. In fact, I believe that the real estate market is indeed
overvalued. However, I also believe that trends often follow the demand of
the investor. In this case, investors decided to take advantage of the low
interest rates and "special" mortgage programs. This demand has
ultimately led to an increase in home sales, and subsequently a rise in home
values.
This
idea that trends often ignore fundamental reasoning can be found throughout
the markets. The US dollar index is another example of this. I consider myself
bearish when it comes to the US dollar. I cannot easily disregard our twin
deficits and a slew of other fundamental reasons on why the dollar is
overvalued. However, since about June 2003, the dollar has experienced three
relatively substantial counter rallies. In fact, we are in the midst of the
most prominent of these rallies. Take a look
at the below dollar index chart.
One
can see that if you would have been short the dollar in 2005, you would have
given back most of your gains that you had accrued in 2004. In addition, you
most likely missed out on pretty good move up in the US Dollar. Once again,
this sizeable move up in the US Dollar index contradicts fundamental
reasoning.
I
am not here to argue that one should liquidate his/her portfolio and attempt
to trade the market based on trends. I do believe that there is value in
having a portfolio with long positions that are fundamentally correct. However,
I also believe that part of your portfolio should include the opportunity to
take advantage of shorter term trends, even if they are contradictory to your
other positions.
One
of the best ways of accomplishing this is through managed futures. The
addition of managed futures can reduce volatility risk in your portfolio and
enhance overall returns. For example, if you hold a portfolio that is
positioned to take advantage of the decline in the US dollar, the addition of
managed futures may help taper the degree of volatility when the dollar
experiences a counter rally. Additionally, managed futures can invest in a
great number of financial, commodity, and stock index products and markets
that are not available with traditional investments. This provides the
opportunity for investors to take advantage of market trends in several
different sectors and stay diversified globally.
In
the last several years, a number of studies have come out detailing the role
of managed futures in a typical portfolio. Probably the most recognized study
was conducted by Professor John K. Litner of Harvard University. In his paper,
""The Potential Role of Managed Commodity-Financial Futures
Accounts (and/or Funds) in Portfolios of Stocks and Bonds," Professor Litner wrote:
"the
improvements from holding an efficiently-selected portfolio of managed
accounts or funds are so large, and the correlation between returns on the
futures portfolios and those on the stock and bond portfolios are so low
(sometimes even negative), that the return/risk tradeoffs provided by
augmented portfolios…clearly dominate the tradeoffs available from
portfolio of stocks alone or from a portfolios of stocks and bonds."
The
ability of futures to enhance the returns of traditional investments has also
been documented in a study conducted by Goldman Sachs. Covering a 25-year
period, the study concluded that by "allocating only 10% of a securities
portfolio to commodities, investors can vastly improve their
performance." Goldman Sachs' conclusion, concerning the value of
commodities, was supported by another study published by the Chicago
Mercantile Exchange (CME), one of the world's pre-eminent futures exchanges. According
to the CME study, "Portfolios with as much as 20% of assets in managed
futures yield up to 50% more than a portfolio of stocks and bonds
alone."
More
clearly, this idea is depicted in the following graph which shows the role
that managed futures play in enhancing the return of traditional investments.
As you can see when you add managed futures to a traditional portfolio, you
are able do decrease your risk while increasing your rate of return.
Another
benefit of managed futures is that your account is being traded by a
Commodity Trading Advisor (CTA) whose main focus is following market trends. These
advisors typically are not swayed by emotion (as some individual investors
might be), but rather rely on quantitative trading systems and sophisticated
money management strategies.
All
in all, whether you decide to use managed futures or whether you decide to
follow the trend on your own, be aware that trends often contradict
fundamentals. This can help you be monetarily correct when you were
fundamentally wrong.
If you are interested in learning more about the commodity
bull market, I urge to pre-order my forthcoming book, "Commodities for Every
Portfolio: How To Profit from the Long-Term Commodity Boom".
Emanuel Balarie
Senior Market Strategist
Wisdom Financial, Inc.
Direct toll free: 866-465-0017
International: 949-548-2021
Emanuel Balarie is the Senior Market Strategist at Wisdom
Financial. As an expert on foreign markets, foreign currencies, and the
precious metals industry, Mr. Balarie often speaks
at public engagements and his research is regularly published in investment
newsletters. You can find out more about Mr. Balarie
and his services at www.wisdomfinancilinc.com
The risk
of loss in trading commodity futures contracts can be substantial. You should
therefore carefully consider whether such trading is suitable for you in
light of your financial condition.
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