Managing Wealth During Bear Markets

Managing wealth during a bull market is easy. More often than not, it's simply a matter of investing your assets in investments (stock, bonds, and/or real-estate) that will likely benefit from a strong economic environment. Over the last decade, this strategy has proven successful as the stock and real estate markets roared to record highs.

In recent months, however, it has become abundantly clear that the economy has come to a slowdown. Consequently, many investors are finding out that managing money during a bear market is not so easy. In this article, I will discuss how managed futures can help investors navigate through this upcoming economic storm.

Dismal Economic Times

Whether or not you believe that we are headed towards a recession, one cannot dispute that a slowing economy has already begun to have a negative impact on the stock market and real estate markets. You need only to look at the recent declines in the stock market and rising foreclosures to see that this is the case. With a slowdown in the economy, typically consumer spending will decline, unemployment will rise, and earnings for companies will decrease. The end result typically is a further decline in the stock market.

If this wasn't enough, rising inflation and a declining US dollar also affect cash and bond investments. Investors are realizing that rising energy and commodity prices are translating into a higher cost of living. And if they have traveled abroad in recent years, they will have realized that that the US dollar has declined substantially against all major currencies.

So what do you do? Is it a foregone conclusion that your portfolio will decline during this upcoming economic storm? Not necessarily.

If you are advisor, should you begin to anticipate a decline in your client book? Not necessarily. Successfully managing wealth during a bear market is what will ultimately separate you from your competitors. By properly adapting to the present market conditions, wealth managers have an opportunity to show their value to their current client base, increase their referrals, and ultimately increase their book of business.

Indeed, whether you're an advisor or you simply manage your own money, reevaluating your asset allocation models, uncovering new investment ideas, and positioning your portfolio to weather this economic downturn are the first steps.

Managed Futures In The Modern Portfolio

One such way that you can adapt to these current economic conditions, is to introduce your clients to the world of managed futures. While this industry is still relatively young compared to the securities markets, some of the world's largest pensions and institutions-like CALPERS and Hermes UK-have already allocated funds to this sector.

The term "Managed Futures" defines an industry that is made up of professional money managers- known as Commodity Trading Advisors- that trade client funds on a discretionary basis using a variety of alternative investment strategies. This is somewhat similar to investing with a mutual fund manager that ultimately decides what type of stocks to buy and when to buy or sell the stocks. There are, however, a couple major differences. The first has to do with the fact that Commodity Trading Advisors strictly trade in the futures and foreign exchange markets. Hence, the term- managed futures. The other difference is that the manager can use a wide range of trading strategies that are not available to traditional managers.

Consider the following trading strategies:

• Trend Following: Trend following is a strategy that simply follows trends based on certain technical indicators, like moving averages and breakouts. CTAs that specialize in this strategy can profit from both rising markets (by being long futures contracts) and declining markets (by being short the futures contracts). Trend followers, however, often do not fare well during choppy or sidewise markets.
  
• Counter Trend: This strategy seeks to profit from trend reversals. If you look at charts, you will notice that no market moves continuously up or down. There are often pullbacks and reversals. This strategy seeks to profit from those types of moves.
  
• Arbitrage: There are a number of sub-strategies that fall under arbitrage. The most prevalent in the managed futures industry is statistical arbitrage. A simple example of this strategy is if one manager simultaneously purchased gold on one exchange (for a lower price) and sold it on another exchange (for a higher price). This strategy looks to profit from the price difference.
  
• Global Macro/Fundamental Focus: Commodity Trading Advisors that trade the markets from a fundamental approach often look at crop reports, weather patterns, and economic data to determine whether to enter a trade. These managers can be implementing any number of strategies- including be short the market
  
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As you can imagine, implementing the various strategies on a wide range of futures markets (from commodity futures to financial futures) can ultimately yield positive returns regardless of the direction of the market. For instance, a trend following manager can simply profit from trends- regardless of the direction of the trend. In addition, many managers often trade for the short-term or intermediate term. As a result, their returns are not based on the longer-term movements in the economy or markets.

Benefits of Managed Futures

According to the Barclay Hedge, (a managed futures tracking firm out of Fairfield, Iowa), the amount of money in managed futures has grown from just over $310 million in 1980 to over $200 billion in 2008. This growth is largely due to the increasing interest that institutions and high net worth investors have placed in managed futures. Another reason has to do with the recent flurry of academic research reports that have highlighted the following benefits of this new asset class.

• Managed Futures has the potential to enhance returns of your client's portfolio
  
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• Managed Futures has the potential to reduce the overall risk of your clients' portfolio
  
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• Managed Futures has the ability to profit from any type of market environment
  
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• Managed Futures provides your investors with the ease of global diversification
  
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Managed Futures Demonstrate Very Low Correlations With Other Asset Classes

At the core of these studies, is the fact that managed futures generate returns that are non-correlated with traditional investments.

For investors that put value in the modern portfolio theory, the simple fact that managed futures exhibit low correlations with traditional investments should be enough reason for them to consider allocating to this asset class. According to Harry Markowitz, the father of the modern portfolio theory, having a diversified portfolio made up of non-correlated assets ultimately reduces overall portfolio risk and ultimately increases returns that would have been achieved without the diversification.

The goal, however, is to have a truly diversified portfolio. Indeed, as the global stock markets become more aligned during economic slowdowns, investors should be aware that simply diversifying their portfolios among international stocks or between small, mid, and large cap stocks might not be the best form of diversification. As an example, consider the stock market sell-off that occurred in February 2007 when the Shanghai market sold off 8.8% in one day. Not only did the international markets (in Asia and Europe) also experience declining returns, but the domestic markets also experienced substantial moves on the downside.

With managed futures, investors can generate returns that are non-correlated with their traditional investments. The reason is that Commodity Trading Advisors use different trading strategies, trade different markets, and implement different trading time frames than traditional stock and bond investments. Because various managers have different ways of generating returns, there will be managers that can profit and thrive during dismal economic times.

Total Return By Asset Class (January 2008 to April 2008)

Consider the following chart that shows the performance of Commodity Trading Advisors versus other investment options during the first quarter of 2008:

Source: TrimTabs Investment Research and BarclayHedge

As you can tell from the above chart, the managed futures sector was able to achieve positive returns, while a number of other sectors posted negative returns. Not surprisingly, TrimTabs Investment Research reported that Commodity Trading Advisors received the largest inflow of new money since January 2000. In April, more than $2.2 billion, a number that represents 3.6% of assets, entered in the industry.

July Update: The Barclay CTA Index was down 2.37% in July. Year to date, the index is up 7.58%

Emanuel Balarie

Jabez Capital Management

www.commoditynewscenter.com