A hint could be gleaned from a simple interview. On a Sunday, in mid-1982, James Baker was interviewed on the television show Face the Nation. He was asked how the Reagan administration’s policy could finance large increases in defense spending and massive tax cuts without incurring inflation. He answered matter-of-factly, "We can borrow it."

With such a prevailing attitude among policy makers, it was clear that investors, not traders, would be the main beneficiaries of this policy shift. The Keynesian (fine-tuning) monetary policies, in effect since World War II, were the reasons for the inflationary cyclical movements in the economy. This inflationary bias escalated with the Vietnam War and accelerated with the Organization of Petroleum Exporting Countries (OPEC) oil price increases, causing Fed policy to become abusive. The Fed lowered interest rates and purchased government debt in excessive quantities, a strategy that climaxed in 1980. The Reagan policy substituted borrowed money for printing money, leading to disinflation. Expectations of higher prices, as witnessed in the 1970s, would dwindle. Following this reasoning, the Fed need not tighten credit or raise interest rates to the same degree as during the 1970s and would extend the duration of economic recoveries.

Borrowing money for economic stimulus is never a problem - unless you can’t afford to do it anymore. Until then, however, continuous building of government debt acts as a stimulus to the gross domestic product (GDP) growth without resulting in inflation. By the early 1990s, following Keynesian policies, the deficits had grown to unsustainable levels, so the strategy had to be changed slightly. This was accomplished by raising taxes and lowering interest rates.

Eventually, however, like inflation, the cumulative debt and the burden of interest-carrying costs lead to public concern, and the political cycle adjusts once more. Today, even President Clinton is discussing a balanced budget, although he is reworking the numbers and adding 50% more time to perform this Herculean task than what Congress is proposing.

When the Future Changed

Prudent Decisions

After a great deal of thinking and research, I have come to the conclusion that a 10% to 15% portfolio allocation into managed futures is the most prudent, and potentially profitable, investment decision available to capitalize on these changes. Individual investors have a major edge over institutions in this case, because the institutional world is always last to be involved in new products and changing trends. This is not because institutional investors are not skillful or insightful managers of money, but rather, it is because they must operate under the beneficiaries’ perception of prudent money management. Few money managers are courageous enough to make important structural decision changes when their colleagues are not heavily involved as well.

However, once a trend is in force and large amounts of profit are being made, institutions will finally invest. By this time, the trend is inevitably on its way, which pushes the markets to extremes, and rsults in the institutions being hurt the most. Examples of this phenomenon can been seen in the 1970s investment into the nifty-50 growth stocks, and more recently, the oil and real estate markets in the mid-1980s.

The profits derived in the commodity/futures markets could be dramatic as cash flow pours into the tiny $25 billion market from at $15 million bond market and a $9 trillion equity market. The institutional drive into managed futures, ironically, could be caused by Employment and the Employee Retirement Income Security Act (ERISA)! The median bear market for stocks since 1896 is 31%. If financial assets decline 30% in value, money managers will not be able to use relative performance as a defense: diversification into managed futures with a small allocation of capital is a prudent hedge against this type of market action. A pension fund manager’s fear of being fired will be overshadowed by the specter of being sued!

Think about it. Doesn’t "3000 on the Dow" have a lawsuit ring to it? If a battery of opportunistic attorneys can sue fertilizer companies because fertilizer can act as a possible catalyst for a bomb, and one angry government paranoid blows up a building; what do you think those attorneys will do to pension fund sponsors, corporate directors and money managers when they lose $2 trillion of beneficiary retirement funds?

The primary protection to pension funds will be managed futures. Other tangible inflation hedges are not as versatile. Pension funds generally can’t short stocks, but, with managed futures, commodity trading advisors (CTAs) can short Standard & Poor’s and bond futures for them. Gold stocks are too thinly traded to allocate 5% of portfolio assets and are only a narrow hedge against inflation. In aggregate, they would become over-valued quickly. But, a diversified list of CTAs easily covers hundreds of different commodities and financial futures, which are generally more liquid as a whole.

The objective of adding an investment class to portfolio is to achieve four goals:

1. Diversification
2. A hedge against inflation
3. Non-correlation
4. Standalone profitability.

Managed futures does all of this.

The most common argument against investing in futures is that they are derivatives, a term that is non-grata with money managers today. Derivatives are neither good nor bad, but simply investment tools: by definition, a derivative is merely an investment vehicle that derives its value from any underlying market, whether that market is a cash product like crude oil, a foreign currency, interest rates or an equity product like the S&P. The risks and losses associated with derivatives come not from derivatives themselves, but from too much leverage and lack of diversification, and those are the given responsibilities of any given manager. Would a prudent money manager put 75% of their equity asset allocation into one illiquid over-the-counter stock. No! But there is no difference between investing in derivatives and in any other investment vehicle, so long as prudence and common sense are employed. Certainly a prestigious firm such as Goldman Sachs recommending a 5% portfolio asset allocation, and Morgan Stanley recommending even more, up to 15%, into commodities confirms this view. So does a publication put out by JP Morgan Securities (a wholly owned subsidiary of JP Morgan and Co, on September 20, 1994, which begins:

"Commodities-a suitable asset class

• Commodities are an appropriate asset class for institutional investors
• Providing a source of strategic diversification
• And offering solid investment performance"

The British financial magazine The Economist summarizes the Results of a Frank Russell study:

"Assuming that insurance premiums fall to zero, and the stock-commodity correlation stays at zero, Frank Russell says that a client with average risk aversity should put 3.7% of its fund into commodity futures collateralized with Treasury bills."

Speculating on Price Changes

On Managed Futures

What does the history of manged futures show? It demonstrates a compelling reason, based on logic and past profits, to invest a percentage of one’s portfolio in this asset class.

Anyone can discover these results with moderate effort, but for convenience, here are some of the findings.

The Barra/MLM index shows that commodities, like stocks, trend. This unleveraged index is composed of 25 equally weighted commodities, with a long or short position in each based on a single 12-month algorithm. The algorithm is recalculated once a month, at which time the position is either reversed or carried for another month. Since 1961, the index has had only one losing year: 1992, with a loss of 0.65%. The Barra/MLM index is a recognized benchmark of the returns available to a futures investor. It is based on daily closing prices of the nearby contract month of a portfolio of the most active futures markets.

The average annual rate of return since 1961 for the Barr/MLM index was 580 points greater than the average annual total return for the S&P 500, or 17.08% (MLM) versus 11.28% (S&P)(Figure 1). The Barra/MLM index was up almost double its average annual rate, or 32.4%, in the down S&P years (1962, 1966, 1969, 1973, 1974, 1977, 1981 and 1990). This correlates with independent academic studies that concluded commodities are negatively correlated to stocks. However, using multiple advisors, managed futures as an asset class does not result in negative correlation, but rather, noncorrelation. The index actually outperformed the S&P in 10 of the 26 up years.

However, an index is not reality. It does not have fees, commissions, or slippage. To construct a real comparison, you must use real CTAs, which should not be chosen solely on the basis of past performance. The real comparisons should be a blue-chip/Dow industrial-type group of CTAs of quantity and quality, diversification and trend following - that is, system traders. This is similar to the Dow Jones Industrial Average (DJIA), in which companies are not chosen just because of their history of being continually profitable.

I selected nine CTAs who would easily exceed almost any due diligence criteria. The combined net (after all fees) performance of these nine CTAs not only achieved all four goals I set out earlier but did so with an adjusted-risk basis equal to that of the S&P. Even if you compare a specific period of strong financial markets such as 1988 todate, managed futures outperformed the S&P. In volatile years, or those where stocks were weak, these CTAs historically have outperformed the market by a wide margin. In the aforementioned period, 1990 was the only down year for the S&P (3.9%), and my blue-chip CTAs netted a 49% gain as a group.

With one minor losing year of less than 1%, these CTAs outperformed the S&P by an average of 3.8% per year, with an average annual compounded return of +17.2% for the CTAs versus an average annual compounded total return of +13.4%. This year, 1995, has also been a good year for this blue-chip group of CTAs; as of the end of July, they had netted 19.2% versus 23.7% for the S&P.

Of course, this is not to suggest that a balanced portfolio should be abandoned. Indeed, it demonstrates that balance works best. Stocks and bonds should always be a fundamental part of a portfolio. But what percentage of a portfolio should be allocated to managed futures? The more bearish the inflation scenario, the higher the allocation should be, up to a maximum of 15% in managed futures. The historical numbers of my blue-chip CTAs index group is obvious; it necessitates a consideration of adding an asset class to this method.