In any investment portfolio, the ultimate goal is to gain the highest degree of diversification possible.  Diversification not only means that you own different “classes” of investments (stocks, bonds, etc.) but it also means that there is a low degree of correlation between each of the investment holdings.

As we move forward, we’ll be quoting studies that were conducted by Goldman Sachs, The Chicago Mercantile Exchange and the Chicago Board of Trade.  These three studies address the diversification benefits of including “managed futures” in a traditional portfolio. Simply defined, Managed Futures are an investment in which a professional money manager trades the futures markets on behalf of their investor clients.  Investors can open Managed Futures accounts directly with a brokerage firm.  However, if an investor instead chooses to participate in a hedge fund (where the hedge fund in turn invests in managed futures), the investor also gains the “limited liability” advantage that is comes with being a hedge fund member.

Goldman Sachs has conducted a study that documents, the ability of certain hedge fund investments (those hedge funds that deal heavily or exclusively in futures markets) to enhance the returns of traditional investments. Covering a 25-year period, the study concluded that by “allocating only 10% of a securities portfolio to futures, investors can vastly improve their performance.” Goldman Sachs’ conclusion, concerning the value of futures, was supported by another study published by the Chicago Mercantile Exchange, one of the world’s preeminent futures exchanges. According to the CME study, “Portfolios with as much as 20% of assets in managed futures (such as thru an investment in a hedge fund) that is heavily weighted in futures markets) yielded up to 50% more than a portfolio of stocks and bonds alone.”
 

The Chicago Board of Trade’s, as well, published in their booklet, Managed Futures - Portfolio Diversification Opportunities, shows a portfolio shows a portfolio with the greatest risk and least returns comprised of 55% stocks, 45% bonds, and 0% managed futures while a portfolio exhibiting the greatest returns and least risk, comprised 45% stocks, 35% bonds, and 20% managed futures.

As you can see from the above study, the portfolio with the greatest returns and least volatility included managed futures.

Hypothetical Examples

The following hypothetical examples should prove quite helpful in better understanding how a relatively small investment in a hedge fund (that invests 100% of the hedge fund assets in managed futures) can increase overall portfolio performance:

Let’s assume your total portfolio is $250,000 and you invest 80% in stocks and bonds ($200,000) and 20%, or $50,00, in a hedge fund (that invests 100% of the hedge fund assets in managed futures). Let’s assume at the end of the year you realize a 5% return on your stocks and bonds and a 25% return on the hedge fund. The result would be as follows:

Now let’s assume you earn 10% on the 80% of your portfolio invested in stocks and bonds, but lose 25% in the hedge fund (that's 100% invested in managed futures). The results would be as follows:

Now let’s assume you lose 5% on the 80% of your portfolio invested in stocks and bonds, but earn 25% in the hedge fund (that's 100% invested in managed futures).  The results would be:

You can see, in these hypothetical examples, by investing only 20% of your portfolio in the hedge fund (that's 100% invested in managed futures), if you were to earn 25%, it would outperform 80% of your portfolio invested in stocks and bonds (if the stocks and bonds earned 5%).

You can also see that a 25% loss in the hedge fund would still leave you with a net profit of $7,500 if your stock and bond allocation returned 10%.

Finally, you can see that if your stocks and bonds lose 5% and the hedge fund earns a 25% profit, the overall result would still be a $2,500 profit.

Note: No matter what the size of your portfolio, 80% invested in stocks and bonds and 20% invested in managed futures, with the same percentage returns, would produce the same percentage results in our hypothetical examples.

Important Disclaimer: The above hypothetical examples are strictly for illustration purposes, to help you better understand the potential impact of portfolio diversification.  All three examples (above) assume at least one component of the portfolio (either stocks and bonds, managed futures or both) earn a profit for the year.  Of course, it is quite possible that in any given year both the stocks and bonds, and managed futures components could post losses.

In no way are the examples to be construed as the returns you might receive in stocks and commodities. Of course, in actual investing, your results can be better or worse. The risk of loss exists in futures trading.