The basis on which this analysis is drawn is to use two well-known indices. For commodities the Reuters-Jefferies CRB index, and for managed futures, the Barclay BTOP 50 index of both the largest and invest able CTA (commodity trading advisers) index. Both of these indices go back to 1994 providing us with nearly 18 years of data. 

 In the chart below I am treating the CRB as an invest able fund with the percentage monthly percentage returns calculated as a net asset value. If the CRB index where invest able you would get a return from 1994 looking like this:

 $1,000 Dollars invested in the index at inception in 1994 would have grown to $2,760 by Oct 2011. This works out to an annualized rate of return of about 5.9%. Note the peak in 2008 when the CRB NAV peaked in June 2008 at over $4,000. Now have a look at the BTOP 50 Index of CTA managers open to investment:

$1,000 invested in the BTOP 50 in 1994 would have grown to $3,242 by Oct 2011. This is an annual rate of return of 6.85% from inception. Notice in particular the remarkably smooth return stream of the BTOP with considerably less volatility than the CRB index, and with far fewer and smaller draw downs. Here is a table below summarizing the comparative Rates of Return, Sharp, Sortino and Downside Deviation of the two indices:

 (Assumes Risk Free Rate of 50bp)

 In summary, the BTOP 50 produced slightly in excess of 100bp of net return relative to the CRB, with less than half the volatility. The BTOP 50 sharp ratio is double that of the CRB, and the BTOP 50's sortino is three times higher. 

 How correlated is the CRB to the BTOP? Have a look at the rolling 12-Month correlation chart below:

 It turns out the two return streams are not that correlated. In fact, the average 12-Month Rolling correlation is a modest +.23. This implies that managed futures should reduce somewhat the volatility of passive commodity long strategies. Here is a backward looking table showing how an allocation to managed futures as represented by the BTOP, would have improved the absolute and risk adjusted returns:

Backward Looking Simulation 

 The table above shows how a steadily increasing allocation to managed futures improves both the Sharp and the Sortino ratios as well as the rate of return. What is surprising is that the allocation needs to be greater than 50% to see a Sortino ratio that is nearly as good as the BTOP on its own. But it should be pointed out, the BTOP is a index of the largest CTA managers, and these managers typically do not have an overabundance of capital allocated to hard or soft commodities, but rather to financials. So in assessing the merits of any particular CTA manager as a diversifier of commodity risk, it is important to establish the percentage of capital that that particular manager allocates to hard and soft commodities. A manager with even a 50% allocation to commodities, is unlikely to be part of the BTOP index, but such a manager would act as a far better diversifier than the BTOP 50 on its own, and for this reason the amount of capital required hedge the commodity risk would certainly be less than 50%. How much less is really a function of what particular managers are chosen, to what degree they are uncorrelated to the CRB and how much their particular strategy is concentrated in commodities.  The other reason for choosing a CTA with a higher commodity exposure, is that the portfolio you are trying to hedge may have a combination of individual stocks that as a group have a higher "beta" to the CRB. This is particularly important if the stock portfolio is drawn from an index with a higher weighting to commodities: Canada, Australia, Brazil, and New Zealand portfolio managers should take note. 

James Rider

Nov 2011

JR@FxVolResearch.com