By: Dean Hoffman+
Here, is a scenario to consider. Two managed futures programs have identical MAR ratios (a risk to reward ratio). In other words, they have the same CAGR (compounded annual growth rate) and the same maximum drawdown. The investor’s job is to pick the better managed futures program to invest in. What tools other than MAR can the investor use?
For many, industry standards like Sharpe Ratio, Sterling Ratio and Sortino Ratio come to mind. Although, it is my opinion that these ratios represent more hindsight than foresight.
Take, for example, the S&P option writing programs of the early to mid 2000’s. One of the best known was ACE Investment Strategies. ACE had performance ratios off the charts (Sharpe, Sterling, Sortino, MAR) with smooth, consistent growth and barely noticeable drawdowns. From just about any measure, investors could not have asked for more. It was the darling of retail brokerage firms with small minimum account size requirements. (See graph below)
But, just like Long Term Capital Management, Ace had a sudden and for most, unexpected implosion! After years of flawless growth, they had close to a 70% drawdown in several months! (see graph below)
In hindsight, ratios such as Sharpe were worthless. They lured many people into the lion’s den!
But, there was one group of risk analysts who did have an excellent handle on the potential for Ace’s implosion. Who was it? The Chicago Mercantile Exchange, that is who.
It was the CME that set the margin requirements, and Ace was trading at high margin to equity ratios of 50% and more. This compares to many Commodity Trading Advisors (CTAs) who trade at less than 20% and some less than 10% margin to equity ratios.
It is my opinion that margin usage is a leading indicator of potential risk and drawdowns, but there is one school of thought that thinks using more margin is not necessarily dangerous because it can add to diversification. To some degree I agree with this, but traders quickly reach a point of diminishing returns.
In the following graph, I have plotted average margin usage against average drawdowns for several hundred Commodity Trading Advisors.
Traders can clearly see from the data and trend line that using more margin on average leads to higher drawdowns.
The bottom line is that I think the exchanges know better than most what the potential risks are and set margins accordingly. As ones margin to equity ratio increases, so is their potential for risk.
Some of us (myself included) wrote publicly before the options writer implosion that we thought they were taking too much risk and were prime for such a catastrophic event.
There is another even more obvious benefit to using less margin to get returns. Specifically, investors can use the excess funds to make better returns elsewhere. Assume there are two managed futures programs that made a $30,000 return. One program used an average of $30,000 in margin, and the other used an average of $15,000 in margin. The investor with the second managed futures program would have made the same returns AND had an extra $15,000 to invest elsewhere.
In summary, what I am suggesting is that investors use margin to equity ratios as a crucial measure when evaluating a Commodity Trading Advisor. It can be a valuable tool for estimating risk. We have learned from hedge funds such as Long Term Capital Management, the option writers like Ace, and the trend followers like Michael Clarke that using past drawdowns or risk-to-reward ratios to predict futures ones is far from reliable.
In all the cases above, had one looked at gearing (leverage) they just might have had a chance to see that a “black swan” was likely in the cards.
I must admit I am somewhat biased in my view because I market my own CTA with an emphasis on low- margin usage (generally less than 10%). Fortunately after nearly 5 years of trading my maximum drawdown has remained under 20%. My smaller account program forces me to use higher margin and has had larger drawdowns.
Past performance is not necessarily indicative of future results. Commodity futures trading carries substantial risks and is not suitable for all investors.
