NEW YORK ( TheStreet) -- Hedge funds that specialize in managed futures have trounced index mutual funds based on the S&P 500.For the decade ending in 2009, the Altegris 40, an index of managed futures funds, more than doubled, while the S&P 500 dipped into the red. The performance of futures funds was particularly notable during the height of the credit crisis. For 2008, the Altegris 40 returned 15%, an intriguing accomplishment in a year when the S&P 500 lost 37% and most hedge funds declined. Managers of futures funds say that the strong showing in the downturn was not surprising. "In periods of turmoil, managed futures have generally done well," says Brian Hurst, a principal at AQR Capital Management, which runs AQR Managed Futures Fund, a hedge fund. Managed futures funds invest in a wide range of futures, including instruments that track stocks, bonds, agricultural commodities and metals. The funds typically follow trends. When spot prices of wheat or dollars are rising, a fund manager will go long the futures, betting that the rally will continue. When prices drop, the manager takes a short position, hoping to profit from continuing declines. Hurst of AQR says that the strategy often works because of the principles of behavioral finance discovered by Daniel Kahneman and Amos Tversky, who were awarded the Nobel Prize for their work on how people make decisions. According to the researchers, people adjust to changes in the market only gradually. Say a pharmaceutical company wins approval for a new drug. The stock may rise a bit, but the shares will not soar as much as the news might justify, explains Hurst of AQR. The price will only gradually rise as investors slowly accept the news and bid up prices. That explains why a trend can begin slowly and persist for a long time. "Traders and investors tend to underreact at first," Hurst says. Of course, trend following doesn't always work. In some instances, trends reverse suddenly, and portfolio managers suffer losses when their long or short bets prove wrong. To avoid stumbling, AQR stays broadly diversified, typically holding 100 different positions. "We often make wrong bets, but we have been right on average," says Hurst.
To appreciate the diversity of positions a fund may hold, consider AQR Managed Futures Strategy ( AQMIX), a mutual fund. On March 31, the fund was short corn futures and long copper. It was also long the Australian dollar and short Japanese yen. Managed futures funds tend to work best when there are sharp trends that persist for long periods. That happened powerfully in 2008. As stocks and oil started to fall, funds went short equity and energy futures, recording big gains. Funds also profited from long positions in Treasury bonds. In 2009, the picture was very different. After falling for months, stocks suddenly snapped back in March. That caused losses for trend followers. Throughout the year, many sectors rose and fell repeatedly, as investors moved in and out of the dollar and energy. As a result, most managed futures funds lost money. For the year, the Standard & Poor's Diversified Trend Indicator, an index that holds long and short futures positions, lost 5.9%. The S&P benchmark provides an indication of the kind of steady returns that managed futures can produce. The index has 50% of its assets in financial futures -- including Treasury bonds and Canadian dollars -- and 50% in commodities, such as precious metals and livestock. When a commodity's price has been rising in recent months, the index automatically takes a long position. It goes short after prices have been falling. During the past decade, the index only suffered one losing year, in 2009. In every year when the S&P 500 recorded a loss, the futures index stayed in the black. "Managed futures offer an appealing way to diversify a portfolio because they have no correlation with stocks or bonds," says Sanjay Yodh, managing director of alternative strategies of Rydex/SGI, a fund company. For an easy way to try managed futures, consider Rydex/SGI Managed Futures Strategy Fund ( RYMTX), a mutual fund that tracks the S&P futures benchmark. During the past three years, the fund returned 0.2% annually, outpacing the S&P 500 by 10 percentage points.
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