Modern Investment Management: A Focus on Investment Sensitivities

Volatile markets have dominated since the turn of the century. Investment portfolio returns

have fluctuated wildly, leaving some investors to question their portfolios’ ability to withstand

even greater market swings. More than ever, how an individual investment responds to moves

in the broad market, and moves in relation to other investments, is critical to understanding how

a portfolio as a whole may respond in various market conditions. Simply investing in various

asset classes does not necessarily equate to diversification. The following defines several key

metrics an investor can use to assess just how one’s portfolio and its many investments may

behave across various market cycles.

Beta

One way to measure an investment’s sensitivity to a particular market is called beta. Beta is a

measure of how an investment’s price reacts to changes in the market, generally represented

by the S&P 500 Index. For example, a beta of 1.0 indicates that any change in the market has,

historically, resulted in a change to the investment of the same magnitude. For this reason, beta

could also be considered a magnitude multiplier. In comparison, a beta of 0.5 indicates that

the investment’s historical percentage price change is half (50%) that of the overall market.

Likewise, a beta of 1.5 shows the investment has a 150% response to market changes. As an

example, if an investment had a beta of 2.0, and the S&P 500 Index was down 1% on any given

day, we would expect the investment to be down 2% on that same day.

Another way to visually demonstrate the magnitude of an investment’s returns compared

to the market is the use of rolling returns. A rolling return shows the trailing 3-month return

(in this case) for each consecutive time period. For example, as of December 31 returns are

shown from October through December, as of January 31 returns are shown from November

through January, and so on. Figures 1 and 2 represent international stocks and managed

futures, respectively, when compared to US equities (“the market”), as represented by the

S&P 500 Index over rolling 3-month time frames.

International stocks fluctuate nearly to the same degree as the market (Figure 1) throughout this

time period. The simultaneous patterns of returns of similar magnitudes reflect a historically

high beta (1.01) for international stocks. On the other hand, managed futures generally do

not fluctuate with and to the same magnitude as the market (Figure 2). The disparate return

patterns of managed futures compared to the general market are reflected by a historically

low beta of -0.10.

To understand the magnitude of how an investment may fl uctuate with the overall market based

on historical patterns, it is important to understand what investments typically have the lowest

or highest beta (FIgUre 3).

By using this exhibit as a gauge, investors can see just how much their investment might move

up or down in response to market moves. For instance, investors who thought international

stocks would provide diversifi cation benefi ts were likely surprised when this investment

fl uctuated, up and down, to nearly the same degree as the general market, demonstrating

its high beta. On the other hand, short bias investments and managed futures were the least

sensitive to general market movements over the past decade. Of course, past performance is

not indicative of future results.

Correlation

Whereas beta measures the magnitude of an investment’s response to market changes, it does

not give a clear measure of how closely in tandem investments can move together. To measure

how any two return streams move together over time, whether comparing an investment to

the market or to another asset class, a frequently used metric is correlation. A correlation

of 1 indicates the two returns move perfectly together, 0 indicates movements are random,

and -1 indicates opposite movements. Figures 4 and 5 represent a correlation comparison of

international stocks and managed futures, respectively, to US stocks over time.

The monthly returns of international stocks have historically been clustered around a diagonal

line (pointing to the top right corner), demonstrating that when US stocks experienced a

profitable (or losing) month, international stocks generally experienced a profitable (or losing)

month as well (Figure 4). This means that US stocks and international stocks have historically

been highly correlated to each other. In comparison, historical returns of managed futures have

shown no clear pattern when graphed, meaning that the frequency of similar monthly returns

between US stocks and managed futures is sporadic (Figure 5). In other words, the monthly

returns of US stocks compared to managed futures have historically been non-correlated. Of

course, past performance is not indicative of future results.

Since US stocks typically represent the core equity portion of an investment portfolio, examining

the correlation of other investments to US stocks may be beneficial to determine the possibility

an investment could be used as a complement to equities in one’s portfolio (Figure 6).

Based on the chart, short bias investments had the lowest historical correlation compared to

US stocks of -0.86, which represents negative correlation. Negative correlation indicates that

two assets move in opposite directions from one another (when the value of one increases, the

other decreases). Managed futures had the second lowest historical correlation compared to

US stocks of -0.15, which represents zero or non-correlation, indicating that the movement of

two assets is random. Of note, six of the 12 asset classes compared to US stocks historically

demonstrated a positive correlation in excess of 0.50. Of course, there is no guarantee that

these relationships of returns will repeat in the future.

Both beta and correlation are useful statistical tools for analyzing one’s portfolio. A side-by-side

comparison may help summarize how each measure is used when comparing investments (Figure 7).

Market Cycle Correlation and Historical Returns

Given the market swings and frequent crisis periods since the turn of the century, many have

come to think that the proverbial “100-year flood” of significant market shocks appears to be more

akin to a 3-year flood. With these more frequent and wider market swings, the traditional buy and

hold strategy may have not worked for many investors, and the belief once commonly held that

markets will, on average, return approximately 7% a year, every year, is a distant memory from

decades past. Since it is impossible to predict if and when consistent market returns can be

expected again, preparing an investment portfolio for the worst (which many could argue was

the decade of the 2000s) is worth examining.

The following charts represent four distinct market cycles since July 2000, ranking each asset

class or strategy from highest historical return to lowest return. Within each chart are gray

diamonds, which show the historical correlation of each investment compared to US stocks.

Time periods 1 and 2 reflect when US stocks declined in value during the “Tech Wreck” and

“Credit Crisis” that lasted from September 2000 to September 2002 and October 2007 to February

2009, respectively. US stocks are seen further to the right in both graphs, depicting a loss of

nearly half their value during each time frame. In comparison, managed futures are seen at the

other end of the spectrum in both graphs. During the “Tech Wreck” alone, managed futures

historically experienced annualized returns of 19% and a correlation to US stocks of -0.54. As strategies drift further to the right in these time periods, historical returns decrease and historical correlation to US stocks typically increase, reflecting that they lost money in tandem with US stocks.

Time periods 3 and 4 depict periods when US stocks increased in value during the bull market

and recovery that lasted from October 2002 to September 2007 and March 2009 to September

2011, respectively. US stocks are further left on the return spectrum depicting its historically

high annualized positive returns during these time periods. As strategies drift further to the right

in these time periods, historical returns decrease as historical correlation to US stocks typically

decrease, meaning their return paths differed from that of US stocks.

In all four time periods, an observable trend appears depicting the relationship of an investments’

return to US stocks. Typically, the closer returns are to US stocks the higher the historical

correlation, and vice versa, as the further returns are from US stocks, the lower the historical

correlation. Of course, past performance is no guarantee of future results.

Know Your Path

Each investment possesses a number of different attributes that may be beneficial to an

investment portfolio. The selection and allocation of each investment depends on the investor’s

own risk and return objectives. A number of measures may be used to determine the similarity

between investments and/or the market, but taking into account beta, historical correlation and

market cycle correlation may help protect against a portfolio skewed unknowingly in favor of

one asset class that is not in line with the goals of an investor.

At Altegris, we believe it is important that you assess your investment portfolio regularly to

determine the impact of the market on your underlying investments. In addition, we believe a

more diverse mix of investments, which may include alternatives, is needed when constructing

an investment portfolio in today’s markets. Knowing the sensitivity investments have to one

another, to the market in general and in various market cycles, may expose previously overlooked

aspects in your investment portfolio that might produce a portfolio to better withstand future

market volatility.

Important Risk Disclosure

Hedge funds, commodity pools and other alternative investments involve a high degree of risk and can be illiquid due to restrictions on transfer and lack of a secondary trading market. They can be highly leveraged, speculative and volatile, and an investor could lose all or a substantial amount of an investment. Alternative investments may lack transparency as to share price, valuation and portfolio holdings. Complex tax structures often result in delayed tax reporting. Compared to mutual funds, hedge funds and commodity pools are subject to less regulation and often charge higher fees. Alternative investment managers typically exercise broad investment discretion and may apply similar strategies across multiple investment vehicles, resulting in less diversification. Trading may occur outside the United States which may pose greater risks than trading on U.S. exchanges and in U.S. markets. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

There are substantial risks and conflicts of interests associated with Managed Futures and commodities accounts, and you should only invest risk capital. The success of an investment is dependent upon the ability of a commodity trading advisor (CTA) to identify profitable investment opportunities and successfully trade. The identification of attractive trading opportunities is difficult, requires skill, and involves a significant degree of uncertainty. CTAs have total trading authority, and the use of a single CTA could mean a lack of diversification and higher risk. The high degree of leverage often obtainable in commodity trading can work against you as well as for you, and can lead to large losses as well as gains. Returns generated from a CTA’s trading, if any, may not adequately compensate you for the business and financial risks you assume. CTAs may trade highly illiquid markets, or on foreign markets, and may not be able to close or offset positions immediately upon request. You may have market exposure even after the CTA has a request for closure or liquidation. You can lose all or a substantial amount of your investment. Managed Futures and commodities accounts may be subject to substantial charges for management and advisory fees. It may be necessary for accounts that are subject to these charges to make substantial trading profits in order to avoid depletion or exhaustion of their assets. The disclosure document contains a complete description of each fee to be charged to your account by a CTA. If you use notional funding, you may lose more than your initial cash investment. If you purchase a commodity option you may sustain a total loss of the premium and of all transaction costs. If you purchase or sell a commodity future or sell a commodity option you may sustain a total loss of the initial margin funds and any additional funds that you deposit with your broker to establish or maintain your position. If the market moves against your position, you may be called upon by your broker to deposit a substantial amount of additional margin funds, on short notice, in order to maintain your position. If you do not provide the requested funds within the prescribed time, your position may be liquidated at a loss, and you will be liable for any resulting deficit in your account. This brief statement cannot disclose all the risks and other significant aspects of the commodity markets, and you should carefully study the disclosure document before you trade, including the description of the principal risk factors of an investment. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

About Altegris

Altegris searches the world to find what we believe are the best alternative investments. Our suite of private funds, actively managed mutual funds and managed accounts provides an efficient solution for financial professionals and individuals seeking to improve portfolio diversification.

With one of the leading Research and Investment groups focused solely on alternatives, Altegris follows a disciplined process for identifying, evaluating, selecting and monitoring investment talent across a spectrum of alternative strategies including managed futures, global macro, long/short equity, event-driven and others.

Veteran experts in the art and science of alternatives, Altegris guides investors through the complex and often opaque universe of alternative investing.

Alternatives are in our DNA. Our very name, Altegris, highlights our singular focus on alternatives, the highest standards of integrity, and a process that constantly seeks to minimize investor risk while maximizing potential returns.

The Altegris Companies, wholly owned subsidiaries of Genworth Financial, Inc., include Altegris Investments, Altegris Advisors, Altegris Funds, and Altegris Clearing Solutions. Altegris currently has approximately $2.88 billion in client assets, and provides clearing services to $780 million in institutional client assets.*

* Altegris and its affiliates are subsidiaries of Genworth Financial, Inc. and are affiliated with Genworth Financial Wealth Management, Inc. and include: (1) Altegris Advisors, LLC, an SEC registered investment adviser; (2) Altegris Investments, Inc., an SEC-registered brokerdealer and FINRA member; (3) Altegris Portfolio Management, Inc. (dba Altegris Funds), a CFTC-registered commodity pool operator, NFA member and California registered investment adviser; and (4) Altegris Clearing Solutions, LLC, a CFTC-registered futures introducing broker and commodity trading advisor and NFA member. The Altegris Companies and their affiliates have a financial interest in the products they sponsor, advise and/or recommend, as applicable. Depending on the investment, the Altegris Companies and their affiliates and employees may receive sales commissions, a portion of management or incentive fees, investment advisory fees, 12b-1 fees or similar payment for distribution, a portion of commodity futures trading commissions, margin interest and other futures-related charges, fee revenue, and/or advisory consulting fees.

Genworth Financial, Inc. (NYSE:GNW) is a leading Fortune 500 insurance holding company with more than $100 billion in assets and employs approximately 6,500 people. Genworth has leadership positions in offerings that assist consumers in protecting themselves, investing for the future and planning for retirement, and also offers mortgage insurance to help consumers achieve homeownership while assisting lenders manage risk and capital.

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