What is the MLM index?

Momentum strategies involve buying assets that are rising in price and selling assets that are falling in price. One of the most common strategies is a moving-average strategy. This strategy involves buying assets that are above the recent average price and selling short those assets that are below the recent average. Some passive indexes have been created that replicate the performance of a moving-average trading strategy in future markets. One such index is the MLM index.

The MLM index aims to offer investors’ access to a futures industry equivalent to the equity market’s S&P 500. The MLM index can be long or short and is composed of the 25 most-liquid contracts traded on U.S. exchanges, rebalanced at the end of each month. The MLM index has the ability to perform independently of the S&P 500. The index includes financial and currency futures but does not include stock index futures. It performs well in volatile markets and meets the needs of investors looking to participate in the futures markets without significant leverage.

Underlying the MLM Index is the fact that the mismatch in commercial firms’ futures positions is greatest, and investors' profits most pronounced, when the underlying market is moving broadly from one price level to another, either up or down.

The MLM Index is now considered by many investors a benchmark of futures market returns and is based on daily closing prices of a portfolio of key futures markets. The Index can be either unleveraged or leveraged. The leveraged version of the MLM Index can be used to improve both risk and return in a portfolio through negative correlation with other asset classes.

There are both benefits and risks associated with the addition of leverage in an investment strategy. The volatility of an investment in the MLM Index is increased through the use of leverage. However, leverage can provide many benefits when added to a portfolio. Adding volatile, but non-correlated assets, to a standard mix of stocks and bonds can both increase expected returns while at the same time lowering the volatility of the portfolio.

Standard Deviation

Standard Deviation

Investors use standard deviation to measure the risk of a portfolio. It is an investment’s average variation from the average return. Knowing the standard deviation tells investors the amount of swing in performance that an investment can be expected to have from year to year.

It is also a measure of volatility: the more a portfolio’s returns vary from the average return, the more volatile it is. The higher the standard deviation, the greater the volatility, and therefore the greater the risk.

If a set of numbers is close to the average of those values, then you may expect to see a low standard deviation. In contrast, if the set of numbers is spread across a greater range, it may present a high standard deviation. Higher standard deviation is often interpreted as higher volatility. In comparison, lower standard deviation would likely be an indicator of stability. The most consistent values will usually be the set of numbers with the lowest standard deviation.

For example, Fund ABC has earned an average of 8% per year over the past 10 years, with a standard deviation of 6. Statistically, there is a 67% probability that returns will fall within 1 standard deviation, and a 95% probability that returns will fall within 2 standard deviations. Thus, 67% of the time, Fund ABC earned between 2% and 14%, and 95% of the time, the fund earned between -4% and 20%.

If two funds have the same average return, investors should prefer the one with the lower standard deviation. To calculate it, take the square root of the variance. The variance is a measure of how spread out a distribution is. It is computed as the average squared deviation of each number from its mean. For example, for the numbers 1, 2, and 3, the mean is 2 (1+2+3/3) and the variance is:

= (1-2) ² + (2-2) ² + (3-2) ²

3

= .667

The square root of .667 (the variance) is .8167; therefore, the standard deviation is .8167.

As another example, consider the following two portfolios and their respective returns over the last six months. Both portfolios increase in value from $1,000 to $1,058. However, they differ in volatility. Portfolio A's monthly returns range from -1.5% to 3% whereas Portfolio B's range from -9% to 12%. The standard deviation of the returns is a better measure of volatility than the range because it takes all the values into account. The standard deviation of the six returns for Portfolio A is 1.52; for Portfolio B it is 7.24.

PORTFOLIO A:

Month	Value	Return %	Final Value
January	$1,000	0.75	$1,008
February	$1,008	1.00	$1,018
March	$1,018	3.00	$1,048
April	$1,048	-1.50	$1,032
May	$1,032	0.50	$1,038
June	$1,038	2.00	$1,058

PORTFOLIO B:

Month	Value	Return %	Final Value
January	$1,000	1.50	$1,015
February	$1,015	5.00	$1,066
March	$1,066	12.00	$1,194
April	$1,194	-9.00	$1,086
May	$1,086	-4.00	$1,043
June	$1,043	1.50	$1,058

Another way to look at standard deviation is to think of it as a band of probabilities. The lower the standard deviation, the narrower the band and the lower the volatility of the numbers in the series.

Think of a series of numbers, the average of which is 30. If the series has a standard deviation of 10, that means two-thirds of the numbers in the series will fall within 10 of the average, in this case between 20 and 40.

If the standard deviation were 18 (and the average were still 30), then you would know that two-thirds of the numbers would fall between 12 (30 minus 18) and 48 (30 plus 18).

The second series of numbers would be much more volatile than the first, even though their averages were identical. Therefore, the lower the standard deviation, the lower the risk. The biggest problem with standard deviation is that it makes no distinction between upward volatility (the type investors want) and downward volatility (the type investors don't want).

In reality, the best way to measure the risk of an investment is by studying what happened in the worst periods that investors had to endure.

Reduce Your Investment Risk

One of the best ways to reduce investment risk is to have a diversified portfolio. Diversification entails spreading money among a number of different types of investments or asset classes, such as stocks, bonds and cash. Among these investments, investors can diversify even further, into large and small or domestic and international companies.

Portfolios should be based on the investor's tolerance for risk and expectations for performance. The portfolio likely will include stocks, bonds, mutual funds and cash.

Diversification prevents one poor investment from ruining the entire portfolio. One of the most effective ways to diversify is to invest in mutual funds, especially if an investor does not have enough money to buy a lot of individual stocks.

Because the markets for stocks, bonds, and cash do not all move in the same direction or to the same degree, an investor's portfolio that combines these asset classes should be less risky than one that includes only one type of investment. A diversified portfolio historically produces better returns than one that is concentrated in more conservative asset classes, such as short-term bonds or cash equivalents.

Although a diversified portfolio won't completely eliminate risk, it's protection during market corrections or crashes.

Asset allocation is another way to reduce risk. Most of a portfolio's return is determined by how investors allocate assets among different types of investments. Asset allocation is important because it determines how risky an overall portfolio is. If all of a portfolio's assets are concentrated in one area, such as stocks, it is likely to be more risky than a portfolio whose assets are spread out among diverse investment categories.

An asset allocation appropriate to an investor's goals and time horizon provides the best chance that an investor will meet his or her financial goals. In addition, an investor should examine his or her overall financial resources and personal ability to tolerate risk when making asset allocation decisions.

Investors should base asset allocation on two factors: the amount of risk they are willing to take and their time horizon. A portion of the money should also be invested in stocks.

All investment goals have a time horizon, which is the length of time between now and when the money being invested will be spent. For example, if you are saving to buy a new car next year, your time horizon would be a short one. If you are saving for a down payment on a house, your time horizon might be medium-term, say four years. If you are currently 45 years old and saving for retirement, you have a long-term time horizon of about 20 years. Over time, of course, long-term goals such as retirement or funding your child's college education will become medium- and short-term goals. As your time horizon shifts, your asset allocation should shift accordingly.

An investor with a short time horizon might want to avoid higher risk investments such as stocks or stock funds, because the growth potential offered by these investments over time can be offset by short-term volatility. In this case, it would be better to concentrate on more stable investments such as bond funds, or even money market accounts.