CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition

29.5 UNDERSTANDING RETURNS

The purpose of this section is to bridge the gap between the world of conventional money management, in which return has a natural and well-understood meaning, and the world of futures, in which the idea of return, by itself, is rather unclear. The disconnect between the two markets is simply this: Real assets tie up real cash. To buy a portfolio of stocks, for example, one invests cash. The stocks then spin off dividends, which constitute part of the return, and the prices of the stocks rise or fall, which constitutes the rest. The resulting gains or losses are converted into a percentage return using a denominator equal to the value of the cash invested in the stocks.

Once one leaves the world of fully invested, conventional assets, estimating returns becomes more of a challenge. What, for example, is the return to a long/short strategy in which the market values of positions are exactly offsetting? This is, in fact, the case with futures, which behave like fully leveraged or geared positions in the underlying commodity. Their purpose in applied finance is to capture changes in the price of the underlying market, which allows them to be used equally well for both hedging and trading. In the hands of CTAs, futures contracts are building blocks from which highly diversified portfolios of positions, both long and short, in the world's financial and commodities markets can be built.

Although futures are like forwards in the sense that they both behave like ...