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Managed Futures Mutual Fund Update

 
By Eric L. DeMico, Investment Analyst
Legend Financial Advisors, Inc.®

 
Managed futures mutual funds (and ETFs) remain a relatively new product. Given our affinity for managed futures as an asset class, it goes without saying that this is something we continue to watch closely. 

As a refresher, managed futures, under most circumstances, refers to systematic trend following. These strategies have long been operated by Commodity Trading Advisors (or CTAs) that use carefully designed programs to profit on the trading of various derivative instruments, from interest rate futures to options on various equity indices. Traditionally, getting access to one of these trading strategies required investments via public and private limited partnerships. This began to change as the boom and bust cycles of recent history have left investors looking for new ways to invest for the long-term without being subject to periodic fallouts in the market. As it happens, managed futures have had a tendency to hold up quite well (if not benefit) during periods of stress in the markets. Most CTAs were up by double-digit percentage figures in 2008, the same year the S&P 500 was down 37.0%. While such periods may lead investors to believe that there is a negative correlation between managed futures and equities, the reality is that, over longer periods, there is virtually no significant correlation between the two. Things like this do not go unnoticed for long; It was only a matter of time before the investment industry’s product development was hard at work to bring managed futures to the masses.

There have been two distinct approaches to the construct of the managed futures mutual fund. Some funds have developed (or purchased) a fixed, signal-based model to buy long or sell short a defined list of currencies, commodities, equity indices etc… depending on various factors; typically moving average crossover. The most famous of these strategies is Standard & Poors’ Diversified Trend Indicator Index (or DTI). This was the strategy behind the first managed futures mutual fund, the Rydex Managed Futures Fund, launched back in March, 2007 and is now the underlying index of the first managed futures ETF, the WisdomTree Managed Futures Strategy Fund. More recently, another type of fund has come to market: The managed futures fund of funds. These mutual funds allocate to actual CTAs versus operating their own fixed, in-house trend following program. A new class of the fund of funds model is actually forgoing the evaluation and selection of CTAs on an ongoing basis and, instead, are choosing a single CTA to manage (or sub-advise) the entire strategy. Most CTA strategies (at least any that will be the sole CTA within a mutual fund, presumably) invest in a wide variety of markets such that there is not any substantial loss of diversification by not allocating to more than one. 

The clear advantage to the fixed, in-house strategy operators is cost. While there may not be any notable difference in the listed expense ratios between these strategies and those that allocate to CTAs, it is important to note that CTAs don’t work for free, therefore their performance is net of their own fees prior to any costs imposed by the mutual fund. Since most CTA management fees are at least partially based on performance, it is difficult to know exactly what the cost of these funds will be on an ongoing basis. Nonetheless, investors should not be shocked to find out that 4.0% (or more) of an investment has been paid in fees of one sort or another. Such expenses are certainly high, but these figures cannot be evaluated in isolation. 

There are two important factors to consider before immediately disregarding the CTA fund of funds option in favor of the aforementioned in-house strategies. First, many CTAs have been doing what they do for ten, twenty, or even thirty years and have been evolving and making improvements along the way. Managed futures is typically very pragmatic and rules-based; But the rules and markets in which those rules can be applied are continuously changing and expanding. Therefore, when a fixed strategy is no longer valid in a given market, or worse, others are front running the widely known strategy, there isn’t much that can be done. This has been evident in the relatively poor performance of some fixed strategy funds versus some of the actively managed, CTA funds. The other important consideration is the cost of researching CTAs and allocating to limited partnerships (if an investor even qualifies) on one’s own. Those that have done this in the past know that this can be quite time-consuming (and costly) given the paperwork and coordination that is involved.

The playing field of managed futures mutual funds continues to expand, however, the early players were all of the in-house strategy type. The Rydex Managed Futures Strategy Fund is the grandfather of the group, approaching its fifth birthday in March. As previously mentioned, the Rydex fund is based on the S&P Diversified Trend Indicator, or DTI, that provides signals on whether to go long or short various commodities and financial positions (currencies and interest rates) triggered by seven-month moving average crossover. Direxion launched two similar funds that utilized sub-components of the DTI Index that focus on commodities or financials, respectively. AQR developed its own trend following program involving both short- and long-term trend identification (versus just a seven-month moving average signal). The AQR Managed Futures Strategy Fund also incorporates some systematic override within the strategy to avoid blindly following a volatile position to the point of sharp reversal. While the AQR fund clearly has a more robust (or at least complex) strategy at work, it still effectively applies the same framework to every market in which it invests. While it could be argued (and it is) that trends are market-agnostic, it is difficult to suppose that applying the same binary system to every security market without any kind of fine-tuning is a model that cannot be improved. Only time will tell, but the AQR fund has been doing a better job of keeping up with the CTAs than the Rydex and Direxion funds thus far.

Of the in-house strategy variety, there is one fund that is a bit different: the Natixis ASG Managed Futures Strategy Fund. This fund is advised by AlphaSimplex Group, LLC (ASG), which is headed by MIT’s Director of Financial Engineering, Dr. Andrew Lo. While ASG has developed its own strategy, it is not as basic as some of its peers. Rather, the ASG fund operates its own proprietary trend-following trading strategies by market and weights its various exposures by volatility, similar to the other established CTAs in the industry. Thus far, the results have been impressive as this fund is among the best performing managed futures mutual funds.

The CTA fund of funds started appearing at the beginning of 2010 with the launch of the MutualHedge Frontier Legends Fund. A few others followed later that year and several more in 2011. While this group of funds is certainly nuanced, there is generally substantial overlap among the CTAs that these various funds utilize. This makes sense as there are only so many CTAs that both possess the size and willingness to set up structures to work within a mutual fund. One exception to this is the Princeton Futures Fund. The fund is sub-advised by 6800 Capital, L.L.C., who has had a rather successful record of managing a fund of funds in a partnership format for several years. In contrast to the other managed futures mutual funds, the Princeton Futures Fund allocates to nearly 20 CTAs (the number varies) versus the typical four to seven of other multi-CTA mutual funds. Furthermore, just about all of the CTAs are unique to the fund. This is, in part, due to the fund’s objective of incorporating some trading strategies that are not necessarily systematic trend following, such as global macro and countertrend. The fund’s performance is still uncorrelated to anything other than managed futures investments, but it is, nonetheless, a departure from the more traditional managed futures strategies of the other fund of funds. What is inspiring about this fund is the acumen that came from 6800 Capital in terms of a proven track record of operating this same strategy as a partnership. What has not been inspiring thus far has been the performance of the mutual fund, unfortunately. 

The other funds of funds have their fair share of similarities. However, there are some key considerations when evaluating this new breed of funds. Rather than reproducing the prospective-level detail in this writing, it may be more helpful to outline some of the items that should be on the radar screen for any prospective investors. 

The first questions that need answered surround the CTA selection process. Anyone can data-mine a good-looking back-test, therefore it is important to determine how the selection process takes place, what criteria are used in selecting/monitoring CTAs, and if/how changes in the CTA line-up will take place. 

Another important consideration is how the cash is managed for the fund. Many investors may not realize that at least 75.0% of the investment in a CTA-based mutual fund will typically be sitting idle in cash, largely as collateral for the derivatives positions in the remainder of the portfolio. Having a well-managed cash equivalents/fixed income program may produce enough additional total return to negate at least some of the high expenses involved with these funds. The cash management can’t be too cute, but an extra 50 to 100 bps a year over money market yields is certainly within the realm of possibility. 

Last, but certainly not least, these mutual funds are the product of some interesting product engineering to circumvent regulation by the Commodity Futures Trading Commission, or CFTC. The operators of these mutual funds have established offshore legal entities (typically in the Cayman Islands) such to negate certain reporting requirements (such as the hidden costs discussed previously) and shelter the futures income from being subject to U.S. tax laws. Effectively, the mutual fund invests in the offshore entity which, in turn, is investing in the CTA programs. While this practice is legal, there are lower requirements for transparency and disclosure versus limited partnership investments. As such, investors are placing significantly more faith in the management of these mutual funds versus a traditional, long-only equity mutual fund, for example. Also, consider that these issues continue to be a topic of interest among the various investment regulatory bodies (and the IRS), so do not be surprised if these funds are subjected to different reporting requirements and/or taxation in the future. Needless to say, the convenience of the managed futures mutual fund versus the limited partnership does not necessarily come without additional risks.

2011 has been an interesting year for managed futures. There have been more losers than winners as markets have been loath to find any sustainable direction. One surprise, however, has been that some of the mutual funds have outpaced many of the stalwarts of the managed futures limited partnership space. Only time will tell if this trend proves to be sustainable. The reality is that the managed futures mutual fund space is still in its infancy. Determining the best of breed will require longer track records and several more data points to evaluate. Until these are made available over time, much more emphasis must be placed on the qualitative data. When offshore legal entities and counterparty risk is involved, it’s all the more important to have a very good idea of who investors are doing business with and why they are doing business with them.     

 




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