A Primer On Managed Futures
Most financial advisors and the general public have little knowledge of managed futures as an investable asset class. In effect, most advisors that we at Legend Financial Advisors, Inc.® (Legend®) know shrug them off and say “high fees” (a true statement) without understanding the merits of such an investment when the words “managed futures” are mentioned.
Managed futures are a sector of the investment industry in which professional money managers actively manage client assets using global futures and other derivative securities as their primary investment instruments. Managed futures managers are also commonly known as Commodity Trading Advisors (CTAs). CTAs are required to register with the Commodity Futures Trading Commission (CFTC). The National Futures Association (NFA) is the self-regulatory organization by which CTAs are regulated. Collectively as an industry, managed futures funds, which for many years were viewed skeptically at best by the financial advisory industry, did not take off as an industry until the 1980s. In reality they have only recently begun to earn respect in the financial advisory community. Many advisors though would still say they have not garnered such respect.
Growth in the managed futures industry has been tremendous. Assets managed by the managed futures industry exceeded $120 billion in 2005. The global futures markets have historically been dominated by agriculture and commodity futures. In 1980, agricultural futures trading approximated 64% of market activity and metals trading comprised a total of 16%. Currency and interest rate futures accounted for the remaining 20%. Today, global futures markets are dominated by financial futures for currency, interest rates, and stock index futures. Twenty years ago, agriculture was the predominant piece of managed futures trading. Currently, it represents less than 10% of the total. In fact, for many of the largest managed futures managers, agricultural futures represent even less of their portfolios.
Managed futures managers can usually be segregated into two primary categories: either the various markets (oil, currencies etc.) that they focus on, or the trading strategies they utilize. The majority of futures managers will typically diversify across numerous markets and oftentimes trade hundreds of different types of futures contracts. Other futures managers specialize in a specific market or a group of similar contracts. For example, a futures manager might focus on the energy category (oil, gasoline, natural gas, diesel fuel, etc.) as opposed to just oil. Futures managers are also grouped together by trading strategies. The majority are trend-followers, which attempt to find trends in price movements of futures and jump on the bandwagon. These trends could last for a few hours, days, weeks or months. Man Investments AHL Group, a trend-following manager and currently the largest managed futures manager, re-analyzes various futures markets with their computers models over 2,000 times per day. This is spread over a 24-hour period since they operate in a global market. Fundamental analysis (more commonly known as discretionary trading) which is less popular relies on analysis of global supply and demand, macroeconomic indicators, and geopolitical forces, which is similar to a macro fund hedge fund manager except that the investment instruments and markets that they follow are far broader.
Trend-following approaches generally rely on quantitative models to perform technical analysis resulting in buy and sell signals. They can be further sub-classified as either trend-following or counter trend-following.
Trend-following managed futures’ trading systems are almost always highly computerized and new models are continually created by the management team. Futures management trading systems tend to be highly diversified across numerous markets. Most trend-followers refrain from trying to predict trends. Instead, they take futures positions that will profit from a continuing trend. They constantly review a number of widespread indicators such as momentum and moving averages. This helps the futures managers to identify the direction of a particular market. Futures managers often use different time horizons to identify the existence of a trend. On the other hand, counter-trend systems look for trend reversals. Futures managers that utilize a counter trend-following strategy typically rely on several technical indicators and methodologies. These include obscurely named indicators (to most financial advisors and investors) such as rate of change indicators. These rate of change indicators are called oscillators and momentum indicators. Counter-trend futures management systems alternatively can use more familiar technical indicators such as head and shoulders patterns.
Furthermore, fundamental (discretionary) managed futures managers also frequently use systematic models, which are based on fundamentals and underlying economic factors. However, the trading decision process is determined by the manager’s thoughts regarding the models results. Because experience and trader-specific skill are critical to the success of fundamental strategies, fundamental futures managers will often specialize in a particular sector or market. However, some fundamental futures managers diversify across strategies by basing their trading on a mix of trend-following and fundamental methods. These managers may or may not diversify their portfolio across numerous markets.
There are three ways to invest in managed futures. The first, public futures funds, in some cases offers investors the managed futures equivalent of a mutual fund. Although this statement is somewhat exaggerated, it is not unusual for a managed futures fund to have a fairly low minimum investor criteria. For example, a $35,000 income and a $35,000 net worth or a $100,000 net worth is not unusual. Some public funds may require investors to be of accredited investor status. Individuals and their spouse must jointly have in excess of $1,000,000, or if an individual, income in excess of $200,000 or $300,000 if held jointly with a spouse for each of the last two years and expect to meet that criteria in the current year. Public funds can often be liquidated on a monthly basis. Expenses are often higher than other managed futures opportunities.
The second way to invest in managed futures is that high net worth and institutional investors (these are either accredited or super accredited investors) can obtain exposure to managed futures through private commodity funds or pools, usually a $500,000 or higher minimum investment. Usually the expenses are lower than a public fund. Private funds offer diversification benefits similar to public funds. A negative is that they often possess the characteristics of hedge funds and other private investment vehicles, with regards to limited transparency.
The third method is that extremely high net worth investors can hire a futures manager directly. While there are advantages to hiring a managed futures manager directly as part of a customized investment program, the cost of doing so usually requires at least a $5,000,000 or $10,000,000 minimum investment.
Many managed futures strategies, in whatever form, when added to a mix of traditional stock and bond investments will likely add significant risk reduction and/or improved returns. Diversification across trading styles and futures markets can significantly enhance a portfolio’s performance with regard to risk reduction and enhanced returns.
Stock and bond portfolio managers derive the bulk of their returns due to risk and return characteristics from the stock and bond markets themselves. Managed futures managers add value primarily through their trading skills and are considered skill-based. As a result, managed futures are considered an absolute return investment strategy. Through their ability to invest in derivatives and to take both long and short positions, as well as invest in hundreds of different types of instruments, managed futures managers offer investors an effective way to gain exposure to investment markets and vehicles as well as investment strategies that are not otherwise easily accessed.
Should One Use Managed Futures?
As a result of Legend’s® studies over the past 18 months on managed futures, we at Legend® have found that well-diversified managed futures funds offer risks and returns comparable to diversified equity portfolios. In fact, like equity managers, diversified managed future managers are similar in nature with regard to risk and reward levels. On average, managed futures managers (at least the ones we have studied) have offered higher returns with less risk, and there also high reward/high risk managers as well. In addition, managed futures historically have had low correlation with traditional stock and bond investments. This is due to the fact that return from managed futures are frequently due to factors different from those affecting traditional stock and bond investments. These low correlations are exactly what Legend® finds attractive from a diversification standpoint. In fact, in our studies, which we will detail in the coming months, Legend® has generally found that most managed futures funds will either enhance return, decrease risk, or both when added to a number of Lower Volatility Portfolios. As mentioned previously, significant risk reduction and/or enhanced returns are possible when combined with traditional mixes of stocks and bonds.
In the numerous studies that Legend’s® Investment Committee has read to date, almost all say that managed futures have the potential to provide downside protection, although losses are entirely possible, along with producing positive returns. These studies also indicate the financial instruments used by managed futures managers are not available to stock and bond managers. Another finding is that both managed futures managers and the stock market indices have a positive correlation in a bull market and are negative in bear markets. This is in all likelihood due to the fact that futures managers will align their portfolios utilizing many of the broad array of investments available to them to structure their portfolios in an appropriate manner, which will take advantage of a strong upward or downward trend in the stock market.
History has shown that managed futures also perform well in rising interest rate markets unlike bonds and stocks. This is particularly important due to the fact that we are most likely in a long-term (secular) bear market for rising interest rates which will eventually have a negative impact on the markets for stocks and bonds.
Several studies have also shown managed futures to have a low or even negative correlation with hedge funds and hedge funds of funds. As a result, managed futures funds further reduce the risk in the portfolios and generally have enhanced returns as well. Some studies have also indicated that managed futures are better diversifiers than hedge funds.
A number of studies have indicated that the key foundation for managed futures returns, is the risk transfer function of the futures market itself. Some commercial market participants, i.e. businesses that consume commodities and/or the suppliers themselves, by hedging, are willing to in effect pay the equivalent of an insurance premium to investors for the assumption of risk. In total and over the long-term, futures markets tend to move in the investors’ favor, and as a result pay a net positive insurance premium. Investors receive this premium in the form of net trading profits because they provide liquidity.
Mutual funds as required by the Securities and Exchange Commission have disclosure requirements. Management companies that manage a mutual fund must report their investment performance and other activities to regulatory authorities. Managed futures managers provide performance information on their funds voluntarily to database vendors. This voluntary reporting is somewhat suspect. This makes accurate performance measurement and, consequently, evaluation difficult. The two most common problems are survivorship bias and back-fill bias.
Survivorship bias, also a common problem with hedge funds, separate equity and bond accounts, as well as mutual funds typically occurs because a manager stops reporting investment performance due to poor results or closure of their fund. As a result, the return for that group of similarly managed funds rises due to the elimination of the poor results.
Back-fill bias for futures managers, and similarly for hedge funds but not mutual funds and not since the early 1990’s by separate account bond and equity managers, occurs when managers decide to start reporting performance. Typically, a manager begins reporting after having achieved good performance for a certain number of months thereby eliminating poor results. Also, some managers may add in performance with back-tested results.
In reality within the managed futures and hedge fund worlds, these biases in reported performance are offset to some degree by termination bias. This type of bias is an election by successful managers who can no longer accept additional monies or investors and simply stop reporting performance to the public databases. This is due to having reached the capacity of their investing style and is similar to small cap managers closing their funds because they have too much money to manage.
Comments on Performance Expectations:
Managed futures funds will not automatically be profitable during unfavorable periods for traditional stock and bond investments, and vice versa. It must not be forgotten that a large part of the returns will be determined by the skills of the manager and the presence of exploitable trends in the futures markets. If trends are non-existent or close to non-existent a la 2004, positive performance will be difficult to produce. How non-correlated a given managed futures fund is will also vary, particularly as a result of market conditions and the manager skill set. In some cases not all managed futures will have significantly lower correlation with stocks and bonds. A fund-by-fund analysis will need to be made. Some funds are quite volatile, while others have less risk but higher returns than U.S. Equities. Nevertheless, these more conservative funds might pale in comparison to their more aggressive, sometimes highly leveraged and more volatile counterparts that provide significantly higher returns.
Managed futures funds offer distinct risk and return characteristics to investors that are not easily replicated through investing in traditional stock and bond investments. Including a modest allocation to managed futures in portfolios of virtually all types can also improve the risk-return tradeoff of long-term asset allocation portfolios even during in a bull market for stocks. Furthermore, managed futures on average will exhibit excellent performance during periods in which most traditional asset classes under-perform, in addition to periods when interest rates are rising.
In short, investors have entered a new era for both stock and bond returns – one of low nominal rates of returns (2% to 4%) for a period of probably another ten to fifteen years. Managed futures funds should be considered as a potential investment to enhance future returns.