A key principle of modern portfolio theory is that both risk and aggregate returns can be improved by diversification. With this consideration in mind, a still-small segment of the institutional investment community has embraced the idea of including alternative assets in their portfolios. The idea is that by allocating a small portion of non-traditional assets to a broader portfolio, the whole portfolio will generally generate higher risk-adjusted returns -- lower volatility for the same expected returns, or higher returns for the same level of volatility -- an unambiguous improvement relative to the performance under the original portfolio composition. In academic circles, this claim is non-controversial, but its validity is contingent upon two critical assumptions being satisfied: (1) the performance of the newly introduced asset class must have positive expected returns, and (2) those returns are uncorrelated with those of the rest of the portfolio.
Managed futures accounts represent one investment design that is used to satisfy this same objective. A managed futures account pairs an investor with a trading manager who is typically designated as a commodity trading advisor or CTA. Whether or not these qualify as true asset classes is somewhat of a semantic minefield. What's important is that managed futures represent trading activities that deliver -- or strive to -- the same benefits that are sought from allocation to alternative assets.
Under the typical arrangement, the CTA trades futures contracts (or options on futures contracts), which are federally regulated contracts that offer exposure to a broad range of markets, including financial markets like stocks, interest rates and currencies, as well as agricultural markets, metals, energy and other commodities. Besides the federal regulatory controls, futures also have the attributes of offering highly liquid markets with excellent price transparency, low transactions costs, and virtually no credit risk.
In the typical arrangement, the CTA earns an administration fee and a participation fee, normally 2% of funds under management 20% of profits, respectively. As futures trading involves the posting a margin deposit in lieu of fully funding positions, the administration fee is ordinarily based on an agreed upon a notional value. Only a portion of this notional value is required to open the brokerage account with the firm that provides the trade execution services.
Traditional CTA strategies
While variants to the rule abound, CTAs generally follow one of the following approaches:
1. Trend-following
2. Mean-reverting
3. Discretionary
Most trend followers tend to trade in a number of markets. Basically, using objective criteria (e.g., moving averages), they buy when they discern a rising trend and sell when they discern a falling trend. The risk in this strategy is that, rather than trending, prices vary within a relatively narrow range. If the perceived trend fails to evolve after the trade is initiated, the CTA would end up generating whipsaw losses -- buying "high" and selling "low," (or selling "low" and buying "high"). Although whipsaw losses are, to some extent, unavoidable, if the CTA can participate in a strongly trending market for only a small percentage of the markets traded, the hope is that this gain would dwarf the whipsaw losses on the non-trending markets. Clearly, if the trending markets are few and/or the magnitudes of their associated price moves are limited, the promise of profits might not be realized. This outcome certainly has to be expected to occur for some time periods.
A mean-reverting strategy is just the opposite approach to that of trend-following. Whereas the trend follower observes a price increase and hopes for a continuation, the mean-reverting orientation looks at sufficiently large price changes as aberrations that will likely be shortly reversed. Like the trend followers, mean-reversion types will generally apply the concept to a host of markets. They're hoping that most of the markets will be relatively stable, and they'll be able to sell "high" and buy "low" (or buy "low and sell "high.") These players are looking to make small gains with high frequency. It should be understood that they're positioning for a reversal which may not occur. That is, they bear the risk that they could get caught in a trend.
Both trend-following and mean-reverting trading programs rely on mechanical trading rules that are devised on the basis of trying to optimize earnings over some past period. The resulting rules are thus dependent on the period analyzed. Choose a different time frame and you get a different trading algorithm. There's something less than satisfying about that result, and simply updating and revising the trading rules periodically doesn't necessarily improve the rules. Future success is likely contingent on the character of the market going forward to be consistent with its character in the prior time that was used for determining the trading rules. Maybe that consistency will hold, but maybe it won't. For the most part, the promoters of either of these approaches point to the fact that they worked in the past for the justification for expecting them to work in the future.
"Discretionary" has become somewhat of a catch-all term that means that the manager can do whatever he or she wants. Sometimes, the underlying trading philosophy is presented transparently, and sometime not. That is, some managers elect to present their ideas openly and answer any questions prospective investors might have. Others seem to take an approach that rests on the "trust me" principle. Both extremes and every gradation in the middle are out there.