They offer a way to increase returns and diversification in a long-term bear market.

    Most financial advisors and the general public have little knowledge of managed futures as an investable asset class. In effect, when the words "managed futures" are mentioned most advisors we know shrug them off and say "high fees" (a true statement) without understanding their merits.
    Let's begin with the basics. With managed futures, 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.
    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. The industry managed more than $120 billion in 2005. The global futures markets historically were dominated by agriculture and commodity futures. In 1980, agricultural futures trading approximated 64% of market activity, and metals trading comprised 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; agriculture 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.
    In general, managed futures managers can be categorized either by the various markets (energy, currencies, etc.) that they focus on or by the trading strategies they use. The majority of futures managers will typically diversify across numerous markets and will trade hundreds of different types of futures contracts.
    The majority attempt to find trends in the price movements of futures and then 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, reanalyzes various futures markets with their computer models more than 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; it is similar to a macrofund 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 subclassified as either trend-following or counter-trend-following.
    Trend-following managed futures trading systems are almost always highly computerized, and new models continually are 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, 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 often will 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 way, public futures funds, in effect, 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 fairly low minimum investor criteria-for example, a $35,000 income and a $35,000 net worth, or a $100,000 net worth-are not unusual. Some public funds may require investors to be of accredited investor status. Public funds can often be liquidated on a monthly basis. Expenses often are higher than other managed futures opportunities.
    The second way to invest is through private commodity funds or pools. This option is usually for high-net-worth (these are either accredited or superaccredited investors) or institutional investors, and the minimum investment usually is $500,000 or higher. Expenses typically are lower than for a public fund. Private funds offer diversification benefits similar to public funds. A negative: Like hedge funds and other private investment vehicles they often have limited transparency.
    The third method is that extremely high-net-worth investors can hire a futures manager directly. While this offers advantages as part of a customized investment program, the cost of doing so usually requires at least a $5 million to $10 million minimum investment.
    In whatever form, when added to a mix of traditional stock and bond investments many managed futures strategies 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 from the risk and return characteristics of the stock and bond markets. Managed futures managers add value primarily through their trading skills. 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?
    Legend Financial Advisors has studied managed futures, and we have found that well-diversified managed futures funds offer risks and returns comparable to diversified equity portfolios. In fact, like equity managers, diversified managed futures managers are similar in nature with regard to risk and reward levels. On average, managed futures managers (at least the ones we have studied) offer higher returns with less risk, and they're also high-reward/high-risk managers as well. In addition, managed futures historically have had a low correlation with traditional stock and bond investments. This is due to the fact that returns from managed futures are frequently due to factors different from those affecting traditional stock and bond investments. These low correlations are exactly what we find attractive from a diversification standpoint. In fact, in our studies (which we will detail in the coming months), we have generally found that most managed futures funds will either enhance return, decrease risk or both when added to a number of lower-volatility portfolios.
    Almost all of the studies we have read to date say that managed futures have the potential to provide downside protection (although losses are of course possible) along with producing positive returns. These studies also indicate that 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 stock market indexes 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 structure their portfolios to take advantage of a strong upward or downward trend in the stock market.
    History has shown that managed futures, unlike bonds and stocks, also perform well in rising interest rate markets. This is particularly important because 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 also have 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 portfolios and generally have enhanced returns as well. Some studies also have 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, such as businesses that consume commodities and/or the suppliers themselves, are by hedging in effect willing to 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 investor's favor and as a result effectively pay a net positive insurance premium. Investors receive this premium in the form of net trading profits because they provide liquidity.

Performance Issues
    The Securities and Exchange Commission (SEC) requires mutual funds to have disclosure requirements. 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; it makes accurate performance measurement, and consequently evaluation, difficult. The two most common problems are survivorship bias and backfill 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 the fund. As a result, reported returns for that group of similarly managed funds rises due to the elimination of the poor results.
    Backfill bias occurs when futures 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, which is an election by successful managers who can no longer accept additional money or investors to  stop reporting performance to the public databases. This is due to their reaching the capacity of their investing style. It is similar to small-cap managers closing their funds because they have too much money to manage.

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 nonexistent or close to nonexistent, as in 2004, positive performance will be difficult to produce.
    How noncorrelated 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 must 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 investors distinct risk and return characteristics that are not easily replicated through 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 in a bull market for stocks. Furthermore, managed futures on average will exhibit excellent performance during periods in which most traditional asset classes underperform, in addition to periods when interest rates are rising.

Lou Stanasolovich is founder and CEO of Legend Financial Advisors in Pittsburgh and is editor of the newsletter Risk-Controlled Investing.