The financial market crash of 2008 brings back good memories for some investors––like, those who shorted the market and those who invested heavily in managed futures. In a year when just about every investment category on the planet went splat, managed futures as a collective group stood tall with a gain of more than 15% (as measured by the Altegris 40 index).

After the crash, investors swooned for managed futures and their potential for non-correlation to stocks and bonds. To meet demand for an asset category formerly reserved for institutions and very wealthy investors who could afford to pay hefty minimums, a growing number of managed futures-oriented ’40 Act mutual funds hit the scene aimed at retail investors, offering much lower investment minimums and providing daily liquidity. Financial advisors and individuals piled in, and a new fund category quickly mushroomed.

According to Morningstar Inc., the first open-end managed futures funds began trading in 2007. By June 2013, the category comprised 51 funds and more than $9 billion in assets. There are also two managed futures-related exchange-traded funds, with roughly $163 million in assets.

But because of an unhappy combination of poor performance and high fees, the party has pooped out for ’40 Act managed futures funds. The latest installment of the annual Morningstar/Barron’s survey of alternative investments usage by financial advisors and institutions found that advisors shied away from managed futures in 2012. This category had been their top pick in the two prior years. As the survey points out, “performance may have been a factor as managed futures ETFs and mutual funds lost 15.6% and 7.4%, respectively, in 2012, similar to their losses in 2011.”

Additionally, the survey notes that both advisors and institutions said they don’t like the undisclosed performance fees managed futures funds frequently charge. (Those fees are disclosed, but are often buried in the fine print.)

“The fact is they haven’t been able to deliver on performance,” says Nadia Papagiannis, Morningstar’s director of alternative funds research. “We don’t know if it’s structural or a cyclical change in the market environment that makes it hard for this strategy.”

That’s an important point to ponder for investors interested in the managed futures space.

Trend Is Your Friend
Managed futures are programs run by commodity trading advisors (CTAs) who are registered with the Commodity Futures Trading Commission. They manage client assets in proprietary programs that trade an array of futures contracts in more than 150 global markets ranging from currencies and commodities to stock indexes and interest rates, and they can take both long and short positions.

Proponents of managed futures say these programs provide diversification by investing in a broad range of assets that offer non-correlation to traditional long-only stocks and bonds. Non-correlation doesn’t mean negative correlation, but it does imply the ability to avoid steep drawdowns such as the 37% nosedive in the S&P 500 in 2008.

In theory, managed futures are supposed to help lower portfolio risk by being more nimble in either bull or bear markets than traditional asset classes. But it’s not a one-size-fits-all approach.

“There’s a big misconception about what managed futures are,” says Brian Cunningham, president and chief investment officer at 361 Capital in Denver, which runs the 361 Managed Futures Strategy Fund. “Financial advisors and investors want to lump them together as an asset class. They’re not really an asset class; they’re a collection of strategies.”
 

 

Among those strategies are trend following, counter trends, arbitrage and global macro. According to Altegris Advisors LLC, a La Jolla, Calif.-based investment advisor that specializes in alternative investments, trend following has traditionally dominated the managed futures space.

Its Altegris 40 index tracks the performance of 40 CTA programs, or less than 7% of the total number of CTAs who report their performance. Trend followers typically make up 75% of the index, with the rest being specialized managers.

Simply put, trend followers seek to take advantage of discernible investment trends––either up or down––in whatever assets they’re following. And they generally do so by employing systemic, rules-based models.

That’s worked well in years marked by sustainable market trends, such as 2008. That year also spotlighted the ability of managed futures to deliver “crisis alpha”––i.e., managed futures tend to do well when traditional stocks and bonds go kaput.

But global markets in the years since the crash have risen––and fallen––in a choppy, risk-on/risk-off environment marked by a high correlation among asset classes. That means fewer long-running, independent trends that trend following managed futures strategies can depend on.

After the Altegris 40 index gained 15.47% in 2008, it lost 7.98% in 2009, gained 11.33% the following year, and declined in each of the next two years with losses of 3.32% and 4.75%, respectively.

“Managed futures did well as a group in 2008, and everyone jumped on board in 2009,” Cunningham says. “Now we’ve been in a 24-month drawdown and they look at the indexes and they say it no longer works. But people aren’t looking at what strategies have worked within managed futures and what haven’t.”

He adds there’s a high dispersion of performance among ’40 Act managed futures fund managers. “The difference between the top quartile and bottom quartile among large-cap value funds in 2012 was 4.8%,” Cunningham says. “The difference between the two groups in the managed futures space was 15%.”

Counter Trend Is Your Friend, Too
As a group, the ’40 Act open-end managed futures funds tracked by Morningstar have produced average negative returns during the past one-, three- and five-year periods (granted, not many funds have been around for five years).

The 361 Managed Futures Strategy Fund has been one of the best performers among ’40 Act funds since its December 2011 launch. Morningstar named it the top performing fund in its category for the 12-month period ended June 30 with an 8.12% return for its institutional share class, which has a net expense ratio of 2.15%. (The Class A shares have a 5.75% load and a 2.4% expense ratio, along with a $2,500 investment minimum.)

The 361 Managed Futures Strategy Fund follows a counter-trend strategy using futures contracts based on U.S. equity indexes. Its M.O. is straightforward: Look to sell short-term, overbought levels and buy short-term, oversold levels when investors overreact to market news.

“Counter-trend strategies work by going against the tide,” Cunningham says. “We’re taking advantage of behavioral finance and the fact that investors make bad decisions. Our inputs are all quantitative, but it’s simply price, volume and the performance of an index.”

The fund’s fee structure seems high at first glance, but is in line with the overall group. According to Morningstar, the asset-weighted average fee for the managed futures funds it tracks is 2.3%.

“If you produce alpha, people will pay for it,” Cunningham says. That seems to be the case with the 361 fund, which recently passed $250 million in assets.

Various Fees
Like many alternative investment vehicles, managed futures strategies aren’t cheap. CTAs typically charge a 2% management fee, plus a 20% performance fee based on any new profits. And annual fees from introducing brokers, or from a manager of managers that oversees managed futures accounts for investors, can range from about 1% to 6%. All reported returns are net of fees.

On the ’40 Act fund side, fees vary based on how funds are structured. Some funds employ single-manager strategies; others use multi-manager strategies that blend returns from the underlying CTAs.
 

 

 

The Altegris Managed Futures Strategy Fund, which accesses an underlying pool of seven different CTAs, charges a 1.5% fund management fee, plus another roughly 1% fee for the underlying managers. In addition, each of the underlying managers charges performance fees ranging from 15% to 30% (Altegris says the average fee is about 20%), which kick in when the fund reaches net new highs during a given year.


When that happens, the fund essentially replicates the 2% and 20% structure of traditional CTA programs, and it means higher costs for investors. But it also means the fund made money and investors kept roughly 80% of the profits.

“Our view is that the managers we access for our fund have long-term expertise and track records in the space through multiple investment cycles,” says Matt Osborne, executive vice president of Altegris Advisors. “It’s hard to say how some of the newer single-manager funds with shorter track records will perform over the long term.”

The investor share class of the AQR Managed Futures Strategy Fund, on the other hand, charges a net expense ratio of 1.40%. The fund employs proprietary quantitative models to identify price trends in four asset classes: equities, fixed income, currencies and commodities. AQR doesn’t outsource any trading, which keeps costs down.

“Our fees alone give us a [performance] head start in the mutual fund space,” says Brian Hurst, principal and head of the global trading strategies group at AQR, an investment management firm in Greenwich, Conn.

As of July 10, the AQR Managed Futures Strategy Fund was up 4% year-to-date and had annualized returns of 1.6% since its January 2010 inception. The latter figure was hurt by a 6.6% loss in 2011.

Absolute Returns
The recent negative returns by many managed futures funds can be off-putting, particularly when viewed against the robust returns of the stock market since March 2009. But managed futures are designed as absolute return strategies that aim to mitigate volatility and achieve positive returns in all market environments by trading many different instruments––often targeting a positive return over cash.

“There are two main reasons why people invest in managed futures––to get a return premium above cash and to get diversification,” Hurst says. “It has delivered on the diversification aspect, but has delivered below average on the return aspect.”

But managed futures proponents stress that recent underperformance belies the category’s long-term positive results. Through June 2013, the compound annual return since 1980 on the Barclay CTA index was 10.55%. The index currently comprises 582 CTAs tracked by Barclay Hedge Ltd., a Fairfield, Iowa-based company that follows the managed futures and hedge fund industries.

And while managed futures are touted for their ability to go north when stocks and bonds go way, way south, they’ve generally produced positive returns even in good years for traditional markets. Since 1990, the Altegris 40 index has recorded negative returns just four times, and three of those four years have occurred since 2009.

Equally (if not more) important, managed futures’ long-term risk/return profile has been solid. During the 23-year history of the Altegris 40 index, the worst drawdown (the peak-to-valley loss relative to the peak for a stated time period) for the index was minus 15%, or far below those for U.S. and international equities, commodities and real estate investment trusts, where the worst drawdowns ranged from 51% to 68%. Only U.S. bonds (minus 5.15%) had a smaller worst-drawdown period.

Going forward, some managed futures strategists believe the eventual end of quantitative easing in the U.S. should lessen the risk-on/risk-off trade and create discernible trends in various asset classes. “Not many asset classes can potentially benefit from rising interest rates, but managed futures is one of them,” Osborne says.

Elsewhere, it’s expected that more funds will try to focus on shorter-term trends to mitigate the deleterious effect of choppy markets, and it’s likely that more funds will adopt counter-trend strategies.

Keeping The Faith
Financial advisors’ ardor for managed futures has dimmed recently, but some advisors still buy into the concept. “I believe they have a role in portfolios to provide a counter balance to equity risk,” says Jerry Verseput, founding principal at Veripax Financial Management in Folsom, Calif.

Verseput uses ’40 Act funds for his managed futures exposure, including the MutualHedge Frontier Legends and Longboard Managed Futures Strategy funds. He says he allocated roughly 10% of client portfolios to managed futures as recently as two years ago, but reduced that to 5% as managed futures struggled. But he sees better trends ahead for managed futures.

“I’m slowly throttling back up,” Verseput says.
 

 

Legend Financial Advisors in Pittsburgh formerly accessed managed futures for clients through private CTA funds structured as limited partnerships, but has switched over entirely to ’40 Act funds. “You can’t beat daily liquidity,” say Jim Holtzman, a certified financial planner at the firm.

He notes that Legend’s main fund of choice is the AQR Managed Futures Strategy Fund. The fund’s investor share class has a $1 million minimum that the firm is able to partake in by grouping together clients into that fund. Legend recently added the 361 Managed Futures Strategy Fund to its managed futures sleeve.

“We still believe in the long-term track record of managed futures and that going forward they’ll help reduce risk in our portfolios and improve our risk/return profile,” Holtzman says.

Elsewhere, Envestnet now includes 36 managed futures mutual funds among the roughly 10,000 mutual funds on its wealth management platforms aimed at financial advisors, says Ryan Tagal, vice president of product management for Envestnet’s separately managed account program. Tagal, who previously covered alternative investments as a research analyst at Cerulli Associates and Morningstar, fully grasps the nuances of managed futures.

“If an investor has a longer-term time horizon and is using managed futures appropriately to provide some diversification in extreme drawdowns, then managed futures can be an appropriate investment,” he says.

When it comes to ’40 Act managed futures funds, though, advisors need to do their due diligence on costs and understand the interplay between different managed futures strategies and the overall economic and financial market environments.