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.