Now that there's another year on the calendar since the market meltdown of 2008, many advisors of high-net-worth individuals are seeking to add diversification arrows to their investment quivers.

For this purpose, some advisors are using managed futures, an investment that has become more accessible to individual investors in the past couple of years.
Managed futures accounts are investments in pools of contracts for the eventual purchase or sale of commodities, foreign currencies, global equities, or interest rates. These investments require investing in specialized commodities trading advisors ( CTAs), and require attention to rigorous back-office work and shifting compliance demands. Specialty advisors are offering them to individual investors through financial planners, wealth managers, brokers and other client-facing advisors.

As these alternative investments tend to have a negative correlation to the stock and bond markets, they've been used by foundations and other institutions for decades to protect portfolios of traditional investments against volatility.
Though the education process for high-net-worth clients can be eased by various materials that some specialty advisors provide, it nonetheless requires commitment from advisors. Indeed, the learning curve for advisors themselves can be challenging, and due diligence on a single offering can be time-consuming. Offering memoranda, for example, can run as long as 200 pages.

Frequently, individual clients ask their advisors to distinguish managed futures from the commodity-linked investment that they know best: exchanged-traded funds (ETFs). With an ETF, they're buying shares in a fund that owns the underlying commodity. With managed futures, they're investing with CTAs utilizing exchange traded future contracts that provide access to highly diversified global markets. Also, the CTAs have trend-following strategies and the ability to go long and short future contracts with low transaction cost and high liquidity.

Not the least of the client education challenges involves communicating information on inherent risks. Advisors who get their clients into these investments must ensure that they fully understand the risks involved with CTA. The CTAs are using futures contracts that have implied leverage in the underlying asset, and thus may incur month-to-month volatility of returns.

Though there are few established futures firms that allow ratios for individual investors of more than 10 to one, advisors must impress upon their clients the importance of maintaining low leverage. After all, this isn't their father's investment vehicle. Rather, it's one that requires considerable caution, even if its use is limited to diversifying traditional portfolios. (Most large managed futures CTA managers only use .30 to .50 leverage, since they net longs/shorts and have cash in the brokerage account.)

Yet, when purchased in dollar amounts appropriate for a client's portfolio goals and risk tolerance, managed futures can be highly beneficial.  

Their negative correlation to the stock and bond markets is a matter of record in the Altegris 40 Index, which tracks the performance of top managed futures programs. In 2008, these programs collectively returned 15.47%, and registered minus 7.53% for the 12 months that ended in August 2009. From 1990 through 2008, there was not a single full calendar year when both the Altegris and the S&P 500 Total Return Index both registered negative numbers.

Managed futures are accessible to high-net-worth investors for as little as $500,000 through specialists working through CTAs. There are currently about 2,200 CTAs, fewer than 50 of which are name-brand programs.
Specialists offering these investments through client-facing advisors sell high-net-worth individuals interests in pools of futures contracts under management by CTAs.

Typically, clients pay fees directly to specialty advisors. These amounts include the fees of client-facing advisors, often running about 60% of the total, which specialists in turn pay to advisors.

Unlike commodities traders, managers of CTAs don't sit down at the computer and decide what to buy and sell that day. Instead, they rely on model-driven analysis and computer trading executed according to algorithms. Designed by physicists, actuaries and economists, these algorithms determine the most advantageous times to sell contracts before their terms expire. By the time a CTA invests in a contract, these algorithms have determined conditional trading instructions that include exit strategies.

Tactically, this process could be likened to the arcade game of Whac-A-Mole, in which the object is to smash the mole's head with a mallet each time it pops up. The more times the player hits the mole before it disappears, the higher the score. The same goes for the algorithms: The more times they correctly identify advantageous times to buy or sell, the higher the profit.

Humans can defeat the mole, but they're no match for computers that run 1,000 trillion calculations per second, so CTAs with substantial resources have a distinct advantage.

Though high-net-worth clients sign contracts with specialty advisors, fiduciary duties of planners, wealth managers and other registered investment advisors require extensive due diligence. In vetting specialty firms, client-facing advisors should ensure that they:

Are members of the National Futures Association, which holds its members to standards and addresses risk-related issues affecting individual investors.
Use CTAs that have a substantial trading volume. Those with extremely low trading volumes aren't required to register with the Commodity Futures Trading Commission, which administers the Commodity Exchange Act of 1936.
Do business only with CTAs who use third parties to custody client assets and separate third parties to handle administration. Such checks and balances are not only essential to protect client assets, but also to increase the comfort level of high-net-worth clients who are understandably skittish in this post-Madoff era.

Robert J. Lindner, CFP, is founder of Lindner Capital Advisors (www.lcaus.com), an advisory firm in Marietta, Georgia that integrates a managed futures component into the portfolios it manages for clients of financial planners and wealth managers. Listen to a podcast interview with Bob Lindner on managed futures and contemporary portfolio management.