Managed Futures Basics
Managed futures have variously been defined as an eclectic mix of investment strategies, a hedge fund category, and a separate asset class. People outside of the industry tend to see them as a risky investment. Regardless of perspective, managed futures exhibit unique properties that make these strategies an attractive investment vehicle.
Managed futures are comprised of professional money managers that seek opportunity on a discretionary and/or systematic basis using global futures and options contracts. The managers are known as Commodity Trading Advisors (CTA). CTAs are registered with the Commodity Futures Trading Commission (CFTC) and National Futures Association (NFA), a self-regulatory organization responsible for reviewing and accepting registrations.
Managed futures are not long-only or even long/short commodities exposure, but actively managed programs where many of the most liquid contracts are financial. Nor are they high risk / high return investments. If the measure of risk is standard deviation, or preferably downside deviation, then many other asset classes are riskier, including stocks, commodities and real estate.
CTAs are unique because they can go short a market just as easily as going long and usually employ technical systematic strategies.
Managed Futures’ Edge
Managed futures’ greatest attribute is the diversification they can provide portfolios. The traditional diversifier for stocks is the bond market, which has a traditional inverse relationship to stocks. Bonds have served well as a diversifier, generating relatively steady streams of reliable revenue. One obvious problem to consider is that the 30-year bull market in bonds has put rates at unprecedented lows. A generation of investors has never seen a bear market in bonds, nor has a substantial majority of those managing money. While there could be some upside left, the risk/reward just is not there, even if rates were to move into negative territory (see “How will it end?” below). The big question is whether bonds will plunge like a popped bubble or just move into a relentless and long-term bear market?
Bonds are a blunt tool of diversification. Managed futures provide investors long or short exposure to equities, bonds, precious metals, currencies, base metals, agricultural commodities, softs and energy commodities. Now you are talking real diversification.
Managed futures may generate returns in any kind of economic environment. You may want to ponder that for a moment as when things go bad, most investments tend to become highly correlated. That is not to say that managed futures programs are not at risk of loss, rather, it is the ability of CTAs to go short as easily as long that provides them with the opportunities to profit in bullish or bearish markets. They can produce non-correlated returns to equities and other asset classes, which is the key to diversification.
The inclusion of managed futures in an investment portfolio can reduce volatility while enhancing returns. The long-term correlations among equities, fixed income and managed futures remain low. While there is risk of loss in managed futures programs, like any other investment, it is these low correlations that make managed futures an excellent component to attain the benefits of diversification (see “True diversification,” above).
Transparency & Liquidity
Managed futures provide three components that can improve risk management: Transparency, liquidity and structural security.
Settlements on futures contracts are determined by the exchanges at the end of each trading day, requiring managers to mark their books to market. Instead of relying on complex models with numerous assumptions, investors know precisely where they stand. Investing via separately managed accounts, a common practice in managed futures, provides the investor with full transparency.
CTAs tend to trade highly liquid, exchange-traded futures and options contracts. The investment terms many hedge fund managers use, such as lock-ups, gates, side pockets, and penalties for early redemptions, rarely apply to investments in managed futures.
Future contracts are traded on regulated exchanges and backed by a centralized counterparty clearing system. The central party guarantee of CME Clearing and other centralized clearing systems throughout the global futures markets ensures the integrity of every trade.
While past performance is not indicative of futures results, it is extremely important in understanding an investment vehicle.
All program performance data is presented net of all fees. This is a CFTC requirement, which is much stricter than performance requirements for Securities and Exchange Commission (SEC) regulated instruments. Since CTA programs are a group of separately managed accounts, the performance data is a composite of all the accounts in the program.
CTA programs’ performance data include a few unique terms. The first is Value–Added Monthly Index (VAMI), and is defined as the growth in value of an average $1,000 investment. VAMI assumes the reinvestment of all profits and interest income. Incentive and management fees have been deducted. The VAMI is the program’s net/net performance of all accounts in the CTA program. The VAMI is presented in almost all performance reports for CTA programs (see “VAMI,” below).
Another term that you do not see frequently on performance data of SEC regulated investments is the maximum drawdown. This term represents the greatest peak-to-trough decline over the life of an investment. The drawdown is the percentage drop in the price of an investment from its last peak price.