Preparing to invest in managed futures

February 28, 2014 06:00 PM

A few weeks ago, an article in The Wall Street Journal captured the essence of managed futures. The article argued that while the inherent risk in managed futures can be daunting, it is precisely what renders the asset class an effective alternative investment. 

To avoid managed futures altogether is to miss out on the opportunity to mitigate the market risk that every investor is exposed to with traditional investments. And because market risk cannot be dealt with through diversification of stock holdings, passing up managed futures excludes the most proven non-correlated investment to diversify your holdings. 

Over the past decade, familiarity with managed futures has grown. The asset class is no longer just for institutional investors; retail investors and family offices are utilizing the space also. But to deconstruct myths and stereotypes and genuinely derive a broader understanding of the importance of managed futures in a portfolio, more quality education is needed. And like all asset classes, managed futures has a variety of products of varying value. Here we will help you learn how to choose the best ones and make the case for a diversified portfolio (see “Top 5 reasons to allocate to managed futures,” below). 

Many investors choose managed futures to reduce volatility in their holdings. Managed futures are non-correlated to stocks and bonds and numerous studies have shown an allocation of 10% to 20% to managed futures tends to reduce overall portfolio volatility and improve returns (see “Optimum portfolio mix,” below). This is something that should catch the attention of almost every investor with current exposure to traditional markets. With tapering under way and the changing stock market dynamics, managed futures are becoming more relevant. Unlike other asset classes, including stocks, where profits only can be made in rising markets, managed futures programs can generate profits in both falling and rising market environments through taking long and short positions (see “A diverse lot,” below). Strategies truly can be neutral, bearish or bullish. 

Key participants 

To fully appreciate the dynamics underpinning investments in managed futures, a basic understanding of the key players in the industry is helpful. While most institutions have found their niche and are highly specialized, it is important to keep in mind that there are important intersecting circles, meaning that the same institution can fulfill a number of functions.

Commodity trading advisors (CTAs): Are responsible for the actual trading of managed futures programs. By and large, CTAs can be characterized by the school of price analysis they subscribe to: Technical or fundamental analysis. CTAs that are mostly technical in nature rely on past market data such as price and volume in formulating their price forecasts and views on the markets. In contrast, there are CTAs that mainly rely on fundamental analysis. This involves evaluating the underlying factors that affect the supply and demand dynamics of futures markets. No one type of analysis is necessarily superior to the other, and there are many CTAs that combine the two. The largest group of CTAs fall into the systematic trend-following space. 

Trading managers/third party marketers: Specialize in assisting investors with the selection of managed futures programs. Most have developed their own proprietary methods of analyzing CTA performance records based on which they recommend and build managed futures portfolios for clients. In building a managed futures portfolio, a good trading manager will make sure that the performance of the individual programs chosen shows a low level of correlation.

Introducing brokers (IBs) and futures commission merchants (FCMs): Help investors access CTAs. They are the firms that execute, clear and carry the actual positions directed by CTAs. Independent IBs can help CTAs access a number of clearing firms and negotiate competitive rates — benefits that can be passed on to the managed futures investor.

Commodity pool operators (CPOs): Invest “pooled” funds of multiple participants in commodity futures or options. Investors in CPOs share in profits and losses on a pro-rata basis. The CPO either makes its own trading decisions on behalf of the pool or it engages a CTA to do so. CPOs are often CTAs offering their strategy in a pooled vehicle or invest in a separate managed futures program.

Investment consultants: Can be a valuable resource for investors interested in the managed futures space. They can assist with selecting an appropriate program that meets the investor’s unique risk management needs, deliver allocations and recommend suitable notional trading levels. Some consultants also monitor the day-to-day trading operations of the managed futures programs their clients are invested in, adding another layer of security. 

Most retail traders don’t have direct access to CTAs so they often access these investments through a third party. While often helpful, this also can add a layer of fees, so be sure to know how each player is being compensated. 

Managed futures’ fee structure

Generally speaking, managed futures investments demand higher fees than stock and bond holdings. This has to do with the fact that investors are paying a manager for his/her market expertise and that their accounts are being traded for them. As is the case in any industry, fees vary and may be negotiable; however, there is a general fee structure that every managed futures investor should be familiar with. Fees tend to be made up of three components: i) commissions (the costs of executing and clearing futures and options calculated, most commonly, on a round-turn basis); ii) a management fee; and iii) an incentive fee. Perhaps most crucially, investors should be aware that regulations require CTAs and CPOs to quote performance information net of any and all fees.

The CTA receives a flat management fee (1%-2% per year) based on assets under management. In addition, the CTA can earn an incentive fee on a new high water mark (20%-25% of profits). Commissions generally cover the fixed costs of trading and reward advisors and intermediaries, including IBs, trading managers and investment consultants. 

3 ways of accessing the managed futures space:

Individualmanaged accounts: Tend to be opened by institutional investors and high-net-worth individuals. This type of account can be customized specifically to the needs of the individual investor. Contractual terms can be designed to include specific termination language and financial management requirements. Keep in mind, though, that there are managed futures programs with low initial investments and the minimum investment level is just a number that defines the gearing of the trading. Investors place their money with an FCM, sometimes through an IB, and only are required to have sufficient margin for their positions. 

Private pools: Because private pools combine the funds of several investors, the initial financial outlay expected of each participant is smaller and the benefits of economy of scale are real. Minimum investments typically range from $25,000 to $250,000. Private pools usually allow for admission/redemption on a monthly or quarterly basis. Pools also may be well diversified, with investments spread out over different managed futures programs. Because of lower administrative and marketing costs, private pools tend to be more attractive than their public counterparts.

Public funds or pools: Much like private pools, public funds and pools provide a way for small- to medium-sized investors to participate in managed futures. As mentioned before, fees can be high with this type of fund/pool because there is another level of fees in the food chain. 

Due diligence

As is the case with any type of investment, due diligence is a must when selecting managed futures programs. It is important to take time to understand the manager’s trading strategy, and to be comfortable with the program’s risk characteristics, including position holding patterns and margin-to-equity ratios. All CTAs that are registered with the National Futures Association (NFA) are obligated to publish their performance records and calculate returns in compliance with the standards set forth by the Commodity Futures Trading Commission (CFTC) and the NFA. Be sure to know whether you are looking at hypothetical returns or actual performance. Managers have to clearly label performance as hypothetical. Solid CTAs will be happy to discuss their program and trading style, so consider contacting the managers on your shortlist. 

Once you have performed the appropriate due diligence on the programs you are most interested in, take some time to honestly assess your own investment needs. It is crucial to match your own investment goals carefully with the right program, all the while keeping in mind the amount of risk you are taking on.

Without knowing what you are trying to achieve, you will not be able to align your own interests with the CTA best able to meet your investment needs. 

A final piece of advice: Read the CTA’s disclosure document! It should be supplied to you as part of the account opening process, but you also can request it from the manager ahead of time. If  you read the disclosure document from cover to cover, most of  the key questions will be answered for you.

Matthew Bradbard, Vice President of Managed Futures & Alternatives at RCM Asset Management, has been creating and executing trading strategies for more than 10 years. Mr. Bradbard regularly publishes market commentary and trading ideas. Bradbard can be reached at mbradbard@rcmam.com.

About the Author

Vice President of Managed Futures & Alternatives at RCM Asset Management, brings hands-on analysis and trading experience to RCM Asset Management clients. Mr. Bradbard has been creating and executing trading strategies for over 10 years, and he is a respected commentator on a number of futures and options markets. Mr. Bradbard regularly publishes market commentary and trading ideas, and he is frequently cited in articles covering the futures and options space, and the role played by commodities in a diversified portfolio.