When the prognosis for US equities markets is bleak, many individual and institutional investors look for alternate investing alternatives. Many investors are looking to managed futures as a strategy to diversify into multiple asset classes, most notably hedge funds.
However, educational materials on this alternative investment vehicle are difficult to come by. So, we’ve put together a good (kind of due diligence) primer on the issue to get you started with the proper questions.
Introducing Managed Futures
Managed futures are a 30-year-old industry comprised of professional money managers known as commodity trading advisors, or CTAs. Before they can offer themselves to the public as money managers, CTAs must register with the US government’s Commodity Futures Trading Commission (CTFC). CTAs must also submit to an FBI background check and present detailed disclosure documentation (as well as independent audits of financial statements every year), which are examined by the National Futures Association (NFA), a self-regulatory monitoring organization.
CTAs manage their clients’ assets primarily through proprietary trading approaches, such as system-based or discretionary tactics. This could entail trading long or short in futures contracts for metals (gold, silver), cereals (soybeans, corn, wheat), equity indexes (S&P futures, Dow futures, Nasdaq 100 futures), soft commodities (cotton, cocoa, coffee, sugar), foreign currency, and US government bond futures.
Benefits
Most investors use managed futures to diversify their holdings. In theory, exposure to managed futures might reduce portfolio risk if equities underperform and hedge fund returns flatten. Many academic studies on the effects of merging traditional asset classes with nontraditional investments such as managed futures back this up. Harvard University’s John Lintner is one of the most referenced researchers in this field.
All Invest Global claims that “In the decade preceding 2005, the managed-futures class delivered comparable returns as an alternative investment class on its own. For example, managed futures had a compound annual return of 6.9% between 1993 and 2002, compared to 9.3% for US equities (based on the S&P 500 total return index) and 9.5% for US Treasury bonds (based on the Lehman Brothers long-term Treasury bond index).”
Risk-adjusted returns were also higher among stocks, bonds, and managed futures between January 1980 and May 2003, as measured by the respective drawdowns (a phrase CTAs use to denote the biggest peak-to-valley drop in a financial asset’s performance history).”
During this time, managed futures had a maximum downside of -15.7%, while the Nasdaq Composite Index had a maximum drop of -75%, and the S&P 500 stock index had a maximum drawdown of -44.7%.”
Risk reduction through portfolio diversification is another advantage of managed futures. Managed futures have historically had a poor connection with asset classes such as equities and bonds. To put it another way, managed futures programs are largely inversely related to stocks and bonds.
Investing in managed futures programs that monitor metals markets (such as gold and silver) or foreign currency futures, for example, can provide a significant buffer against the damage that such an environment might have on equities and bonds during moments of inflationary pressure. As a result, if equities and bonds fail to owe to increased inflationary fears, certain managed futures programs may outperform under the same market conditions. As a result, integrating managed futures with various other asset classes may maximize your investment capital allocation.
CTA Evaluation
Before investing in any asset class or with an individual money manager, you should conduct some preliminary due diligence, and most of the information you need to do so can be found in the CTA’s disclosure statement. The NFA specifies the format in which CTAs must write this document.
Even if you are still considering investing with the CTA, you must be provided with disclosure papers upon request. The disclosure document will include critical information regarding the CTA’s trading strategy and fees, which are typically 2% for management fees and 20% for performance incentives.
Trading Program
Knowing about the CTA’s trading program is an important stage in the evaluation procedure. These are typically trend-following or market-neutral techniques. Trend followers employ proprietary trading methods based on either technical or fundamental trading methodologies, or both, to provide recommendations for whether to go long or short in specific futures markets. Spreading tactics are frequently used by market-neutral traders to produce gains. Writing options is an important aspect of their trading strategy. Options-premium sellers who utilize delta-neutral systems are another form of trader in market-neutral programs. Spreaders and premium sellers make money by using non-directional trading tactics.
Drawdowns
The maximum peak-to-valley drawdown is likely the most crucial piece of information to check for in a CTA’s disclosure statement, regardless of the type of CTA. This is the money manager’s greatest cumulative percentage drop in portfolio value. This informs the potential investor about the actual danger that this CTA’s trading program has encountered. However, this does not rule out the possibility of future drawdowns exceeding this amount. “Past performance is not predictive of future results,” as the customary statement in every disclaimer implies. It also illustrates how long it took the CTA to regain those losses. The less time it takes to recover from a drawdown, the better the performance profile. CTAs are only permitted to apply incentive fees on fresh net profits, regardless of how long they have been in operation (that is, they must clear what is known in the industry as the “previous equity high watermark” before charging additional incentive fees).
Annualized Return Rate
Another thing to consider is the annualized rate of return, which must always be reported net of fees and trading costs. These figures are presented in the disclosure document, although they may not reflect the most recent month of trade. CTAs must update their disclosure document at least once every 12 months, but if the performance is not up to date in the disclosure document, you can request information on the most current performance, which the CTA should provide. You’d especially want to know whether there have been any significant drawdowns that aren’t reflected in the most recent version of the disclosure statement.
Return on Investment (ROI)
If you want to get more formal about risk assessment after determining the type of trading program (trend-following or market-neutral), what markets the CTA trades, and the potential reward given past performance (by annualized return and maximum peak-to-valley drawdown in equity), you can use some simple formulas to make better comparisons between CTAs. Fortunately, the NFA mandates CTAs to use standardized performance capsules in their disclosure filings, which is the data utilized by the vast majority of monitoring services, making comparisons simple.
Return on a risk-adjusted basis is the most essential metric to compare. A CTA with a 30% annualized rate of return, for example, may appear better than one with a 10% annualized rate of return, but such a comparison may be misleading if they have significantly different loss dispersion. The CTA program with a 30% annual return may experience average drawdowns of -30% every year, whereas the CTA program with a 10% annual return may experience only -2% average drawdowns. This means that the risk involved in achieving the relative returns is considerably different: the 10%-return program has a return-to-drawdown ratio of 5, whilst the other has a ratio of one. Using this, the CTA with a 10% yearly return has a stronger risk-reward profile.
The dispersion of monthly and annual performance from a mean or average level is a common basis for evaluating CTA returns. These figures are provided by many CTA tracking-data firms for simple comparison. Other risk-adjusted return metrics, such as the Sharpe and Calmar Ratios, are also available. The former displays annual rates of return (minus the risk-free rate of interest) in terms of the annualized standard deviation of returns, whereas the latter displays annual rates of return in terms of maximum peak-to-valley equity drawdown. Furthermore, alpha coefficients can be used to compare performance to certain conventional benchmarks, such as the S&P 500.
Account Types Required to Invest in a CTA
Unlike hedge fund investors, CTA investors have the option of opening their own accounts and viewing all of the trading that occurs on a daily basis. A CTA often works with a certain future clearing merchant and does not get commissions. Indeed, it is critical to ensure that the CTA you are contemplating does not share commissions from their trading program, since this could lead to CTA conflicts of interest. The minimum account equity requirements might range from $10,000 to millions of dollars. Most CTAs have minimum equity requirements ranging between $50,000 and $250,000.
In conclusion
It never hurts to have more knowledge, and it may help you avoid investing in CTA programs that do not meet your investment objectives or risk tolerance, which is a crucial consideration before investing with any money manager. Managed futures, with sufficient due diligence on investment risk, can provide a viable alternative investment vehicle for small investors wishing to diversify their portfolios and thereby spread their risk. So, if you’re looking for ways to improve risk-adjusted returns, managed futures may be the next best place to go.
If you want to learn more, the two most important objective sources of information about CTAs and their registration history are the NFA’s website and the CFTC’s website in the United States. The NFA gives registration and compliance histories for each CTA, while the CFTC offers further information about legal actions taken against non-compliant CTAs.