Many individual and institutional investors search for alternative
investment opportunities when there is a lackluster outlook for U.S.
equity markets. As investors seek to diversify into different asset
classes, most notably hedge funds, many are turning to managed
futures as a solution. However, educational material on this
alternative investment vehicle is not yet easy to locate. So here we
provide a useful (sort of due diligence) primer on the subject,
getting you started with asking the right questions.
Defining Managed Futures
The term "managed futures" refers to a 30-year-old industry made up of
professional money managers who are known as "commodity trading
advisors" (CTAs). CTAs are required to register with the U.S.
government's Commodity Futures Trading Commission (CFTC) before they
can offer themselves to the public as money managers. CTAs are also
required to go through an FBI deep background check, and provide
rigorous disclosure documents (and independent audits of financial
statements every year), which are reviewed by the National Futures
Association (NFA), a self-regulatory watchdog organization.
CTAs generally manage their clients' assets using a proprietary
trading system or discretionary method that may involve going long or
short in futures contracts in areas such as metals (gold, silver),
grains (soybeans, corn, wheat), equity indexes (S&P futures, Dow
futures, NASDAQ 100 futures), soft commodities (cotton, cocoa,
coffee, sugar) as well as foreign currency and U.S government bond
futures. In the past several years, money invested in managed futures
has more than doubled and is estimated to continue to grow in the
coming years if hedge fund returns flatten and stocks underperform.
*The Profit Potential*One of the major arguments for diversifying into
managed futures is their potential to lower portfolio risk. Such an
argument is supported by many academic studies of the effects of
combining traditional asset classes with alternative investments such
as managed futures. Dr. John Lintner of Harvard University is perhaps
the most cited for his research in this area.
Taken as an alternative investment class on its own, the
managed-futures class has produced comparable returns in the decade
before 2005. For example, between 1993 and 2002, managed futures had a
compound average annual return of 6.9%, while for U.S. stocks (based
on the S&P 500 total return index) the return was 9.3% and 9.5% for
U.S. Treasury bonds (based on the Lehman Brothers long-term Treasury
bond index). In terms of risk-adjusted returns, managed futures had
the smaller drawdown (a term CTAs use to refer to the maximum
peak-to-valley drop in an equities' performance history) among the
three groups between Jan 1980 and May 2003. During this period managed
futures had a -15.7% maximum drawdown while the Nasdaq Composite Index
had one of -75% and the S&P 500 stock index had one of -44.7%.
An additional benefit of managed futures includes risk reduction
through portfolio diversification by means of negative correlation
between asset groups. As an asset class, managed futures programs are
largely inversely correlated with stocks and bonds. For example,
during periods of inflationary pressure, investing in managed futures
programs that track the metals markets (like gold and silver) or
foreign currency futures can provide a substantial hedge to the damage
such an environment can have on equities and bonds. In other words, if
stocks and bonds underperform due to rising inflation concerns,
certain managed futures programs might outperform in these same market
conditions. Hence, combining managed futures with these other asset
groups may optimize your allocation of investment capital.
*Evaluating CTAs*
Before investing in any asset class or with an individual money
manager you should make some important assessments, and much of the
information you need to do so can be found in the CTA's disclosure
document. Disclosure documents must be provided to you upon request
even if you are still considering an investment with the CTA. The
disclosure document will contain important information about the CTA's
trading plan and fees (which can vary substantially between CTAs, but
generally are 2% for management and 20% for performance incentive).
Trading Program
First, you will want to know about the type of trading program
operated by the CTA. There are largely two types of trading programs
among the CTA community. One group can be described as trend
followers, while the other group is made up of market-neutral traders,
which include options writers. Trend followers use proprietary
technical or fundamental trading systems (or a combination of both),
which provide signals of when to go long or short in certain futures
markets. Market-neutral traders tend to look to profit from spreading
different commodity markets (or different futures contracts in the
same market). Also in the market-neutral category, in a special niche
market, there are the options-premium sellers who use delta-neutral
programs. The spreaders and premium sellers aim to profit from
non-directional trading strategies.
_Drawdowns_Whatever type of CTA, perhaps the most important piece of
information to look for in a CTA's disclosure document is the maximum
peak-to-valley drawdown. This represents the money manager's largest
cumulative decline in equity or of a trading account. This worst-case
historical loss, however, does not mean drawdowns will remain the same
in the future. But it does provide a framework for assessing risk
based on past performance during a specific period, and it shows how
long it took for the CTA to make back those losses. Obviously, the
shorter the time required to recover from a drawdown the better the
performance profile. Regardless of how long, CTAs are allowed to
assess incentive fees only on new net profits (that is, they must
clear what is known in the industry as the "previous equity high
watermark" before charging additional incentive fees).
_Annualized Rate of Return_Another factor you want to look at is
the annualized rate of return, which is required to be presented
always as net of fees and trading costs. These performance numbers are
provided in the disclosure document, but may not represent the most
recent month of trading. CTAs must update their disclosure document no
later than every nine months, but if the performance is not up to date
in the disclosure document, you can request information on the most
recent performance, which the CTA should make available. You would
especially want to know, for example, if there have been any
substantial drawdowns that are not showing in the most recent version
of the disclosure document.
Risk-Adjusted Return
If after determining the type of trading program (i.e. trend-following
or market-neutral), what markets the CTA trades and the potential
reward given past performance (by means of annualized return and
maximum peak-to-valley drawdown in equity), you would like to get more
formal about assessing risk, you can use some simple formulas to make
better comparisons between CTAs. Fortunately, the NFA requires CTAs to
use standardized performance capsules in their disclosure documents,
which is the data used by most of the tracking services, so it's easy
to make comparisons.
The most important measure you should compare is return on a
risk-adjusted basis. For example, a CTA with an annualized rate of
return of 30% might look better than one with 10%, but such a
comparison may be deceiving if they have radically different
dispersion of losses. The CTA program with the 30% annual return may
have average drawdowns of -30% per year, while the CTA program with
the 10% annual returns may have average drawdowns of only -2%. This
means the risk required to obtain the respective returns is quite
different: the 10%-return program with a 10% return has a
return-to-drawdown ratio (see Calmar Ratio) of 5, while the other has
ratio of one. The first therefore has an overall better risk-reward
profile.
Dispersion, or the distance of monthly and annual performance from a
mean or average level, is a typical basis for evaluating CTA returns.
Many CTA tracking-data services provide these numbers for easy
comparison. They also provide other risk-adjusted return data, such as
the Sharpe and Calmar Ratios. The first looks at annual rates of
return (minus the risk-free rate of interest) in terms of
annualized standard deviation of returns. And the second looks at
annual rates of return in terms of maximum peak-to-valley equity
drawdown. Alpha coefficients, furthermore, can be used to compare
performance in relation to certain standard benchmarks, like the S&P
500.
*Types of Accounts Required to Invest in a CTA*
Unlike investors in a hedge fund, investors in CTAs have the
advantage of opening their own accounts and having the ability to view
all the trading that occurs on a daily basis. Typically, a CTA will
work with a particular futures clearing merchant (FCM) and does not
receive commissions. In fact, it is important to make sure that the
CTA you are considering does not share commissions from his or her
trading program - this might pose certain potential CTA conflicts of
interest. As for minimum account sizes, they can range dramatically
across CTAs, from as low as $25,000 to as high as $5,000,000 for some
very successful CTAs. Generally, though, you find most CTAs requiring
a minimum between $50,000 and $250,000.
*The Bottom Line*
Being armed with more information never hurts, and it may help your
avoid investing in CTA programs that don't fit your investment
objectives or your risk tolerance, an important consideration before
investing with any money manager. Given the proper due diligence about
investment risk, however, managed futures can provide a viable
alternative investment vehicle for small investors looking to
diversify their portfolios and thus spread their risk. So if you are
searching for potential ways to enhance risk-adjusted returns, managed
futures may be your next best place to take a serious look.
If you'd like to find out more, the two most important objective
sources of information about CTAs and their registration history are
the NFA's website and the U.S. CFTC's website. The NFA provides
registration and compliance histories for each CTA, and the CFTC
provides additional information concerning legal actions against
non-compliant CTAs.
*by John Summa*,CTA, PhD, Founder of OptionsNerd.com and
HedgeMyOptions.com
John Summa, Ph.D., is the founder and president of OptionsNerd.com
LLC. He co-authored "Options on Futures: New Trading Strategies and
Options on Futures Workbook" (2001). He is also the author of "Trading
Against The Crowd: Profiting From Fear and Greed in Stock, Futures and
Options Markets" (2004), which presents contrarian sentiment trading
indicators and trading systems for stocks, futures and options.
Founded in 1998, OptionsNerd.com provides professional training and
educational support to stock, options and futures traders. Summa is an
economist, author, options trader and former professional skier, and
he presents small-group, online and in-person training seminars.
Source: Investopedia.Com
