There are many types of investment strategies that portfolio managers can implement for their clients’ portfolio. Managed futures is one of these strategies, and this one is unique and has special characteristics compared to other traditional strategies.
Managed futures is a term that describes the industry for trading futures by Commodity Trading Advisors (CTAs). These professional money managers, manage client assets on a systemic or discretionary basis.
No matter if you are an investor, trader or businessman, Diversification is Key! That’s why even if you trade on your own or manage a business, you can still invest in managed futures and diversify your performance by allocating money to other professionals.
Before you do it, we suggest that you educate yourself and understand all the details of the business. After reading our Managed Futures resource page you will be able to spell out ‘Managed Futures’, ‘Commodity Trading Advisors’ and ‘Crisis Alpha’ in a second. Let’s start with why managed futures offer good investment opportunity.
5 Reasons to Invest in Managed Futures
1. Outstanding Risk/Reward Profile through Diversification Beyond Traditional Investments in Stocks.
Managed futures can help you reduce your portfolio volatility and offer you a risk-return profile, that is very different than the traditional profiles of stock traders and hedge funds.
CTAs who manage futures are usually trading between 50 and 100 markets. Some money managers trade even 150 global markets; from grains and gold to currencies, stock indices and exotic markets such as potatoes in India or emissions in Europe. Many CTAs further diversify their returns by using many trading approaches and time-frames for trading. They go long and short and there is always a winning market to hedge a losing one. This usually reduces risk and allows CTAs to have lower maximum drawdown and annual volatility than stock managers which trade in a market with high internal correlation.
Now, lets compare managed futures performance with stocks and bonds. The easiest way to calculate the most important investment metrics is to divide annual compound returns by maximum drawdown and by annual standard deviation. These are very simple but good enough ways to compare investments long-term. If we choose to trust the many stock market out-performance studies*, less than 1.5% of market traders and investors beat the market. This means that we can use the S&P 500 Total Return index risk-reward profile to compare to managed futures’ one.
|1993-2013 (20 years)||Barclays CTA Index (At equity volatility||S&P 500 Total Return||50:50 Combination|
|Average Return (Annual)||10.19%||9.22%||10.37%|
|Standard Deviation (Annual)||14.94%||14.94%||10.10%|
|Sharpe Ratio (Annual)||0.68||0.62||1.03|
Source: Trend Following with Managed Futures Book – Alex Greyserman and Kathryn M. Kaminski
As you can see the Sharpe ratio is very similar but still higher with managed futures. But we at OctaFinance believe that measuring sharpe is not enough. We as traders, measure our success by our maximum drawdowns. If maximum drawdowns never happen, we would be able to leverage our investments more and compound money at a crazy rate. So how does S&P500 Total return index stands to managed futures when it comes to maximum drawdowns? Managed Futures has 0.52 ratio AR/MDD while S&P500 Total Return Index has 0.18 ratio. This ratio is almost 3 times better for managed futures and shows why their risk-adjusted returns are much smoother and better as can be seen on the chart below.
Source: CME Group
2. Crisis Alpha – Profit from Crisis
When we look at times when global economies and markets are in crisis, we see many enormous market moves. Sometimes we call them “tail risk” events as they are either not supposed to happen or happen very rarely. Managed Futures provide crisis alpha opportunities, which are profits generated by exploiting trends that occur across many markets during a crisis time.
This is a special characteristic of CTAs because they go as easily long as short. Because most of the managed futures’ commodity trading advisors utilize trend following, when we have a crisis periods such as: global macro events, global economic crisis, regional events, their managers short assets that are going down (are in downtrend) and make positive returns. This happens in a period when traditional assets such as stocks, mutual funds go down. That’s also the reason why diversifying a portfolio of stocks with managed futures is super smart, especially if you expect a stock market correction.
We at OctaFinance, even suggest increasing managed futures exposure in advance of giant expected stock market corrections. Important thing to keep in mind is that you have to measure CTAs crisis alpha and their ability to go short. For example there is a widespread trend today, for CTAs to look for short-term better risk-adjusted returns by not shorting stocks as they are in an uptrend. If they don’t switch to shorting at the right time (we doubt they will), they might lack the crisis alpha we are discussing here. That’s why you have to choose carefully and not only measure CTAs performance by historical risk-adjusted returns but also understand what they are doing and how. This will help you understand whether you are positioned correctly for the future. Below we show what crisis alpha mean to managed futures managers:
Source: CME Group
3. Big Industry Growth and More Competition
We are strong believers that competition is good for the world, for your business and for you. Today, with more than 1700 CTAs to choose from, the choice who to manage your money in futures is easier. The managers also have longer track records which allow us to better study what they are doing and how they will probably perform in the future.
You can even use them to express your macro views. If you expect a big market correction for example, there are CTAs that are good at providing higher crisis alpha and will profit huge if such a correction takes place. They are more aggressive short sellers and have studied better how to short markets. If you believe that agriculture will make a huge move 100%+ in a few years, then you can invest in CTA that trade agriculture. They will catch the bull wave for sure and bring you profits. If you need help in choosing or making due diligence on CTAs, feel free to contact us.
4. More Transparency and Better Liquidity than Hedge Funds
Investment in managed futures usually offers better transparency as CTAs report their returns every week or month. Some of them also offer the ability to withdraw quick, in a week or two. This is because they invest in very liquid futures markets and can close positions much easier than hedge funds which are know to invest more in illiquid markets. Even though these advantages are present at many CTAs not all of them work that way. You should always get these details from any prospective CTA, you plan to invest in.
5. CTAs are Regulated. Their Futures Trading is also Regulated by the Exchanges
HISTORICALLY, futures exchanges have been very effective at not only protecting market participants but also from letting them perform better. For an example Forex Futures on regulated exchanges offer better carry, less slippage and same quotes unlike Spot Forex. When trading spot forex, every broker has different quotes and that means different performance for CTAs. This is without even mentioning questionable slippage from time to time. As it comes to carry – if CTAs trade for example USDRUB short, and the interest differential is +10%, their spot forex brokers will probably pay them max 8%. With forex futures, its much better. Interest is calculated automatically in the futures contracts and there is nobody to steal from you. That’s why you will probably get interest more close to 10% and for sure better than spot Forex brokers.
Managed futures are definitely more advantageous than direct equity investments. This is because the profits or losses that one realizes from this form of investment are not directly correlated to a specific market sector. Commodity trading advisors are still able to get profits from the investments they make on their clients’ behalf whether the stocks, or any other commodity, go up or down in price.
In other words, CTAs and managed futures have the unique position of being able to profit on either side of the markets. Future trading is all about positioning oneself correctly as according to the perceived movement of the market. Futures traders are not limited to bullish or bearish markets as well, because there are strategies unique to futures trading that allow profiting even from flat or neutral markets. Traders can use options and spreads to profit from a very unique market situations.
Because of CTAs exposure to various markets, managed futures offer better diversification and risk mitigation as compared to other forms of investment. This capability also provides investors adequate hedging against inflation while remaining liquid and transparent.
Futures Performance in Bullish and Bearish Markets
Futures have low correlation with traditional markets, which means that they are not significantly impacted by the actual performance of a specific asset class. Futures also inherently have leverages built into their contracts and, depending on the actual set up, make large profits possible for the investor or asset manager. It is the low correlation, however, that is a major factor in the futures’ capabilities to reduce volatility and provide true diversification even during bear markets.
The low correlation between futures and traditional markets remains misunderstood. Uninitiated investors make the assumption that managed futures and stock trading have an inverse correlation, which means that when one goes up the other goes down. That is not the case. Although there was an event of a negative correlation in 2009 and 2013, there are other events where the movements of futures and stocks were not directly correlated.
How Futures Guarantee Exceptional Liquidity and Transparency
Other alternative forms of investments leave much to be desired when it comes to being transparent and liquid. Investors are not always able to follow prices accurately and expect that the price at which they have placed their investments is the actual value that their stocks or equities are assigned with.
In addition, several investment practices also leave investors unable to pull out their investments when they desire it. This results to problems when the investment faces a bearish situation that requires a quick pullout to minimize losses.
With managed futures, however, investors are guaranteed transparency and liquidity. The prices that dictate purchases and sales in managed future exchanges are universal. The prices are updated periodically, making it possible for investors and counter-parties to see prices as they are at any time, as prices are accurate even to the minute. Counter-parties are also secured in the transaction through the posting of performance bonds that guarantee the exchange.
The Fundamentals of Futures Trading
The idea of futures trading was born out of a more conventional concept in agriculture. In the middle of the 19th century, farmers entered into contracts with buyers for the prices of their produce if the sellers wish for their purchase to be delivered at a later date. These contracts were called forward delivery contracts. The idea of forward-dated contracts eventually transformed into what we know today as “futures trading.”
Though the fundamentals are the same, there are major differences. Both futures and forward delivery contracts signify an agreement between two parties to purchase or dispose of assets at a specific price at a predetermined point in time. However, forward contracts are private and directly negotiated between the two involved parties. In futures trading, an exchange center regulates the contracts and standardizes the contents of the agreement, including the price.
Futures trading covers a wide range of markets, and these include the markets for agriculture, precious metals, energy products, foreign exchanges, equities and interest rates.
Investors Who Typically Engage in Futures Trading
These are the types of investors who are likely to put money into futures contracts in addition to their existing investments in the market:
Hedgers are usually commodity providers that seek to stabilize their costs and avoid the losses that can be brought about by sudden drops in prices. The best way for them to mitigate risks is to identify sale positions with a long-term perspective, which is exactly what is needed when investing in exchange-traded futures.
By selling commodities at a fixed price for a later date, these hedgers are able to achieve fixed costs for what they are trading regardless of the actual price in the market.
- Individual traders
Individual traders operate mostly by speculating on the movement of a specific asset. Information these days help traders to be up-to-date as much as people on the field. However, in the past, speculation was dangerous and difficult because of the lack of access to updated information. Traditionally reserved for institutions, this information, as well as the strategies and markets that they can be applied to, are now available for individual traders through the internet and electronic trading.
- Prop shops
Prop shops are another term for companies that train budding traders to earn money from the market by allowing them access to the firm’s capital for use in their own trades. Trading with the assistance of prop shops gives traders the advantage of learning advanced strategies and achieving more leverage compared to trading using their own money. Prop shops earn from the profits realized by the traders’ transactions.
Hedge funds work to minimize risk by executing a diverse set of financial strategies intended to maximize the returns from the investors’ portfolio. Exchange-traded futures are ideal for hedge funds because of their liquidity. The liquidity allows hedge fund managers to control the exposure of the funds to different markets while executing transactions with large values involved.
- Market Makers & Futures Arbitrageur
Market makers are responsible for keeping the market going by both bidding and offering when the time requires. They do that in order to keep the market liquid. When market makers intervene, they would expect that trading fees will be reduced. Their earnings come from either the spread between bidding and offering prices, or from their trading in futures markets of their choosing.
Fees and Documents Associated with Futures Trading
Like all other portfolio management services, CTAs will charge management and incentive fees to the investor. That is how the futures manager earns his or her money in return for managing and making sure that their clients earn profits.
Typical annual management fees are at 0% to 3%. The incentive fees are higher, at 10% or, at most 30%. While this may discourage some investors – as they want to keep most of their profits – these fees actually work to the advantage of the investor. In order to be able to charge their fees, CTAs have to make sure that the client does realize profits from the portfolio that they have entrusted to the managers.
Before an investor could allow a Commodity Trading Advisor handle his or her investments, they must sign a Disclosure Document. This is more than an agreement that gives the CTA the right to make decisions that could potentially enrich the client. It is also a document that the CTA uses to outline the strategy as well as the risks that the investors’ money could be exposed to. The Disclosure Document should also specify the fees that the CTA expects to charge for the services extended.
There should be no upfront fees to be paid when an investor opens an account with a Commodity Trading Advisor. Upfront fees are disadvantageous and could be the cause of a loss, instead of a profit, for the investor.
For one, the value of the upfront fee will be deducted from the profits that will be earned in addition to the management and incentive fees. Second, while the practice is gaining ground in the CTA community, participation in a CTA program has never required the payment of upfront fees. We suggest never to invest in CTAs with upfront fees.
Notional Funding – Investors’ Leverage
The concept of notional funding allows an investor to trade at a specific amount without having to put up that exact value when executing contracts. This is made possible by rules in the futures exchanges that require buyers to put up a bond to guarantee the counterparty’s earnings in the midst of volatile market environments.
Buyers typically have to put up a fraction only of the agreed amount as bond so they could end up investing only a notional fund of, say, $50,000 in a contract that has a value of $80,000 or even a $100,000. However, the fees will apply to the actual value rather than the notional value.
Types of Manage Futures Investment Opportunities
1. Public or the so-called Retail Pools
These pools, introduced recently offer retail and small investors an option to invest with a low minimum in an investment program that was exclusive only to large investors before. In the USA, CTA’s business and trading activities are regulated and supervised by the – Commodity Futures Trading Commission – (CFTC) and the National Futures Association (NFA). Offerings of managed futures to the public are supervised by the Securities and Exchange Commission (SEC) also as well as the Financial Industry Regulatory Authority (FINRA) and other financial commissions depending on the investor’s state. Public CTAs and managed futures funds are required to be audited by an independent firms to follow very strict disclosure requirements.
2. Individual Accounts
Individual managed accounts are customized specially for High-net-worth individual (HNWI) and institutional investors. To be setup, these accounts require a huge investment so the CTAs are able to diversify by investing in a variety of markets, time-frames and strategies in accordance with the investor’s requirements and desire for risk, returns. This means that investors are allowed to require some markets not to be traded or traded in a specific way. Contract terms are also customized.
3. Private pools
Private manage futures pools, attract money from a group of investors and are usually legally formed as a limited partnerships. These pools usually have minimum investment requirements of $250,000 US Dollars. These limited partnerships usually give investors the option to redeem on a weekly, monthly or quarterly basis. Investing in managed futures could also be structured with a diversification on mind. Investors can invest with multiple commodity trading advisors, that utilize different trading strategies, markets and time-frames.
Managed Futures Tax Benefits
While futures contracts can be valid for only a few days or a couple of months, the contract is still taxed annually. This gives investors of managed futures accounts the unique advantage of being able to write off 60% of their earnings as taxable at the end of the year. This is because 60% of profits in managed futures investments are considered as long-term capital gains.
The 40%, obviously, is gains over capital realized in the short term. Because of the annual taxation, trades are not accounted for individually. Instead, an investor only has to pool all his gains for accounting at the end of the year. In other words, even if the investor has executed several trades in a year, they are taxed only once. In addition, losses can be written into the books for three years.
Futures trading and managed futures investments are, without doubt, a great way to complement an existing investment portfolio and also to provide a hedge against the risks associated with investing. Coupled with the skills of a reputable commodity trading advisors, any investor will find himself gaining significant profits from his or her investment.
* Managed futures indices such as the Barclay CTA Index do not represent the entire universe of all CTAs. Individuals cannot invest in the index itself. Actual rates of return may be significantly different and more volatile than those of the index.
* According to Barras, Scaillet and Wermers who tracked 2000+ actively managed US stock mutual funds between 1976 and 2006, only 0.6% had and showed any true skill at outperforming the market long-term, “statistically indistinguishable from zero,” they concluded.
* Their study is in line with a research done by Brad Barber of UC Davis and Terrance Odean of UC Berkeley who concluded that only about 1% of active traders outperformed the market. Barber and Odean concluded that the more frequently people trade, the worse they perform.
* Todd R. Tresidder, founder of FinancialMentor.com stated in 2010 – “All the evidence supports the disappointing fact that regular investors as a whole underperform the market. As long as they try to ‘beat the market’ they actually underperform.”
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