November 23, 2018
A On-Going Series of Posts on Investing in Managed Futures
For most investors, managed futures are somewhat of a mystery. To help educate and shed some light on this opaque corner of the investment world, I will produce a series of posts explaining various features of managed futures and highlight some programs that are worth taking a look at for qualified investors.
What are Managed Futures - Really
To begin, the most fundamental aspect of managed futures programs to understand is that they are really trading programs, nothing like a traditional investments. Managed futures programs are very different from mutual funds or exchange traded funds (ETF's). The source of potential growth is based on successful, active trading. When investing in stocks, bonds or real estate the goal is to participate in an expected increase in the price of those assets over time. Investing money with a managed futures program means letting the manager make trades with the expectation that those trades will be net profitable in the end. Simply, managed futures programs results are dependent on the success of their trading style and their manager, not necessarily the trend in price of the underlying markets. That being said, this is exactly what makes them attractive from a diversification aspect since by nature they should have have little correlation to other asset classes.
With this distinction in mind, the way to analyze a managed futures program is going to be very different how one looks at mutual funds and exchange traded funds (ETF's). You must understand how the manager makes their trading decisions, how much leverage is applied, and then attempt to judge the overall risk and reward. With stocks, bonds and real estate, either directly or through a fund, the focus is on the underlying asset, its current price and potential to increase in value. Actively managed mutual funds have managers, but they are still just selecting a sub-set of an asset class and waiting for prices to go up. This focus on transactions and trading instead of asset price trends makes it much more difficult to choose the right program for investment. If one can work with this fact and the added risk it brings, their is the potential to add substantial diversification to a portfolio of stocks, bonds and real estate.
The rest of this post will cover the fundamentals: legal structure, types of strategies, longevity and consistency, minimums and diversification, and fees and expenses.
A rather unique thing about managed futures is their legal structure. They are most commonly offered as separately managed accounts or through private limited partnerships. There are a few packaged in mutual funds but that is not the norm. For those that have not encountered a separately managed account, these are brokerage accounts opened in the normal fashion with power-of-attorney added so the commodity trading advisor can make trades. With this arrangement, the CTA can trade all the accounts under their management in the same way (which is also a regulation). The other type is a pooled account structure which usually takes the form of a limited partnership with each investor participating proportionally. Neither is better or worse than the other, separate accounts are more transparent so the investor can see exactly what trades are being done and follow the performance daily. That may or may not be a good thing, depending on your mindset. Having the opportunity to see the actual trades in your account does allow a first hand view of the manager's style and presents an opportunity to judge the methods and risk being taken. Human nature though can make it hard to keep good analysis separate from over monitoring. Pooled limited partnerships are generally preferred by managers since it is easier to manage one account instead of many. The legal duties and costs associated with pooled accounts are more than separately managed accounts, so only the larger programs tend to be offered in this way.
The managing entities or individual of a managed future program are referred to as “commodity trading advisors” or "CTA" for short. They are not really "advising" anyone directly but instead acting as money managers (really traders). The term "commodity trading advisor" is the name given to them by the self-regulating body for the futures industry, the National Futures Association (NFA). A commodity trading advisor should not be confused with a registered investment advisor (RIA). In order to legally operate as a CTA, a manager must register their company with the National Futures Association. One should not view this registration as any sort of approval, it is more like a licence with rules to follow pertaining to presentation and the trading process. The NFA does not assess the nature or quality of the trading programs with this registration.
This registration process is centered around a formal “disclosure document” ("Ddoc"). This is a not the same or as deep as a stock market prospectus but it does give some background on the company, the principals, a description of their trading method and all recent performance history. These documents are not usually difficult to understand, so I recommend reviewing the “Ddoc” carefully. The principal members must list all their recent trading performance from any source. This broad view of the manager's trading performance is helpful in the overall assessment of the program. If the managers have had any regulatory issues, this should be there as well.
Types of strategies
Within the universe of managed futures programs there are many different types of trading styles and approaches, but they can be broadly grouped into three categories, trend-following, option writing and discretionary. There are various agencies and entities that try to create benchmark indices for different types, but because of the vast diversity in programs, they provide very little useful information.
As the name suggests, these attempt to jump on trends in prices, either up or down, with the goal of capturing the bulk of any consistent, one-way move in a market. They are almost always mechanical in nature, which means little human discretion in each trade but a rules-based approach that buys and sells when prices and other variables meet those rules (though, like any computer program, someone had to create the rules). Over time, commodity prices have been known to have some relatively large moves in one direction as the market adjusts to changing fundamentals and then fueled by leverage and speculation. If all goes as planned and the markets cooperate by producing a few big moves a year, a trend-following system can produce substantial profits. What usually trips up this style of mechanical trading is a lot of short-term volatility. This leads to the program to get in and out of the market often, usually losing a little each time. These small losses then add up to create some big drawdowns (net losses) before the next big trend comes along. The rise of computing power has made the number crunching needed to execute this type of trading easier. Ironically, computerized trading has also probably led to more volatility which in turn, has been a factor in reducing the number of smooth, steady price trends. Some of these trend-following firms that have been around a long time. Most produced their best results many years ago (before wide use of technology) using very simple trend-following techniques. Investing in a trend-following program now means the investor must be ready to hang on through some very large drawdowns before potentially catching the big trends.
Option writing, especially unhedged (naked) selling of options, has been nicknamed “collecting pennies in front of steam roller” and for good reason. When an option is sold short without being fully hedged by the underlying item, the potential profit is limited to the amount of money received when the option is sold but has the potential for loss that is much greater. That being said, a well-run program can often create consistent profits which can add up slowly over time and produce what looks like a smooth, non-volatile way to make money. This smooth performance draws many investors to option writing programs, especially those dabbling in managed futures for the first time. In all likelihood though, this style by nature will at some point(s) in time experience large drawdowns. It is only a matter of how large these drawdowns are relative to the time and ability for the program to recover. For this strategy to be effective, the manager needs solid risk management and market awareness to have a chance at success. Regardless, an investor in an option writing program should be prepared for the possibility of a relatively large drawdown compared with the average returns usually being generated by the program.
These are akin to "macro" hedge funds that use their own research, experience and technical indicators to make their trading decisions. In the form of a hedge fund or managed futures program, this type of program completely depends on skills of the manager. This can be the hardest type of program to judge since they will normally provide limited information to assess their abilities other than a general description of their methods, their bio and a historical track record. Nevertheless, this group has the potential to provide a very unique opportunity. Trend-following and option writing programs tend to be very correlated with equity markets but discretionary programs have the possibility of offering very independent results. Many times, the manager will specialize in one area such as currencies or a particular commodity type such as grains or energy in which they have specialized expertise and experience. Finding a good discretionary manager is kind of like choosing a great stock picking mutual fund, very hard but uniquely valuable if you can find a good one.
Longevity and Consistency
Just like when looking at mutual fund managers, longer track records with consistently good results are a good start. It does not mean these past results will continue (a line repeated over and over in the legal documents), but it certainly is significant if they were able to succeed for an extended period. Similar to mutual funds, many programs do not last long. When you look at the available programs, many of them have a short track record while the poor performers have closed and disappeared.
One specific thing to take close look at is the time when a new program transitioned from a small (usually unknown) money manager to a large one. The move to the big-time many times can trip up managers. Sometimes they recover from a poor transition and do fine, other times this is the beginning of the end. It can sometimes hard to replicate hat has been a successful trading style with small amounts of money to a larger size. So keep in mind there is added risk investing when a manager has recently become popular.
Another thing to look out for are track records that include at the beginning the results the managers own account or a just few client accounts. The NFA rules permit certain trading performance data of this type to be inserted at the beginning of the programs actually trading record. I usually ignore this data in making my decision, it is much different to be trading other people's money as a business compared with privately managing your own account.
Minimums and Diversification
With so much of a particular program’s performance riding on the manager and their strategy (rather than the trend in the stock market, for example), portfolio diversification and limiting exposure is paramount. If one is investing in small cap stock funds, they can sometimes be more volatile than the overall equity market, but as a group they will generally follow the same path. There is no base correlation in managed futures, each has its own risk and reward. This can be great overall when trying to add truly non-correlated diversification to your portfolio but much harder when comparing one program to another.
In the description above of the three different styles, they each had there particular susceptibility to large drawdowns. One way to deal with potential drawdowns is to invest in a set of programs with different styles to potentially diversify away some risk. Minimum investments will come into play then because it will usually take a relatively large sum to achieve real diversification. Most programs fall into two size brackets, in my opinion, those with minimums of up $50,000 to $500,000 and those requiring at least $500,000 to $1M. There are some with even greater minimums that are geared towards institutions. The smaller category fits nicely into most investors portfolios and even allows for the possibility of investing in a few programs for diversification. The trouble is there are a lot of weak candidates at this level. It is hard to weed through the many choices and find a few good candidates. The higher bracket includes those that have graduated through success to the big time and also managers that came from certain background experience that inspire others to give them substantial sums to start. That being said, size does not guarantee a good program - there are plenty to avoid at both levels. One way around the minimums in creating a diversified allocation to managed futures programs is to invest in what is called “fund of funds”. As it sounds, one investment in these funds will get you exposure to a group of funds. There is normally an extra layer of fees for this service though which many times can make them impractical.
Fees and Expenses
Speaking of fees, an investor in managed futures programs must be careful. Many programs are fairly active and generate a lot of commissions (which sometimes can vary between brokers for the same program). Many programs (if not most), carry the “traditional” 2% annual management fee plus a 20% cut of the net (new high) profits. Many times, this is assessed monthly. A good run of performance can mask high fees, but once the program goes through a tough patch, things can look different. The fees can seem like a substantial drag. Some investors do not care about fees; the thinking goes, if a manager can surmount the costs and still meet all the investor’s return parameters, good enough. Even if one accepts that argument, there is no question that in times of poor performance high costs can make things much worse. The fee details should be available within the disclosure document that comes with each program. It makes sense to spend some time understanding exactly what the costs will be relative to past and potential profits.
Bottom line, what makes a program worth a closer look?
Understand the strategy. You should understand to how the program achieved those past results that look so good as well as possible.
Choose managers with integrity. This can be hard to assess, but you try your best to make a judgement call.
Be aware of the style risk. Generally, each type of program will have their market conditions they are better suited for. Here is where diversification can help.
Managed futures programs are not for many investors, but they can add some interesting and potentially uncorrelated potential to a portfolio. Those that do participate should take extra care and do their due diligence.
Once you start shopping around for a managed futures program to consider, you will quickly find the marketplace is fragmented. The industry is dominated by small, lesser-known firms. The major brokerage firms and online brokers usually do not offer much. One way this can work in your favor is to contact the commodity trading advisors directly. Because they are usually small operations that cater to a relatively small number of investors, the managers or key staff members are many times willing to get on the phone with you or at least answer emails.
Hopefully this information about managed futures increased your knowledge on the subject and will help you decide how to approach the asset class. Future posts will cover more topics such as the following:
managed futures mutual funds (there are a few, but they have little in common with the typical stock and bond version),
managed futures versus trends in commodity prices,
and some reviews of specific programs.
Notaro Wealth Advisory is a registered investment advisor. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital.
The views and opinions expressed in this blog post are as of the date of the posting, are subject to change based on market and other conditions. This blog contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
Please note that nothing in this blog post should be construed as an offer to sell or the solicitation of an offer to purchase an interest in any security or separate account. Nothing is intended to be, and you should not consider anything to be, investment, accounting, tax or legal advice. If you would like accounting, tax or legal advice, you should consult with your own accountants, or attorneys regarding your individual circumstances and needs. No advice may be rendered by Notaro Wealth Advisory unless a client service agreement is in place.