Alternative Investments: An Introduction to Managed Futures

In the fast paced business of commodities trading, it can be difficult to find someone who wants to take the time to help you understand the potential profit opportunities as well as the risks involved in today’s markets. At Pro Managed Futures, we pride ourselves on our ability to help our clients and prospective clients navigate the world of alternative investments including managed futures. Pro Managed Futures is a d/b/a of Orion Futures Group Inc. (NFA ID# 0283253). We are a Guaranteed Introducing Broker of Vision Financial Markets LLC. Orion Futures Group Inc. is registered with the CFTC (Commodity Futures Trading Commission) and is a member of the NFA (National Futures Association) and the NIBA (National Introducing Brokers Association) See: www.promanagedfutures.com

With the equity markets currently going through a rough patch, many institutional and individual investors are looking at alternative investments. In an effort to diversify their portfolio among different asset classes, many investors are looking at managed futures as a way to hedge their equity bets. In this article we will look at what exactly are managed futures, the types of returns possible, an overview of Commodity Trading Advisors (CTAs) and how to invest in managed futures.

Much like mutual funds, managed futures are run by professional money managers who have authority to place trades on behalf of their clients. Managed futures have been around for about thirty years and have seen a dramatic infuse of capital the past fifteen years. Managed futures are run by Commodity Trading Advisors or CTAs who are licensed and registered with the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC). CTAs have to hold a current Series 3 license in order to solicit money from the general public. CTA s also go through a intense background check via the FBI as well as provide rigorous disclosure documents (similar to a prospectus for an IPO) which outline returns, risks and the strategy of the fund. Managed futures funds are independently audited every year to ensure their statements accurately reflect their returns. These audited statements also reviewed by the NFA to ensure their accuracy and truthfulness.

CTAs will have a very specific strategy, much like mutual funds, which will limit what markets they trade and how they trade them. Some managed futures funds will only go long or only go short, only trade the metals (gold, silver, copper), only trade currencies, so on and so forth. Option only managed futures funds have become quite popular the past few years. One thing to note is that managed futures funds usually have a high minimum investment which can range anywhere from $25000 to over a one million dollars, depending on their returns.

With stocks basically ensuing a lost decade, many new investors are looking at managed futures. One of the more attractive features of managed futures would be the potential profit as well as lowering the risks of portfolios. Professor Harry Markowitz was awarded a Noble Prize for Modern Portfolio Theory in which he proves that by using non-correlated assets classes together increases return as well as lowers overall risks.

Over the past few years, managed futures, as a whole, have produced returns comparable to those of the S&P and US Treasury bonds. Although managed futuresโ€™ returns have been a little lower than those of the S&P, the risks and volatility with managed futures have been significantly lower. Over the past thirty years, the S&P has seen a maximum drawdown of over 40% while managed futuresโ€™ max drawdown was 15%.

Another benefit of having exposure to managed futures is that you are reducing the risks and volatility of your portfolio. Managed futures are an independent asset class with a negative correlation to real estate, stocks and bonds. With the recent turmoil in the stock market, one would have made good money by investing in a managed futures fund which went long metals as gold is hitting all time highs (at the time of this writing).

Before investing in any managed futures fund, one should do their due diligence to completely understand the risks associated with investing in futures. The first place to start is by looking at the individual CTAโ€™s disclosure document. The CTAโ€™s disclosure document must be provided to the investor before they can deposit money into an account. Not only will the disclosure document explain the risks associated with the fund but also go over the fees. Most managed futures fund follow the 2 and 20 rule of hedge funds (2% fees for management of the fund and 20% of profits).

One of the first things to consider when investing in a managed futures fund is the trading strategy being utilized. For the most part, managed futures funds fall into two major categories: trend following and option writing. Trend followers usually will have a proprietary technical or fundamental trading style which will give them signals of when to go long (or short). Option writing managed futures funds are trying to profit on the time erosion of options and are usually market neutral. Although most options do expire worthless, by selling options you are taking on limited returns with unlimited risks.

After deciding what type of CTA you want to invest in, the next thing to look at would be the drawdowns of that particular fund. In the disclosure document, each CTA is mandated to include their peak-to-valley drawdown. The peak-to-valley drawdown shows the largest decline in equity that that particular CTA has seen. As the risk disclosure says, past performance is not indicative of future results but the drawdown will give you an idea of actual risks involved with the fund. Although the CTA can not charge their 20% incentive/performance fee until the fund gets back to its high water mark, they do not credit clients when the fund loses money.

Obviously everyone who invests in managed futures wants to make money. One of the best ways to asses the profitability of a fund is by looking at the annualized rate of return. The annualized rate of return will give you an idea of how the fund has performed over a period of time. CTAs must update their disclosure document every nine months to include the latest returns possible. The annualized rate of return must be net of fees and trading cost.

Another important aspect of a CTA to check is their return on a risk adjusted basis or itโ€™s Calmar Ratio. The Calmar Ratio is computed by dividing the annual return by the maximum drawdown. The higher the Calmar Ratio, the better (meaning it is safer or less risky).

Many investors also like to look at the Sharpe Ratio which measures the return of a managed futures fund versus a risk-free return (like a 10 year US Treasury bond). The Sharpe Ratio basically shows you whether or not the returns are coming from smart investments or if the fund is taking on risky investments.

To invest in a managed futures fund, one must find a commodity broker that they are comfortable with and who understands the investorsโ€™ needs. After finding an appropriate broker, then one must find a managed futures fund that fits their risk profile and has a manageable minimum investment. Barclays publishes a list of the top performing CTAs on a monthly and annual basis. Currently there are over five hundred CTAs in their index. A good thing about the Barclay CTA Index is that to be considered the fund must have a minimum four year track record. After you find the fund that you like, you will need to open an account with the clearing firm (or FCM) the fund is using for its trades. The next step would be to read the fundโ€™s disclosure document and then sign and date it. After that, you fund the account and let the CTA do his work.

Managed futures funds are a great way to diversify your assets on an asset class scale. There are many different types of CTAs who trade using a multitude of trading styles. Be sure you and do your homework and understand the risks involved since futures are a leveraged investment (meaning you could lose more than your original investment).