WHAT ARE MANAGED FUTURES ? / MARKETS INSIGHT ( RECOMMENDED READING )

What Are Managed Futures?


by CME Group

The term managed futures describes an industry made up of professional money managers known as commodity trading advisors (CTAs). As investors look for greater diversity in their portfolios, these trading advisors manage client assets on a discretionary basis using global futures markets as an investment medium.

Investment management professionals have been using managed futures for more than 30 years. More recently, institutional investors such as corporate and public pension funds, endowments and trusts, and banks have made managed futures part of a well-diversified portfolio.

Four Benefits of Managed Futures


1. Reduced Portfolio Volatility Risk.

The primary benefit of adding a managed futures component to a diversified investment portfolio is that it may decrease portfolio volatility risk. This risk-reduction contribution to the portfolio is possible because of the low to slightly negative correlation of managed futures with equities and bonds. One of the key tenets of Modern Portfolio Theory, as developed by the Nobel Prize economist Dr. Harry M. Markowitz, is that more efficient investment portfolios can be created by diversifying among asset categories with low to negative correlations.


2. Potential for Enhanced Portfolio Returns.

While managed futures can decrease portfolio volatility risk, they can also simultaneously enhance overall portfolio performance. Adding managed futures to a traditional portfolio can help to improve overall investment quality. This is substantiated by an extensive bank of academic research, beginning with the landmark study of Dr. John Lintner of Harvard University, in which he wrote that "The combined portfolios of stocks (or stocks and bonds) after including judicious investments...in leveraged managed futures accounts show substantially less risk at every possible level of expected return than portfolios of stocks (or stocks and bonds) alone." (Lintner, John, "The Potential Role of Managed Commodity Financial Futures Accounts (and/or Funds) in Portfolios of Stocks and Bonds," Annual Conference of Financial Analysts Federation, May 1983)


3. Ability to Take Advantage of Any Economic Environment.

Managed futures trading advisors can take advantage of price trends. They can buy futures positions in anticipation of a rising market or sell futures positions if they anticipate a falling market. For example, during periods of hyperinflation, hard commodities such as gold, silver, oil, grains, and livestock tend to do well, as do the major world currencies. During deflationary times, futures provide an opportunity to profit by selling into a declining market with the expectation of buying, or closing out the position, at a lower price. Trading advisors can even use strategies employing options on futures contracts that allow for profit potential in flat or neutral markets.


4. Ease of Global Diversification.

The establishment of global futures exchanges and the accompanying increase in actively traded contract offerings has allowed trading advisors to diversify their portfolios by geography as well as by product. For example, managed futures accounts can participate in at least 150 different markets worldwide, including stock indexes, financial instruments, agricultural products, precious and nonferrous metals, currencies, and energy products. Trading advisors thus have ample opportunity for profit potential and risk reduction among a broad array of non-correlated markets.


Types of Investment Opportunities




According to the Barclay Trading Group, Ltd. in 2006, it was estimated that over $170 billion was under management by futures trading advisors worldwide. Currently, there are three primary categories of managed futures.

Individual Accounts are usually opened by institutional investors or high net worth individuals. These funds usually require a substantial capital investment so that the advisor can diversify trading among a variety of market positions. An individual account enables institutional investors to customize accounts to their specifications. For example, certain markets may be emphasized or excluded. Contract terms may include specific termination language and financial management requirements.


Private Pools commingle money from several investors, usually into a limited partnership. Most of these pools have minimum investments ranging from approximately $25,000 to $250,000. These futures partnerships usually allow for admission-redemption on a monthly or quarterly basis. The main advantage of private pools is the economy of scale that can be achieved for middle-sized investors. A pool also may be structured with multiple trading advisors with different trading approaches, providing the investor with maximum diversification. Because of lower administrative and marketing costs, private pools have historically performed better than public funds.


Public Funds or Pools provide a way for small investors to participate in an investment vehicle usually reserved for large investors.


Participants in the Managed Futures Industry

There are several types of industry participants qualified to assist interested investors. Keep in mind that any of these participants may, and often do, act in more than one capacity.


Commodity Trading Advisors (CTAs) are responsible for the actual trading of managed accounts. There are approximately 800 CTAs registered with the National Futures Association (NFA), which is the self-regulatory organization for futures and options markets. The two major types of advisors are technical traders and fundamental traders. Technical traders may use computer software programs to follow pricing trends and perform quantitative analysis. Fundamental traders forecast prices by analysis of supply and demand factors and other market information. Either trading style can be successful, and many advisors incorporate elements of both approaches.


Futures Commission Merchants (FCMs) are the brokerage firms that execute, clear, and carry CTA-directed trades on the various exchanges. Many of these firms also act as CPOs and trading managers, providing administrative reports on investment performance. Additionally, they may offer customers managed futures funds to help diversify their portfolios.


Commodity Pool Operators (CPOs) assemble public funds or private pools. In the United States, these are usually in the form of limited partnerships. There are approximately 1,500 CPOs registered with the NFA. Most commodity pool operators hire independent CTAs to make the daily trading decisions. The CPO may distribute the product directly or act as a wholesaler to the broker-dealer community.


Investment Consultants can be a valuable institutional investor resource for learning about managed futures alternatives and in helping to implement the managed fund program. They can assist in selecting the type of fund program and management team that would be best suited for the specific needs of the institution. Some consultants also monitor day-to-day trading operations (e.g., margins and daily mark-to-market positions) on behalf of their institutional clients.


Trading Managers are available to assist institutional investors in selecting CTAs. These managers have developed sophisticated methods of analyzing CTA performance records so that they can recommend and structure a portfolio of trading advisors whose historic performance records have a low correlation with each other. These trading managers may develop and market their own proprietary products or they may administer funds raised by other entities, such as brokerage firms.


Evaluating Risk from an Investor's Perspective


Investors should understand that there are risks associated with trading futures and options on futures. The Commodity Futures Trading Commission (CFTC) requires that prospective customers be provided with risk-disclosure statements which should be carefully reviewed. Past performance is not necessarily an indicator of future results.


Potential investors will want to become familiar with industry definitions for evaluating the risk-return element of managed futures performance. The following equations, with some variations, are often used.


Measure of Volatility


Standard Deviation: The dispersion (distance) of observations (performance data) from the mean (or average) observation. This measure is often expressed as a percentage on an annualized basis.


Measure of Capital Loss


Largest Cumulative Decline or Maximum Drawdown: The largest cumulative percentage (peak-to-valley) decline in capital of a trading account or portfolio. This measure of risk identifies the worst-case scenario for a managed futures investment within a given time period.

Measure of Risk-Adjusted Return


Sharpe Ratio: A ratio that represents a rate of return adjusted for risk, calculated as follows: Annualized rate of return - Risk-fee Rate of return Annualized standard deviation