Some investors are looking for alternative assets to diversify their holdings after taking a beating in the markets last year, and others need to rebalance their portfolios to account for changes in their asset allocation over time. One investment that might provide a vehicle for diversification and enhanced returns is managed futures funds. Some of these funds offer lower minimums for retirement accounts and are available through self-directed individual retirement accounts (IRAs).
The managed futures industry has been around for about 30 years. It is made up of commodity pool operators who form limited partnerships that provide investment vehicles for individuals and institutions. The fund’s investment decisions are made by commodity trading advisers (CTAs) who generally use a proprietary system or theory to invest a portion of their assets in derivatives (futures, forwards and options) across a wide variety of segments. The remainder is put into Treasury bills or other extremely safe investments that essentially serve as collateral so that the fund will have the capital to fulfill its obligations under the derivatives it invests in.
Most managed futures funds invest across six major sectors: energy, precious and base metals, grains and other commodities, foreign currency, global fixed income and stock indices. Because their reach is so broad, their correlation to the two main asset classes – stocks and bonds – is quite low, and therefore they can be expected to behave differently from those investments in most economic climates. They also tend to be extremely well diversified, with investments in commodities, metals, and currencies as well as securities. This diversification helps them do well in both up and down markets.
A typical managed futures portfolio could have exposure to more than 50 global markets at a single time, according to Robert L. Lerner, chief executive officer of Ruvane Fund Management, a commodity pool operator based in Princeton, N.J. “The word ‘commodity’ is somewhat misplaced because managed futures funds and their CTAs invest in a wide variety of markets,” Lerner said. For example, many invest in derivatives based on securities and fixed income investments as well as those based on commodities.
The diversification and noncorrelation that managed futures funds bring to a portfolio have the effect of lowering the overall risk of the portfolio. Studies have shown that, when adding risk into the mix, a portfolio with 10 percent of its assets invested in managed futures, 55 percent in equities and 35 percent in fixed income can be expected to have higher risk-adjusted returns than one invested 60 percent in stocks and 40 percent in bonds.
While they tend to lower the risk of an overall portfolio, managed futures investments can involve significant risk because they are speculative and volatile. Therefore, as with any investment decision, it’s important to evaluate each fund you are considering. This evaluation is possible because managed futures funds are regulated and have to make certain information available to potential investors. In addition, some funds file annual and quarterly reports with the Securities and Exchange Commission containing information you can use to evaluate them.
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Here are some things you should understand about each fund under consideration.
How do the fund’s CTAs decide what to invest in – what is the basis for their trading platform or strategy? Some funds follow trends, while others rely on spreads to make their profits. Although their platforms are proprietary and their tactics can be confidential, they should be willing to divulge enough about how they make investment decisions to give you or your financial adviser confidence in them. You should find this information in the fund’s confidential offering document, which it must make available to potential investors.
What is the fund’s performance record? The fund should disclose its historical returns so that you can compare its performance with other indices and other funds during the same period. You’ll want to look for its worst loss, or drawdown, measured from peak to valley and see how long it took the fund to recover. You should find this information in the fund’s offering document, along with annualized rates of return and risk-adjusted returns. Comparing risk-adjusted returns of funds you are considering should be part of your decision process. Also, to find out if previous customers have had problems with the fund, potential investors can go to the National Futures Association’s Web site, www.nfa.futures.org, to research whether a fund has had complaints filed against it in the past.
What are the terms and qualifications for investing in the fund? States are allowed to set parameters for who can invest in a public managed futures fund, including minimum net work, investable assets, and/or income. Fund managers may have even higher qualifications, and their investment minimums vary widely. In addition, some funds restrict withdrawals by setting a minimum holding period and/or allowing redemptions only at the end of each month or quarter. According to Lerner, managed futures funds tend to be very liquid and don’t need the same restrictions on withdrawals that hedge funds typically have. Even so, these terms may affect your ability to put money into and take money out of these investments, so you’ll want to understand them before investing.
What will the investment cost? Managed futures can be expensive as they typically carry annual charges in addition to any sales commission due to the broker on purchase. Most CTAs charge 2 percent per year in management fees, and commodity pool operators typically charge about 1 percent annually, but these fees can vary from fund to fund. In addition, CTAs generally get an incentive bonus or performance fee when the fund hits a new “high water mark,” typically 20 percent of the amount exceeding the previous high. These fees must be disclosed in the fund’s offering document and presented in a break-even table.
Many financial advisers use managed futures in their clients’ portfolios but caution that their volatility and relative riskiness keep them from being good choices as stand-alone or core investments. Conservative financial planners recommend that investors put up to 10 percent of their portfolios in alternative assets, and managed futures funds are easier to negotiate than direct purchases of the derivatives they invest in. With some funds setting account minimums as low as $10,000 to $25,000 (and as low as $2,000 in retirement accounts), that puts these funds within reach of many people.
Even so, managed futures require a lot of evaluation before investors decide whether to put money into them, and if so, which ones and how much. Among the factors complicating this analysis:
- Although managed futures lower the risk of an overall portfolio, the investments themselves are risky because they are speculative and volatile. That makes your analysis even more important.
- While the industry goes back at least 30 years, most funds haven’t been around that long and there is a lot of turn-over in the industry. Many funds are too new to have a long track record, which is essential to assessing their performance.
- The funds are subject to disclosure requirements and other regulatory reviews, but that in itself doesn’t make their documents any easier to understand. If you can’t wrap your mind around the fund’s explanation of its theory or trading platform, you need to get a better explanation – preferably from someone who doesn’t stand to gain from your decision. If the fund isn’t willing to help you and your financial adviser understand its fundamental ideas, you might want to look elsewhere.
- The liquidity question is particularly important if your small allocation to managed futures outperforms your core investments and eventually surpasses your target. In that case, not only would the ease of withdrawals be important, but also you must make the counterintuitive decision to reallocate a share of your portfolio out of this top-performing investment.
- Although, historically, managed futures funds have performed well in both up and down markets, there are times they may not be expected to outperform other investments. For example, they aren’t likely to do well when the market is stagnant and there are no trends to follow, and their managers may not be able to keep up with sudden swings. At the end of the day, you are still left with the task of predicting the future.
Those who can’t or don’t want to perform this much “due diligence” may want to consider other investment vehicles or other ways to gain exposure to commodities, currencies and other alternative asset classes.