Managed Futures

(Overview)

Managed futures traders - also called Commodity Trading Advisor (CTA) - mostly gain market exposures through global futures, forwards, and option contracts. They typically have a strong directional bias, i.e net long or short exposures and can apply leverage. While there are a number of trading strategies among CTAs, some of the most popular ones focus on systematic trading rules which use technical data to anticipate future price movements.

CTA funds are a compelling choice for investors seeking to improve the risk-adjusted performance of both traditional portfolios (stock and bonds) and funds of hedge funds. Such funds offer a low correlation to almost all other investments an can thus enhance the risk-adjusted performance of a diversified portfolio. Stress testing and a favorable distribution of returns are also a strong argument for allocating to managed futures. Institutional investors will be attracted by the transparency and the cash efficiency they offer. And the fact that most managed futures managers are well regulated, and have always been so, is an additional argument for investors demanding regulatory oversight.

Most managed futures strategies seek to benefit from trends. These trends are a persistent price phenomenon that stern from changes in risk premiums. - the amount of return investors will demand to compensate the risks they are taking. Risk premiums vary massively over time in response to new market information, changes in economic environment or even intangible factors like shifts in investors sentiment. When risk premiums decrease or increase, underlying assets will have to be re-priced. Since investors typically have different expectations, large shifts in markets result over several months or even years as expectations are gradually adjusted. As long as there is uncertainty about the future, there will be trends for CTAs to capture.

Managed futures managers continuously research new technologies and trading approaches in order to identify and profit from these trends. This scientific approach to managed futures trading has spawned a wide variety of different trading strategies which today allow traders to capture even small trends. In addition, the introduction of electronic trading allows managed futures managers to execute their trades and, if needed, reduce their positions more quickly and with less cost, making even shorter-term and smaller scale opportunities accessible and thereby expanding the investable universe for the investment approach.

This combination of market growth, persistent trends and ongoing research means that there is still substantial room for development in the managed futures industry. However, as strategies become more sophisticated and the race to develop new techniques and trade infrastructure heats up, the gap between the most developed trading managers and the following pack will widen further.

Managed Futures ' trading methods

As with many trading approaches, managed futures trading came to prominence in the US in the 1980s following the liberalisation of financial markets. Global assets under management in managed futures has risen from around $5 billion at the end of the 1980s to over $150 billion at the end of the second quarter of 2007. The growth of the futures markets in the 1970s and the explosive development of technology have helped transform managed futures into one of the fastest growing hedge fund strategies.

Managed futures funds are pools of futures or forward contracts managed by professional money managers. They are similar to a mutual fund in that individual or institutional investors have a share, though the investments in this case are mainly futures and forwards contracts.

Unlike basic securities such as stocks and bonds which are held within mutual funds, a future or forward contract is a derivative instrument, the value of which depends on the value of an underlying instrument. While the notion of using derivatives to generate returns may create some associations with excessive leverage and risky investment, managed futures managers apply strict risk control and mostly trade with high quality counterparties on risk averse exchanges. Furthermore, futures can also be less risky than the underlying investments.

Futures markets have a number of properties that make them an attractive investment medium. First, they tend to be highly regulated by government appointed bodies, such as the Commodity Futures Trading Commission (CTFC) and the National Futures Association (NFA) in the US. They also use clearing houses which guarantee transactions, thus removing counterparty risk. The high liquidity of futures markets is an added benefit - transaction costs are typically only a fraction of those charged in corresponding cash market.

Today, CTAs are investment companies which need multi-billion dollar assets under management to fund their technology and research teams. Systems-driven trading represents the lion's share of futures trading volume and CTA managers use a vast range of different trading techniques. The table below is not intended to be exhaustive, but gives a snapshot of some of the techniques used today:

A sample of CTA trading methods

Managed futures managers-whether systematic or discretionary- allocate a significant amount of their time to risk management. The major risk monitoring measures and focus areas are the following:

1. Value-at-risk (VaR) - measures the expected maximum loss from an investment portfolio when future market conditions are similar to those in the model. The value is determined for a specific time interval and certain level of confidence,

2. Stress testing- measures current market positions against historical price data. This allows the CTA manager to see how this current position sizes would have performed historically, especially during periods of market stress.

3. Implied volatility - is a forward-looking measure of potential risk that is analyzed for each market.

4. Leverage - if levels approach certain multiples of prevailing net asset value reach predefined levels, a review is triggered.

5. Margin-to-equity ratios- if initial margin requirement relative to prevailing net asset value reach predefined levels, a review in undertaken that may result in a reduction in positions

6. Net exposures to sectors and different currencies.

But at the end of the day the infrastructure of the managed futures manager is relevant. Only managers that stay at the forefront of new research and trading ideas will be able to cope with the more and more difficult risk monitoring challenges that exist today.

Summary

Managed futures have a proven long term performance track record. This, alongside with features such as high liquidity, strong regulations, low or no counterparty risk, transparency and cash efficiency, combine to create an appealing investment proposition on a standalone basis.

However, while managed futures may be an interest as a stand alone investment, they really add value as a portfolio diversifier. When combined to a fund of hedge fund portfolio or to equities and bonds, managed futures substantially reduce downside deviation and worst drawdown, thereby smoothing the overall risk/return profile.

Additionally, the futures industry is evolving as new technologies and trading approaches are continuously developed. This process is driven by continuous research and requires persistent investment in infrastructure and systems. As a result, it is creating clear economies of scale and constantly widening the gap between the largest and most established players and the rest of the industry while creating massive barrier to entry to new players.

An investor considering all allocation to managed futures should view them as long-term investment, with a holding period of at least three to five years. A manager's  track record, reputation and the experience should all be considered when selecting a CTA manager. Alternatively, investors can obtain a CTA allocations by investing into a fund of hedge fund portfolio that includes managed futures.