The managed futures industry, though still in its infant stages, grew exponentially in the period between 1980 and 2008. In 1980, there were approximately $310 million invested in the managed futures sector. In 2008, that figure topped $175 billion. The unique benefits of managed futures include professional management, the ability to profit from up, down and sideways markets and the simple fact that managed futures are not strongly correlated to other asset classes.
Asset growth has resulted in the increase of the number of traders that make up this industry, but it has also provided investors with a much more difficult process when it comes to selecting the right commodity trading advisor (CTA). Therefore, while managed futures as an asset class might make sense, not all traders are alike. The returns of the traders are based on several different factors. Here, we'll look at some of the ways that CTAs differ and how these differences can affect returns for investors.
What Are Commodity Trading Advisors?
Commodity trading advisors are the professional money managers or traders that make up the managed futures industry. CTAs trade their clients' money on a discretionary basis and transact almost exclusively in the futures markets. At first glance, one might assume that all commodity-trading advisors are alike, but CTAs differ in terms of their trading strategies, the markets they trade, their experience levels and the style of trading they use.
Because of their differences, it is important to distinguish the different types of CTAs. Comparing a manager that trades gold and silver on a short-term basis against a manager that trades corn futures on a long-term basis is hardly the best form of evaluation. In a sense, it is like comparing a manager of a technology mutual fund against a manager of a utilities-oriented fund. Therefore, the first process in evaluating the managed futures industry is to differentiate between the various ways that managers yield returns.
The most obvious difference between the different commodity trading advisors is the markets they trade in. There are some managers who focus exclusively on a sector or group of markets (such as precious metals or grains), and there are other managers who trade a wide array of markets (sometimes 30 to 40 markets). The managers who trade a wide array of markets will usually use technical analysis to make trading decisions. In other words, a chart is a chart, no matter which market it represents.
There are generally two styles of trading in the managed futures industry. Discretionary CTAs are traders who use their own decision-making skills to determine whether to enter or exit a trade. For example, a discretionary CTA might focus on both fundamental crop reports and chart patterns to determine if they will buy cotton. Systematic CTAs, on the other hand, do not transact trades based on human decisions. Trades are conducted based on a trading signal that is generated by a computer program. While the programs were initially put together by actual people, these "black box" programs now trade the markets without any input from human emotions and fundamental information.
One of the benefits of the managed futures industry is that managers are able to trade the markets using a number of different strategies. Ultimately, using these different trading strategies allows CTAs to potentially profit from any market environment. For example, if the market is heading higher, traders can be long. If the markets are trading lower, traders can be short. Beyond traditional long/short strategies, there are a number of other strategies that commodity-trading advisors implement. Here are just a few examples:
- Trend following: Trend following is a strategy that simply follows trends based on certain technical indicators (e.g. moving averages, breakouts, etc.). CTAs that specialize in this strategy can profit from both rising markets (by being long) and declining markets (by being short). Trend followers, however, often incur drawdowns during choppy market environments because they often are stopped out of trades.
- Counter Trend: This strategy seeks to profit from trend reversals. If you look at any chart, nothing will move straight up or down. There are often pullbacks and reversals. This strategy looks to profit from those type of moves.
- Arbitrage: There are a number of sub-strategies that fall under arbitrage. The most prevalent in the managed futures industry is statistical arbitrage. A simple example of this is simultaneously buying gold on one exchange (for a lower price) and selling gold on another exchange (for a higher price). This strategy looks to profit from the price difference.
- Option Writing/Sellers: Option selling is a strategy that focuses on writing options (and collecting their premiums) that are likely to expire worthless. The idea is that the commodity-trading advisor will benefit from the premium he or she collects from the buyer. The risk associated with this strategy, however, is that the options will not expire and the contract will go in the money. Within this strategy are naked option writers and spread option writers.
- Global Macro/Fundamental Focus: Commodity trading advisors that trade the markets from a fundamental approach will often look at crop reports, weather patterns, economic reports and other fundamental data to determine whether to enter a trade.
There are a number of other different strategies that make up the managed futures sector. What you can see from the above strategies is that the different strategies not only determine when they will transact a trade, but also which type of market environments are most suited for their strategies.
Different CTAs might trade the same markets from a systematic approach and use the same trading styles, but their returns will differ drastically. Why is that? It has a lot to do with their trading time frames. Traders also differ based on whether they are short-term traders, intermediate term traders or long-term traders. Consider, for instance, two systematic trend followers. Trader A trades the market from a long-term trend-following basis; Trader B implements an intermediate trend-following strategy. Over the hypothetical intermediate period, the market is choppy (thus, stopping out the intermediate trend follower on a number of different occasions). From a long-term perspective, however, the market is still in an upward trend. In this scenario, Trader A will still be able to profit handsomely as the trend eventually continues upward.
Emerging Vs. Established CTAs
Another differentiating factor between commodity trading advisors is whether they are emerging or established. There are various opinions of what defines emerging and what defines established. The general definition, however, focuses on the fact that emerging managers typically have less than a three-year track record and less than $50 million under management. At first glance, it might seem that the only difference between an emerging and established CTA is their experience levels. However, this is not true.
Many emerging CTAs have a substantial amount of experience working for other companies and who have finally started their own shop. Thus, while they might only have a few years' experience trading in their own fund, they are established traders in the industry and well versed in its practices.
The major difference in distinguishing among emerging and established CTAs has a lot to do with how they generate their returns, as emerging CTAs can often outperform established managers. There are two main reasons for this. The first has to do with the fact that emerging CTAs are smaller and more nimble. Because they are nimble, they are often able to make transactions in certain markets that would be impossible for a larger, more established fund. The second reason is that emerging CTAs are often eager (and more aggressive) to putting up numbers that allow them to pop on the radar screen of investors. An established billion-dollar fund might not have that extra incentive to be aggressive.
There are also negatives to selecting an emerging CTA over an established CTA. While emerging CTAs might sometimes outperform their more established counterparts, the attrition rate is also higher. Many emerging CTAs often do not even make it past their first year in business and some traders that put on the CTA hat do not have any experience beyond trading for themselves.
The last point of distinction between commodity-trading advisors is their minimum investment requirements. The minimum to invest with a commodity-trading advisor ranges from $10,000 to tens of millions. Typically, managers who have low minimum requirements are either emerging managers who are trying to attract capital or managers who only trade a certain market or strategy. Established managers tend to have higher minimum requirements, as do managers who trade with a strategy that requires a larger amount of capital.
The Bottom Line
If you are considering managed futures for a slice of your portfolio, take time to consider the wide array of options of strategies and managers. Any reputable CTA should have an audited track record with one of the two regulating bodies for managed futures, the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA).