The sales pitch: "During periods of great future uncertainty …" though "future certainty" seems like any oxymoron, so a translation: "during periods of investor anxiety about the markets, you should consider managed futures which offer attractive returns in bull and bear markets as well as reduces risk by providing diversification."
Sounds fantastic, I'll take two please. Unfortunately, it's not really that simple. It is time we take a closer look at the common misconceptions about Managed Futures and why investors today should just take a pass.
TUTORIAL: Futures Trading 101
Managed Futures Are an Asset Class. The first thing to realize is that "managed futures" are just an investment in future derivatives being managed. It could be a strategy focused solely on precious metals, or might include every commodity, all the currencies and all the capital markets. Additionally, a strategy can be long, short or long and short, based on an automated, rules-tracking process to "trend" to a specific benchmark, or open to wherever the commodity trading advisor's (CTA) "gut intuition" wants to go. The number of iterations is endless.
The core issue with this misconception is that managed futures are actually a motley mix of eclectic investment strategies, not an asset class, and that is a very important distinction. Past performance data on asset classes can be analyzed to create some basis for future expectations, but unrestrained, eclectic investment strategies can't be. (To know more about asset class, read Diversification: It's All About Asset Class.)
Misconception # 2
Managed Futures Have Had Attractive Returns. Remember that "managed futures" refers to a multitude of strategies, most of which are private programs with "suspect" investment data, therefore, it's difficult to really know if the returns have been attractive to the investors.
There are a few publicly traded securities that we can look to for more verifiable performance data. Arguably the granddaddy of publicly traded managed futures is the Rydex|SGI Managed Futures Strategy H, a mutual fund which began investing in late 2007 and as of 2011 has roughly $2.5 billion in assets. The fund invests substantially all of its net assets in commodity, currency and financial-linked instruments, whose performance is expected to correspond to that of the S&P Diversified Trends Indicator. The fund manager (Rydex) charges about 2% in fees per year. Given the complexity of the fund and SEC exemption, it isn't possible to identify if there are, or are not, any additional underlying expenses, such as fees to commodity trading advisors (CTA), which usually average 2% plus about 20% incentive fees on the gains. These are eye-popping expenses, to me, but pretty typical for managed futures.
So with RYMFX as our proxy for managed futures, how attractive has the performance been?
|Symbol||RYMFX||SPY (S&P500)||SHY (1 -3 Treasury)||TLT (20+ Treasury)|
If attractive returns are relative, then managed futures (RYMFX) were very attractive in 2008, relative to the S&P500 (SPY), but no more attractive than the one to three year Treasury (SHY); compared to the 20+ Treasury (TLT), managed futures were not very attractive. Since 2008, the relative attraction among the group continues to change, but the point here is that in relative perspective to more traditional and much lower cost options, managed futures really haven't been all that attractive.
Managed Futures Reduce Risk and Improve Diversification. If the temperature variations in Lake Michigan were negatively correlated to stocks, would you be interested in buying a "Lake Michigan Temperature Volatility Fund?" An investment should provide a positive expected return, not just reduce risk. Yet, managed futures are a "zero-sum game," which means there will be an equal number of winners as losers, in other words, there are no expected positive returns in managed futures.
Cash and high quality, short-term bonds have a positive expected return, low to no correlation to the stock market and a long history; they are transparent, easy to access and are very low cost. That is much more favorable when compared to managed futures, which have no expected return, uncertain correlation benefits, unproven history as a portfolio investment, opaque, limited access and extremely high cost. (To know more about bond market, read Understanding Interest Rates, Inflation And The Bond Market.)
Managed Futures Provide a Substantial Hedge Against Inflation. This is theoretically true, perhaps, yet there isn't enough verifiable data to support the claim that an investment in managed futures helps hedge against inflation. If you are only worried about inflation, you could just buy treasury inflation protected securities (TIPS), or I Saving Bonds. (To know more about TIPS, read Treasury Inflation Protected Securities.)
Managed Futures Will Help in a Repeat of 2008. Perhaps if the exact same circumstances all happened again, as they happened in 2008, in exactly the same way, in the same sequence and the same severity, then maybe this misconception could be true. However, history doesn't repeat itself exactly, nor will investors behave exactly the same way. The truth is that managed futures, including RYMFX, have very little verifiable performance data, so no one really knows how they will perform for investors.
Commodity Trader Advisors (CTAs) Provide Performance Disclosures. CTAs do provide disclosures, there is no argument, there. Yet, you have to remember that CTAs are allowed to assess incentive fees only on "net profits" and 20% is pretty compelling. So, if a CTA has a bad year, they must recoup that loss for those clients and get up over the "high watermark," before they can take incentive fees. This should be good for investors, after all, if the CTA lost 20% in year one, then they shouldn't get any bonuses until they break even. However, if CTAs do fall under the watermark, they can close shop, start a new shop and get a new disclosure. The truth is, the CTA has a really strong incentive to start over. If the CTA makes 20% the next year trying to get an old client back to even, they get no bonus. However, if they make a new client 20%, they get a big bonus. This is why many managed futures firms have multiple CTAs under their umbrella; it gives the picture of history, yet allows them to disclose the attractive CTAs and to close CTAs that are too far underwater.
Managed Futures Are Well-Regulated and Audited. CTAs register with the Commodity Futures Trading Commission, are required to get an FBI background check, provide disclosures and have independent audits of financial statements every year. However, the good old open-ended mutual fund is publicly traded, audited daily, has multiple independent checks, and balances are a gazillion times more regulated and audited than the managed futures industry. Yet mutual funds still have issues now and then. At the end of the day, managed futures, especially private placements, in many ways are the Wild West, where investors better be very wary.
Managed Futures Mutual Funds Are at Least as Well-Regulated as Other Publicly Traded Mutual Funds. This simply isn't true. The SEC requires most mutual funds that invest in other managers to disclose those fees. Yet, the managed futures mutual funds have an exemption, because they can invest through off-shore subsidiaries. Even RYMFX may invest up to 25% of total assets in a wholly-owned and controlled Cayman Islands subsidiary.
Billions Are Invested in Managed Futures, so It Must Be Real. It is true that there is a lot of money in managed futures, but how much is for "business applications," versus investments? The futures market was created for business risk reduction, not investing. Aluminum producers, airlines, chemical companies, farmers and so on, are why the futures industry evolved and why there are CTAs and futures in the first place.
The Bottom Line
Managed futures are an exciting idea, and some people have made a lot of money, if mostly futures managers and CTAs. With annual fees averaging 2%, plus 20% of profits, the headwinds against anything realistically being left for the individual investor is low. Think about the real economic value you are capturing, by investing in managed futures; there is not that much, if any.