If the 10 years ending in 2010 are considered the lost decade, managed futures could be considered the lost asset class. Largely ignored by the advisor community, the Managed Futures Index returned 10.23% annualized over the 30-year period ending December 2010. Barclays Capital U.S. Aggregate Bond Index returned an annualized 8.92% and the S&P 500 returned 10.71% annualized.
There is an argument posed by some financial professionals that managed futures should not even be considered an asset class. Regardless of your view, they have a very stabilizing effect on a portfolio. They also provide equity-like returns with bond-like volatility. They are non-correlated to every major asset class and, when allocated to a diversified portfolio of stocks and bonds, almost always lower the portfolio's standard deviation for all periods.
The dilemma faced by advisors is how much to allocate toward this component of a portfolio. Advisors must develop an understanding, and then educate the investor. First, one must have a basic understanding of managed futures and the role they have played in the financial markets for the past several centuries.
The Old, New Asset Class
Futures markets in America existed as early as 1752, and evolved from practices that date back to the ancient Greeks and Romans. But it was in 1983 that managed futures gained significant recognition when Professor John V. Lintner of Harvard University presented his seminal research paper, "The Potential Role of Managed Commodity-Financial Futures Accounts (and/or Funds) in Portfolios of Stocks and Bonds." The findings of his work simply stated that portfolios of equities and fixed income exhibit substantially less variance, at every possible level of expected return, when combined with managed futures. Lintner recommended a 40% allocation of managed futures to a diversified portfolio of stocks and bonds. He hypothesized this allocation would achieve the lowest volatility in a portfolio. Recognizing that most investors are unwilling to commit such a significant allocation, our analysis demonstrates that at least a 25% allocation is necessary to effectively achieve a satisfactory level of risk reduction.
By their very nature, managed futures provide a diversified investment opportunity. Trading advisors can participate in more than 150 global markets, from grains and gold to currencies and stock indices. Many funds further diversify these investment instruments by using several trading advisors with different trading approaches. These strategies can be either short term or long term, and either discretionary or systematic.
The benefits of having managed futures within a well-balanced portfolio include: 1) the potential to lower overall portfolio risk; 2) the opportunity to enhance overall portfolio returns; 3) to opportunity to broadly diversify investments; 4) the opportunity to profit in a variety of economic environments; and 5) the potential to limit loss due to a combination of flexibility and discipline.
Managed futures are relatively new to some investors, banks, corporations and mutual fund managers. However, foundations, endowments and the industry have used futures markets to manage their exposure to price change. Futures markets allow these organizations to hedge or transfer their risks to other market participants, including speculators, who assume the price risk in anticipation of making a profit.
Without speculators, price discovery would occur only when both a producer and an end user execute transactions at the same time. When speculators enter the marketplace, the number of ready buyers and sellers increases; hedgers are then able to execute larger orders at their convenience without affecting a dramatic change in price, providing additional liquidity, which ensures market integrity. By selling futures when prices are rising and purchasing futures as prices fall, hedgers' trading can have a stabilizing effect on volatile markets.
Tracking Recent Growth
Sol Waksman, founder and president of BarclayHedge, believes the recent growth in managed futures assets is directly related to the underlying characteristics of the asset class, which match up well with current investor sentiment. Waksman notes that futures are exchange-traded, with total transparency and positions marked-to-market daily. Further, even the largest fund managers can readily liquidate their holdings, which means that investors are not restricted from immediate redemptions. In terms of downside volatility, the Barclay CTA Index's worst peak-to-valley decline since 1980 was 15.66%, compared with 50.95% for the S&P 500, 49.30% for the Dow Jones Industrials, and 67.65% for the S&P GSCI Commodity Index during that same time period.
Originally, because of minimum investment requirements, commodity trading advisors (CTAs) could only be accessed by endowments, foundations and the ultra-wealthy. Historically, for others, managed futures were accessible through limited partnerships. Investors had to qualify as an accredited investor, meaning individual income greater than $200,000, joint income in excess of $300,000, or a net worth exceeding $1,000,000 (excluding any equity in the primary residence). CTAs typically charge both a management fee and a performance fee. Management fees range from 1% to 4%, with 2% being the typical charge, per annum. Performance fees are calculated on the basis of the fund's profit. Although 20% is common, some managers charge as high as 50% of the upside return.
Last year, managed futures became accessible in a structured note format. A structured note is a debt obligation of the issuer to fulfill the terms of the contract. When coupled with managed futures, the structured note possesses characteristics that reflect the underlying performance of the CTAs selected by the manager.
Although only available to accredited investors, the structured note offers numerous advantages over both the limited partnership and the mutual fund.
Tax treatment for the structured note is treated as long term if held to maturity (which is characteristically 13 to 14 months). Structured notes offer transparency not found with their counterparts. Tax reporting, similar to a mutual fund, is done using IRS form 1099, versus an IRS form K-1 provided by a limited partnership. Some structured notes offer daily liquidity and daily pricing, while the limited partnership may have lockup periods ranging from 30 to 90 days, or longer. The structured note carries the credit quality of the underlying issuer, which is typically a highly rated financial institution, and is subject to default by the implied credit risk of the issuer.
Typically, modest surrender charges are associated with the structured note depending upon its liquidity. A prudent investor should always inquire about the credit risk of the issuer and any penalties associated with redemption of a structured note prematurely.
Mutual funds investing in managed futures proliferated during the same time period (2010). Though mutual funds may open the door to the retail investor, the products are very different from those offered to accredited investors. Those funds that provide daily liquidity with no holding periods typically do not have access to the biggest and best managers. The overall performance of a mutual fund might suffer as a result. Expenses on the structured note, by design, are kept lower than their competitive counterparts. Typically, no surrender charges are associated with the structured note. Mutual funds and limited partnerships do not provide a credit quality rating. They are subject to credit and market risk.
A Look To The Future
As the year advances, expect managed futures to continue their hyper-evolution. Lower fees, broader choices, more transparency, immediate liquidity and easier access for all investors will show improvement. Long term, in the managed futures world, is less than 18 months. Once exposed to managed futures, most investors will find cause to retain them in their portfolios. All investments carry a certain degree of risk and it is important to review investment objectives, risk tolerance, tax objectives and liquidity needs before choosing an investment style or manager. Diversification does not ensure a profit or protect against a loss. No chart, graph, or other figure should be used to determine which strategies to implement, or which securities to buy or sell. Investors should do their own research or seek the help of an advisor to assist them in making the appropriate choices for their investments.
Robert J. Lindner, a certified financial planner,
is founder of Lindner Capital Advisors (www.lcaus.com),
an advisory firm in Marietta, Georgia, that integrates
a managed futures component into the portfolios it manages
for clients of financial planners and wealth managers.