In a recent Bloomberg article, the author lambasted the managed futures industry for non-performance, high fees and being confusing. In our opinion, the research done by the author and the facts presented were not representative of the industry as a whole. The article’s research analyzed the commonly available managed futures investments to the retail investor in the form of mutual funds and summarized their shortcomings.
The problem is not with the managed futures asset class or its place in the investor’s portfolio, but with the vehicle through which they are available to the general public.
In our article, Managed Futures Mutual Funds Don’t Work. Here is Why published in December 2012, we pointed out these mutual fund shortcomings for investing in alternatives and why they could not deliver what they promised or aspire to do.
According to Opalesque, assets in US alternative mutual funds “have ballooned to $550 billion” with an equally impressive growth in the asset class in Europe. It is therefore imperative that financial advisors understand the shortcomings of mutual funds in delivering what they promise and seek out alternative vehicles that are available to the retail investors.
Lack of Exposure and Costs
Mutual funds, which are registered under the 1940 Act, limit the non-security exposure of a mutual fund to no more than 25%. This creates two problems for mutual fund when investing in futures contracts or CTAs. The first is obviously not enough exposure to the asset class as they are limited to investing only 25% of capital directly into managed futures.
The second problem comes when mutual funds try to circumvent the 25% limitation. A mutual fund will set up an offshore vehicle in the Caymans or British Virgin Islands and invest 25% of the mutual fund’s capital in this offshore vehicle. Then the mutual fund will engage in a total return swap between the offshore vehicle and a prime broker to leverage their exposure to managed futures. This practice is not illegal, but the conduit involving a foreign corporation and swaps adds another 0.50% to 2% in costs annually to the mutual fund investor and an added layer of counterparty risk where the mutual fund investor is now exposed to the credit risk of the prime broker.
A hedge fund registered under the 1933 Act is not limited by how much it can invest in managed futures and therefore does not have to set up offshore vehicles and incur additional costs. Contrary to popular belief that hedge fund structures are only available to accredited investors with high minimums, usually $1 million, and lock up an investor’s money for a long time, there are managed futures offerings listed with the SEC as hedge funds that are available to non-accredited investors with minimums as low as $5,000 and no lock-ups.
Increased Performance Dispersion Requires Skill in Picking the Right Strategy
A look at the Barclay CTA Index shows not just a drop in performance but also increased dispersion of returns. The CTA index has performed poorly since 2008 both on an absolute basis as well as on a relative basis when compared to the S&P 500 Index.
†Estimated YTD performance for 2013 calculated with reported data as of November-6-2013 14:29 US CST
This poses a challenge for the portfolio manager who is trying to create a fund of managed futures strategies. Given the poor overall performance and the large dispersion between the successful and the average strategies, the portfolio manager needs to possess an investment edge.
The dispersion of 449 CTA one-year returns shows an extremely wide distribution.
The highest one-year return is 56%.
The lowest one-year return is -87%.
The percentage of CTAs with positive returns is 35%.
The percentage of CTAs with negative returns is 65%.
And worse still, 13% of these CTAs are so deeply negative that most likely they will go out of business.
Source: BarclayHedge, MA Capital Management. Data is a compilation of one year returns of 449 CTAs from 7/2012-7/2013.
The above dispersion chart of 449 CTAs shows that 33% of CTAs have positive returns for 2013, even though the index is negative and 24% have performed very well in 2013 with returns greater than 10%.
This clearly shows that the managed futures as an asset class is a viable performer even in a low volatility year like 2013, but it also shows the need for expertise on part of the portfolio manager in identifying the right strategy to put in their portfolio.
Unfortunately, most managed futures mutual fund portfolio managers do not have this required expertise, as few have ever traded futures or managed other futures traders in their careers, which means that they provide little to no edge when picking strategies for their mutual funds.
In the book, The Future of Hedge Fund Investing (Wiley,09) our Chief Investment Officer, Monty Agarwal, states that portfolio managers who invest in alternative strategies need to understand how these strategies work and how to pick the right traders to trade them. The only way to acquire these skills is through experience in trading and managing traders. Just as you would not go to a heart surgeon who does not possess the right education and experience, similarly, an investor should not invest with a managed futures mutual fund portfolio manager who has not traded these strategies himself.
Alpha is Not a Constant but Depends on Market Volatility Cycle
In one of our papers, Constructing a Robust Absolute Return Portfolio, we showed that there are three types of markets, trending, shock and noise with different volatility profiles. But more importantly, a managed futures strategy exhibits different risk/return profile under different market cycles. It is the job of the portfolio manager to understand these cycles and how different strategies behave under these cycles and allocate capital accordingly.
A systematic allocation of capital that changes with the market volatility cycles can ensure that the managed futures portfolio performs well in not just a 2008 type market cycle, but also in a 2013 market cycle.
If you would like to learn more about an alternative vehicle other than a mutual fund or are interested in distributing it to your clients, please email us at email@example.com.