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THE CORDANT WEALTH FINANCIAL CLARITY BREAK

Q1 Educational Topic – Managed Futures

By: Isaac Presley, CFA®AAA
Q1 Educational Topic – Managed Futures

Key Points:

  • Futures are an agreement to purchase something in the future with the price set today.
  • Managed futures funds typically seek to capture returns by taking advantage of “momentum” in investment prices.
  • Investing in managed futures is not as straight forward as other investments. There are several things to be aware of.

Last time on the blog, we reviewed first quarter performance. One of the best performers was the asset class of ‘managed futures’. As part of these quarterly investment reviews, our aim is to provide an overview and educate you on different parts of the portfolio so you will understand why we include them in certain portfolios.

Let’s take a deeper look at managed futures and learn what drives its returns.

What are Futures

Managed futures is a strategy of buying and selling futures contracts. The first thing to understand is: what are futures? Futures are financial contracts with a price agreed upon today, but with the purchase happening sometime in the future.

For example, imagine you agreed today to buy a pair of shoes for $60, but the transaction date is set for one month out. That’s a futures contract. If the price of the shoes in a month is $70, you’ve made a $10 profit (or saved yourself $10). Conversely, if the price goes down, say to $50 dollars, you’ve lost $10.

So, if futures are a financial contract, how are they “managed”?

How are Futures “Managed”?

Managed futures is a trading strategy where a manager buys (or sells) various financial future contracts—stocks futures, interest rate futures, currency futures and commodity futures. Typically they do this according to a rules-based, trading system.

It’s well documented in the academic literature that recent winners (stocks or assets classes), in general, continue to win and losers continue to lose over the short-term (called momentum). So, a managed futures fund exploits this behavior by buying the futures contracts doing well recently and selling (or shorting) the futures contacts doing poorly.

This works in large part due to a behavioral explanation—the Recency bias. We tend to give extra weight to things that have just happened, ignoring data in the more distant past, and extrapolating recent events into the future. If a stock has been doing well, people tend to think it will continue to do well going forward. On the flip side, with a stock that lost money recently, we tend to develop stories why this particular stock will never make money.

Now neither of these things is true in the long-term. This is not a market timing strategy, one of calling the market tops and bottoms. But this behavior, in the short term, drives the momentum in asset classes. A managed futures strategy seeks to take advantage of this behavior.

Because of this, it works best in markets with strong trends. For example, the U.S. equity markets spent most of 2008 declining, with the S&P 500 down 37% for the year. However, managed futures strategies returned a positive 18% in the same year.[1]

2009 however, was a different story. Equity markets were down the first quarter, and then reversed to finish the year up over 26%. Because of the strong reversal in trend, managed futures struggled and lost nearly 7% for the year.

But it’s not just a strategy that does well when equity markets are down. 2014 was a good year for stocks (up 14%) and managed futures were also up 18%.

Because of their ability to capture returns by taking advantage of momentum in markets and their power to add an important source of diversification (like they did in 2008), managed futures can be a valuable piece of a portfolio.

Things to be aware of with Managed Futures

We just saw that managed futures can be a valuable addition to a portfolio. However, it’s not as straightforward as buying a stock or bond fund. The proper amount of research and due diligence needs to be done. All managed futures strategies and funds are not created equal.

Some important things to consider before investing in managed futures:

  • The risk of managed futures — There are certain risks of investing in futures; specifically a high degree of leverage can be obtained. This obviously can magnify both gains and losses. Any investor should do the proper due diligence before investing—making sure they understand both the risks and potential returns of a managed futures investment.
  • Placement and (or) subscription fees – Some managed futures funds have a subscription or placement fee. This can be as much as 5% of your initial investment. Make sure, especially for anyone working with a broker, you know how much they stand to make for recommending a particular fund. It’s not necessary to work with a broker to get access and we don’t recommend paying a fee upfront to get this exposure.
  • Concentration – Some funds will concentrate on a particular futures contract (e.g., commodity futures only). And some funds will only attempt to exploit one time period (such as a focus on short-term trends; ignoring the medium and long-term trends). Just like with anything else, a particular contract-type or time period will not always work. A better approach is to be diversified with the exposure.
  • Expenses – Once you’ve avoided the upfront fee, and targeted the “right” exposure (not overly concentrated) it’s important to minimize the annual management fee you pay for the exposure. Because these funds are trading strategies, they are more expensive than owning an indexed stock or bonds fund. However, one can pay 3% or more annually for a Managed Futures fund. This is not necessary as there are some good funds available with annual expense ratios in the low 1% range.

Hopefully this was a helpful recap of investing in managed futures. If you found this useful, please consider signing up for our newsletter. You will stay up to date with all our articles and receive posts like this straight to your inbox.

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[1] Stocks are represented by the S&P 500 and managed futures by the Credit Suisse Managed Futures Index