Managed Futures

Managed futures are a type of professionally managed asset offered by broker-dealers. Managed futures are funds that trade futures contracts for the benefit of the investors of the fund. Managed futures are generally marketed to high net-worth individuals, primarily because of their risk and their high initial investment requirement, usually at least $25,000. Unlike hedge funds, there is no lock-in period, although there are some restrictions. Investors can enter or leave a fund once a month, usually with a 5-business day notice.

The 2 main advantages of managed futures are diversification and a tax advantage unique to futures contracts. Managed futures have little or no correlation with stocks and bonds, so managed futures can effectively diversify a portfolio held by most investors. As §1256 contracts, 60% of the gains of futures contracts are taxed according to the long-term capital gains rate, which varies from 0% for low income taxpayers to 20% for those in the 39.6% tax bracket; for most investors, the long-term capital gains rate is 15%. The remaining 40% of gains is taxed at ordinary income rates. These tax rates apply regardless of how long the investor has held the contracts. However, futures accounts are marked to market, so taxes must be paid on any gains even if the futures contracts are still held by the end of the year. To understand managed futures, you must understand futures.

Futures

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A futures contract specifies the obligation to buy or sell an underlying asset at a specified price on the delivery date. Underlying assets include commodities, such as agricultural products, financial futures, and currency futures. A short position delivers the underlying asset, the long position receives it.

The futures market, including managed futures, is regulated by the Commodity Futures Trading Commission (CFTC). Futures are traded on exchanges. The Chicago Mercantile Exchange (CME) is the primary futures exchange for commodities. No cash is paid for futures, but margin, sometimes referred to as a performance bond, must be posted. The initial margin account requirement is the amount necessary to establish a position, whereas the maintenance margin requirement is the amount necessary to maintain a position and is usually lower than the initial margin requirement. If the value of the futures contract falls below the maintenance margin requirement, then the investor will be subject to a margin call to bring the account value back to the initial margin requirement; otherwise, the broker will sell enough of the investor's position to return the equity of the account to the initial margin requirement. Generally, margin requirements vary from 5 to 10% of the underlying asset value, up to 15% in volatile markets. Most often, U.S. Treasuries are used for collateral, which earns additional income.

The futures market has 3 types of traders: speculators, hedgers, and arbitrageurs. Speculators buy and sell futures contracts in the hope of earning a profit. They have no intention of delivering or taking delivery of the underlying asset. Hedgers use futures to hedge a position that they already have or will have, so that they can set the delivery price for a future date. Arbitrageurs simply trade contracts on different markets to take advantage of price discrepancies. Speculators are necessary for a thriving futures market, but they usually have to post a higher margin than hedgers.

Because only a small amount of the contract value has to be posted as margin, the investor gains significant leverage, which increases profits and losses. Because commodities are usually the underlying asset, the prices of futures contracts are restricted by how much the underlying asset varies, so leverage helps to increase profits from smaller changes in asset prices-. If the underlying asset increases, then the short position suffers because the underlying asset could have been sold at a higher price, while the long position benefits because only the delivery price must be paid, not the higher spot price; the obverse is true when the underlying asset price decreases.

Futures contracts have a finite life; therefore, to maintain a position, the contracts must be rolled forward to new contracts with later delivery dates. A consequence of the spot-futures parity is that the price of futures contracts necessarily converges to the spot price on the delivery date; otherwise, arbitrage will equalize the prices.

If the prices of futures contracts that expire after the delivery date are less than the spot price of the underlying asset, then the scenario is referred to as normal backwardation; otherwise, the market is said to be in contango, where later future contracts cost more than the spot price of the underlying asset. In normal backwardation, a trader can profit from rolling his position forward; in contango, a trader would suffer rolling losses. The amount of roll profits or losses is generally referred to as the roll yield.

The futures yield curve shows how spot prices compare with prices of futures contracts with different delivery dates. An upward sloping futures yield curve shows contango, while a descending curve shows normal backwardation.

Managed Futures

The primary objective of most managed futures is to hedge rather than speculate. Managed futures are usually structured as a limited partnership, where the securities firm acts as a general partner. A commodity trading advisor (CTA) or, in some cases, a commodity pool operator (CPO) manages the accounts. Regulated by the National Futures Association (NFA) and the CFTC, CTAs are required to pass the Series 3 examination and register with the CFTC before accepting money from the public.

Managed futures are mostly marketed to high net worth individuals, since a large initial investment is generally required, sometimes as high as $250,000 or more. The managed futures fund is a discretionary account, where the CTA usually has the power of attorney in regards to managing the investments for the investors. Once the account is established, the CTA does not need permission from the investors to trade the account.

There are 2 main investment strategies to managed futures funds. Trend following funds take a long or short position in anticipation of a rising or falling market for the underlying commodity. CTAs following a market neutral strategy seek to take advantage of price discrepancies in different markets, thereby being able to profit in a nondirectional market.

Advantages and Disadvantages of Managed Futures

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Unlike hedge funds, futures funds have transparency: all trades undertaken by the managed futures fund is available to its investors because they are in separate accounts that can be viewed by the investors even though the account is managed by the CTA. Furthermore, because of the low correlation between futures and stocks and bonds, a managed futures fund provides diversification. Further diversification is achieved by the CTA trading in the more than 150 futures markets that are available worldwide.

The Economic Recovery and Tax Act of 1981 (ERTA) promoted the futures market by changing the taxation of profits, leading to one of the major benefits of managed futures. With other capital assets, gains are taxed at the lower long-term capital gains rate, which varies from 0% to 20%, depending on the income of the taxpayer, if the capital asset was held for longer than 1 year; otherwise, the short-term rate applies, which is the marginal tax rate. With futures contracts, the holding period is immaterial: 60% of net profits are taxed at the long-term capital gains rate, while the remaining 40% is taxed at the ordinary marginal rate, regardless of how long the contracts were held.

Another peculiarity of futures taxation is that gains or losses are netted to determine taxable income, including contracts that are still held by the taxpayer. The taxation of futures does not depend on closing out the contract, since all futures contracts are marked-to-market at the end of each trading day, so the net value of the futures contracts held by a taxpayer on the last trading day of the year plus any net gain or loss of trades that were closed out by either buying or selling an offsetting position or by making or taking delivery during the tax year determines the net amount subject to taxes.

Another advantage of managed futures is a high risk-adjusted return, meaning that a higher return is earned for a given level of risk. A common method of measuring the risk-adjusted return is the Calmar ratio (or drawdown ratio) and the drawdown, which is the maximum continuous peak-to-valley drop in the value of the fund over a 3-year period. Note that this is not necessarily the same as the largest individual drawdown, which is the difference between the maximum and minimum value of the fund over the 3-year period. The drawdown is measured from a peak to the next valley, which may not be the lowest valley. The Calmar ratio is like the Sharpe ratio, but uses the drawdown rather than the standard deviation in determining the risk. Note, also, that the drawdown is a positive number, even though it represents a decline in value.

Calmar Ratio = (Compounded Annualized Rate of Return over a 3-Year Period – Risk Free Rate) ÷ Drawdown

Example: Calculating the Calmar Ratio

Case #1:

Case #2:

Note that, in the above 2 cases, the investment returns are the same, but Case #2 achieved the same result with half the risk.

High Management Fees

A major source of risk in futures is the use of leverage, which can increase profits but also losses. However, the main disadvantage of managed features is the high management fees. Like managers of hedge funds, managed futures funds generally charge a 2% management fee and a significant performance fee of 20% of net profits. The 2% management fee is always charged and will reduce profits and increase losses, but even if there are profits, the 20% performance fee will significantly reduce returns. However, the CTA can only earn the performance fee on profits at or above the high watermark, which is the highest profit earned previously. So if a fund reaches a profit peak, then declines, then ascends again, as securities of all types usually do, then the CTA only earns the 20% on any profit that exceeds the previous profit peak. Although the 20% performance fee is to compensate managers for producing superior returns, it is rare that investors will receive a superior return after subtracting the 20% performance fee plus other expenses. Indeed, many hedge funds and some managed futures do worse than index funds.

The details of the managed futures program are presented in a disclosure document, similar to a mutual fund prospectus, which includes the fees charged and the minimum investment required. In addition to the 2% maintenance fee and 20% performance fee, a front-end sales load, often 5%, may also be charged. Some funds will charge a lower maintenance fee with a higher initial investment.

Measuring Managed Futures Performance

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There are various methods of measuring the performance of managed futures, some of which have already been discussed:

The annualized rate of return is the annual rate of return minus all fees and trading costs and is published in the disclosure document, though it may not be up-to-date. The alpha coefficient is a return that exceeds a certain amount of risk as determined by the capital asset pricing model.

CTA Indexes

There are a number of CTA indexes that allow a quick comparison of managed futures funds. However, these different indexes differ in their construction and methodology, minimum asset requirements, number of CTA programs that are tracked, and financial audit requirements.

A major drawback to these indexes is that there is a survivorship bias and self-reporting bias. Generally, if a managed futures fund does not survive, then it is removed from the index, yielding a higher index that may not be representative of how well managed futures actually do as a group. There is also a self-reporting bias, in that indexes generally depend on reports issued by the fund managers, so if a fund is not doing well, the managers are less apt to report it. Some of the more common indexes include:

A good list of managed futures: List of Managed Futures Discretionary Funds Worldwide - Bloomberg

Alternative Investments

Most investors will not be able to invest in managed futures because they will not be able to meet the minimum wealth requirements and the high initial investment. However, most investors can profit from commodities through exchange-traded funds and exchange-traded notes based on a commodity index. Considering that they charge much lower fees, they will often earn a higher annualized rate of return than managed futures.