DUBAI, 10 January 2005 — It has been a difficult year for managed futures, as turbulent market conditions have undermined performance of strategies that benefit from a clear market direction, but the strategy continues to offer clear benefits to investors.
After a torrid spell of underperformance over the preceding six months, managed futures strategies returned to profit in September, as the CSFB/Tremont managed futures index rose 2 percent on the month and the S&P managed futures index rose 3.9 percent.
Also known as Commodity Trading Advisors (CTAs), managed futures are a pool of futures or forwards contracts managed by professional money managers. They are similar to a mutual fund, in that individual or institutional investors have a share, only the investments in this case are mainly futures contracts. Unlike basic securities such as stocks and bonds which are held within mutual funds, a future is a derivative instrument, one whose value depends on the value of an underlying instrument.
Background
The development of managed futures has mirrored the traditional hedge fund industry to a great degree. Standardized commodity contracts were first traded in 1865 in Chicago and the first futures fund was launched in 1949. A new age and a boom in futures began in 1972 with the introduction of financial contracts. Academic studies, technical market analyses, chart models and commodity pool operators triggered an increase in demand among private investors in particular.
Today, managed futures provide direct exposure to international financial and non-financial asset sectors. Trading advisors have the ability to trade in over 100 different markets worldwide. These markets include interest rates, stock indexes, currencies, precious metals, energies and agricultural products. Managed futures tend to have a low to negative correlation with traditional investments. In contrast to traditional hedge funds, the futures markets offer greater regulation, transparency and liquidity.
Features of Managed Futures
Futures markets provide unique opportunities to generate profits in many market environments because it is just as easy to sell short contracts as it is to buy them. In traditional markets it is often difficult, or even impossible, to sell assets not already owned, necessitating a more traditional buy and hold approach that depends on rising markets to generate profits.
The purchase of a futures contract does not involve payment of the entire value of the transaction. Only a fraction of the value, known as a margin payment, is deposited. Margin is a good faith deposit that indicates the trader’s willingness and ability to fulfil all financial obligations that may arise from trading futures. One effect of the marginal deposit requirement is that a proportion of remaining funds can be allocated to other markets.
Types of Managed Futures
Typically managed futures use a systematic approach to investment, although some use discretionary trading methods. Discretionary trading relies on the judgment of the manager and their expertise within a particular market to make investment decisions.
The more prevalent systematic approach relies on the application of technical analysis to evaluate the movements of markets, such as changes in price and volume.
The trading is based on the systematic application of quantitative models that use moving averages, break-outs of price ranges, or other technical rules to generate buy and sell signals for a set of markets. This tends to be automated, particularly with the emergence of electronic trading systems
In general, most managed futures managers tend to view price trends as a function of supply and demand for a particular commodity or financial instrument. As the interaction of these elements form continuous market movements they try to capture profits. In short, managed futures managers attempt to identify the beginning of a trend, take a position and exit it as it ends.
Protective stops can be adjusted daily and more positions might be built up if the trends are stable, or quickly reduced during adverse or highly volatile periods. Also the amount of risk on groups of related markets and on the total portfolio can be controlled. Further risk reduction is achieved by means of market diversification.
Managed futures investments can benefit from the application of a range of trading systems or investment strategies, such as systematic, arbitrage, and spread trading strategies. Investment approaches can also be differentiated by trading frequency and duration.
Managed Futures Within a Portfolio
The developments over the last twenty years have made managed futures a specialized but increasingly significant asset class within the investment industry. Importantly, high quality managed futures funds are capable of achieving attractive returns with risks comparable to those of a traditional stock investment. Furthermore, managed futures can enhance the diversification of a portfolio and therefore play an important role in improving the risk and reward characteristics of that portfolio.
Because managed futures provide an opportunity to profit from directional moves in the underlying assets and cover a wide range of commodity and financial contracts, it is possible to achieve a low level of correlation with traditional forms of investment. This means that the performance of managed futures need not be tied directly to the price movements of the underlying assets being traded.
Optimal diversification can be achieved when there is no, or only low, correlation between the constituent elements of a traditional investment portfolio. The more independent of market performance the returns of a futures fund are, the more the fund is suited for inclusion in a traditional portfolio.
Exposure across the full range of market sectors helps to smooth out peaks and troughs in performance due to the tendency of markets in each sector to display broadly different behavioral characteristics. For example, the factors affecting world commodity markets frequently differ from those influencing traditional asset classes.
Futures funds themselves can be structured with a high level of diversification. The significant growth in the number and diversity of futures markets in recent years has facilitated a broadly diversified approach across geographical regions and asset classes, avoiding over-concentration in any market or market sector.
Conclusion
Managed futures offer a transparent and liquid investment that is inherently diversified across a broad range of futures markets and time horizons, making them a valuable tool for portfolio diversification.
Furthermore, managed futures have delivered strong returns over time. That makes them an ideal tool for institutional and retail investors looking to pep up returns and manage risk, and should continue to drive demand for managed futures for as long as they continue to meet investors’ risk and return requirements.
(Antoine Massad is head of Middle East and Asia at Man Investments. He is based in Dubai.)
