These are investments in global markets including futures, options and forwards on traditional commodities, financial instruments and currencies. Managed futures managers—also known as commodity trading advisors (CTAs)—are active investors who trade in a very broad range of commodities and financial markets, from agricultural commodities such as corn and wheat to energy commodities, such as oil and natural gas to currencies and to financial indices. These CTAs use futures, options and other derivatives as the means of investment. They trade in highly liquid securities and can easily take long and short positions.
Managed futures’ ability to access global markets, take either long or short positions efficiently and easily plus its historically low correlations to traditional and other alternative assets make it a potentially attractive strategy for investors seeking to provide positive returns, manage risk and add portfolio diversification. Because, as a strategy, managed futures has only a limited correlation to other asset classes and financial factors, returns can be largely expressed as excess return. Managed futures’ correlations to the equity markets are negative when equity returns are negative, and positive when equity returns are positive. They may be a very attractive way to minimize downside risk in the portfolio as a form of portfolio insurance. In general, CTA strategy involves identifying trends in markets and employing trading strategies that allow these managers to capture value from movements or the continuation of movements in prices.
Managed futures managers fall into two broad categories. A great majority of them are systematic trend followers who primarily use price as the input to their analysis. The other major group of managers attempts to predict trends based on fundamentals. These traders, who form a much smaller part of the managed futures universe, attempt to bring to apply macroeconomic factors, supply and demand characteristics and other information as a means of identifying price trends and relative valuations. For trend followers, the futures markets possess several attractive features. The high degree of liquidity in most futures markets makes entering and exiting them relatively easy, especially thanks to the growth in the variety of futures that have become available. Transaction costs are generally very low. Finally, the standardized nature of contracts available on the futures markets means that the cost impact of liquidity in the market is generally lower than block trades on the equity markets.
Because managed futures managers have access to many types of securities, they can achieve either long or short exposure to many of the global markets quickly and efficiently. As is the case with hedge funds, CTAs’ ability to short securities that they believe will fall over time is an advantage over traditional long-only managers because they can sell short in markets that they expect to fall and profit by closing out at much lower prices.
Managed futures investments tend to generate their strongest returns when stocks perform most poorly. In fact, there have been six identifiable down markets for stocks during the past fifteen years as measured by the performance of the S&P 500. In every one of those down markets, managed futures benchmarks showed that average returns were strongly positive. In other words, managed futures seem to have less correlation to conventional assets.
An important reason for the consistency of managed futures portfolios is the existence of identifiable market trends. The commodity trading advisors (CTAs) who direct managed futures portfolios are essentially trend followers. In normal market times, they take small positions across currency, fixed income, equity, and commodity markets. Then, when large directional movements begin to manifest themselves, CTAs can increase their exposure to those trends quickly. When strong trends in two or three sectors kick in concurrently, CTAs can post good performance.
The Commodity Trading Advisor (CTA) is a registered professional whose activities are closely monitored by government authorities as well as the industry’s self-regulatory organizations. A registered CTA can collect clients’ commodity funds together and to trade them as a pool. CTAs are audited periodically by outside regulators and held to strict standards about performance reporting and other disclosure. In other aspects, however, a CTA is just like any other investment manager. CTAs are given the authority to buy and sell financial instruments — mostly futures contracts — at their discretion, on any of the world’s regulated public futures markets. Because each CTA typically has proprietary methods and systems, each is in effect unique in the ways that he or she trades.
There are multiple global futures markets that are liquid enough to support the activities of CTAs. These are the markets with standardized listing requirements for the actual contracts, transparent pricing of trades, and formal trading mechanisms for matching anonymous buyers and sellers. Among them, they offer trading opportunities in virtually every type of futures contract — including financial commodities, tangible commodities, equities, and bonds.
Over the long term, the volatility of managed futures has been very much in line with the volatility of other asset classes. However, as with other investment strategies, there is clear variation in individual performance among CTAs. To minimize the impact of this variability on overall portfolio performance, portfolios of CTAs can diversify that risk. These blended portfolios of investment approach can be tailored to the investor’s desired level of volatility.
Our approach highlights many important implications for investors and their advisors:
Managed futures have many potentially attractive features in the context of a broader portfolio. First, they have the possibility to enhance returns due to their ability to access markets that are not traditionally available and can easily take both long and short positions. Second, they have the ability given this same logic to reduce the overall level of portfolio volatility given their low levels of correlation to other asset classes.
Managed futures provide a mechanism for reducing the downside risk of the portfolio because of the similarity of this asset class to holding a long straddle (equivalent to holding both long put and long call options). Because, historically, managed futures have provided attractive returns when adjusting for both volatility and downside risk, we think an allocation to managed futures has the potential to add value to a portfolio.