In the popular 1983 film "Trading Places," Eddie Murphy and Dan Aykroyd play two men duped by successful commodities brokers, the Duke brothers. In the penultimate scene, the characters played by Murphy and Aykroyd conspire to turn the tables on the Dukes by passing to them a falsified early crop report showing an orange grove freeze. The Dukes bid up orange concentrate futures, while Murphy and Aykroyd take the other side of the trade. When the real crop report comes out showing normal weather, prices plummet. The Dukes lose their fortune; our heroes have their revenge and make a fortune.
Futures trading remains a specialized field due in part to the very leverage that brought down the fictional Duke Brothers. Futures are a contract to buy or sell something in the future at a certain price. That something can be a commodity like coffee or oil, or it can be a financial obligation like the S&P 500 Index or Treasury bonds. Real-world buyers and sellers (for instance, farmers and cereal companies) use futures to lock in prices ahead of delivery or need. Speculators and traders make directional bets for profit. Margin requirements are low for futures, but traders need to be well capitalized with cash collateral since, if the trade moves in the wrong direction, margin calls can quickly become multiples of the initial cash investment. Broker-dealers require investors to qualify to trade futures.
For these reasons, most financial advisors do not recommend direct investment in futures to their clients. However, commodities can offer asset diversification for classic stock and bond portfolios and trading in futures allows investors to jump on long-term trends outside the stock market. With this in mind, advisors have been turning to "managed futures" funds as a less risky way to capture the benefits of commodity futures for their clients.
THE TREND-FOLLOWING MODEL
Available as limited partnerships, mutual funds and, more recently, exchange traded funds, managed futures funds generally adhere to the "trend-following" model to make money both long and short in commodity and financial futures. Using this strategy, experts aided by computers seek opportunities in any futures market that looks as if it is making an intermediate or long-term move up or downan approach that's almost impossible for individual investors to duplicate.
Adding managed futures to a portfolio doesn't necessarily improve performance, but it may add resilience. Morningstar reports that the five-year average annual return of managed futures mutual funds was a negative 4.88% at the start of 2014. Ryan Issakainen, SVP and exchange-traded fund strategist at ETF sponsor First Trust Advisors, compared a 60/40 stock and bond portfolio with a hypothetical 45/40/15 stock, bond and managed futures mix for the period 1988 to 2012 (see chart). His figures, using commonly quoted indexes, showed a slightly lower annual return with the managed futures added, but less volatility.
AQR Capital Management in Greenwich, Conn., back-tested managed futures strategies for the last 100 years. Its work demonstrates that trend-following futures strategies did well when stock and bond portfolios performed their worst. AQR's hypothetical look at the 10 worst performance periods for a 60/40 stock and bond portfolio since 1914 showed gains for a hypothetical trend-following managed futures strategy during those same periods, except for the abrupt October 1987 stock and bond market crash.
The CME Group, the world's largest futures exchange, cites 30-year returns from managed futures besting the S&P 500, as reported by independent data collection firm BarclayHedge. But 30-year returns are misleading. Since only small cash balances are required to control large futures positions, funds invest most of their assets in short-term Treasuries held as collateral. In the 1980's and early 1990's, the return on this cash added substantially to performance, but with short-term rates near zero, this source of return is not currently available to investors.
Mutual funds generally offer investors more transparency and lower fees than limited partnerships, but some mutual funds hold other funds that charge another layer of fees that lower their returns.
Of all the mutual funds in this category, Morningstar has a positive rating for only one fund, AQMIX, run by AQR. One of the largest U.S. managers of alternative assets, with more than $90 billion under management, AQR has built its reputation on highly disciplined, algorithm-driven momentum trading. Its managed futures mutual fund has garnered almost $6 billion in assets since its launch in 2010. Morningstar reports a three-year annual return of 1.47% for AQMIX compared with the investment research firm's Managed Futures three-year category average of negative 5.74%.
Morningstar fund analyst Josh Charney likes AQR because it manages assets directly and has a strong track record in momentum investing. But Charney, while nominating AQMIX as one of his top three 2013 picks for alternative fund managers, also notes that these funds aren't for the "average Joe." AQMIX, for example, requires a $5 million minimum investment and is available to investors only through their financial advisor.
THE RIGHT MANAGER
Just as in any other investment category, choosing the right manager is critical. Even though the vast majority of managed futures funds employ trend-following strategies, performance varies depending on the computer algorithms and the categories each fund emphasizes. Some funds are weighted to commodities, while others concentrate in financial futures. Diversified futures funds invest across the major asset classes, from agricultural commodities, energy and metals to interest rate, stock market and currency futures. Funds also vary according to whether they follow shorter- or longer-term trading trends.
That makes it difficult to compare the holdings of different managed futures funds. Some funds, such as Nataxis ASG Managed Futures Strategy A (AMFAX), offer detailed quarterly holdings on their website. The fund, which has $830 million in assets, was ranked third by Morningstar for 2013 performance, having gained 12.5%.
But not all managed futures funds invest in futures at all times. The 361 Managed Futures Strategy Funds (AMFZX or AMFQX) prospectus indicates that "there will be significant periods during which the fund will not hold any long or short futures positions." The 361 Funds, ranked second by Morningstar for one-year performance, can hold ETF's as a substitute for futures positions. The A Fund's minimum investment is $2,500 and has a 2.24% annual expense fee.
All of which begs the question: Is now the time to be looking at these funds?
"When markets are going up, people get disappointed in managed futures strategies," says Luciano Siracusano, chief investment strategist at WisdomTree, an ETF sponsor. "When markets go down, that's when you need the potential to generate a positive return."
Managed futures ETFs, like WisdomTree Managed Futures Strategy (WDTI) with a $150 million in assets, are three years old and didn't exist in 2008, the last time managed futures had a good year. Siracusano says managed futures generate profits by exploiting market trends during times of crisis and suggests that investors concerned about the effect of a prolonged rise in interest rates on their bond holdings might benefit from a managed futures fund that shorts 10- and 30-year U.S. Treasuries.
A new ETF from First Trust, the First Trust Morningstar Managed Futures Strategy Fund (FMF), follows the Morningstar Diversified Futures Index. FMF launched in August of 2013 and has just over $5 million in assets. The ETF structure "democratizes this whole asset class," asserts First Trust's strategist Issakainen. Issakainen points out that like most ETF's, FMF is "rules-based and transparent." But given the complexity of the futures market and the fund's strategy, First Trust prefers to market itself to financial advisors rather than to individual investors.
Managed futures are esoteric, but for the past five years products have been appearing that offer more access, transparency and fee options for advisors and their clients. Performance has been more elusive, but that could be next on the list.
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