[Editor's Note: Occasionally I get a guest post that is well-written and otherwise interesting, but find myself in disagreement with the recommendations in the post, or perhaps just feeling like the post lacks an important point of view. I generally offer the submitter the opportunity to do it as a “Pro/Con” post. They generally write the Pro side and I write the Con side. This is the case with today's post on Managed Futures, written by Jeannette Showalter, CFA. I'm at a bit of a disadvantage in this argument, in that Jeannette almost surely knows more about managed futures than I do. However, I do plan to make full use of my sole advantage- whether or not you invest in managed futures makes no difference to my financial well-being. Jeannette and I have no financial relationship.]
Pro -Managed Futures Help Manage Portfolio Risk and Simplify Portfolio Composition
2008 offered many a surprise to high net worth investors. Post-crash, they realized that their supposedly diversified portfolio failed to yield any benefits of risk reduction; that investments promoted as liquid were illiquid in the crash; and that seemingly simple portfolios were actually complex. A solution to these various portfolio problems is found by inclusion of managed futures in a portfolio.
Managed futures overview
But what is it exactly? The money managers (who are registered by the National Futures Association) who manage portfolios invested in global futures markets are called Commodities Trading Advisers (“CTAs”).
Some CTAs offer broadly diversified managed futures portfolios (e.g. commodities, currencies, and financial indices etc.); others are narrow in focus (e.g. solely agricultural or solely currencies.) As futures contracts are a leveraged asset, tight money management rules are often employed. The majority of CTA portfolios are systematic in that they rely on computerized rule sets; they are further disciplined to exclude human interpretation of the rules.
The benefits of managed futures: attempt at risk reduction, simplicity, liquidity, and transparency. Portfolio benefits have been empirically proven and were observed in the last equity crisis.
Risk reduction: In 1983, Harvard Professor, Dr. John Lintner, showed that the risk-adjusted return of a portfolio of stocks and bonds exhibited substantially less variance at every level of expected returned when combined with managed futures. This empirical evidence went largely unheeded until 2008 when research turned into reality. The CME updated the 1983 research in 2012 and reached similar findings about risk reduction (“Lintner Revisited: A Quantitative Analysis of Managed Futures”) In normal equity periods, managed futures is non-correlated to equities … and in periods of crisis, as per the chart below, managed futures moves to a nearly perfect negative correlation. That is what we consider to be true diversification: to have an asset class deliver gains while equities deliver losses. (Past performance is not necessarily indicative of future results.)
How can this be? Nassem Taleb’s characterizes asset classes by their ability to handle market volatility; equity and bonds are “fragile” asset classes and managed futures is an “anti-fragile” asset in that it thrives on volatility. How so? Most systematic portfolios are designed to find and take positions in strong trends (up or down); typically strong trends emerge in crises.
Liquidity: Global futures contracts, the underlying assets, are highly liquid and remained liquid during the 2008 crisis.
Transparency: Clients are provided with detailed daily reports for every account.
The costs of managed futures
A typical CTA receives a 2% management fee and, if/when the CTA rises above the previous high water mark, a 20% incentive fee is earned. The commodities broker who represents the client receives commissions on trades.
Standard high net worth investment process
Medical professionals often find their RIA by referral and they skip the step of interviewing several advisers. Typically, this single adviser is an RIA affiliated with a local, large investment firm which touts an exclusive/almost exclusive access to “top tier, institutional grade” portfolio managers whose funds are not available to the general public.
The RIA then identifies client “risk tolerance” and allocates a portfolio within the confines of their firm’s risk models. Often low risk skews the portfolio into greater bond allocations and higher risk into greater equity allocations (although we may soon approach a period when government bonds might not be a safety net… and when all traditional assets are higher risk.)
Bond/equity allocations can be complex and might not reduce risk
Most portfolios are allocated to seven (+/-) of these select managers. Simple…but as each manager will generally own 100 plus names, the client, resultantly, will own hundreds of small/odd lot positions. e.g. 35 shares of X, and 155 shares of Y and $5000 of Z bonds! Clients wrongly assume that such extensive holdings deliver diversification. Unfortunately, diversity across managers does not necessarily reduce risk in an equity crash; if all the assets in your “diversified” portfolio go downward in unison in an equity crash, then there is just diversity in your losses!
Managed futures offers what we consider to be true diversification
What truly diversifies a portfolio in our opinion is the inclusion of an asset that moves to a nearly perfectly negative correlation with equities in a crash… namely, managed futures. Per the chart below, in 2008, managed futures outperformed the S&P by over 50%.
Expect your RIA to change portfolio allocations AFTER you are in the next crisis
Case in point: I asked a client’s RIA how he handled risk in the prior 2008 crisis. Answer (paraphrased): In the middle of the crisis, the firm’s allocation committee decided that clients should buy junk bonds as they were deeply oversold; that change in allocation made a lot of money that buffered losses. Well…my client then knew that 2008’s portfolio allocations did not work and it took a major portfolio change to recoup losses. Talk about risk!!!!!
Commodity broker investment professionals have a unique perspective.
Commodity brokers are outsiders looking inward at their client’s traditional asset portfolios. Though not an RIA, many commodity brokers bring relevant expertise to the portfolio discussion. A commodities broker’s perspective should not be discounted.
Commodity brokers are not looking “to take an account away” from any RIA as 80-90% of a client’s money will remain managed by an RIA and 10-20% of the portfolio will be allocated to managed futures. . Some RIAs are on the leading edge of risk reduction and have created a blended portfolio for clients that includes managed futures. Most RIAs do not have the expertise to address optimal portfolio risk reduction because they simply do not have expertise in managed futures.
It’s not all roses for managed futures.
Per the chart of historical returns, from 1980 – 2008, managed futures experienced three losing years, since 2009 the managed futures index has experienced four such years of losses. Why? It is partly due to global economies being manipulated via governmental intervention which has translated into slow and steady growth ( good for “fragile assets”) and low volatility in the commodity markets ( bad for “anti fragile” assets.) (In contrast, since mid-2014, volatility has returned to markets.)
Calculate your portfolio’s performance hypothetically for 2008 and answer a core question: how would your current portfolio have performed then? Review your current holdings. Hundreds of positions might reduce alpha, adds to complexity, and might not reduce risk. Most importantly, supplement your investment advice to include a commodities professional as risk management through managed futures is their area of expertise.
Footnotes and Disclaimers:
The Investment Company Act of 1940 allowed for up to 25% managed futures to comprise a fund offered by an RIA. Outside of such a fund, RIAs are able to structure a relationship with a CTA so that the CTA product is offered to their clients and is part of their asset fee base. An investment in futures contracts is speculative, involves a high degree of risk and is suitable only for persons who can assume the risk of loss in excess of their margin deposits. You should carefully consider whether futures trading is appropriate for you in light of your investment experience, trading objectives, financial resources, and other relevant circumstances. The addition of managed futures to a portfolio does not mean that a portfolio will automatically be profitable, that it will not experience substantial losses or volatility and that the results of studies conducted in the past may not be indicative of current time periods or of the performance of any individual CTA. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. This article contains information that has been prepared by third-parties that Postrock Brokerage LLC believes to be reliable. At this time we have not however independently verified any of the information contained in the presentations we have included in this article. Please review and utilize this material at your own risk noting that all Futures and Options trading involves the risk of loss. Also that the use of managed futures in an investment portfolio may not mean that you as an investor will be profitable, not experience losses, and/or be able to materially reduce overall return volatility. Worldwide Futures Systems is a registered branch office and dba of Postrock Brokerage, LLC [NFA ID: 0413763] Full disclaimer page here.
The original post submitted to me looked quite a bit differently from the one you just read. It did not include any information about the cost nor any information about years when managed futures did not perform well. Even worse, the original post included a nearly 600 word disclaimer (3 times the size of the one above.) I understand that financial firms have to deal with many compliance issues, but any time the disclaimer gets to be that large, you've got to pause for a second and say to yourself, “Now why would the government require such a massive disclaimer?” The answer is because lots of people have lost a lot of money investing in this investment. That doesn't necessarily make something good or bad, but it sure should make you wary about investing in it. Let's look at a few of the specifics in the disclaimer:
- A registered investment adviser can not offer a client a fund where more than 25% of his assets are invested in managed futures. Hmmm…why would the government put this regulation on a “safe asset class” like managed futures but not on a risky one like stocks. Very curious.
- The investment is speculative. I prefer to invest rather than speculate.
- This investment is high risk. What? I thought it decreased risk. I don't need more risk in my portfolio.
- You may lose more than your entire investment. Even rookie investors know that investing on margin isn't a hot idea, yet this asset class seems to require it.
- Past performance may not be indicative of future performance. Pretty standard, but always worth remembering when the main selling point is “look how great it did in 2008.”
- Managed futures are derivatives, like options. Derivatives have a function for insurance purposes, but in general are a drain on returns. The expected after-expense return for options is negative. Insurance isn't free. To make matters worse, the guy on the other end of your trade almost surely knows more than you do.
The Effect of 2 and 20
Jeannette mentions in her post that typical costs for your managed futures investment are “2 and 20.” But what does that mean, exactly? This is a relatively standard amount charged by hedge fund managers. It means 2% of the assets being managed each year, and if the asset makes money, 20% of the gains go to the managers. Would you invest in a mutual fund or with an advisor that charged EITHER of those fees, much less BOTH of them? I wouldn't. I don't even pay that much to have syndicated real estate managed, and as most investors know, investing in real estate is more like a second job than anything.
Add it all up. Let's look at two scenarios. The first where the asset gains 12% before fees, and the other where the asset gains 4% before fees. At “2 and 20” the investor in the 12% scenario gets 8% and the manager gets 4%, or 1/3 of the profits. The investor in the 4% scenario gets 1.2% and the manager gets 2.8%, or 70% of the profits. To make matters worse, since the manager gets 20% of gains but does not share in the losses, he is incentivized to take a lot of risk in the hope of generating an outsized gain. All of the benefit, none of the risk. Sounds like a great job, but not a great investment! Even if it was just 2%, consider what that means.
This chart, from a paper by Neufeld in the Journal of Financial Planning in 2014, demonstrates “the tyranny of compounding costs.” The Y axis is the percent share of market gains that the manager gets from various fee levels. The green line is an AUM fee of 0.5%, the pink line is 1%, and the black line is 2.5%. The moral of the story is that if you're paying 2% plus over 30 years, your manager will take half or more of your gains. But that data is from investing in stocks. Is there any data specific to the managed future funds Jeannette is advocating? There sure is. According to data filed with the U.S. Securities and Exchange Commission and compiled by Bloomberg, 89% of the $11.51 billion of gains in 63 managed-futures funds went to fees, commissions and expenses during the decade from Jan. 1, 2003, to Dec. 31, 2012. And you thought 50-60% over 30 years was high. How about 89% over 10 years?
A Cheaper Way to Invest In Managed Futures
Are there cheaper ways to invest in managed futures? Sure, there are some ETFs out there. In fact, there are currently three-WDTI, FMF, and FUTS, with ERs ranging from 0.75-0.95% per year. Those are still more expensive than the vast majority of my portfolio, and 40 times as expensive as some of my holdings. But they're 1/3 the price of an actively managed fund at 2 and 20. Not to mention only one of the three has been around even three years. Not exactly a proven commodity.
What Is The Barclay CTA Index Anyway?
When looking at the charts in the Pro section, you, like me, might be wondering what the Barclay CTA index really is. Well, if you go to their website, this is what you find:
The Barclay CTA Index is a leading industry benchmark of representative performance of commodity trading advisors. There are currently 535 programs included in the calculation of the Barclay CTA Index for 2015. The Index is equally weighted and rebalanced at the beginning of each year.
To qualify for inclusion in the CTA Index, an advisor must have four years of prior performance history. Additional programs introduced by qualified advisors are not added to the Index until after their second year. These restrictions, which offset the high turnover rates of trading advisors as well as their artificially high short-term performance records, ensure the accuracy and reliability of the Barclay CTA Index.
Let me translate. It's the average of the returns of all the managed futures funds they felt like putting into the index. That means there is some serious survivorship bias going on. If you look at the fourth table above, you'll notice all the really good performance seemed to be in the 1980s. Well, there weren't nearly as many of these funds in the index in the 1980s. Rather than the 535 in there now, there were as few as 15. Perhaps, like with other expensive hedge funds, the talent has been severely diluted along with the returns. It is also not clear to me if that performance is pre or post fees, but it would not surprise me to learn the index does not include fees.
Even ignoring the survival bias, the return for this index over the last ten years annualizes out to just 3.4% per year. To put that in perspective, consider the 10 year annualized returns for other asset classes:
- US Stocks: 8.36%
- International Stocks: 5.06%
- ST Bonds: 3.42%
- LT Bonds: 7.45%
- TIPS: 4.38%
- REITs: 9.51%
So what did managed futures beat in this ten year period that includes the worst stock market crash since the Great Depression? Well, they beat cash in its worst decade in recorded history (1.6%.) Seems like expensive insurance against 2008 happening again. Besides, if your goal is really to insure against another 2008, there is an asset class that did far better than the 14.1% return that managed futures reportedly had. The Vanguard Long Term Treasury Fund had a 24% return that year. An even better strategy is to simply ride out the 5 or 6 bear markets you know your portfolio will pass through during your investment horizon by using a “know-nothing” fixed asset allocation. My 75/25 portfolio lost 33% in 2008. But you know what? The annualized return from 2004 to present is still over 9%, and my portfolio balance has increased every year from 2004 to 2015, including 2008.
The Straw Man
My opponent compares the return of managed futures to the return obtained by a typical RIA who thinks diversification is putting your money into the hands of multiple active managers who all then buy the same stocks in different proportions and change their asset allocations during bear markets. That's a bit of straw man argument. I don't disagree with Jeannette; that is a stupid way to invest. But the solution to that problem isn't to add even more manager risk by adding an actively managed futures fund charging 2 and 20. It's to get rid of the managers, the overlap, and the expense by investing in a diversified portfolio of low-cost, passively managed funds.
Jeannette also suggests that investing in managed futures is simple and transparent. We apparently have different definitions of simple.
Now, all that said, if someone wants to add a small slice of managed futures to their portfolio, say 5 or 10%, and can keep their expenses for doing so to less than 1%, then I say more power to them. There is certainly a compelling diversification story there. But a 5-10% slice of managed futures would not have prevented an overall portfolio loss in 2008. If you really want an “anti-fragile” investment, you need something that would have gone up 100% or more in 2008. Managed futures is not that asset.
PRO Rebuttal – Jeannette Showalter, CFA
Wow! Not sure how to respond to a shot in the head…. but I will begin with relevant facts and end by addressing your peripheral concerns.
Fact #1: Your extensive analysis of fees relative to performance is not relevant to my post about CTA product as yours is based on a 2013 Bloomberg column which took a little bit of understanding and very wrongly applied it to all asset classes with “managed futures” in their name. The column’s SEC statistics applied to products offered by broker/dealers (i.e. managed futures fund or managed futures mutual funds…which are expensive fee-laden products) …but NOT to CTAs.
Fact #2: The ROR for equities (before fees and commissions) has been approximately equal to the ROR for managed futures (net of fees and commissions) with much less risk taken by managed futures. Over the period 1980 through 2014:
- Performance comparison: The return for the S&P 500 has been 339%. The ROR for managed futures has been 388%. The S&P is a price index for 500 large companies and therefore is NOT net of fees, commissions, loads, etc. The Barclay’s CTA Index is an index of reporting CTAs, NET of all fees and commissions. So any performance comparison is skewed to favor the S&P and yet the net of fees CTA index is comparable.
- Risk comparison:
-The largest drawdown for S&P is 51%; the largest drawdown for managed futures is 16%
-Volatility (as measured by yearly standard deviation) for the S&P is 16.2%, for NASDAQ is 24.1%; volatility for managed futures is 14.7%.
Fact #3: Performance is best measured from equity peak to peak, not arbitrary time periods. How so? Normally uncorrelated with equities, managed futures become nearly perfectly negatively correlated in a crash.
Fact #4: We deal with rational investors who want the highest level of return for the lowest level of risk. Just take a look at the below charts and you can see the portfolio risk reduction by inclusion of CTAs (net of fees).
Fact #5: Futures ETFs are not a solution. They traded like stocks in 2008. The equity market is a market of buyers selling to other buyers; the futures market is sellers and buyers mutually creating a contract; in a crash, there are natural buyers.
- The standard medical disclosure is expansive language required by their business; catastrophic is not their norm … but is possible and needs disclosure. So, too, for us.
- As to “high risk” and “speculative”, such absolutely characterizes individual futures contracts…managed by inexperienced investors…using minimal margin …using a buy/hold strategy (e.g. the typical equity strategy). CTAs are professionally managed, actively managed (minimize losses and let profits run), and substantively capitalized. Investors should seek a broker with an unblemished record, other money management credentials and breadth of investment experience.
We work directly with clients and with independent RIAs and family offices who seek efficiency in risk reduction.
If any readers would like more information, please do not hesitate to contact me directly.
*Statistics from Yahoo finance
A shot to the head? You clearly haven't spent much time in the comments sections of the posts on this site about whole life insurance if you thought that was bad! At any rate, a few last comments:
Fact # 1 Fees are always relevant to performance.
Every dollar paid in fees is a dollar that is not compounding toward the future. You state the Bloomberg column doesn't apply to your specific model of managed futures but only to “high-fee” models. Yet you also state that 2 and 20 (plus commissions) is standard for your model. 2 and 20 is high in my book. I can't imagine that doesn't add up over the years to a significant portion of the gains of the strategy.
Fact # 2 S&P 500 Returns without dividends is a straw man.
Ms. Showalter states the S&P 500 return from 1980 to 2014 was 339% (and that CTA returns were comparable or even better.) I don't have a great source of data on CTA returns and am somewhat skeptical about the quality of your sources. However, I have an excellent source of data on S&P 500 returns from 1980 to 2014. It shows an average annual return of 13.3% per year, an average annualized return of 11.87% per year, and over that time period, a $1 investment in stocks would have become $50.70. I'm no mathematician, but that seems an awful lot more than 339%. More like 4970%. Kind of dwarfs the claimed 388% return on CTAs. Yes, that is before fees. But when there are investments out there like the Vanguard 500 Index Fund available for under 5 basis points a year, that doesn't seem like much of a crime.
Fact # 3 Performance is best measured over my investment horizon.
While it may be convenient to measure equity peak to equity peak, the only performance that matters to me is the performance from the time I invest the money until the time I withdraw the money. So that's the performance I measure. I suppose it is interesting to see what the performance of CTAs are from equity peak to equity peak, but it does make you wonder how bad equities can be if they are the benchmark against which other investments are measured! At any rate, I agree that what really matters is overall portfolio investment performance. If CTAs can increase performance, or maintain performance while lowering risk, they seem a wonderful asset class to include in a portfolio. I'm just skeptical they can do that if you're paying 2 and 20 for them.
Fact # 4 That chart shows that adding CTAs lowers returns.
Ms. Showalter's chart shows yet another “index” (the BTOP 50) that I'm sure readers are not familiar with. Again it's a list of the average returns of 50 traders who have been in business at least 2 years. The list itself has been around less than 5 years. Not quite the same thing as the S&P 500. At any rate, as near as I can tell, adding any amount of it to a 60/40 portfolio lowers returns. If my goal were simply to lower volatility and I were willing to accept lower returns for that, then I'd just add some bonds or heck, whole life insurance. Having a standard deviation 2 or 3 percentage points lower doesn't do much for me. I can't eat standard deviation. But lower returns take money out of my pocket. There's also kind of a disconnect with the chart. It shows 9% annualized returns for CTAs. Yet she states the ROR for managed futures from 1980 to 2014 is 388%, or about 4.1% per year. One of the things I really don't like about this asset class is that getting solid returns in it seems highly dependent on successfully picking a highly skilled manager. The track record for investors doing that with mutual funds is so bad that I don't have much faith in my ability to do so. I'd rather avoid manager risk whenever possible.
Fact # 5 Futures ETFs don't work either?
My opponent says futures ETFs don't work. That may or may not be true; I have no idea. They certainly haven't around very long. But there goes any hope we had for getting into this asset class for less than 1% a year.
Well dear reader, it's time for you to weigh in. What do you think? Do you invest in commodities? Do you invest in managed futures? Why or why not? If so, how do you do it? How much are you paying in fees? Do you feel like the diversification benefit is worth the costs? Comment below!