Demand for managed futures is soaring as investors, stung by losses from equities during the bear market and attracted by historically high returns from the strategy, stream into alternative investments to pep up their portfolios and diversify risk.
Total assets in managed futures have more than doubled since the end of 2002, rising from US$ 50.1 billion to US$ 104.6 billion on 31 March 2004, according to data from Barclay Trading Group. In the first quarter of this year alone, assets in managed futures rose by US$ 18.1 billion, or 20.9%, with a lot of that new capital coming from traditionally conservative institutions.
The idea of using managed futures, or even alternative investments, to improve the risk and return characteristics of an investment portfolio would have found little support a decade ago. Today, however, investors have come to recognise that a disciplined approach to portfolio construction can enable statistically predictable risk-adjusted returns to be generated from investment in futures.
Overview
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.
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 correlation with traditional investments. In contrast to traditional hedge funds, the futures markets offer greater regulation, transparency and liquidity.
They also have traditionally offered high returns, with a commensurate degree of risk, as the tables below demonstrate.
| Managed Futures Snapshot (Jan 1987 - Dec 2003) | |
|---|---|
| Compound Annual Return | 13.58% |
| Sharpe Ratio | 0.44 |
| Worst Drawdown | 15.66% |
| Correlation vs S&P 500 | 0.00 |
| Correlation vs US Bonds | 0.05 |
| Correlation vs World Bonds | 0.16 |
| Source: Barclay Capital Group |
| The performance of managed futures: 1980 to 2004 | |||||
|---|---|---|---|---|---|
| 1980 | 63.69% | 1990 | 21.02% | 2000 | 7.86% |
| 1981 | 23.90% | 1991 | 3.73% | 2001 | 0.84% |
| 1982 | 16.68% | 1992 | -0.91% | 2002 | 12.36% |
| 1983 | 23.75% | 1993 | 10.37% | 2003 | 8.67% |
| 1984 | 8.74% | 1994 | -0.65% | 2004 | 1.89%? |
| 1985 | 25.50% | 1995 | 13.64% | ||
| 1986 | 3.82% | 1996 | 9.12% | ||
| 1987 | 57.27% | 1997 | 10.89% | ||
| 1988 | 21.76% | 1998 | 7.01% | ||
| 1989 | 1.80% | 1999 | -1.19% | ||
| †Estimated YTD performance for 2004 calculated with reported data as of May-13-2004 06:23 US CST Source: Barclays Capital Group |
Diversification
Futures investments benefit from the ability to diversify, very broadly, by sector and by geography. A key step in constructing a futures fund is the careful selection of the markets to be included in the fund portfolio. The greater the number of markets traded, the greater the portfolio diversification and thus the potential for enhanced risk-adjusted returns.
The growth in the number and liquidity of futures markets has made it possible to avoid over-concentration in any market sector. It is worth adding that certain markets, such as stock indices, can only be accessed via futures and related derivatives like options.
Exposure across the full range of market sectors reduces risk because it helps to smooth out peaks and troughs in performance. This is due to the tendency of markets in different sectors to exhibit broadly different behavioural characteristics.
Growth in Rising and Falling Markets
A second advantage offered by futures funds is the potential to generate profits in many market environments. This relates to the fact that in futures markets it is possible to sell short contracts as well as buy them, thus being able to profit in falling markets. In physical markets it is often difficult, or even impossible, to sell assets you do not own, necessitating a more traditional 'buy and hold' approach that is dependent on bull markets to return profits. In addition, by applying specialised strategies to the trading of futures markets, investment managers are able to generate profits when markets are rangebound or moving sideways or, indeed, choppy and volatile.
Low Correlation with Traditional Investments
A further advantage of managed futures investments is their potential to show low correlation with traditional investments, thus enable combined portfolio of managed futures and traditional investments achieve improved risk return characteristics. Futures markets are linked to their underlying assets - be they stocks, bonds, currencies or commodities - and there is no escaping the correlation between price movements in the futures contracts and those in the underlying assets. But what is important is the approach to investing in the futures markets.
Because managed futures provide an opportunity to profit from both upward and downward directional moves in the underlying assets, it is possible to achieve a low level of correlation with traditional forms of investment. In other words, the performance of managed funds need not be tied directly to the price movements of the underlying assets being traded.
Fund Structuring
Correlation is also an important issue in combining constituent markets (and strategies) in a judicious way to form an investment portfolio. Careful calculation of the correlation of each market traded can ensure that no highly correlated sectors are given too great a weighting in the overall portfolio. Excess risk is also kept to a minimum by constantly measuring the volatility of each market in the portfolio and adjusting positions accordingly. The intention is to keep within target levels of risk capital for each market traded as well as for the portfolio as a whole. Typically, as a market becomes more volatile, exposure to that market is reduced. Thus the unit of risk for each market is kept fairly constant and the risk attached to the portfolio as a whole stays within predefined limits.
Guarantees
An important feature of futures markets is the fact that they are traded using margin deposits. This enables the creation of an important class of investment vehicles that guarantee the return of at least the initial investment capital at maturity. Many investors have found these structures very attractive as the guarantees can be constructed in such a way as to have no impact on performance potential.
In futures markets, traders only need to deposit a comparatively small proportion of capital (margin) in order to take positions. Margin acts as a security deposit called in by the exchange clearing house to protect all parties from the effect of default. The amount of margin required relates to the worst probable loss on a position in one day and will vary subject to market volatility. Trading on margin makes it possible to leverage futures: for a low outlay it is possible to gain a large exposure to the asset being traded.
Since the capital exposure to the markets required is relatively low, a properly constructed futures fund can be positioned to achieve its target performance whilst still carrying a reasonably high proportion of cash. In open-ended funds (no specified maturity date), this is placed in short-term deposits whose yield enhances performance. In so-called 'guaranteed funds' typically, some of the cash is invested in secure longer-term highly-rated securities (such as zero coupon Treasury bonds) whose maturity dates match those of the fund and thereby underpin the guarantee.
Futures investments offer diversification by sector, geography and trading approach. They are able to profit in most market conditions and show little correlation to traditional investments. Because of these valuable features, futures investments are today playing an increasingly important role in improving the performance characteristics of a wide range of investment portfolios.
