Jeffrey L. Stouffer, Principal
Mercantile Capital Group
Managed Futures as an asset class, has been gaining attention and popularity. This class of investments offer returns that have little or no correlation to the equity and fixed income markets.
A result of this increased popularity is the proliferation of investment vehicles that allow access to this unique asset class. The different programs that are available are designed to make entry into this group considerably easier than what historically has been an investment reserved for the wealthy investor.
The term ‘Managed Futures’ was coined as the description for hiring a trained, licensed, and registered professional to trade futures contracts according to a predetermined discipline outlined in a document. This professional is known as a Commodity Trading Advisor (CTA) and the program is detailed in the disclosure document. Historically, CTAs have required that a client present a high minimum amount of investable assets in order to hire the trading manager. These high thresholds have allowed direct exposure to the futures markets by those who can withstand the account valuation changes that are a direct result of the high degree of leverage and the compression of time associated with futures and options on futures trading.
The next stage in the evolution to permit the average investor access to this asset class came from the direct competition of new CTAs entering the marketplace. In order to attract assets, lower thresholds of investment minimums were established and the programs that were offered tended to operate in smaller, less liquid markets than what the large well-entrenched CTA traded.
Another concern of futures trading is market liquidity and capacity. Large CTAs that have considerable sums of funds to manage are generally restricted to very large and liquid markets which allow them to take positions that can be allocated to all accounts. Smaller markets do not allow such trading of vast sums of funds. Usually large CTAs are focused on interest rate, stock index, energy, and currency markets. A smaller CTA can also access these, plus markets such as grain, metals, livestock, soft items (e.g. coffee, sugar), cotton and more. Due to the high degree of leverage in futures trading, diversification is better attained with an optimal amount of risk capital as opposed to a significant and large investment.
Because the above concepts are operating under the oversight of the National Futures Association and the Commodity Trading Futures Commission, access to such programs is available only from individuals and firms that are licensed and registered with these agencies. The concentration of market participants tend to be in a few large metropolitan areas such as Chicago, New York City, and Los Angeles.
Financial engineers from a wide range of product distribution companies have brought to the market products and programs that are approved as securities and are overseen by the Financial Industry Regulatory Authority (FINRA) and the Securities Exchange Commission. These package products are now available for local financial advisors in the form of mutual funds, exchange-traded funds, and limited partnership programs. The ability to market and distribute these programs at a local level is possible and a wide range of options that permit lower capital commitment and ease of access to investors has been created.
As such offerings seem to answer the question of how to distribute the access of managed futures to the general public, there are some flaws in this concept that have embedded a loss of theoretical diversification and an additional layer of fees and costs, which can impact the returns.
For discussion purposes, a mutual fund has brought to market a program that offers exposure to the managed futures asset class and during the high demand for this vehicle has been able to raise in excess of $500 million. This fund then manages the assets in a 25%-75% allocation with the 25% going to CTAs to manage sub accounts. The remaining 75% is placed with a sub-advisor who manages this amount in fixed income investments of various maturities. The 25% going to CTAs is then equally allocated to five CTAs that each have $25 million to manage.
The larger CTAs that are capable of handling the larger accounts tend to be restricted to the large markets that offer the liquidity and market size needed to handle the trading. Because there are very few large markets, allocating funds to various large CTAs that are restricted to these markets only gives a diversification of manager style, not asset class. Proper diversification is not attained. This is one of the obstacles that impede the returns from such programs.
The other obstacle is the use of CTAs to handle portions of the funds. These professionals usually charge a 2% asset and a 20% incentive fee. This means that 2% of the assets placed are subject to ongoing depletion and this is generally used to offset CTA operating expenses. The incentive fee is designed to align the interests of the CTA and client by allowing the payment for profits attained as a result of successful management of funds. Net new profits are subject to this fee.
These fees are embedded in the operating cost of the mutual fund and have its own management and operating expenses. If such a fund charges a 5% sales load and has a 2% annual operating expense on top of what the various sub-advisors charge, the gross performance of all the sub-advisors has a high threshold to meet before the returns are filtered through the various cost structures and make it as profit to the investors.
It is my belief that such large programs that are offered by widely recognised names will be a modern day example of a bull running in a china shop. Access to the managed futures asset class by individual investors is best done by engaging CTA programs that are different from each other and have lower investment minimums. Fees, costs, and expenses are easily done at the onset.
Trading futures and options involves substantial risk that can lead to loss of capital and is unsuitable for many investors. Past performance is not indicative of future results. Speculate with risk capital only, defined as funds you can afford to lose without adversely affecting your lifestyle. These risks remain present irrespective of whether you hire an outside manager to trade an account.
Jeffrey L. (Jeff) Stouffer is the principal of Mercantile Capital Group, a Herndon VA based introducing broker registered with the CFTC and a member of National Futures Association. He has earned the privilege to use the CFP® and CAIA marks, and holds several FINRA licenses. As a practicing financial advisor serving the needs of individuals and small businesses, he believes in using a wide range of investment strategies, including alternative investments. All strategies are client centric and unique. For more details, please visit http://www.examiner.com/investing-in-arlington/the-increasing-popularity-of-managed-futures