Alternative Investing

Managed Futures FAQs

Managed futures have been one of the fastest growing asset classes over the past several decades. First Capitol Ag offers managed futures as an alternative investment solution for investors.

View answers to common managed futures questions below.

Managed futures refer to professionally managed assets in commodity and financial exchange traded derivatives, including futures, options on futures, and to a lesser extent, forward contracts. Management of client assets is directed by Commodity Trading Advisors (CTAs) and Commodity Pool Operators (CPOs) under the regulatory auspices of the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA), a self-regulatory body. Accounts are held with clearing firms called Futures Commission Merchants (FCMs), and Introducing Brokers (IBs) serve as guaranteed or independent correspondents.

A professionally-managed futures account is a discretionary trading account where you give permission to a Commodity Trading Advisor (CTA) to make all trading decisions on your behalf through a revocable power of attorney or a third party trading authorization.

Investing in a managed account relieves you of the concerns associated with the trading facet of investing (i.e. market timing, asset allocation, stop loss protection, etc). However, you make the large decisions of who to authorize to manage your account and how much risk capital to invest. To facilitate this, you review ranking, profile, and performance measurement reports and of course the individual CTAs disclosure document to screen and qualify the investment for your particular circumstances.

Managed futures and hedge funds share a similar history and legacy — the first commodity fund was started in 1948, and the first hedge was fund established in 1949. Technically, hedge funds are privately organized pooled investment vehicles which operate under various exemptions related to securities regulations. Interestingly, CPOs are a hybrid between managed futures and hedge funds, and it is noted that while some hedge funds actively trade futures they can avoid CFTC registration. Admittedly, hedge funds are better known and have more assets under management. Yet despite the size and status of hedge funds relative to managed futures, the latter’s impact upon the alternative investment space is writ large in two significant and related ways: first, managed futures, unlike its brethren hedge funds, operate in a highly regulated environment; second, this same regulated environment which imposes disclosure and reporting requirements, compelled the data on managed futures to be made public, which in turn helped academics advance early studies on alternative investments, prior to developing any substantial research on hedge funds. In effect, managed futures were key to institutionalizing alternative investments.

A CTA is professional trader known as a “Commodity Trading Advisor”. A CTA is an individual or firm who, for pay, trades accounts for individual clients or for commodity pools and/or who provides analysis, reports or advice concerning futures and options trading. Traders with this designation are generally required by the US Government to submit a disclosure document which outlines who he or she is, states the fees and expenses charged to accounts and reveals the trader’s performance track record. Additionally, information on the Advisor’s trading program is explained, as well as any conflicts of interest or disciplinary history that may be material.

Both commodity trading advisors (CTAs) and commodity pool operators (CPOs) provide advice to the public with respect to investment in commodity and financial futures, and options on futures. CTAs typically provide advisory services in the form of a separately managed account, which is just like any futures brokerage account except that the account is managed by a third party — the CTA. On the other hand, CPOs commingle the assets of investors into a pooled vehicle, usually a limited partnership, and then subsequently allocate client assets to be traded by CTAs or by the CPO itself. The managed account vehicle utilized by CTAs is a more transparent and liquid investment by its very nature/structure. Whereas a commodity pool is less transparent and usually provides only monthly or quarterly reporting; further, it is less liquid in that redemptions are facilitated on a monthly or quarterly basis. There are advantages to the commodity pool structure though, including the ability to invest in CTAs with high minimums, as well as professional selection/oversight of CTAs.

This question is worthy of a book. Briefly, commodity exchange traded funds (ETFs) are a new type of investment vehicle which allows investors to invest in commodities as if the instrument was a stock. Just a few years ago, the only way to invest in commodities was either through the futures/derivatives market or through a pooled investment vehicle. Commodity ETFs are usually long-only, and marketed on the basis of three types of returns: (i) “collateral return,” which results from investing monies into fixed income instruments which collateralize the derivatives that provide commodity exposure for the ETF; (ii) “spot return” which is the change of price in the underlying commodity exposure; and (iii) “roll return” which supposedly results from the “rolling forward of futures contracts.” The “roll return” is a hotly debated concept within academic circles, but Wall Street markets the idea nonetheless. There is a fourth source of return, less often stated, which is the “strategy return” that comes from rebalancing the portfolio. Managed futures differs from commodity ETFs in that “strategy return” is the main focus, and most CTAs will go long and short a market taking advantage of “spot returns” either way. With respect to “roll returns”, certain CTAs employ calendar spreads which effectively arbitrage for this particular source of return. At the same time, managed futures accounts can be invested in fixed income allowing an investor to obtain “collateral return.” However, it should be noted that managed futures involves leverage whereas commodity ETFs usually invest on a fully collateralized basis.

First Capitol Ag combines analytics with technology and market expertise to identify CTAs with risk/returns that fit a variety of individual investor needs. Based upon your needs and risk tolerance, First Capitol Ag will show you CTAs that fit your requirements. Some of the criteria we use include strategy, experience, drawdown, volatility, assets under management (AUM), minimum investment, track record, markets traded, and margin-to-equity ratio.

Most CTAs have minimum investment amounts that allow them to trade their strategies without sacrificing return. This initial investment will require you to complete new account documentation with First Capitol Ag, who will process trades at the direction of the CTA. The assets you invest are deposited with First Capitol Ag, are only accessible by you, and prelims are viewable intraday. First Capitol Ag is regulated by both the NFA and CFTC.

In addition to commission, regulatory and exchange fees, typically there are two fees associated with investing in Managed Futures: management fees and incentive fees. A management fee is charged by the CTA to manage the assets they trade. An incentive fee is the percentage a CTA will charge on any new trading profits on the account. The incentive fee is paid on performance: if the CTA does not make a profit, you do not pay an incentive fee. Generally management fees are 2% of AUM/yr, and incentive fees are 20% of new trading profits.

It is important to know the type of trading program operated by the CTA you are researching. There are largely two types of trading programs among the CTA community, systematic and discretionary. Within these two groups CTAs can be further categorized between trend-followers or market-neutral strategies.

Trend-followers use proprietary technical or fundamental trading systems, which provide signals of when to go long or short in certain futures markets. The goal of most trend-followers is to profit from extended price movement in either direction, though some CTAs may only capture very small trends or short-term moves in the market. Market-neutral traders tend to look to profit from either arbitrage or spreading different commodity markets. Included in market-neutral strategies are the options-premium sellers who may use delta-neutral programs. The arbitragers, spreaders and premium sellers aim to profit from sideways or non-directional trading markets. In addition to styles and strategies, CTAs may trade diversified portfolios of as many as 100 world-wide commodity markets or they may be market specific and specialize in only one market like the S&P 500.

Although most investors tend to look at the returns a particular trading program has generated over time, a drawdown spectrum (a list of cumulative declines in equity) may provide an investor insight into the type of risk he may have to absorb in order to realize those returns. A list of historical losses, however, does not mean drawdowns will remain the same in the future (drawdowns can get larger or smaller in the future), but can provide historical information on the depth, length and time of recovery of each of the drawdowns. Obviously, the shorter the time required to recover from a drawdown the better the performance profile. Regardless of how long a drawdown lasts, CTAs are only allowed to assess incentive fees on new net profits (that is, they must clear what is known as the “previous equity high watermark” before charging additional incentive fees).

The annualized rate of return, which is required to be presented always as net of fees and trading costs by the CTA, is the returns an investment program has generated in the past. These performance numbers must be provided in the disclosure document, however they may not be the most recent month performance. CTAs must update their disclosure document no later than every nine months, when performance is not up to date in the disclosure document, you can request information on the most recent performance, which the CTA should make available. Additionally you would also want to know if there have been any drawdowns that are not showing in the most recent version of the disclosure document.

After determining the type of trading program you are interested in, which would include type of strategy, markets traded, and the potential reward given past performance (by means of annualized return and maximum peak-to-valley drawdown in equity), an investor should expand his evaluation using various Risk-Adjusted methods to get more a complete picture of the program. The NFA (National Futures Association) requires CTAs to use standardized performance capsules in their disclosure documents, which is the data used by most of the tracking services.

The most important measure you should use to compare different trading programs, is return on a risk-adjusted basis. For example, a CTA with an annualized rate of return of 35% might look better than one with 10% at first glance, however, simple comparisons of return may be quite deceiving. The CTA with 35% returns may have had numerous drawdowns in excess of 50% of equity to generate his returns, while the CTA with 10% returns may have had only minor drawdowns of less than 2%. In order to evaluate and determine the trading program that is right for you, several statistical measures have been developed to help investors compare trading programs on a risk-adjusted basis.

A ratio developed by Nobel Laureate Bill Sharpe to measure risk-adjusted performance. It is calculated by subtracting the risk-free rate from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns.

The Sharpe ratio tells us whether the returns of a portfolio are because of smart investment decisions or a result of excess risk. This measurement is very useful because although one portfolio or fund can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater a portfolio’s Sharpe ratio, the better its risk-adjusted performance has been.

Sterling Ratio

A ratio used mainly in the context of hedge funds and managed accounts. This risk-reward measure determines which investments have the highest returns while enduring the least amount of volatility. The formula is as follows:

Sterling Ratio

Calmar Ratio

A ratio used to determine return relative to drawdown (downside) risk in a hedge fund or managed account. Calculated as:

Calmar Ratio

A higher the Calmar ratio is generally better. Some programs have high annual returns, but they also have extremely high drawdown risk. This ratio helps determine return on a downside risk adjusted basis. Most people use data from the past 3 years.

Volatility is a statistical measure of the tendency of an investment to rise or fall sharply within a period of time. Standard Deviation is one of the most commonly used statistics in determining the volatility of a trading program. A trading program that is volatile is also considered higher risk because its performance may change quickly in either direction at any moment. The standard deviation of a program measures this risk by measuring the degree to which the program fluctuates in relation to its mean return (the average return of a trading program over a period of time). Many CTA tracking-data services provide these numbers for easy comparison.

How a trading programs returns are distributed over time can be very valuable in evaluating a trading program. If the majority of monthly returns are between -5% and +5%, then ups and downs of a trading program may be more palatable, than a program where returns fluctuate between -25% and +25%. Many performance measurement reporting services provide charts that graphically represent these dispersions. Bear in mind, while past performance results are not indicative of future returns.

The correlation of a trading program to other investments is an integral part of building a successful investment portfolio. Not only is it important to not be correlated to other CTAs in the portfolio, it also very important that the CTA you are considering fits in your traditional stock and bond portfolio. The goal of a well-balanced investment portfolio is that when some assets are losing value, the other assets are gaining value.

Here is an interesting fact: the face value of over-the-counter derivatives is approximately $500 trillion; this amount stands in stark contrast when compared against the combined GDPs of all nations in the world, estimated to be $50 trillion. Question is, how is it possible that these derivatives are worth ten times more than all the economies of the world? The answer is that this $500 trillion amount refers to the nominal value, which is the stated value of the derivative. Simply, this amount does not represent real money, but references an amount used to construct the contract.

Futures contracts are also constructed around the concept of a nominal face value. This amount fluctuates based on the contract’s trading unit size and quoted price. For example, wheat futures are quoted as 1/4 cent per bushel, and a single wheat contract involves the delivery of 5,000 bushels as a result, assuming the contract settles at $8.96, the contract’s mark-to-market value is $44,800. This is the amount which a buyer would need to pay if he/she were to take delivery of 5,000 bushels of wheat. It is important to note, however, that commodity futures traders seldom make or take delivery of the underlying cash asset, but instead liquidate the futures contract before the delivery period. Accordingly, a futures trader does not need to come up with the $44,800 cash, but instead, is only required to put up an initial margin requirement. Margin requirements for futures are akin to a good faith deposit. This is very different from how margin is defined for the purpose of trading securities. When trading securities, an investor “borrows” money from the broker which is collateralized by other assets held in the account. The limit on borrowing in this manner is currently set at 50% of marginable securities. This limit has not been changed in many years.

On the other hand, the good faith deposit required to trade a futures contract can be as low as just 2% of the contract’s nominal face value. As of this writing, the initial margin requirement for a wheat futures contract is $6,075 and the maintenance margin requirement is set at $4,500. This is all that the investor has to maintain in his/her account to trade a wheat futures contract. However, if the mark-to-market value of the account drops below the maintenance requirement, additional monies must be deposited in order to maintain the position. Otherwise, the position must be liquidated. This relationship between margin requirement and the nominal face value of a futures contract constitutes leverage. Leverage allows commodity trading advisors the potential to produce high returns as well as large losses. An important factor to know then is the average and maximum amount of margin a trading program requires to be traded.

Margin-to-Equity Concept

The above description serves as necessary background in order to begin discussing managed futures and notional funding. This is where the proverbial rubber hits the road. When a commodity trading advisor designs a trading program, he or she usually establishes a baseline account level which determines the number of contracts that he/she will trade for that unit size. The aggregate margin requirement for these contracts is then divided into the account level in order to determine the margin-to-equity ratio.

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