Hedge Fund Strategies: Managed Futures

Introduction

reaearch--Managed-Futures-1Managed futures are a subset of the alternative investments asset class in which professional advisors, known as Commodity Trading Advisors (CTAs), actively trade a diversified set of derivatives instruments in order to exploit directional price trends in various markets. Through the use of proprietary trading systems, CTAs trade across varying time periods and predominately in the futures contracts of financial assets, commodities and currencies. These rather liquid markets offer CTAs the ability to take both long and short positions, which provides the potential to profit from both positive and negative developments across global markets. Of significant importance, is the low correlation characteristics that CTAs have historically exhibited, which not only allows for enhanced diversification benefits when incorporated into a traditional stock and bond portfolio but also when included in a portfolio of distinct hedge fund strategies. Due to their unique risk-return attributes, liquidity, and diversification potential, Managed Futures has been one of the faster growing strategies within alternative investment. By taking a closer look at the basic characteristics of the Managed Future strategy, advisors can consider whether the strategy is prudent as part of a larger diversified investment portfolio. Our Customized Hedge Fund Portfolio Solution provides access to leading institutional-quality managed futures funds; access which is usually reserved for the large institutional investors. Our services include access to institutional quality hedge fund portfolios coupled with an operational infrastructure that features independent service providers for added investment oversight, hedge fund due diligence, portfolio construction technology, reporting and more.

What Are Managed Futures?

Managed futures are a subset of the alternative investments asset class in which professional advisors, known as Commodity Trading Advisors (CTAs), actively trade a diversified set of derivatives instruments in order to exploit directional price trends in various market conditions. While derivatives may include such instruments as futures, forwards, options and swaps, a large majority of CTAs primarily utilize future contracts as these are exchange traded instruments that limit counterparty risk and tend to offer enhanced liquidity.

CTAs generally manage their clients’ assets using a proprietary trading system or discretionary method that may involve going long or short in futures contracts in areas such as metals (gold & silver), grains (soybeans, corn, & wheat), equity indexes (S&P futures, Dow futures, & NASDAQ 100 futures), soft commodities (cotton, cocoa, coffee, & sugar) as well as foreign currency and U.S. government bond futures.

Most CTA strategies run a diversified portfolio comprised of a combination of the various futures contracts. In addition, many CTAs employ leverage; not through traditional means of borrowing from prime brokers but rather through the inherent nature of trading futures contracts on margin. Due to the embedded leverage of these contracts, CTAs can typically reach 100% gross exposure by only investing a fractional amount of the allocated capital in futures contracts while maintaining a significant portion invested in high quality, liquid, short term securities, such as U.S. Treasuries. While this allows a CTA to increase their exposure to a particular market rather quickly, most CTAs operate within strict risk limits and leverage is controlled through the proper management of margin-to-equity levels, which are generally maintained in the 10%-20% range.

Outsized Growth in Industry Assets

reaearch--Managed-Futures-5Due to their highly liquid nature, the ability to adjust exposures quickly, and their diversification benefits, assets under management in the CTA space have soared to $328.3 billion. A large percentage of the growth in the industry has occurred over the past several years as investors with a renewed interest in the space have expanded the industry’s assets at a compounded annual growth rate of 15% between 2008 and 2011.

Sub-Strategies

Systematic vs. Discretionary Trading Strategies

The Managed Futures space can be divided into two general types based on their trading strategy approach: Discretionary and Systematic strategies. A Discretionary trading strategy, which is often compared to macro hedge funds, encompasses the judgment and expertise of the manager to make investment decisions. By and large, discretionary traders utilize fundamental analysis, such as analyzing a certain commodities’ supply and demand factors, to predict future price movements. A Systematic trading approach relies on quantitative and highly computational analysis of historical relationships and price data to uncover future price movements. Systematic trading systems can be further classified into Trend Following, which attempts to exploit medium to long-term trends in a market, or Counter Trend, which seeks to profit from notable reversals occurring in the markets. In general, trend following systems are the more prevalent of the two systematic trading approaches.

Short-Term vs. Long-Term Trading Strategies

The Managed Futures space can be further divided based on the investment time horizon they are attempting to exploit: Short-term vs. Long-term. Short-term CTAs seek to capture trends lasting one to seven days and focus on the “market micro-structure and the price formation mechanism.” Short term trend followers will generally enter into a new position as soon as the first strong movement occurs following a trend reversals and commonly incur high trading costs in the process. Long-term trend followers seek slower developing trends that usually develop over a one to six month period, which typically results in less trading activity when compared to their short-term trend follower counterparts. However, identifying trend reversals with a longterm trend following strategy generally requires more time to uncover.

The Advantages of Managed Futures

Diversification from Traditional Asset Classes/Reduction of Overall Portfolio Volatility

reaearch--Managed-Futures-2CTAs invest across a broad spectrum of markets and have historically maintained a low-to-negative correlation to many traditional asset classes (Table 1). Adding low correlation assets to a portfolio offers diversification benefits and will reduce the overall risk of a portfolio without meaningfully sacrificing return.

Protection in Challenging Environments

Overall, CTAs have performed considerably well during many periods that were rather challenging for equity markets and other hedge fund strategies. Due to their rapid ability to alter exposure levels and profit from upward and downward trending markets, CTAs have demonstrated a compelling argument during market drawdowns and periods of dislocations. (Table 2-3)

reaearch--Managed-Futures-4
Liquidity

Managed Futures strategies trade exclusively in highly liquid and efficient futures markets. As a result, adding a Managed Futures vehicle to a portfolio of alternative investments will typically improve the overall liquidity profile of the alternatives allocation.

Conclusion

CTAs have historically performed well during challenging times and can provide stability to a portfolio. Advisors seeking diversification, liquidity and uncorrelated returns from traditional stock and bond portfolios should carefully consider the potential benefits of including CTAs within a larger investment portfolio.

reaearch--Managed-Futures-3

You can download this article as a PDF file here.

For more information about the content of this article, please contact John Chatmas at jchatmas@waterloocap.com or call (512) 693-4363.

IMPORTANT DISCLOSURE

Leave a Comment