• “The improvements from holding an efficiently –selected portfolio of managed accounts or funds are so large – and the correlation between returns on the futures portfolios and those on the stocks and bond portfolio are so surprisingly low (sometimes even negative) – that the return/risk tradeoffs provided by augmented portfolios… clearly dominate the tradeoffs available from portfolios of stocks alone or from portfolios of stocks and bonds.” Professor John E. Linter, Harvard Business School
• The number and variety of markets tradedin managed futures investments may add substantial diversification to an investment portfolio.
• Financial instability and the regulatory environment have set the stage for the strategy to prosper with no correlation to traditional markets.

Introduction
As financial markets suffered this past year, one strategy in particular continued to stand out as leading the pack with good returns. Historically, managed futures have been a more under recognized asset class among global investors. In a year that was mainly marked with investment losses, the Barclay CTA Index was up nearly 14% in 2008. Benefiting from clear price trends, managed futures handily beat the overall markets, with the average hedge fund losing nearly 22%, according to BarclayHedge. The Standard & Poor’s 500 Index and the tech-laden Nasdaq Composite Index lost nearly 40% in 2008, while the Dow Jones Industrial Average fell 33.8%. The sector, with nearly $206 in assets under management, is expected to receive substantial inflows as investors seek strategies away from the traditional markets and hedge funds that performed so poorly in 2008.

The case for managed futures
As individual and institutional investors seek alternative investment opportunities, especially when US equity markets are underperforming, many turn to managed futures for an additional layer of portfolio diversification. With the ability to go both long and short, futures are highly flexible financial instruments that have demonstrated the potential to profit from rising and falling markets. Fund managers who utilize the futures markets make speculative investments in corn, cotton, crude oil, gold and other commodities, as well as financial futures such as stock indexes, currencies and interest rates. Managers will use technical or analytical formulas to capitalize on price fluctuations of various durations. This paper examines the current state of the managed futures industry and also offers a fresh perspective on one approach to managed futures investing that is not typified by traditional trend-following strategies. Instead it focuses solely on financial futures trading in only a handful of markets. Indeed, since managed futures intend to profit in a volatile environment, the past few years have been fertile for investors with managed futures portfolios. Financial instability and the regulatory environment have set the stage for the strategy to continue prospering with low to negative correlation with traditional investment classes (Fig. 1).

Managed futures strategies tend to profit in both bear and bull markets because they seek out price trends regardless of direction. Once certain trends in futures markets are signalled, managers attempt to realize as much gain from the trend by either buying long or selling short in the same direction as the trend, holding on to positions for as long as the trend is intact. They tend to thrive in periods of extreme directional bias and turmoil. For instance, last year, 60% of the managed futures strategy’s 18.3% return came in the final three months. By way of comparison, the S&P’s fourth quarter decline of 29.6% represented 77% of the index’s 38.5% full year decline, according to the Barclay Group. As a speculative and cyclical investment strategy, however, managed futures investing is intended to be a longer-term strategy since clear price trends may take some time to develop. As with all investments, prospective investors must evaluate both qualitative and quantitative factors of a managed futures fund before determining whether to allocate capital. However, it is becoming increasingly clear that managed futures funds are a good complement to most portfolios. In the Nobel Prize winning research on risk management performed by professors John E. Lintner and William Sharpe of Harvard University’s Business School which laid the foundation for Modern Portfolio Theory, managed futures returns from trading advisors and public funds were analyzed in comparison to stocks, bonds, and treasury bills. Lintner concluded that: “The improvements from holding an efficiently-elected portfolio of managed accounts or funds are so large – and the correlation between returns on the futures portfolios and those on the stocks and bond portfolio are so surprisingly low (sometimes even negative) – that the return/risk tradeoffs provided by augmented portfolios… clearly dominate the tradeoffs available from portfolios of stocks alone or from portfolios of stocks and bonds.” These results account for both inflation-adjusted and real rates of return (Fig. 2).

Pros and cons to consider before investing in managed futures
The advantages of investing in managed futures have also been cited in business and trade media throughout the past few years. Considerable attention has focused on factors such as: low to negative correlation to equities and hedge funds; negative correlation to equities and hedge funds during periods of poor performance; the ability to profit in both bull and bear markets; access to global markets; varied opportunities in markets/manager styles; market liquidity; transparency; and level of regulatory oversight and control. The strategy’s disadvantages, as reported, may include high volatility, high fees, and the necessity for strong oversight, depending on the manager and level of transparency. Commodity trading advisors, or CTAs, who trade global futures and options markets, have traditionally differed from hedge fund and mutual fund managers in several basic ways, including transparency, liquidity, regulatory oversight, and use of exchanges. Because futures contracts are traded on the global exchanges, investors may access publicly quoted bid and offer prices on specific contracts in order to easily determine the current value, gain or loss on outstanding positions. Hedge funds, however, may frequently engage in transactions involving over-the-counter (OTC) derivatives with market values that are not readily available because they are not traded on a centralized exchange. This can severely inhibit the ability of a manager to manage risk because there is no clear price transparency. Valuation is almost never an issue when it comes to managed futures funds since the prices of all the securities held are always available.

The exchange-based nature of futures contracts is also a critical factor in liquidity. Positions can be readily entered and exited without searching for multiple pools of liquidity. To enter an E-mini S&P 500 contract traded on the Globex exchange simply requires access via a futures broker. Even when trading in significant volume, anonymity is relatively secure since all orders go to one exchange. Contrast this with trading a significant size in any single stock. This process could involve calling multiple brokers to mask orders in order to limit market impact. It could also mean that timeliness has to be sacrificed because of liquidity. Liquidity in the futures markets is a fundamental tactical advantage in limiting significant drawdowns and thus losses for investors. It allows CTAs to reduce and/or eliminate significant positions during periods of sharp declines.

Managed futures strategies – overview & analysis
Managed futures investing seeks to profit from sharp price movements. A major difference as compared to other strategies is that a speculator trades directly while the managed futures investor employs a CTA to trade on his or her behalf. Managed futures investors may be private commodity pools, public commodity funds, or hedge funds. Although hedge funds that engage in futures trading are considered to be managed futures investors, they differ from private pools and public funds in that futures are not the core of their strategy, but rather are a single component of a synthesis of instruments. In terms of portfolio structure, managed futures are designed for either a single investor or a group of investors. Separate or individually managed accounts are usually structured for institutions and high net worth individuals. Managed futures portfolios that are structured for a group of investors are either private commodity pools or public commodity funds. Public funds, often run by leading brokerage firms, are offered to retail clients and often carry lower investment minimums and concomitant higher fees. Private pools are for group investors and are intended for institutional and high net worth investors. CTAs base trading decisions on technical or fundamental analysis, or a combination of both.
Technical analysis is based on the fact that markets can reveal valuable information that can be used to predict future commodity prices, including facts related to daily, weekly, and monthly price fluctuations, volume variations and interest fluctuations. Fundamental analysis relies on the study of external factors such as the economy, politics and weather to predict future prices. It is also important to note that CTAs may use discretionary, trend following or systematic methodologies, and that these categories may overlap. Discretionary advisors, for example, rely on fundamental research and analytics to determine trade executions. Systematic traders would wait until this fundamental data is reflected in futures price before trading. Few advisors are solely discretionary. In fact, most depend on systems to some extent and many incorporate emotion into their trades. Some systematic advisors design systems that analyze historical price relationships, probability measures, or statistical data to identify trading opportunities, and most are trend followers. As a method of trading, trend following determines market positions based on price trends, analysis of market price movement and statistical measures, thus recognizing that prices move from equilibrium into transition and then back into equilibrium. Trend followers attempt to capture this divergence of prices through the detection of various signals, and are typically classified as a systematic advisor. Trend followers respond to existing trends by seeking to close out losing positions quickly and hold profitable positions as long as the market trend is favourable.

There are, however, new strategies emerging that offer the same advantages of managed futures, e.g. liquidity, transparency, etc. while offering more consistent levels of returns. The Liquid Capital strategy first involves analyzing decades of historical price data from equity market indexes. The data is analyzed to uncover periods of price volatility that have a high statistical probability of reversing. These periods are essentially changes in price over a given number of trading sessions that differ by a certain standard deviation from average historical price fluctuations. Once these changes have been modelled, they are programmed into a trading platform that can instantly signal the next occurrence. When they do occur, a decision is made to either buy long or sell short the particular market using futures as a proxy. One key advantage is that there is no long or short bias to trade execution. For instance, there is no technical limit to how much can be shorted versus bought long. Compare this with a traditional equity position where in order to short a stock, an adequate number of shares must be borrowed first. In addition, shorting stocks requires margin accounts which add costs to carrying a position. There is no such carrying cost for short positions in the futures markets. As a position is established, the necessary risk allocation takes place which insures a limit to potential loss. Typically, this will be 3%, but can vary depending on the volatility of recent returns for the portfolio. For instance, acceptable losses will be lower if recent portfolio volatility has been high. Indeed, no strategy can be complete without effective risk management. This risk allocation is analogous to a target profit level for individual trades.

Unlike trend following strategies, which look to maximize a favourable direction in the market, Liquid’s strategy does not seek to maximize because of the very short-term nature of each particular trade. Instead, it targets small profits and waits to be right or wrong with the odds favouring that the program will be right more often than it is wrong.

Conclusion
As investors continue to recognize managed futures ability to generate favourable returns in varied market conditions, the strategy likely will continue to grow in popularity. However, it is also essential to avoid the tendency to lump all managed futures strategies into a trend following bucket and design one’s portfolio accordingly. Different managed futures managers employ different techniques and it is essential to consider a fund’s competitive edge, level of transparency and track record before investing. Not all managed futures funds are created equal, in other words!

Brian Kim began his career as a proprietary trader in 1997 at Heartland Securities in New York. In 1999, he joined First Security Investments as a portfolio manager. Since 2002, he has been developing Liquid Capital’s Investment strategies and platforms.