What are Managed Futures, or CTAs?
(This is part 1 which focuses on the basics of "Managed Futures" if you’d like to read about trading strategies you can read part 2)
Investing terminologies might sound complex. Yet their concepts are usually simple.
Futures are contracts, in which two parties agree to trade on a future date. The amount and price of the trade is agreed upon in this contract.
The main purpose of the futures contract is protection against price changes.
Looking at the example above. It doesn’t matter what the price of cattle will be in six months, the buyer and seller will trade at a price written in the contract.
A cattle snack producer wants to sell cattle snacks to a retail chain. The producer knows that he needs 200 units of cattle to make those snacks. If he buys 200 units of cattle now, which he will need in 6 months. He can calculate the fixed price, and be sure that he will get the 200 units.
Note that the snack producer has an advantage in buying the 200 units of cattle today, and so does the cattle farmer who is to produce those units.
The farmer who sells the 200 units will need to know the price of the cattle in half a year. The cattle farmer has an advantage in selling the cattle today. Since it gives him security that the 200 units will be sold at a certain price. In short, he does not have to worry that he won’t be able to sell the cattle within 6 months.
From the scenario above, it is clear that the cattle snack producer and the farmer find it beneficial to buy and sell cattle over a futures contract.
Continuing with the example, let’s assume the farmer needs to sell 300 units, but the snack producer can only buy 200 units at the moment. Now, where can the farmer sell the remaining 100 units if there is no demand? Introducing CTA or Managed Futures Manager.
The managed futures manager can calculate the price of 100 units of cattle after 6 months. He can buy the 100 units from the farmer knowing that he will be able to sell those at a higher price later. The managed futures manager helps smoothen the gaps in supply and demand. The knowledge that the cattle price will increase, can be estimated from the price of Soy and Corn to feed the Cattle or from the demand factors. The managed futures manager could even sell the 100 units with the delivery date of 6 months, with another futures contract in 5 months if he can make a profit. This is called a spread and is discussed later on.
Futures can have a variety of underlying assets such as commodities (i.e., corn, cattle, coffee, gold etc.) and even stock market indexes such as S&P 500, or NIKKIE 225.
Global commodities futures market: Common Commodities
Futures market has grown considerably in the last 30 years.
Below is the comparison of Managed Futures with the U.S. Stocks and international stocks from 1980-2008.
This impact is also worth mentioning since a large number of firms use futures prices in developing price expectations, consumption schedules, and production plans. They help to determine the price of goods sold in the spot market.
This brings us to Managed Futures, which is an advanced form of investing in the futures market.
Managed futures refers to the investment technique where a professional actively manages a portfolio of futures contracts for his client.
Think of these accounts as Mutual Funds, where investors get exposure to various futures based securities.
Why haven't you heard of "Managed Futures" before?
Banks, insurance companies, and mutual funds are the primary users of managed futures.
Managed futures have to be seen in the macro environment. After the 2008 financial crisis central banks took over the markets and pushed money and liquidity and decided to make interest rates close to zero. This money has flooded into stocks.
Stocks markets have increased since the 2008 financial crisis and some markets might have tripled now. A "Buy and hold" strategy has delivered double digit returns in many years and managed Futures have come out of the public interest as there was no need to "manage". If everything goes always up there is no need to manage, investors just need to participate in the general growth.
As interest rates will increase once upon a time in the future and money might be pulled back from stocks it can be foreseen that the general market will not increase so strong for some time and the time for Managed Futures will come again like before the 2008 crisis. If the general market is flat or goes down Managed Futures are likely to outperform the market.
Moreover, just like many (presumably) complex investment tools, managed futures get sidelined by retail investors.
Managed futures fall under alternative investments category. Mostly, institutional investors and funds use these to acquire both the market and portfolio diversification.
The way this mitigate portfolio risk is not possible with conventional securities such as stocks and bonds.
In other words, a portfolio designed on the principles of Modern Portfolio Theory (MPT) would find a perfect fit in futures. Since these are either weakly or inversely correlated to the stock and bond markets.
Read the Details on MPT Here
Investors have started using futures as an alternative to hedge funds. And this strategy has proven quite effective.
Institutional investors use hedge funds in their portfolios to diversify since these are actively managed in the futures market. But managed futures proved to be a better fit. Gradually these are replacing hedge funds.
Evolution of Managed Futures or CTA's
Where did Managed Futures come from?
Interestingly, these were the result of gradual standardization and regulation of the derivatives market.
The Commodity Futures Trading Commission (CFTC) Act and the National Futures Association (NFA), defined the roles of Commodity Trading Advisor (CTA) and Commodity Pool Operators (CPO). CTA's and CPO's are different from typical financial advisors and professional money managers, in that they have extensive experience in trading derivatives.
Such measures gave confidence to the average investors when it came to investing in derivatives.
Common Trading Strategies
Most managed futures accounts have their investing strategies mentioned with them. Usually, these include trend following and market-neutral strategies.
In the latter, the investors seek to profit from arbitrage and opportunities of mispricing. While in the former, the profit comes from taking long positions and short positions as a result of the technical or fundamental analysis.
CTA dealings are transparent; investors can request the disclosure documents, which contain all the trading strategies and performance measures.
Impact of Interest Rate
The norm is that investors fear rising interest rates. Stock investors fear this trend. However, with managed futures, rising interest rates might not be that bad.
CTAs generally trend followers who use proprietary trading algorithms, which can potentially benefit from higher short-term interest rates. Since these accounts hold about 80% to 90% cash as collateral for futures contracts. These contracts have naturally built-in-leverage.
What this means, is that you only need to put in €750 to control €20,000 worth of corn. The exposure is immense considering the relatively small deposit.
With the remaining €19250, the investor could leave it with the clearing firm and earn interest on the T-bills.
The short-dated treasuries are the better fit for this job since the portfolio is not skewed too much towards bonds. With the rise in the short-term interest rates, the investor can potentially earn a good profit.
In short, in the context of interest rates, where other asset classes underperform futures thrive.
Why should you invest in Managed Futures?
These are used extensively in portfolios as an alternative investment strategy to mitigate risk through portfolio diversification, mainly because these have low correlation with Stocks and Bonds.
For example, during inflation, commodity and foreign currency futures are not only expected to thrive but also offset the losses of Bonds and Equities.
Understand that the market has a mind of its own. It moves up, down or sideways, and investment makes money, loses or breaks even. The dominant futures strategy is to diversify the portfolio beyond the basics, so that it survives, grows, and makes money even when others are losing.
(BTOP50 Index seeks to replicate the overall composition of the managed futures industry)
Here are the significant reasons why retail investors should be intrigued by managed futures:
Long and short positions allow earning profits, even when the market are falling. In fact, these are now renowned for generating high returns, both in bearish and bullish markets.
These are not directly correlated to other forms of investments.
Futures investments help the real world. Farmers need futures trader to gap time and keep the market liquid.
Portfolios holding futures are diversified beyond the traditional asset classes.
Transparency: CTAs are obligated to give investors details and access to all account activities. Their accounts are settled daily, which means that professional money managers can monitor day-to-day operations.
Many CTA investing decisions are based on computer models, which eliminates the dependency on human judgment.
CTAs apply different strategies like trend following, spreads, long short and others.
CTAs help to improve consistency when similar strategies are repeatedly employed.
More diversification is achieved by using a suitable assortment of various sectors and types of futures.
These are not pooled investments like fund investments. Instead, they operate under SMA (separately managed account), where each investor’s portfolio is handled separately as a single account, offering more transparency to the clients.
Since futures trading is monitored by regulatory bodies, the level of trustworthiness and credibility is higher than in other types of investments.
Futures are traded on "real" regulated exchanges like Eurex CME, Comex and a broad supply and demand ensures that investors get a fair price and fair spread.
Disadvantages of managed futures:
Managed futures are only for big accounts as most futures contracts are big, for example the DAX futures contract is 25 Euro for each basis point (this is called the BP or big point value). It has a value of 12 000 x 25 = 300 000 Euro. If the DAX contract moves by 1% a loss of 3 000 Euro is made. By combining different contracts losses can ad up fast.
Futures have to be handled with care and responsibility. Regular leverage of futures is x 20 (or with other words the regular margin is 5%, means trading with 100 000 USD contract needs only 5 000 USD in the account).
Big losses (as well as big gains) can be achieved in short timeframes.
Futures have their specialities. They can a limit up or limit down (and cannot be traded anymore), they have delivery dates, gaps between contracts and other special topics which the manager needs to understand well.
Futures need to be tracked regularly as contracts have an end date, there is no "buy and hold" possible.
Futures are standardized, regulated and without counterparty risk since exchange clearinghouses ensure that traders fulfil their obligations. Due to low correlation with the conventional market, futures are ideal tools for diversifying the portfolio.
Banks, pension funds and commodity merchants extensively use futures as a hedging or risk management technique.
However, before investing in futures one needs a thorough understanding of the underlying assets in these contracts. Licensed professionals trade managed futures accounts, which takes the burden off of the investors.