FAQ

The term “Alternative Investment” generally refers to any investment that does not depend on continued upward movement in the stock market for successful performance. Alternative investments are also described as “absolute return” strategies, meaning investment strategies that should perform well each year whether the stock market goes up, down or sideways. This does not mean that alternative investments always make money - it merely means that a continued decline in the stock market should not present a material risk for a true alternative investment strategy. In uncertain times like these, alternative investments can make a big difference in the performance of overall portfolios.

 

Alternative investments include investments such as real estate, venture capital and private equity, hedge funds, hedge fund of funds, and managed futures.

 

The following comments focus on Managed Futures—what they are and why they are becoming the preferred alternative investment strategy.

 

 

 

Historically investors have “diversified” by investing in various stocks, bonds and mutual funds. According to Modern Portfolio Theory however, portfolios consisting only of stocks, bonds and mutual funds are not adequately diversified. In his article on portfolio selection Professor Harry Markowitz illustrated that holding stocks, bonds and mutual funds does not adequately lower an investor’s risk because each of those types of investments move in concert with each other. He concluded that diversification “reduces risk only when assets are combined whose prices move inversely, or at different times, in relation to each other.” In other words, investors can properly diversify their portfolios only when investing in different asset classes having no correlation with each other. Since stocks, bonds and mutual funds are all correlated assets and generally move in concert with each other, other asset classes are needed to properly diversify a portfolio.

 

 

 

Managed Futures are a type of alternative investment established to trade in the global commodities, futures, and options markets. Successful performance in these markets does not depend on continued upward movement in traditional equity or bond markets. Unlike other futures accounts, however, in a Managed Futures account a professional trader known as a commodities trading advisor (CTA) is responsible for determining what trades to make and when, pursuant to a power-of-attorney or limited trading authorization.

 

Although you do not need a professional money manager to invest in the futures and options markets, statistical evidence demonstrates that professional traders greatly outperform individual investors. The futures markets are so vast that it is difficult, if not impossible, for an individual to master more than a small segment of trading. The term “Managed Futures” describes a managed approach to futures market participation whereby professional money managers, called Commodity Trading Advisors (“CTAs”), trade futures and forward contracts pursuant to a power-of-attorney or limited trading authorization. CTAs are professional money managers who specialize in trading futures and forward contracts. The term “CTA”, however, is a misnomer - while futures and forward contracts may represent agricultural products, energies, cattle, hogs, metals, and other commodities, many CTAs also focus on trading currencies, financial instruments, stock indexes and single stock futures. CTAs work full time to trade and manage investments and are usually registered with national organisations (in the US for example the National Futures Association).

 

Investors may engage a CTA to trade individually managed accounts or invest collectively with other individuals in a commodity pool or fund, thus sharing the potential risk and rewards of many different markets among investors in the pool or fund.

 

When investing in Managed Futures, the goal is to profit from moves in the contract prices of commodities, stocks, bonds and currencies -- not an appreciation in value of the underlying asset -- and each CTA employs his or her own strategy for profit maximization.

 

 

 

Unlike stocks and bonds, which involve the outright ownership of a security, futures allow investors to take a "position" in a market. That means an investor can speculate on whether a particular market, such as stock index futures, will rise or fall without having to buy a particular security. Futures also allow investors to take advantage of leverage, which can increase the earning power of an investor’s money. Through leverage, an investor only need to put up a certain percentage of the value of a futures contract, known as margin. Investors need to be aware, however, that any profits and losses are predicated on the full value of the contract, and not the amount of margin. Futures also allow investors to be "long" or "short" in a market with relative ease. Thus, by going short in stock index futures, for example, an investor can potentially make a profit if the market declines. This also allows a stock portfolio to be hedged against an adverse market move.

 

 

 

A professionally Managed Futures account is like any other brokerage account established to trade futures except that you give permission to make all trading decisions on your behalf through a revocable power of attorney to a Commodity Trading Advisor (CTA). In this sense, the CTA is the account “manager.” The CTAs compensation is normally a management fee and an incentive fee, tied to the profitability of the account.

 

 

 

With a Managed Futures account, only the investor (or the manager in a CTA Fund) and the brokerage firm have access to the cash. The CTA has limited power of attorney to initiate trades, but he or she cannot withdraw funds for any purpose.

 

 

 

Many investors including individuals, corporations and institutional investors can benefit from adding Managed Futures to their portfolios because Managed Futures, as an asset class, can provide valuable diversification to a traditional portfolio of equities and fixed income investments. Managed Futures are not suitable for everyone. Although Managed Futures can provide badly needed portfolio diversification for many portfolios, only investors with risk capital who understand and can deal with the risks and rewards involved in trading futures should invest in Managed Futures. Is is very important to understand both the risks and possible rewards of this type of investing. Generally, in addition to having the required risk capital, an investor needs to have realistic expectations about returns on investment and tolerance to temporary drawdowns that inevitably will occur with Managed Futures products.

 

 

 

Because futures markets tend to be cyclical, we do not recommend that investors treat a Managed Futures account as a short-term investment. Rather, you should view Managed Futures as a “core” portfolio asset class. Money invested in Managed Futures should be allocated on a mid to long-term basis.

 

 

 

Although portfolio holdings and investment objectives vary widely from one customer to another, Managed Futures will add a deeper layer of diversification to a typical portfolio comprised of stocks and bonds. Modern Portfolio Theory illustrates that a portfolio containing negatively correlated assets and positively performing investments usually produces better risk-adjusted returns, rather than any of the portfolio’s underlying individual investments. Research indicates that Managed Futures have been negatively correlated to traditional portfolios of stocks and bonds when they experience prolonged losses, and positively correlated when they experience sustained gains. All things being equal, adding Managed Futures to a traditional portfolio of stocks and bonds should reduce overall volatility while improving overall returns.

 

 

 

Over the long term, Managed Futures have been negatively correlated to traditional stocks and bond portfolios when they have experienced prolonged losses and positively correlated when they have experienced prolonged gains. That means that investors who add Managed Futures to their portfolios may benefit by reducing overall volatility and enhancing overall returns.

 

The following data illustrates the benefits of Managed Futures over the S&P 500 and NASDAQ for 2000-2003:

	2000	2001	2002	2003
S&P 500	-10.1%	-13.0%	-23.4%	26.4%
Nasdaq	-39.3%	-21.0%	-31.5%	50.0%
Managed Futures	10.63%	5.39%	15.22%	15.99%

 

The data shows that the average rate of returns for Managed Futures was negatively correlated with the NASDAQ and the S&P 500 during the down years of 2000, 2001 and 2002 and positively correlated with the NASDAQ and the S&P 500 during the recovery in 2003. This data supports the conclusion that there is little or no correlation between Managed Futures and traditional equity markets.

 

	VAMI Change	Duration Months	Peak Date	Valley Date	Recovery Months
S&P 500	-46.28%	25	Aug '00	Sep '02	N/A
Nasdaq	-75.04%	31	Feb '00	Sep '02	N/A
Managed Futures	-11.97%	6	Oct. '01	April '02	3

 

 

Both the S&P 500 and NASDAQ experienced significant losses from 2000 through 2002. As of July 2005, neither the S&P 500 nor NASDAQ had recouped those losses. Managed Futures, on the other hand, only experienced a relatively small loss and recovery only took 3 months.

 

 

 

A measure of how much risk a fund or portfolio assumed to earn its returns. This is usually expressed as a number or a rating. The more return per unit of risk, the better. The most popular and commonly referred to measurement of this is the Sharpe Ratio.

 

 

 

A ratio developed by Bill Sharpe that is calculated by dividing the rate of return for a portfolio that is above the risk free rate of return (ie treasury bills) and dividing it by the standard deviation of the returns. It tells us whether the returns of the portfolio were because of smart investment decisions or by excess risk.

 

 

 

Harvard Business School Professor John E. Lintner found that including Managed Futures in a portfolio "reduces volatility while enhancing return." Such portfolios "have substantially less risk at every possible level of return than portfolios of stocks, or stocks and bonds." For the period January 1, 1980, to December 31, 1998, data show that Managed Futures investments (as measured by Barclay CTA Index) had a compound annual return of about 15.8%. That compares very favorably with the 17.7% return that common stocks had during the same period, one of the strongest stock markets in U.S. history. Further, it exceeded the 11.8% return on bonds. Moreover, during a similar period (January 1, 1980 to December 31, 1997), analysis showed that a portfolio that comprised some Managed Futures had similar profitability with far less risk. A similar analysis by Managed Accounts Reports MAR, a firm that tracks investment performance, found that portfolios with as much as 20% of assets in Managed Futures yielded up to 50% more than stock and bond portfolios having comparable risk.*

 

*It should not be assumed that all portfolios including Managed Futures accounts have had - or will have - the same or similar results. Investment performance is influenced by the structure of the portfolio, market conditions, and the success of the trading advisor.

 

 

 

There is no single reason, but high on the list is that Managed Futures may perform best when other investments are performing relatively poorly. During the S&P 500's worst two declines in the past decade, Managed Futures recorded net profits of 9.7% and 18.6%. A study by the University of Massachusetts Finance Professor Thomas Schneeweis compared the S&P's worst and best 12 months and found that Managed Futures posted gains during both periods. An important advantage of futures is the opportunity they provide to respond swiftly, on a highly leveraged basis, whenever major price movements in the financial and commodity markets occur. Moreover, these price changes can occur on the upside or downside of the market. Best of all, you can achieve this without liquidating other investment holdings or adding to your overall portfolio risk.

 

 

 

CTAs can take advantage of price trends. During periods of inflation, they can buy futures contracts in anticipation of a rising market. Conversely, they can sell futures contracts if they anticipate a falling market. As shown from the data above, the potential for profit exists regardless of the overall direction of traditional markets.

 

 

 

Quite to the contrary, these markets are actually wide ranging and very actively traded. During the last decade, the futures markets have expanded to include single stock futures, stock indexes, debt instruments, currencies and options, in addition to conventional commodities. These new categories created global markets, expanding the scope of investment opportunities even more.

 

 

 

Managed Futures are some of the most transparent investment vehicles in existence. Full transparency means that investors (or the manager of a CTA Fund) can see each individual trade made by a CTA. The brokerage firm holding individually managed accounts will send investors confirmations on each trade - ensuring 100% transparency. Hedge funds and hedge funds of funds often trade exotic over-the-counter (“OTC”) instruments that cannot be easily priced because they are traded in unregulated, non-public markets and many do not report trading activity to investors on a daily or monthly basis. Thus, investors in hedge funds and hedge fund of funds generally do not have transparency into the fund’s underlying holdings.

 

 

 

A CTA Fund is an investment company designed to offer individual investors access to a well diversified and professionally managed portfolio of CTAs. To reach the diversification the manager of the CTA Fund will chose highly qualified and experienced CTAs which are trading different styles and strategies for futures, option and other financial instruments with different underlying values (stocks, commodities, currencies, etc) in different markets. CTA Funds aim to reach an over-average absolute return with a relatively low volatility. The manager of the CTA Fund sets specific goals for each CTA and follows the development of the investments on a regular basis. The manager of the CTA Fund is usually paid by a management and an incentive fee.

 

 

 

Because there are so many futures markets, it is virtually impossible for an individual investor to be well versed in each sector of Managed Futures. Sophisticated investors allocating substantial means in this asset class can hire consultants to assist them in building and monitoring a specific portfolio of Managed Futures accounts. For a smaller investor a investment in a CTA Fund makes much more sense as the fund manager will ensure an appropriate diversification and as the fund manager will constantly monitor the performance of the different CTAs and adjust the allocation. In addition, a CTA Fund will be able to negotiate better fee arrangements with the CTAs and the brokers than an individual investor could obtain on his or her own. Furthermore, a CTA Fund has access to industry specific information about CTAs, that is too expensive or difficult for smaller investors to obtain.

 

 

 

Hedge funds use a broad range of investment styles, strategies and techniques to trade different asset classes and financial instruments to try to make profits for their investors. Hedge fund managers provide expertise in managing risk and portfolio management, and their returns are largely due to their talent and skill instead of general appreciation in the asset classes traded. Theoretically, hedge funds can generate positive returns independent of what happens in the stock and bond markets. Individual hedge funds tend to trade a limited number of strategies and many of them focus on just one strategy. Some of the strategies used by hedge fund managers include: Commodities and futures, Distressed securities, Special situation funds, Equities long/short, International opportunistic, International regional, Industry sector, Strategic block, Relative value, Convertible Arbitrage, Statistical Arbitrage, Mergers and reorganizations funds. Sophisticated investors usually invest in a mix of all or part of the previously mentioned types of hedge funds on a private placement basis or through a Fund-of-Fund (see below). Hedge funds are usually organized and managed on a day-to-day basis by the traders responsible for implementing the fund’s strategies who are, in turn, paid management and incentive fees by the fund. Save only a few exceptions, hedge funds are unregulated and provide low-to-no transparency.

 

 

 

A HFoF invests in multiple underlying hedge funds in an attempt to achieve greater portfolio diversification and better returns by spreading investment risk over a number of managers and strategies. Very often, the fees of HFoF are comparably high as management and incentive fees are paid on different levels. HFoFs are generally structured as privately placed unregistered investment companies. Some of the HFoFs are also publicly traded.

 

 

 

In answering this question it might be easier to point out the similarities between a CTA Fund and a Hedge Funds or HFoF, before discussing their differences. All of these investments provide:

 

 

In addition to these shared characteristics, a CTA Fund usually offers greater accessibility, transparency, liquidity and security than most Hedge Funds and HFoFs (except in those cases when the HFoF is publicly traded).

 

Accessibility: Commitment requirements in a CTA Fund are usually much lower than many other alternative investments. Most alternative investments require a bigger capital commitment and are usually only made available to “sophisticated” investors.

Liquidity: The funds lock-up periods are usually substantial where Hedge funds and HFoFs are concerned. Sometimes it is measured in years. Managed Futures, in the great majority of cases, can be liquidated immediately. Most CTA Funds accept subscriptions from new investors and additional capital contributions from existing investors every month. Many Hedge Funds and HFoFs, on the other hand, are closed to new investment once they raise enough capital to begin doing business or only accept new capital contributions annually or quarterly after they begin trading.

Transparency: A CTA Fund usually provide substantially greater transparency than a Hedge Fund or a HFoF. The accounts managed by the different CTAs can be valued basically every day. As of the valuation day (for example at the end of each month) the performance of the different CTAs and of the CTA Fund in total can be exactly determined and reported to the investors in the CTA Fund.

Security: Investments in Managed Futures through a CTA Fund may provide investors greater security than investments in a Hedge Funds or a HFoF. Funds invested in the different Managed Futures accounts are held in specific fund accounts and the CTA is trading the account only on the basis of a limited power of attorney (withdrawals of fund by the CTA are not possible). Through a customized structure the risks of each Managed Future account are segregated.