VOLUME 1, NUMBER 23/August 14, 1995
***************************************************************** DERIVATIVES 'R US is a weekly non-profit publication on the Internet user group misc.invest.futures that provides a simple non-technical treatment of various topics in derivatives. DRU is written by Don M. Chance, Professor of Finance at the Center for the Study of Futures and Options Markets at Virginia Tech. He can be contacted at dmc @ vt.edu or by phone at 540-231-5061 or fax at 540-231-4487. DRU is for educational purposes only and does not provide trading advice. Back issues of DRU available by anonymous ftp from fbox.vt.edu/filebox/business/finance/dmc/DRU or can be accessed using a Web browser at http://fbox.vt.edu:10021/business/finance/dmc/DRU. The file contents.txt can be viewed to see a list of old filenames and topics available for reading or downloading. *****************************************************************
MANAGED FUTURES
This week's topic is managed futures. Amid the hoopla and publicity over the growing use of exotic derivatives, the managed futures industry has achieved remarkable growth trading the rather mundane exchange-traded futures and options.
Just what exactly is managed futures? There is a large industry of futures traders known as Commodity Trading Advisors or CTAs who manage futures accounts for clients. Those clients might be individual or institutional investors. These traders are allocated a certain amount of funds and they use those funds to take positions in futures contracts on behalf of their clients. The industry is large with an estimated $25 billion under management.
Why are managed futures attractive? Studies have shown that the correlations of managed futures to stocks and bonds are quite low; thus, adding them to a diversified portfolio of stocks and bonds gives the portfolio lower risk. This low correlation arises from the fact that managed futures traders can trade across markets, can go short as easily as long, and frequently pay little attention to what stock and bond traders are doing. I should note, however, that these correlations tend to hold over a long period of time. Five years is probably the minimum holding period to count on a low correlation. Over a much shorter holding period, don't be surprised to see the correlations get as high as .8.
Managed futures programs can generally take three forms. First there is the commodity fund. Today, however, the term "futures fund" is being used more often because the majority of futures trading is not in commodities but rather in financial futures. A futures fund is essentially a mutual fund that specializes in futures trading. Investors deposit money with the fund, which pools the money and trades futures. Some funds are guaranteed in the sense that the fund organizers have agreed that their investors cannot lose more than they originally invest, an attractive feature given that we all know that futures contracts can lead to losses greater than the initial margin. Typically the fund invests only a percentage of the money in a margin account(20 - 30 % is fairly common), holding the rest in an interest-earning account or putting it in T-bills.
Futures funds have been studied at great length in academic journals. In all honesty, the results are not favorable. The funds have generated enormous expenses and their returns have been volatile and inconsistent. It is not even clear that they provide the much touted diversification benefits arising from the low correlation between futures and stocks.
A second form of managed futures is the commodity pool, which is essentially a private futures fund. A commodity pool operator (CPO) organizes the pool by soliciting funds from selected investors. The pool then operates in much the same manner as a commodity fund. Some pools provide a guaranteed return of initial investments, some do not. The research on pools is not favorable either. Their performance is similar to that of the funds and their costs are quite high. One interesting study found that CPOs tend to have periods of strong performance before organizing a pool. I suppose this strong performance then induces them to organize a pool after which their performance is usually back to its normally volatile and inconsistent way.
A third form of managed futures is a private arrangement. This is common with large institutional investors. Say a pension fund decides to allocate a portion of its funds to a managed futures program. There are a number of ways in which a program can be structured. One common way is to have one person or firm in charge of administering the entire program. That firm or person might go out and hire one or more other firms that specialize in selecting and monitoring individual CTAs. In any case, the institutional investor can negotiate the overall cost structure. Typically the cost of this kind of program is substantially lower than the fund or pool structure. However, the costs are still much greater than the costs of the more traditional equity or fixed income professional investment management.
Individual CTAs are often small, sometimes one-person firms, and may manage money under all three structures. They are hired and fired at will. Many of them tend to specialize in certain markets like interest rate futures or agricultural futures but many also diversify. Their trading strategies tend overwhelmingly to be of a trend-following, technical nature.
As you can tell, cost is a key factor in managed futures. Costs include management fees and incentive fees. The industry is beginning to come to grips with the fact that this form of money management is extremely costly relative to equity or fixed-income money management. I have never been able to tell exactly why this industry is so costly though I have heard that many CTAs and CPOs have very small operations, thus having a low overhead base. That should matter little, however, to a pension fund manager who would demand a reasonable fee structure. When CTAs begin to recognize this point, you will see more pension funds get into managed futures.
As in most of my other essays, there is a lot more to be said and in fact, I have done so elsewhere. My 80-page monograph "Managed Futures and Their Role in the Investment Portfolio," provides an overview of the industry, the research on managed futures and much more. It is available from the Association for Investment Management and Research at 804-980-3647 or 804-977-0350 (fax) for $20 plus shipping. Let me emphasize that I do not receive any royalties on this monograph (though judging from its sales, I wish I did).
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DERIVATIVES QUOTE FOR THE WEEK
"The worst thing a trader can have is an attitude'. The best thing a trader can have is discipline."
Donald R. Katz, "The Boys in the Pits" Esquire, January, 1981, p. 38.
(No way. The worst thing a trader - or anyone - can have is an IRS auditor on his back. The best thing a trader can have is a lot of luck.)