What is Managed Future Strategy?

Explanation

A managed futures account or managed futures fund is a type of alternative investment through which trading in the futures market is managed by another person or entity instead of the fund’s owners. These accounts are not necessarily limited to commodity pools and are operated by Commodity Trading Advisors (CTA’s) or Commodity Pool advisors (CPO’s), which are generally regulated in the U.S. by the Commodity Futures Trading Commission (CFTC) through National Futures Association before they can offer services to the general public. These funds can take either a buy (long) or sell (short) positions in Futures contracts and options in the Commodities (cotton, coffee, cocoa, sugar) Interest rate, Equity (S&P futures, FTSE futures), and Currency markets.

Source: Arrow Funds

Managed futures are one of the oldest hedge fund styles, having been in existence for the past three decades. The CTA’s are required to go through an FBI background check, which is required to be updated every year and to be verified by the NFA.

Also, check out Hedge Fund Strategies

source: Arrow Funds

The strategies and approaches within “managed futures” are extremely varied. The one common unifying characteristic is that these managers trade highly liquid, regulated, exchange-traded instrument s, and foreign exchange marketsForeign Exchange MarketsThe foreign exchange market is the world’s largest financial market that decides the exchange rate of currencies.read more. This permits the portfolio to be “marked to market” every day.

  • Trend following CTA’s develop algorithms to capture and hold longer-term trends in the markets, which may last from several weeks to a year. They make use of proprietary technical or fundamental trading systems or a combination of both.Countertrend approaches attempt to capitalize on the dramatic and rapid reversals which take place in such long-term trends.

Benefits of Managed Futures

One of the benefits of including managed futures in a portfolio is risk reduction through portfolio diversificationPortfolio DiversificationPortfolio diversification refers to the practice of investing in a different assets in order to maximize returns while minimizing risk. This way, the risk is kept to a minimal while the investor accumulates many assets. Investment diversification leads to a healthy portfolio.read more by means of low or negative correlation between asset groups. As an asset class, managed futures programs are uncorrelated with stocks and bondsWith Stocks And BondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more. For e.g., during times of inflationary pressure, investing in managed futures which trade in commodities and foreign currency futures can provide a counterbalance to the losses which may occur in the equity and bond market. If stocks and bonds are underperforming in inflationary scenarios, managed futures might outperform in the same market conditions. Combining managed futures with other asset classes may improve risk-adjusted portfolio returnsRisk-adjusted Portfolio ReturnsRisk-adjusted return is a strategy for measuring and analyzing investment returns in which financial, market, credit, and operational risks are evaluated and adjusted so that an individual may decide whether the investment is worthwhile given all of the risks to the capital invested.read more over time.

The benefits of Managed Futures can be summarized as follows:

  • Potential for returns in Up and Down markets with the flexibility of taking long and short positionsShort PositionsA short position is a practice where the investors sell stocks that they don’t own at the time of selling; the investors do so by borrowing the shares from some other investors to promise that the former will return the stocks to the latter on a later date.read more, which allows for-profit in both rising and falling markets.No- Correlation to traditional investments like equities and bonds.Enhanced diversification of the portfolio.

The Drawback of Managed Future Strategies

Despite these benefits, there are certain drawbacks of managed futures strategies:

  • Returns may be biased upwards: The returns for indexes of CTA managers tend to be biased upwards due to the voluntary nature of self-reporting of performance. A CTA with a less impressive performance for a length of time is less likely to report unfavorable returns to such databases, resulting in an index that mostly includes impressive performance.Lack of natural measuring stick: Other asset classes like EquitiesAsset Classes Like EquitiesAssets are classified into various classes based on their type, purpose, or the basis of return or markets. Fixed assets, equity (equity investments, equity-linked savings schemes), real estate, commodities (gold, silver, bronze), cash and cash equivalents, derivatives (equity, bonds, debt), and alternative investments such as hedge funds and bitcoins are examples.read more or bonds have a natural benchmark for performance reporting. Market capitalization-weighted benchmarks for traditional investments mathematically represent the average return applicable to the investors. Such aggregate performance measures are difficult to apply in the case of managed futures space.CTA’s are known to charge very high fees for their services. Generally, the fee structure is similar to that a hedge fund utilizing the 2/20 structure (2% Management Fees and 20% Performance fees on achieving a high water-markHigh Water-markA high watermark in hedging means the level or peak an investment has achieved since its establishment, which is useful for measuring fund managers’ incentives and as a protection for the investors. However, a high watermark may discourage the employees, which may be a hurdle in achieving specified objectives.read more)

Strategy Strengths & Weakness

While discretionary CTA managers still exist, the majority of managed futures trading advisors comprise strategies that rely on systematic, computerized approaches to generate market trading decisions. Theoretically, systematic trading strategies strive to eliminate any chance of generating alpha. However, with investment decisions, there are certain strengths and weaknesses associated with systematic strategies:

Strengths

  • Decisions are determined by computer models, which guide in maintaining a consistent and disciplined investment approach by removing emotional hurdles and reliance on manager discretion.Allows for the historical study of price data to research, develop, and test strategies so that results in a repeatable process can be quantified and studies to improve consistency.Construction of the portfolio using various markets and sectors to increase diversification.Investing in a passive manner reduces the impact of certain traditional obstacles of investing in CTA’s. It also reduces the burden of how to find and monitor the best CTA managers.

Weakness

  • System-based trading is unable to adapt to news or environments which are different from past environments through which the models were initially derived.The amount of fees charged is very high, which may not necessarily balance out the effects of any downfalls, which can be caused due to choppy conditions.

Risk Measures of Managed Futures

Risk management is often seen as a key success for CTA strategies. A futures portfolio is built by taking positions/exposures in futures contracts across various markets.

A simple way to determine the position size is the below equation:

Portfolio size = Portfolio scaling factor * (Market Conviction * Market Risk allocation) / Volatility of the market

Market conviction defines the direction (buy or sell) and the level of confidence of each market. The market risk allocation is the quantum of risk allocated to an individual market or industry. Given these factors, each position in the number of contracts is set by the amount of volatility in each market. For instance, if Salt is less volatile and Oil is highly volatile, the position taken will be smaller, all other aspects remaining equal.

For many CTA’s portfolio constructions can be simplified into a 3 step process which can be displayed with the help of the below diagram:

source: caia.org

If the portfolio construction process is simplified into the above stages, stage one is a Model conviction, while stages two and three indicate risk management.

Risk Management of Managed Futures

Once stage one is separated from risk management and kept constant, risk management decisions can be isolated for creating risk management based factors. The risk management process is dependent on the below factors:

  • The Liquidity factor measures the effect of allocating relatively more risk to highly liquid markets like the money marketsMoney MarketsThe money market is a financial market wherein short-term assets and open-ended funds are traded between institutions and traders.read more. Liquidity is defined by the volume and volatility for each market. In terms of the liquidity factor, the risk allocation across markets will tilt more towards the liquid markets. When this factor indicates a positive return, it means that a portfolio that allocates more risk to more liquid markets outperforms the equal dollar risk portfolio.The Correlation Factor measures the effect of incorporating correlation into the risk allocation process. This allocation is determined by ranking the markets based on their “correlation contribution” for each market. When a market is highly correlated with multiple other markets, but the initial markets are not in an offsetting position, less risk shall be allocated to it. The idea is that if one market is falling, the other market should be in a position to compensate for the same. When the correlation factor returns are positive, it means that a portfolio incorporating correlation in risk allocation outperforms an equal dollar risk portfolio.The Volatility Factor measures the effect of reacting more slowly to changes in the market volatility through the “volatility of market” mentioned in the above equation. The strategy will generally involve a three month look-back period, which means the volatility will be analyzed in the past say 3-6 months. A positive return for this factor means that over that time frame, the portfolio with the slower volatility adjustment outperforms the baseline.The Capacity factor measures the effect of re-allocating risk based on capacity constraints. This factor compares the performance of a portfolio, which trades at $20 billion in the capital, with the baseline strategy trading at $5billion in the capital. The same volatility target, limits, and restrictions are applied to each of the $5bn and $20bn strategies, except a few of these limits are more binding for a larger portfolio. In response to these limits, a larger portfolio will re-allocate risk to other positions for achieving the total risk target. When the capacity factor returns are positive, it is an indication that the portfolio shall outperform the baseline portfolio.

For every individual factor, the impact of each risk management aspect can be measured across the set of included markets (equities, commodities, fixed income, and currency).

The below table indicates the performance statisticsStatisticsStatistics is the science behind identifying, collecting, organizing and summarizing, analyzing, interpreting, and finally, presenting such data, either qualitative or quantitative, which helps make better and effective decisions with relevance.read more for the benchmark strategy and the above risk management factors.

Since 2001, the liquidity and correlation factor returns have been positive on average, while the volatility and capacity factors have been on the negative trend. The Capacity factor has the most negative realized Sharpe ratio during this period indicating re-allocation of risk due to capacity constraints underperforming the baseline strategy by 0.94% per year on average from 2001-2015.

The correlation factor became more positive post-2008 though the element of volatility continues to exist, suggesting that adjusting risk for correlation would have improved portfolio performance post-2008. The liquidity factor was positive prior to 2005 and again post 2011. There seem to be certain time periods where the capacity-constrained portfolio either underperforms or outperforms the targeted baseline strategy (trading at $5billion). This suggests that exposure to capacity constraints can cause performance to deviate from the baseline strategy.

Sharpe Ratio

The Sharpe RatioSharpe RatioSharpe Ratio, also known as Sharpe Measure, is a financial metric used to describe the investors’ excess return for the additional volatility experienced to hold a risky asset. You can calculate it by, Sharpe Ratio = {(Average Investment Rate of Return – Risk-Free Rate)/Standard Deviation of Investment Return} read more is a measure for calculating the risk-adjusted return and has become an industry standard for such calculations. It is calculated using the below formulae:

Sharpe Ratio = (Mean Portfolio Return – Risk Free Rate) / Standard deviation of portfolio returnStandard Deviation Of Portfolio ReturnPortfolio standard deviation refers to the portfolio volatility calculated based on three essential factors: the standard deviation of each of the assets present in the total portfolio, the respective weight of that individual asset, and the correlation between each pair of assets of the portfolio.read more

A drawdown is a period of negative positions, i.e., the percentage changePercentage ChangePercentage Change can be defined as a % change in value due to changes in the old number and new number and the values can either increase or decrease and so the change can be a positive value (+) or a negative value (-). read more in the NAV between a high peak and subsequent trough. It takes into account the accumulated losses over a period of time, i.e., multi-period risk measures. A drawdown is not necessarily a sign of distress, but tightly connected to the fact that the markets are not always trending, and managed futures programs, in general, are expected to generate positive returns during such periods.

A maximum drawdown is a worst-case scenario a CTA manager has experienced for a specified period of time most commonly, since inception. For correct evaluation, corrections should be made to account for track length, frequency of measurement, and volatility of the asset.

Calmar Ratio

The Calmar ratioCalmar RatioThe Calmar ratio is a measure of the relationship between average annual rate of return and risk in hedge funds and investments. It’s derived by dividing the average annual rate of return by the maximum drawdown over the previous three years, and it’s used to compare hedge fund performance and make investment decisions.read more was developed as an alternative to the Sharpe ratio, which is known to have its own shares of flaws. This ratio is used to evaluate a return from one period to against the maximum drawdown the program has experienced during the mentioned period.

Calmar Ratio = (Annualised Return t)  / (Maximum drawdown t)

A high Calmar ratio indicates that for a given annual returnAnnual ReturnThe annual return is the income generated on an investment during a year as a percentage of the capital invested and is calculated using the geometric average. This return provides details about the compounded return earned yearly and compares the returns supplied by various investments like stocks, bonds, derivatives, mutual funds, etc.read more, the manager had attained a low drawdown.

Conclusion

Managed Futures Strategy Managed futures are part of an Alternative investmentAlternative InvestmentAlternative investments refer to investments made in assets classified as non-traditional investment vehicles.read more strategy, especially in the U.S. through which professional portfolio managers make extensive use of Futures contracts as a part of their overall investment strategyInvestment StrategyInvestment strategies assist investors in determining where and how to invest based on their expected return, risk appetite, corpus amount, holding period, retirement age, industry of choice, and so on.read more. Such strategies aid in mitigating portfolio risks, which are difficult to achieve indirect equity investments.

Being in possession of more information never hurts, and it can help avoid investing in CTA programs that do not fit investment objectives or risk toleranceRisk ToleranceRisk tolerance is the investors’ potential and willingness to bear the uncertainties associated with their investment portfolios. It is influenced by multiple individual constraints like the investor’s age, income, investment objective, responsibilities and financial condition.read more ability, an important consideration before investing with any money manager. Given the proper due diligence about investment risk, however, managed futures can provide a viable alternative investment vehicle for small investors looking to diversify their portfolios, thereby spreading their risks.

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