FAQ: Professionally Managed Futures

A. Alternative investments are a rapidly growing investment category generally including Professional Money Managers who are many times not readily accessible by the retail level or individual investor. Many of these non-traditional money management firms utilize both buy and sell strategies to capitalize on up and down movements in a variety of global markets. Additionally, What if you could make an investment that was in no way tied to what the stock market will do in the next 10 years? Such an investment could do well in the face of extended declines in the stock market, and do well if there is a market recovery. Such an investment is, by definition, lowly correlated with the stock market. This ability to achieve returns independent of stock market performance is the defining characteristic of alternative investments.

Specific Benefits of Alternative Investing:

• Returns independent of Stock Market Performance
• Reduction of risk via portfolio diversification
• Have historically performed exceptionally well during stock market crises (Black Monday - 1987, Iraq invades Kuwait – 1990, Russia defaults - 1998, DotCom crash – 2000, Terrorist attack – 2001, Credit Crisis 2007)
• Low correlation to traditional investments such as stocks, real-estate, and bonds

Absolute Returns
The allure of alternative investments lies in their ability to provide absolute returns regardless of conditions such as a strong or weak economy, high or low inflation, bullish or bearish stock market. And indeed, one of the key benefits of alternative investments is this ability to profit in virtually any economic environment.

Not surprisingly, the amount of assets allocated to alternative investments such as managed futures (VAM's specialty) has increased dramatically over the past several years as investors search for alternatives to the stock and bond markets.

A. The websites of the CME Group and the National Futures Association may be helpful.

1. What are Managed Futures strategies?
   Managed Futures are a diverse subset of active hedge fund strategies that trade liquid, transparent, centrally-cleared exchange-traded products, and deep interbank foreign exchange markets. Managers in this sector are called Commodity Trading Advisors (CTAs). This name goes back to the origin of the strategy when, unlike today, most CTA activity was in commodities. Currently, their strategies are largely focused on financial futures markets — equity indices, fixed income, and foreign exchange — with additional allocations to energy, metals, and agricultural markets. There are also Commodity Specialist Managers that focus mainly or exclusively on commodity markets. They may further specialize in one or more asset classes within the commodity space, such as energy or agricultural.
2. Have Managed Futures strategies changed since they became popular in the 1970s?
   The predominant strategy remains trend following, but this approach has evolved significantly in sophistication in recent years, and the overall space has become increasingly diverse.
   
   »» In general, trend followers aim to identify and exploit sustained capital flows across asset classes as markets move back out of and into equilibrium, often after prolonged imbalances. Other CTA styles thrive on volatility and choppy price action that accompanies these flows, as well as a variety of other market phenomena.
   »» The number and variety of short-term programs has risen sharply with the advances in trading technology, data analysis, and increased interest from quantitative traders in establishing their own trading firms.
3. Why should investors include Managed Futures in their portfolios?
   Managed Futures strategies can be a source of uncorrelated alpha because they are directionally unbiased, often cover a variety of time frames in their position holding periods, and have historically sought returns independently of the prevailing economic or volatility regime.
   
   Overall, these strategies have performed well during many periods that were difficult for equity markets and other hedge fund strategies. This is a result of the internal diversification, unbiased directionality, and the risk management styles of CTAs.
   
   The market conditions that have traditionally been difficult for CTAs employing trend following strategies have been those in which there is no follow through on trends, such that prices are mean-reverting. As a result, many CTAs incorporated additional strategies in an effort to capture these types of market characteristics as a complement to their trend following.
   
   »» Managed Futures strategies tend to reduce portfolio variance. The addition of uncorrelated variance may also have a beneficial effect on other performance and risk metrics.
   »» The exchange-listed underlying instruments used by CTAs facilitate risk management and mitigate many of the risks associated with model risk. The margining process also allows for flexible and effective cash efficiency.
   
   On the risk side, Managed Futures present risks for investors just like any other hedge fund style. Investors can potentially experience volatility and substantial drawdowns, especially if the trading manager has set a higher return objective and takes more risk to try to obtain it. Investors should always conduct thorough due diligence to properly understand the potential risks and weaknesses of trading programs before investing. This is especially important because the trading methodologies employed by CTAs, the level of risk and return that is targeted, and the quality of the operational infrastructure of trading managers may vary widely across the space. Regarding model risk, it is important to note with any hedge fund strategy that there is no guarantee that any model will capture or properly account for every aspect of reality. Certain types of modeling techniques may be susceptible to curve-fitting or over-optimization.
4. What is the general approach CTAs take to risk management?
   The risk management style of trend followers tends to create a positive convexity return profile, similar to what can be achieved using options. Although there is no guarantee that risks can be strictly controlled, trend following managers generally seek to preserve upside potential and limit downside risk to predetermined levels through the use of stop-loss orders and other means.
5. What is the long-term track record of Managed Futures?
   The following is presented to illustrate long-term performance comparisons among Managed Futures, equities, and several leading equity hedge fund and fund of funds indices. Further information and additional comparisons can be found in CME Group’s paper, “Lintner Revisited: A Quantitative Analysis of Managed Futures in an Institutional Portfolio”
   
   Returns – For the period of January 1980 – November 2010 the Barclay CTA Index had an average annual return of 11.55 percent vs. 7.9 percent for the S&P 500.
   
   Correlations – During that same period, the correlation between the Barclay CTA Index and the S&P 500 was insignificant at +0.01.
6. Do CTAs employ leverage in their trading?
   CTAs do not employ leverage in the traditional sense of borrowing money to increase exposure. Funds that are not being used as margin can be invested in treasury securities or various liquid instruments that meet the requirements of the customer’s FCMs. Futures contracts have implicit leverage, which is generally controlled, to a large extent, by the conservative margin to equity ratios employed by CTAs. These ratios imposed by clearing firms refer to the percentage of margin in a customer account that is permitted to be deployed as margin.
   
   Clearing firms act as third parties that aim to protect their interests by maintaining conservative margin-to-equity ratios.
   
   It is important, however, to note that risk policies at various clearing firms and CTAs vary and that customers should inquire with their own clearing firm(s) as to what the ratio would be for the customers’ account(s).
7. Are the products that CTAs trade liquid?
   CTAs generally utilize the most liquid exchange-traded products with the highest level of open interest, which enables them to offer investors excellent liquidity terms.
8. Do your fund managers impose gates and lockups on investors?
   Our fund managers generally have liberal redemption policies, usually monthly or quarterly with no restrictions, if not better. Some fund managers offer daily liquidity. Unlike what took place in some other hedge fund strategies, CTAs generally did not impose either gates or lockups during the financial crisis of 2008 – 2009. With separately managed accounts, investors can terminate a trading manager’s power of attorney and liquidate positions themselves. Our fund managers cannot restrict customers from making withdrawals from their managed accounts.
9. Is there research that supports the inclusion of Managed Futures in portfolios?
   There is a substantial body of research, including John Lintner’s landmark research study in 1983 and countless recent articles, which demonstrate the portfolio benefits managed futures can offer. The Lintner research was updated and expanded recently and is available in a long and short version from CME Group.