By: Frank Armstrong
By: Frank Armstrong, III, CFP„¢, AIFA®
Welcome to the wild west of managed futures. Even before the highly publicized fiascoes at Peregrine and MF Global we wondered why anyone might want a managed futures account. Our position has always been we wouldn’t touch them with a ten foot pole.
The sales pitch: “During periods of great future uncertainty”, though “future certainty” is an oxymoron so I’ll translate that for you, “during periods of investor anxiety about the markets, you should consider managed futures, which offer attractive returns in bull and bear markets as well as reduces risk by providing diversification.”
Sounds fantastic, I’ll take 2 please. Unfortunately, it’s not really that simple. It is time we take a closer look at the common myths about managed futures and why I recommend you just say no.
Myth #1: Managed Futures is an asset class
First thing to realize is “managed futures” is just an investment in future contracts, i.e. derivatives, being managed. It could be a strategy focused solely on precious metals or it might include every commodity, all the currencies, and all the capital markets. Additionally, a strategy can be long, short or long & short. A strategy could be based on an automated, rules-tracking process to “trend” to a specific benchmark or open to wherever the commodity trading advisor’s (CTA) “gut intuition” wants to go. The number of iterations is endless.
The core issue with this myth is that managed futures is actually a wide variety of investment strategies, not an asset class and that is a very important distinction. Past performance data on asset classes can be analyzed to create some basis for future expectations. Unrestrained, eclectic investment strategies don’t.
Myth # 2: Managed Futures have had attractive returns.
Remembering that managed futures refers to a multitude of strategies, recognizing that most are private programs and understanding that most of the managed futures benchmark returns are suspect due to the many reporting biases, how can anyone really know if the returns have been attractive to the investors?
Fortunately there are over 31 publically traded mutual funds that we can look to for more verifiable performance data yet most haven’t been around for very long. Thirteen of the thirty one were started in 2011 and only five funds have a three year track record. Arguably the granddaddy of publically traded managed futures is the Guggenheim Managed Futures Strategy H (RYMFX), a mutual fund which began trading in late 2007 and today has roughly $1.9 billion in assets. The fund invests substantially all of its net assets in commodity, currency and financial-linked instruments whose performance is expected to correspond to that of the S&P Diversified Trends Indicator.
The fund manager (Guggenheim) charges ~2% in fees per year. Given the complexity of the fund and SEC exemption (see #8), it isn’t possible to identify if there are or are not any additional underlying expenses such as fees to commodity trading advisors (CTA) which usually average an additional 2% plus ~20% incentive fees on the gains. These are eye-popping expenses to me but pretty typical for managed futures.
So with RYMFX as our proxy for managed futures, how attractive has the performance been
If attractive returns are relative, Table #1 does show that Managed Futures (RYMFX) were very attractive in 2008 relative to the S&P500 (SPY) but no more attractive than the 1-3 year Treasury (SHY) and compared to the 20+ Treasury (TLT), managed futures were not so attractive. Since 2008 the relative attraction amongst the group continues to change, but the point here is that in relative perspective to more traditional and much lower cost options, managed futures really haven’t been all that attractive.
Myth #3: Managed Futures reduce risk and improve diversification because they might be negatively or non-correlated.
If temperature variations in Lake Michigan are uncorrelated to stocks and bonds, would you be interested in buying a “Lake Michigan Temperature Volatility Fund“? Besides, an investment should provide a positive expected return, not just reduce risk. Yet Managed Futures is a “zero-sum game” which means there will be an equal number of winners as loser, i.e. there is no expected positive return in managed futures.
Just to summarize, cash and high quality, short term bonds do have a positive expected return, low to no correlation to the stock market as well as a long history. They are transparent, easy to access and are very low cost. Compare that to managed futures which have no expected return, uncertain correlation benefits, unproven history as a portfolio investment, opaque, limited access and extremely high cost.
Myth #4: Managed Futures provide a substantial hedge against inflation.
Theoretically, perhaps, yet there isn’t enough verifiable data to support the claim that an investment in Managed Futures will guarantee a hedge against inflation.
If you are only worried about inflation, just buy Treasury Inflation Protected Securities (TIPS) or I Saving Bonds.
Myth #5: Managed Futures will help in a repeat of 2008.
Maybe, maybe not. Perhaps if the exact same things all happen again as they happened in 2008, exactly the same way, in the same sequence and the same severity, then maybe. But history doesn’t repeat itself exactly nor will investors behave exactly the same way. The truth is managed futures, including RYMFX, have very little verifiable and comprehensive performance data, so no one really know how they will perform for investors.
Myth #6: Commodity Trader Advisors (CTAs) provide performance disclosures.
CTA’s do provide disclosures, no argument. However, CTAs assess incentive fees only on “net profits” and 20% is pretty compelling. So if they have a bad year, they must recoup that loss for those clients and get up over the “high watermark” before they can take incentive fees. Don’t you suppose they might just close that specific program, open a new program and start over? After all, they have a really strong incentive to start fresh. If they makes 20% the following year trying to get an old client back to even, no bonus, yet if they make a new client 20%, big bonus.
Interestingly enough, a study done by Gregoriou, Hubner, Papageorgiou and Rouah reviewed 1,500 managed futures funds, both alive and dead, spanning over 14 years. They concluded that the median survival time for funds was only 4.42 years. Obviously this is the median so some funds survived much longer while other funds for much shorter periods. But a median life span of only 4.42 years certainly is concerning. Additionally, this type of performance-based fees may create an incentive for them to make investments that are even riskier or more speculative than those they otherwise would have made in an attempt to get back to even, sort of a doubling down effect. Either way, the simple fact that CTAs provide performance disclosures may not insures that investors are getting the complete story about past performance.
Myth #7: Managed Futures are well regulated and audited.
CTAs do register with the Commodity Futures Trading Commission (CFTC), are required to get an FBI background check, are required to provide disclosures and have independent audits of financial statements. Yet all this does very little to reduce conflicts of interests nor does it assure adequate investor protection. After all, the mortgage industry could have largely made similar claims about being regulated and audited yet it’s pretty clear today how ineffectual that was.
Granted, the CFTC’s stated mission is to protect investors and the public from fraud in the commodity futures and options markets. Unfortunately the CFTC proved woefully insufficient to stop the roughly $1.6 billion dollar fraud at MF Global in 2011 or the $215 million dollar fraud of PFGBest in 2012.
The good old open-ended mutual fund which is publically traded, audited daily, has multiple independent checks and balances are a gazillion times more regulated and audited than the managed futures industry. Yet mutual funds still have issues now and then. At the end of the day, managed futures, especially direct private placements, is still an open frontier where investors better be very, VERY wary.
Myth #8: Managed Futures Mutual Funds are at least as well regulated as other publicly traded Mutual Funds.
Nope. The SEC requires most mutual funds that invest in other managers to disclose those fees. Yet the managed futures mutual funds have an exemption because they can invest through off-shore subsidiaries. To quote from one prospectus, “The Subsidiary and the Trading Entities are not registered under the 1940 Act and, unless otherwise noted in this Prospectus, are not subject to all of the investor protections of the 1940 Act.” Even our granddaddy, RYMFX may invest up to 25% of total assets in a wholly-owned and controlled Cayman Islands subsidiary. To quote from Morningstar, “managed-futures mutual funds are able to establish the CFCs (controlled foreign corporation) and trade futures through those offshore shell entities.” I don’t know about you but “offshore shell entities” tends to be a pretty big red flag for me. In addition to being less regulated, these offshore shell entities create a black hole of information.
Myth #9: Trillions of dollars are invested in futures so it must be real.
We’ll yes, there is a lot of money in future contracts. But how much is for “business applications” versus investments? The futures market was created for business risk reduction, not investing. Aluminum producers, airlines, chemical companies, farmers and so on are why the futures industry evolved and why there are CTAs and futures in the first place.
Managed futures are an exciting and sexy idea, and people have made a lot of money, mostly the futures industry and CTAs. With annual fees typically around 2% plus 20% of profits, the headwinds against anything realistically being left for the individual investor is slim to none. Think about what is the real economic value of what you are capturing by investing in managed futures? There isn’t any. Managed futures economic rational as an investment strategy today must essentially be the belief that your ‘expert’ manager is so much better than everyone else’s ‘expert’ manager, that you can afford to pay 2% plus 20% and still make a profit. Really?
Do yourself a favor and just pass on managed futures.