Insights
Managed Futures: A Primer
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Insight Article
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November 01, 2022
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Managed Futures: A Primer
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November 01, 2022
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Managed Futures: A Primer
Managed Futures: A Primer |
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What are Managed Futures and Commodity Trading Advisors?
Managed futures investment strategies may provide qualified investors access to the world’s exchange-cleared and regulated futures, options on futures, and currency forward markets. These investment strategies are employed by Commodity Trading Advisors (CTAs). Historically, the CTA universe is comprised of a wide array of investment approaches that manage client assets. CTAs are professional asset managers with membership in the National Futures Association (NFA) and are registered with the Commodity Futures Trading Commission (CFTC).
There are several characteristics of managed futures which differentiates it as an investment strategy. Below are a few of the primary fundamental underpinnings and features of managed futures as an alternative investment strategy.
Absolute Return Strategy:
There is often the misconception that managed futures only make profits when stocks are down and vice versa when stocks rally. In reality, managed futures is an absolute return strategy whose long-term returns are independent not only of stock market performance but also any other asset class. One of the key reasons this is often the case is because a CTA can go long or short in any market they trade in with relatively equal ease. Thus, a managed futures strategy can capitalize when markets are exhibiting bullish tendencies, but also record gains from downside price moves. It is the ability to be long or short in the global futures marketplace which, over time, gives managed futures its low correlation not only to traditional stock and bond investments, but other alternative strategies as well. And, because managed futures have been complementary to these other investment strategies, an inclusion of managed futures to a qualified investor’s portfolio can potentially improve the portfolio’s overall risk/return characteristics. (However, it is important to remember past performance is not indicative of future results.)
Inherent Diversification:
Another key aspect of managed futures is the style differentiation and integration of two separate and unique investment styles, quantitative systematic and fundamental discretionary trading.
Systematic Strategies:
- These strategies typically utilize proprietary trading models to identify pricing trends ranging from short-term to long-term, with short-term strategies holding trades for only a few days, and longer-term strategies seeking to capitalize on price trends over weeks or months. Systematic CTAs are unemotional in their investment-making processes. Each systematic CTA has its own proprietary trading models that have the advantage of optimally adjusting exposures as opportunities ebb and flow, without the “in the moment” emotion that can be involved with discretionary decision-making.
- Trading models across CTAs differ greatly with regards to markets traded, time horizon, type of analysis employed, and input data analyzed. These models attempt to determine the future trajectory of prices or relative relationships based on historical data inputs and using scientific methods. Accordingly, research departments at CTAs are staffed primarily by experts with quantitative backgrounds such as mathematicians, physicists, engineers and scientists from other quantitative-related disciplines.
- More powerful computing technology, data availability and collection, and overall growing market diversity has been the primary drivers behind the evolution of systematic trading strategies over the last few decades.
- This automated style of trading has many advantages. Most importantly, a systematic CTA can monitor and trade in multiple markets at one time. Most CTAs trade between 75 and 200 markets at once, many of which have little to no correlation to one another. This broad exposure to multiple market opportunities lies at the foundation of managed futures trading. Using strict risk controls, liquid markets and daily mark-to-market practices, CTAs have positions in numerous trades, adjusting position sizes accordingly as opportunities develop or challenging trading environments arise.
Fundamental Discretionary Strategies:
- These strategies tend to be less technical and more fundamental, seeking to anticipate market moves rather than capitalize on existing price trends. They tend to trade with larger position sizes, in a smaller number of markets. Discretionary strategies may also focus their expertise on a single market or market sector.
- Discretionary CTAs acquire deep expertise in their areas of specialty. They analyze fundamental supply demand data, gather quantitative and qualitative information from niche, not easily obtainable, data sources, including other experts in a particular field related, directly or indirectly, to the markets traded by the CTA. Quantitative and qualitative analyses are performed to identify individual market price imbalances that offer attractive risk reward opportunities. This expertise tends to result in fewer, larger positions than a systematic manager would normally have. Discretionary managers, whether they trade futures or securities, can share this trait.
- Discretionary CTAs are required to possess expert knowledge. They are typically focused on a particular sector, such as energy, for example, or can be even further specialized to a market within a sector, natural gas being one. In addition, position sizing and timing of trade entry and exit is of extreme importance. Fundamental CTAs rely on their risk management expertise, developed over their professional careers, suited to their personalities and their clients’ risk tolerances.
Unique Diversification Through Broad Global Market Access:
Futures markets allow direct access to markets that are important to the world’s economic flows and may offer opportunities that are difficult for investors to access via other investment options. Currently, there are dozens of futures exchanges globally and hundreds of individual futures markets trading on those exchanges, with new market contracts added frequently. This allows for broad global market diversification (Display 1) across a wide range of market sectors, including: Currency, Fixed Income, Equity Indices, Commodity (energies, grains, softs, metals, livestock).
Futures contracts traded on individual markets are based on standardized terms and set dates. As such, CTAs typically do not trade in individual physical markets or securities, but rather, futures contracts based on representative asset prices for a future date. We believe the breadth of the futures markets is one of the main reasons that managed futures funds have historically performed differently from stocks, bonds and other alternative investment strategies.
In general, futures markets provide commodity producers an opportunity to hedge against fluctuating market prices.
An investment in these dynamic markets can offer investors an opportunity today to potentially protect their investment portfolios from adverse market environments as well as add important portfolio diversification that can potentially improve overall portfolio risk-adjusted returns.
Below are some of the other key aspects which differentiate managed futures funds from traditional investments as well as other alternative investment strategies:
- MANAGED COUNTERPARTY RISK: Futures contracts are exchange-cleared instruments, which means the risk between counterparties is managed effectively by the respective exchanges and limited to an exchange’s members. Each exchange has a clearing corporation that consists of multiple institutional members. The clearing corporation takes the offsetting positions of each participant and clears them so that all parties are made whole, and all transactions are completed. Clearing members have a financial obligation to support this function. A clearing corporation’s multiple members help to minimize the risk of single counterparty default—a risk that exists for securities that are not cleared via a clearing corporation.
- LIQUIDITY: Futures contracts are liquid financial instruments that trade and settle daily on regulated exchanges, which allows for transparent market pricing.
- REGULATION: Subject to oversight by CFTC and National Futures Association (NFA).
- TAX EFFICIENCY: The majority of the trading-related gains and losses from managed futures funds are taxed annually at 60% long-term /40% short-term tax rates and reported via Schedule K-1.
- TRANSPARENCY: Unlike many other alternative investments, managed futures are able to mark-to-market daily, providing a higher level of transparency and frequency of valuation.
Low Correlation to Other Asset Classes:
- Historically, managed futures have had low correlation to traditional asset classes and other alternative investments, which can make them a powerful portfolio diversifier. Unlike long-only and long-biased equity and bond portfolios, which tend to rise and fall with their respective markets, managed futures investments generally profit when sustainable trends, either up or down, exist. This is represented by the correlation chart in Display 2 which shows the long-term correlation between managed futures, as represented by the Barclay CTA Index, versus other traditional and alternative asset classes.
- Over time, managed futures have proven to be a source of downside protection, delivering positive returns during periods of equity market weakness. In fact, managed futures investments have historically experienced their strongest performance when traditional markets are experiencing extended and severe weakness and heightened, directional volatility. The previous chart indicates the performance of the Barclay CTA Index during periods of extended equity drawdowns represented here by the S&P 500 Total Return Index. As the below chart shows, historically, managed futures have tended to perform well in periods of extended equity weakness.
- Managed futures, with the scope and breadth of both systematic and discretionary strategies, trade both long and short across a universe of potentially hundreds of markets on exchanges around the globe, and can be a source of diversification in traditional stock and bond portfolios, as well as to other alternative strategies like private equity and hedge funds.
| MSIM's Managed Futures Investment Team: | |||||
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PATRICK EGAN
Executive Director
Head of Managed Futures Group
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SRDJAN TESLIC, PH.D.
Executive Director
Chief Investment Officer
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SCOTT DUNLAP
Vice President
Portfolio Manager
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MSIM's Managed Futures team, which has roots dating back 40-plus years, specializes in providing high net worth and institutional investors access to multimanager investment solutions. In our view, an allocation to managed futures is an essential component of a well-diversified portfolio. Over the long term, we believe these strategies provide important diversification benefits versus other traditional and alternative asset classes.
For more information, please contact the MSIM Alternative Investments Hotline at (212) 296-7676.