How To Select A Managed Futures Investment

Written on Sep 13, 2010 | by Ashley Johnson

Managed Futures

Over the last seven years, the amount of money invested in Managed Futures has more than quintupled! According to hedge fund tracking firm Barclays, assets under management rose from about 41 billion dollars in 2001 to more than 219 billion dollars today!

As global demand for commodities proceeds to heat up and more investors (institutional and individual) start viewing commodities as a smart investment vehicle, we anticipate this trend to continue. This expansion has also elevated the demand for ways to select a Commodity Trading Advisor. In this article, we will summarize what we feel are some of the best tools, and techniques available to the individual investor when deciding on a managed futures product.

Managed Futures Defined

Let?s first establish what managed futures are and what they are not. Managed futures are not stocks or ETF?s that simply make investments in commodities. Managed futures accounts are investments in which funds invest in mainly leveraged, future dated contracts for commodities or financial instruments. Commodities may consist of sectors such as food, energy, raw materials and financial instruments like interest rates and stock indices.

The leverage, risks and rewards can be (but are not always) substantially higher when investing in the futures markets vs. the stock market. The National Futures Association and the Commodity Futures Trading Commission regulate managed futures investments in the United States (unless the firm / fund have ?exempt? status). Regulated firms hold a Commodity Trading Advisors (CTA?s) or Commodity Pool Operators (CPO?s) license, but keep in mind, just because a firm carries a license is in no way an endorsement of future performance. Futures trading can carry large potential risks and is not for everybody. Investors should be familiar with all the risks before investing.

Obtaining databases of possible Commodity Trading Advisors to look through is relatively simple if investors know where to look. Organizations such as Barclays Trading Group, Stark Research, Autumn Gold and Altegris Investments have directories of manager data available. One resource we like is www.autumngold.com. AutumnGold summarizes a free (with registration) online repository of more than 450 Commodity Trading Advisors. In addition, the programs may be sorted by a broad variety of parameters such as minimum account size, funds under management, and numerous performance statistics.

The only difficulty we notice with the online directories is that it can come to be somewhat overwhelming to try and narrow down the choices to just a handful of managers. To help simplify the process, we would like to reveal what we think are a few of the best performance metrics.

Managed Futures Evaluation

The first recommendation is to ignore return! The least significant statistic frequently is a Commodity Trading Advisors return. How can that be? What matters is RISK ADJUSTED RETURN. Just because somebody bet the farm and got fortunate does not mean it was a nifty idea. Sooner or later (most often sooner) the inescapable wipe out will happen with a manager betting too aggressively.

There are many traditional risk adjusted return measurements, the most popular of which being the Sharpe ratio. The Sharpe Ratio compares the return relative to the underlying volatility in the investment. Although we are in agreement with the Sharpe Ratio?s logic, we feel it has one serious flaw. The flaw is that the Sharpe Ratio only views past volatility and does not try and predict future volatility. As a result, we feel the Sharpe ratio does not give an adequate view of the potential risks involved in a program.

A good example of this comes from the world of the ?option writers? (those who sell options). Since most options end up expiring worthless, it is not uncommon for managers that sell options to have excellent Sharpe Ratios. They can have smooth looking equity curves that have produced for many years, but just because an equity curve looks smooth and consistent does not mean it will stay that way. What happened is meaningless if new investors do not have the same results. Option sellers with longer term excellent track records tend to have quick, spectacular ?blowups?. The problem is that past volatility is not a reliable predictor of future volatility.

What is a dependable predictor? One of the finest volatility forecasters is the ?Margin to Equity Ratio? (MTE). The MTE tells an trader roughly how much of their investment could be used for margin purposes. This number will fluctuate day-by-day for a given manager, but traders can obtain the average range. If, for example, a managers MTE is 10%, this indicates that for every $100,000 invested the manager uses about $10,000 of this for margin. Keep this in mind; the exchanges set margin dependent on their approximations of risk. The greater the exchange perceives the risk in a contract the higher the margin they set. We encourage thinking just like the exchanges and raise the expectations for potential risk as the MTE goes higher. If we go back to the example of the option writers with excellent Sharpe ratios, investors will also see that they frequently have high MTE ratios. We believe that these large MTE ratios were the tip off that could have prevented many disastrous scenarios. Once again, just as the exchanges usually increase margin requirements as their expectation of volatility rises, so too do we see the possibility for volatility (risk) to be higher as the MTE rises.

Another essential use of the MTE comes down to pure mathematics. If there were two Commodity Trading Advisors that made $30,000 returns, yet one used $30,000 in account margin to do it, and the other used $60,000 in account margin to do it, then the outcomes are different. Based on margin utilization one manager?s return was two times as high as the others. This is essential to keep in mind, because usually managers can appear to have similar performances, but when digging down into their margin utilization investors will see large dissimilarities.

Exactly what is an ideal MTE? We do not like to observe margin to equity ratios much above 10%. This is on the lower end of the spectrum for managed futures accounts and cuts out most managers. Although it is correct that low MTE percentages are no assurance of reduced risk, we feel that, at the very least, it is probably a good gauge of sound risk management. Once again, we feel that as the MTE increases so does the potential for risk. There is also a related risk measurement often referred to as ?portfolio heat? that utilizes related principles.

In summary, what we suggest is that potential investors compute returns not based on what the manager reported, but rather based on the return on margin (risk and drawdown should also be computed the same way). This will level the playing field and allow an apples-to-apples comparison. We are also in favor of being on the conservative side of the MTE spectrum, for us that means that we would likely reject any manager with a ratio above 10%. Using this method can help narrow down the list of choices to a manageable number rather quickly. After doing this then look and compare all the other risk adjusted performance measures and further refine the selection. (At this risk of this article being too long, we will save the other risk adjusted performance measurement discussions for future installments).

We want to care once again that, in the end, no measure is a guarantee or assurance against risk or losses. Past performance is not always indicative of future results. Futures? trading entails risks and is not for everybody. We are merely sharing what we feel is the best technique by which to pick a manager.

Dean Hoffman Hoffman Asset Management

We believe that these high MTE ratios were the tip off that could have avoided many disastrous scenarios. Finding lists of potential managers to sort through is fairly easy if investors know where to look. Managed Futures The MTE tells an investor roughly how much of their investment would be used for margin purposes.

Perfect Business!