Ways To Pick A Managed Futures Investment
Managed Futures
Managed Futures
Over the last seven years, the sum of money invested in
Managed Futures has more than quintupled! According to hedge fund monitoring firm Barclays, assets under management increased from approximately 41 billion dollars in 2001 to more than 219 billion dollars today!
As worldwide demand for commodities continues to heat up and more investors (institutional and individual) start seeing commodities as a sensible investment vehicle, we expect this trend to continue. This growth has also raised the need for ways to select a Commodity Trading Advisor. In this article, we will outline what we believe are some of the best tools, and methods available to the individual investor when choosing a managed futures product.
Managed Futures Defined
Let?s first define what managed futures are and what they are not. Managed futures are not stocks or ETF?s that just invest in commodities. Managed futures accounts are investments in which funds invest in mainly leveraged, future dated contracts for commodities or financial instruments. Commodities can include 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) significantly higher when trading in the commodities 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 companies hold a Commodity Trading Advisors (CTA?s) or Commodity Pool Operators (CPO?s) license, however keep in mind, just simply because a firm carries a license is in no way an endorsement of future performance. Futures trading can carry significant potential risks and is not for everybody. Investors ought to be acquainted with all the risks before trading.
Finding lists of potential managers to sort through is fairly easy if investors know where to look. Firms such as Barclays Trading Group, Stark Research, Autumn Gold and Altegris Investments have databases of manager information available. One resource we like is www.autumngold.com. AutumnGold summarizes a free (with registration) online database of over 450 programs. Also, the programs can be sorted by a wide range of parameters such as minimum account size, funds under management, and various performance measurements.
The only problem we see with the online databases is that it can become somewhat overwhelming to try and narrow down the choices to just a handful of managers. To help simplify the process, we would like to share what we think are some of the best performance metrics.
Managed Futures Evaluation
The first recommendation is to forget return! The least significant statistic often is a manager?s return. How can that be? What matters is RISK ADJUSTED RETURN. Just because somebody bet the farm and got lucky does not mean it was a nifty idea. Sooner or later (most often sooner) the inevitable wipe out will occur with a manager betting too aggressively.
There are many traditional risk adjusted return measurements, the most well-known of which being the Sharpe ratio. The Sharpe Ratio compares the return compared to the underlying volatility in the investment. Although we are in agreement with the Sharpe Ratio?s logic, we feel it has one significant flaw. The drawback is that the Sharpe Ratio just views previous volatility and does not try and predict future volatility. As a result, we think the Sharpe ratio does not give an adequate view of the possible 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 shows an investor roughly how much of their investment would be utilized for margin purposes. This amount will vary day-by-day for a given manager, but investors can get the typical range. If, for example, a managers MTE is 10%, this means that for every $100,000 invested the manager uses about $10,000 of this for margin. Keep this in mind; the exchanges set margin based on their approximations of risk. The higher the exchange thinks the risk in a contract the higher the margin they set. We recommend thinking just like the exchanges and raise the anticipation 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 additionally observe that they often have high MTE ratios. We believe that these high MTE ratios were the tip off that could have avoided many unfortunate scenarios. Once again, just as the exchanges frequently increase margin demands as their expectation of volatility rises, so too do we see the possibility for volatility (risk) to be greater 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 usage one manager?s return was twice as high as the others. This is essential to keep in mind, since often managers can seem to have similar performances, but when digging down into their margin utilization investors will see large differences.
What is an ideal MTE? We do not like to see margin to equity ratios much above 10%. This is on the low end of the spectrum for managed futures accounts and cuts out most managers. Although it is true that low MTE ratios are no guarantee of lower risk, we feel that, at the minimum, it is possibly a decent gauge of sound risk management. Once again, we believe that as the MTE rises so does the potential for risk. There is also a related risk measurement often referred to as ?portfolio heat? that uses similar concepts.
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 caution 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 involves risks and is not for everybody. We are simply sharing what we feel is the best method by which to select a manager.
Dean Hoffman Hoffman Asset Management
by: Dean Hoffman
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