The Pros And Cons Of Managed Futures

[Editor’s Note: Don Wieczorek is a managed futures fund manager at Purple Valley Capital and is married to an emergency medicine physician. He reached out to me with a request to do a guest post on managed futures. He has previously written a guest post for the White Coat Investor several years ago. I initially rejected his guest post, but agreed to instead to do a Q&A format where I would ask him some of the questions I had about managed futures trading.

Mr. Wieczorek understands that managed futures trading is far outside the main points of this blog, but it’s important to understand all aspects of the financial industry. I personally do not invest in managed futures and do not plan to in the future, but every investor must decide for themselves what’s right for them.

Mr. Wieczorek can be contacted by e-mail at don@purplevalleycapital.com. We have no financial relationship.

Without further introduction, let’s get into the questions. -WSP]

1. Tell me a little bit about yourself and how you got into managed futures trading.

I have always been fascinated by all type of markets. I studied economics, psychology, and mathematics at Williams College before launching my futures trading CTA firm upon graduation almost 10 years ago. While there are a myriad of ways to approach markets, and I experimented with many of them, I found that a long-term systematic trend following approach fits me best. I trade by the following ethos: cut losers, ride winners, manage risk, trade long-term, and stick to the system. While I believe markets are unpredictable, I do feel markets can move in large ways (i.e. big trends, bubbles, or “fat tails”) that are beyond what a normal distribution of market returns would suggest, and those trends can offer wonderful trading opportunities for reactive systematic trading styles. My job is to try to capture such trends for clients. I use futures markets because they grant me a large and diverse array of markets on which to over lay my trend following system. I trade over 40 futures markets, including metals (gold, silver, copper), grains (soybeans, corn, wheat), equity indexes (S&P futures, NASDAQ 100 futures), soft commodities (cotton, cocoa, coffee, sugar) as well as foreign currency, U.S government bond, and even bitcoin futures. Again, if any of these markets are in large bull or bear trends, my job is to get positioned accordingly and attempt to follow and capture the trend. While researching and developing my strategy, I looked to other trend trading pioneers like John Henry (owner of the Boston Red Sox), Ed Seykota, and the “Turtles” for inspiration.

[WSP: While trend following and the Turtles trading strategy is slightly different than pure technical analysis, I’ve stated my thoughts on technical analysis for trading in a White Coat Investor guest post.]

2. What are managed futures?

By definition, managed futures are an alternative asset class in which trading in futures markets is managed by another person or entity. This industry has been around for decades, and the professional money managers are known as Commodity Trading Advisors (CTAs). My firm, Purple Valley Capital, Inc., is registered as a CTA for example. While CTAs can have varying styles and methods of trading, the majority tend to be systematic and trend following in nature. I believe this is due to the inherent leverage in futures markets; if losses aren’t kept small, you can lose your shirt. To be profitable, winners must outweigh losers. The old adage “the trend is your friend,” is extremely important.

[WSP: Risk management is important in trading, especially when you are leveraged. It’s also important in index investing — this is done by choosing an appropriate asset allocation.]

3. What does your typical client look like?

I have over 60 clients, and they range in age, net worth, future income prospects, and risk tolerance. Their allocations to my strategy vary based on these parameters. Most importantly, they believe in me, understand the strategy, and have a long-term perspective.

[WSP: To invest in most CTAs, you need to be a qualified eligible person, similar to an accredited investor for hedge funds or other unregistered securities.]

4. Managed futures represents what percentage of your typical investors’ portfolio?

Since managed futures are an alternative asset allocation used for diversification, a typical client will allocate 5-15% of their investible assets to a managed futures program. The allocation will differ based on a client’s financial landscape, goals, and risk tolerance. For example, I have one client who is a young professional downhill skier who embraces high volatility. This client has a much higher allocation to me than another one of my clients who is older, retired, and prioritizes capital preservation and crisis alpha over aggressive portfolio gains.

[WSP: I do not hold any commodities in my portfolio, and most asset allocation models I see that do hold commodities generally have about 5% in this asset class.]

5. What are the benefits of managed futures?

The main potential benefit of allocating to managed futures is the diversifying aspects of the asset class, with the added potential benefit of providing crisis alpha during times of financial stress, like in 2008. Managed futures products aim to create this non-correlation by trading different assets, over different time frames, both long and short. When blended with traditional assets like stocks and bonds, an allocation to managed futures can have the ability to increase returns while lowering volatility at the portfolio-wide level. For a more complete picture of the benefits, it is best to speak with a CTA directly and read through their disclosure document.

[WSP: I agree that commodity returns are relatively uncorrelated to stock and bond returns, but the question is whether you can get these benefits through an index ETF or must you go through a CTA.]

6. What are the risks of managed futures?

Although allocating to a CTA can be a fantastic diversifier if used properly, there certainly are risks to getting involved, and the use of such a strategy is not for everyone. First and foremost, CTAs buy and sell futures contracts, which are inherently leveraged products and carry with them a risk of large potential loss. Because trend following CTAs, almost by definition, aim to be positioned in the hottest markets (those hitting new highs or new lows), performance can be volatile and have deep drawdowns as well. Psychologically, this type of investment can be very difficult, because it can produce frequent small losses in exchange for infrequent but large gains. Drawdowns can be lengthy. For a more complete picture of the risks, it is best to speak with a CTA and read through their disclosure document which disclosures all of the risks.

[WSP: Risk management is important in trading as well as investing. Hedge funds have an incentive to take risk, as they capture a portion of the profits when the hedge fund succeeds, but are limited in their downside risk (i.e. the firm shuts down, but the managers can always start a new fund.)

7. What are the historical returns of managed futures accounts?

The Barclay CTA Index (https://www.barclayhedge.com/research/indices/cta/sub/cta.html) is a leading industry benchmark of representative performance of commodity trading advisors. There are currently 522 programs included in the calculation of the Barclay CTA Index. The Index is equally weighted and rebalanced at the beginning of each year. However, it is not an investible index. Without going too deeply into specifics, which would require a long list of disclosures required by my regulators, I will keep the performance discussion relatively vague. Generally, when commodity markets are trending, the majority of CTAs tend to do well. When markets are range bound and volatile, most CTAs perform poorly. CTA performances can be cyclical, and some CTAs have better performances than others. Performances tend to be uncorrelated, and sometimes even slightly negative correlated, to equity and bond returns. Returns can be lumpy, with frequent small losses and infrequent but large gains. If you’d like to learn about a specific CTA’s performance, contact them directly and read through their disclosure document.

[WSP: Managed futures as an asset class have their ups and downs — Barron’s ran an article in 2014 discussing managed futures’ poor returns in the years leading up to the publication in that article. And judging by the returns of the largest managed futures ETF, the returns have not improved since then.

That being said, individual CTA returns can vary from fund manager to fund manager. Unfortunately, it’s hard to know in advance who will do better than the average and who will underperform.]

8. How much fees does the typical managed futures account charge?

CTAs tend to charge a management fee and performance fee. These fees can range significantly from firm to firm, and are flexible, so it is best to contact the CTA directly and discuss it with them. On average, a firm may charge a yearly 2% management fee, and then a 10-20% incentive fee on new net profits, subject to high water marks.

[WSP: The typical hedge fund uses this “2 and 20” fee structure. There are high water marks rules, but you can do a back-of-the-envelope calculation to estimate the fees. If the fund returns 10% before fees, the managed futures fund might take about 2% of assets under management and approximately another 20% * 10% = 2% in fees because of profits. Your 10% returns, after fees, ends up actually being approximately 6% returns. For investors used to paying less than 0.1% in fees for index funds, Mr. Wieczorek and other managed futures funds have a huge hurdle to overcome in order to beat more passively managed investments.]

9. Why not invest in futures and/or commodities myself using an index fund or ETF?

Unfortunately, comparing commodity ETFs to managed futures is like comparing apples to oranges. Both have their merits, but have vast differences. Commodity ETFs are easily accessible, left to the buying and selling decisions of the individual, and are beta driven instruments that seek to generate returns solely from the market with little dependence on manager skill or alpha. Yes, they can still offer some diversification, but they are long-only biased. I think it’s important to remember that commodities don’t grow earnings and produce dividends like equities; there is no rule that commodities will go up over time. Their prices simply move up and down based solely on supply and demand. Buying and holding commodities may not be the best way to use them for long-term portfolio diversification purposes. In my opinion, high beta does not exist in commodity markets to the extent that is does in equities.

CTAs on the other hand, operate under a different set of conditions and have many more dimensions to their diversification benefits. CTA strategies seek alpha returns and are far more flexible than a long-only approach. They are entering and exiting markets actively, trying to capture trends as prices fluctuate up and down over time. There is no long or short bias—they simply follow the price action at the time. The portfolio itself is dynamic, as is the long or short bias and time frame of holdings. This can offer much greater diversification benefits than simply buying and holding a commodity ETF. Those who hire CTAs are effectively buying an actively managed trading strategy, run by an experienced professional, who you can actually speak to on the phone.

[WSP: If I were to invest in commodities (I currently don’t), I would invest in a passively managed index fund. When you invest in a managed futures fund, you are investing as much in the fund manager as you are in the asset class. You need to believe that he or she can deliver value above and beyond his or her high fees.]

10. What should an investor be looking for if they want to invest in a managed futures fund?

In my opinion, an investor considering an allocation to managed futures should:

• Want diversification beyond the assets and strategies they already have
• Be prepared to stay invested for the long run (3-5+ years minimum)
• Fully understand the manager’s trading program
• Look for managers with experience, expertise, and strong underlying business
• Understand that investing in managed futures can be risky and volatile
• Only invest risk capital
• Read the CTA’s disclosure document which outlines the risks, benefits, trading plan, and expenses

[WSP: You need to be prepared to ask tough questions of your fund manager. Just like you explain the risks, benefits, side effects, and alternatives to treatment with your patients, you need to be sure that your financial advisor or fund manager explains these same things to you before you give them your hard-earned money.

Even if you rely on a financial advisor to manage your investments, you need to have a cursory understanding of what you are investing in. Just like patients shouldn’t say “whatever you think is best, doctor”, investors should not blindly trust their financial advisors to take care of their money.]

Finally, here are Mr. Wieczorek’s legal disclosures:

FUTURES TRADING IS SPECULATIVE & INVOLVES A HIGH DEGREE OF RISK. IT IS NOT SUITABLE FOR EVERYONE. THERE CAN BE NO ASSURANCE THAT THE STRATEGY WILL ACHIEVE ITS OBJECTIVES, RISK MANAGEMENT TECHNIQUES WILL BE SUCCESSFUL OR THAT LOSSES WILL BE AVOIDED. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Thank you to Mr. Wieczorek at Purple Valley Capital for educating us about managed futures accounts. What do you think? Have you invested in managed futures? Do you have any questions about managed futures for Mr. Wieczorek?