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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 international demand for commodities continues to heat up and more investors (institutional and individual) start viewing commodities as a smart investment opportunity, we expect this trend to continue. This growth has also increased the need for techniques to pick a Commodity Trading Advisor. In this article, we will outline 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 (however are not always) significantly higher when trading 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, however keep in mind, just simply because a company carries a license is in no way an endorsement of future performance. Futures investing can have significant potential risks and is not for everyone. Investors ought to be acquainted with all the risks before investing.
Finding lists of possible Commodity Trading Advisors to look through is fairly simple if investors realize where to search. Organizations such as Barclays Trading Group, Stark Research, Autumn Gold and Altegris Investments have listings of manager data available. One source we enjoy is www.autumngold.com. AutumnGold summarizes a free (with registration) online repository of over 450 Commodity Trading Advisors. In addition, the programs may be categorized by a wide variety of parameters such as minimum account size, funds under management, and numerous performance measurements.
The only trouble we notice with the online databases is that it can come to be fairly confusing to attempt and narrow down the selections to just a handful of managers. To help simplify the process, we would like to reveal what we believe are some 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 simply because someone bet the farm and got fortunate does not suggest it was a great idea. Sooner or later (most often sooner) the inescapable wipe out will happen with a manager betting too aggressively.
There are many standard risk adjusted return measurements, the most popular of which being the Sharpe ratio. The Sharpe Ratio analyzes the return compared to the underlying volatility in the investment. Whilst we are in agreement with the Sharpe Ratio?s logic, we think it has one serious drawback. The flaw is that the Sharpe Ratio just views past volatility and does not try and forecast future volatility. As a result, we think the Sharpe ratio does not offer an adequate view of the potential risks involved in a program.
A excellent example of this comes from the world of the ?option writers? (those who sell options). Given that most options finish up expiring worthless, it is not rare for managers that sell options to have exceptional Sharpe Ratios. They can easily have smooth looking equity curves that have produced for many years, however just simply because an equity curve appears smooth and steady does not suggest it will remain that way. What has happened is worthless if new traders do not have the same results. Option sellers with longer term excellent track records tend to have quick, spectacular ?blowups?. The difficulty 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 important use of the MTE comes down to pure math. If there were two managers 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 results are different. Based on margin usage one manager?s return was twice as high as the others. This is essential to keep in mind, because often managers can appear to have similar performances, but when digging down into their margin usage investors will see large differences.
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 conclusion, what we recommend is that prospective investors calculate returns not based on what the manager reported, but instead based on the return on margin (risk and drawdown should also be computed the same way). This will level the playing field and permit an apples-to-apples comparison. We are also in favor of staying 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 approach can help narrow down the list of choices to a manageable number rather quickly. After doing this then search and compare all the other risk adjusted performance measures and additionally refine the choice. (At this risk of this article being too lengthy, we will save the other risk adjusted performance measurement conversations 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
For example, how do traders know if a 5% return is acceptable or not? Most institutional size funds are nearly confined to the trading of financial and energy instruments. Another important use of the MTE comes down to pure math. Managed Futures
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