Investors who understand the benefits of diversification know that different asset classes often move in opposite directions. The very point of a diversified portfolio is to avoid making bets on a particular type of investment, like large-cap U.S. stocks, to the exclusion of others. Instead, the idea is to own different types of stocks, as well as bonds and alternative investments.
Alternatives, which include real estate and commodities, often show low correlation to stocks and bonds. Many advisors include alternatives in client portfolios to smooth returns and hedge against poor performance in more traditional investments.
One category of alternative investment, managed futures, caught on after the global financial crisis between 2007 and 2009. The term “managed futures” usually refers to a trading strategy that may use long or short exposure to instruments such as metals, agricultural commodities, equity indexes, currencies and U.S. government bonds. Because it’s impractical to take possession of gold bars or wheat bushels, managers often turn to derivatives, particularly futures. This gives managers the flexibility to trade more liquid investments.
Until fairly recently, managed futures strategies were only available to institutions and wealthy individuals who were qualified to invest in hedge funds or separately managed accounts. In the past few years, mutual fund managers figured out how to package these strategies in a way that allows access for smaller investors.
According to Morningstar, there are now almost 50 distinct managed futures portfolios being marketed as mutual funds. There are also a few exchange-traded funds. Many were launched in the past three to five years.
Investors who believed these funds would offer better performance than stocks, at least in the short term, have been disappointed. Between 2011 and 2014, the average return in Morningstar’s managed futures mutual fund category underperformed the Standard & Poor’s 500 index every year.
However, managed futures funds may have a role as part of a diversified portfolio. Investors who can resist the urge to bail out when the funds underperform may benefit from the lack of correlation when stocks finally end their multiyear rally.
Isaac Presley, director of investments at Cordant Wealth Partners in Portland, Oregon, uses managed futures funds in client portfolios. He cautions that they are complex products, and they’re not for everyone.
“Because of the extra attention that is required when selecting a managed futures fund — to understand the strategy, the leverage employed, the risk management mechanisms used, the level of diversification within the strategy itself and the fees — they are best used with clients that have a desire to optimize their portfolio and are willing to take on additional complexity, and are willing to spend extra time to understand more about the investments they own,” he says.
Managed futures strategies are designed to capitalize on momentum, or the idea that an investment will continue moving in its current direction for some period of time. Because managers can take short positions, the funds can potentially benefit from a declining stock market or a drop in a commodity’s price.
“The academic research strongly supports the existence of a momentum premium, but the trick is in the execution,” Presley says.
One aspect to executing properly is simply remaining invested. The inherent structure of the funds means they respond to market conditions, going long on investments doing well and going short on those doing poorly. It’s counterproductive to use the funds as market-timing vehicles.
“The funds are already dynamic or tactical at the strategy level, so being tactical with the allocation as well doesn’t make sense,” Presley says.
Josh Charney, alternative investments analyst at Morningstar, says his biggest concern about the funds is investors’ propensity to chase performance by piling into an asset class that’s done well recently.
“Most what we’ve seen with alternatives is people rushing into hot funds and then rushing out very quickly. The faster money goes in, it almost goes out at twice the speed, which is unfortunate,” he says.
Blair duQuesnay, principal and chief investment officer at ThirtyNorth Investments in New Orleans, says the funds provide diversification, but they require some patience. “The two alternatives we use are global real estate and managed futures,” she says. “We know we have to wait for the performance, and we’re very comfortable with the strange ups and downs. In order to get negative correlation, they have to not act like stocks and bonds. It may look weird on a performance report, so we always point out to our clients that it’s actually a good thing, and that’s the reason we own it.”
Individual investors must also use caution when it comes to fund expenses. The typical actively managed mutual fund has administrative and marketing expenses that are explained, albeit using jargon, on the prospectus or fact sheet. As a general rule, managed futures mutual funds have higher expense ratios than stock and bond funds because the trading costs are higher.
However, the funds often use subadvisors who trade the underlying commodity funds. That’s because mutual funds, by law, are not allowed to own commodity futures. They work around that rule by using vehicles such as swaps or offshore funds called controlled foreign corporations. That’s perfectly legal, but there’s currently no requirement to disclose fees paid to these offshore managers. Managed futures mutual funds may invest up to 25 percent of total assets in a controlled foreign corporation. These corporations, in turn, may invest in entities known as commodity trading advisors, which cannot be affiliated with the mutual fund manager. These CTAs are regulated by the U.S. Commodity Futures Trading Commission.
Because of the complex nature of managed futures mutual funds, there is some extra due diligence for investors to understand what they own. In some cases, duQuesnay says, there may be fees from the offshore subadvisors that are not clear in a fund’s prospectus.
“I would tell investors and even other advisors to ask those questions. Because the funds that are very open and honest will tell you that whatever is going on offshore, there are expenses with that. But they’re shared with the offshore fund, and it’s not in addition to what’s in the prospectus,” she says.
At Morningstar, which is known for taking a deep dive into asset classes and individual funds, only two managed futures mutual funds have positive ratings. Those are the AQR Managed Futures Strategy and the Natixis ASG Managed Futures Strategy.
“Other than that, there are a lot of really expensive funds out there, and funds that don’t have good track records or have short track records,” Charney says. “There are a lot of issues with some of the underlying products, which is a little uncomfortable, because before you invest in an asset class, you want to see more winners than losers. A rising tide lifts all boats. But at the same time, it’s good to be picky in this case and focus on the ones with truly good, sound strategies.”
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Should You Invest in Managed Futures? originally appeared on usnews.com
