The Investment Scientist

Is Managed Futures an Asset Class?

Posted on: June 17, 2011

Recently, a high-net-worth investor came to me for my portfolio review service. What caught my attention was that a large chunk of his money was allocated to various commodities trading advisors (CTAs).

CTAs are folks who are licensed to take your money and speculate with it in the futures markets. In 2008, managed futures reportedly returned a total of 14%, beating the equity market by 50%. Since then, CTAs have been heavily promoted by major Wall Street brokerages and wealth management firms as an alternative non-correlated asset class.

But is managed futures an asset class?

In my view, it’s not, for the following simple reason: Every futures contract has two sides, and the futures market is basically a zero-sum game. If the long wins, the short must lose by the same amount. The counter-parties of all CTAs are just themselves. If some CTAs make a great deal of money, some CTAs must lost a great deal of money. The winners happily report their returns. The losers–at least the big losers–do not; they just close up their shop and start another one. As a matter of fact, according to Jason Zweig, 20% of all CTAs disappear every year! Just wonder what happen to their investors.

And here is the real insult: For investors to get into this zero-sum game, they must pay the CTAs a 2% management fee and 20% of the profit, if there is any. That officially turns a zero-sum game into a loser’s game. According to research by Gordon and Rouwenhorst, two Yale professors, even among those skillful (or lucky) CTAs who reported their numbers voluntarily, there were hardly any crumbs left for the investors after fees. Let me quote them:

“We analyze the performance of all CTAs that voluntarily report to the Lipper-TASS database. . We estimate that between 1994 and 2007 the average bias-adjusted CTA returns after fees have been statistically indistinguishable from the average return on an investment in US T-bills. The average CTA has therefore not created value for their investors. This conclusion mirrors the finding of Elton, Gruber and Rentzler (1987, 1989, 1990) who – almost two decades ago – found that publicly traded commodity funds did not create positive returns for investors.”

The bottom line, if you give money to CTAs, some of them will win, and some of them will lose. The winners extract most of the profits through fees; the losers just walk away. If this is an asset class, Las Vegas is an asset class – at least you have fun there.

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9 Responses to "Is Managed Futures an Asset Class?"

Great info. The hot ones have an easy sell and the average investor doesn’t know what he is getting into.

There is a CTA in my community (Chinese American) who I watched for comic relief.

He used to have track records of 10 different trading strategies on his website that show 20% to 40% returns.

Then one of his strategy would experience a 80% to 90% drop, the strategy would be subsequently removed from the website, and replaced by a “new and improved” strategy. He cycled through all his strategies and eventually they all disappeared from his website.

His firm got sued, and the news was on front page of google when people searched his firm name. No problem at all, he started another firm (with a totally different name.) Now he appears in Fox News regularly offering investment advice.

As a CTA, sadly I agree with much of what you are saying. CTAs tend to disappear and simply come back with new fund names or work somewhere else if their product doesn’t work out. Like anything, it is absolutely not a great place to invest if you make investments based on past performance or do not understand what you’re investing in. Also fees are frequently too high and erode gains (though not all of us charge 2/20, me included).

However, I’m sure you can understand that much like investment advisers, there are bad ones and there are good ones. Also similar to investments advisers, even the good ones are not appropriate for all or even most investors.

Fees that are too high are not unique to CTAs, many equity products charge similarly though the 2/20 model comes to mind when you think of hedge funds. 20% of CTAs disappearing is absolutely an exceptional number, though hedge funds, mutual funds, ETFs etc also disappear every year. My guess is the “frontier” nature of the business, complication of derivatives, lack of understanding, and the leveraged nature of futures contribute to this high disappearance rate. Still, this alone shouldn’t exclude “CTA’s” as an asset class.

You said “CTAs are folks who are licensed to take your money and speculate with it in the futures markets.” Futures can also be used to help you hedge your portfolio without creating a taxable sale event or to simply gain exposure to assets beyond stocks and bonds. Though I would agree that most CTAs do invest for profit (not hedging), speculation can be a 4 letter word in the investment industry and applying it to all CTAs is over-broad.

You said “Every futures contract has two sides, and the futures market is basically a zero-sum game. If the long wins, the short must lose by the same amount. The counter-parties of all CTAs are just themselves.”

Every stock also has a buyer and a seller, one will win and one will lose thus also creating a zero sum game. The first seller is the company itself, the first buyers are the IPO purchasers, everybody wins or loses as the stock moves creating a zero sum game (actually less if you include transaction fees, though the same applies to futures).

The counter parties to CTAs are not just themselves. The futures market was created because companies need to be able to lock in their prices and thus better plan their business expense. Producers of commodities sell futures to lock in their profits, businesses that consume them buy futures to lock in their prices. Southwest Airlines famously hedged (still hedges?) their fuel prices with futures.

Though much of the market is CTAs or other “speculators”, the price of the future has an underlying value based on the commodity (or interest rate or stock or exchange rate etc). Stocks also have an underlying value, which is the expected future value of excess returns to the underlying business. Futures are not so different after all, they just come with an expiration date.

Additionally, one should remember that CTAs are not just for “commodities” as we generally think of them. I couldn’t tell you the first thing about frozen concentrated orange juice or pork bellies. In fact, many of them deal exclusively with stock index futures.

I believe that a small allocation to a diverse group of CTAs is appropriate for some (though not all) investors. And whether or not you believe they are an asset class, CTAs should be judged on their individual merits, just like RIAs.

Steve,

First thank you very much for giving this long and candid comment on my post. I truly appreciate you feedback and the time you put into writing it.

I can not agree with your last statement though. I still would not recommend CTAs to ordinary investors. I have been a speculator before, first in weather derivatives then in stocks. I even started a hedge fund for that. My experience tells me the hedge fund business is by and large not a honest business. I decided that to be on the side of ordinary investors, teaching them simple investment principles and helping them stay away from things they don’t understand are far more rewarding than making a lot of dishonest money.

Now back to the topic of CTA. I am not saying there are no good CTAs, There are. In fact, just by the tone of your comment, I have a feeling you are a very CTA yourself. The problem is, it’s impossible for the average investor to tell who is good and who is bad. In fact, I must admit, I don’t have the skill to tell a good one from a bad one as well, despite all the academic paper I read. (When it comes to stock investing, I am much more comfortable about my judgement.)

I surmise that a good CTA (like a good hedge fund) only wants smart money, since dumb money could hurt returns. However, the bad CTAs want any kind the money, they are not in the business of generating returns from the market, they are really in the business of generating fees. Unfortunately, for the average investors, they only have access to the bad CTAs by definition they are not smart money.

Michael

Michael,

Thank you for responding to my comment so quickly!

I think you and I are actually pretty close to agreement. When I said I believed CTAs were appropriate for some investors, I did not mean average investors. I agree with you that CTAs are in all likelihood not appropriate for the average investor due mostly to the factors that you pointed out. It is never a good idea to invest in something you don’t understand, and sorting through the mountain of CTAs and complicated strategies out there just isn’t something the average investor has time for. I’ll admit, manage futures are a complicated mess and the industry does include bad people trying to take your money (reminiscent of the old days of stocks, brokers, and investment advisers eh? Thank goodness for fee only).

However, I would also argue that the average investor doesn’t take enough time to research equity or bond investments. For most of us, it is simply a matter of time that we would rather be spending elsewhere. This, of course, is where fee only investment advisers like you come in. Therefore, there must also exist someone like you who can and does take the time to sort through and understand the mountain of managed futures data and find the gems for a reasonable fee. Sadly, I don’t know where that person is, but theoretically they exist. As the futures industry matures and becomes more mainstream, he or she should hopefully be easier to find.

I absolutely understand why you posted what you did because your target audience is the average investor. If I were to sum up my feelings about it in one sentence it would be this: “You cannot dismiss managed futures for ALL investors, though dismissing them for the average investor with a caveat that they are not completely wrong for everybody is fine by me.”

In any case I have been reading your blog for a couple of months now and I love what you do. Keep it up!

-Steve

Michael,

Can’t say we agree with you. You’re right- there are some dishonest people in managed futures. There are also dishonest people in stocks, bonds and elsewhere. If investors were to determine asset class investments solely based on an absence of dishonest participants, our savings accounts would be kept in our mattresses.

You make a point that a large part of the reason you would not suggest managed futures to an ordinary investor is because they do not understand how the investments work or how to determine a good CTA to invest with. On one hand, you’re right. Investors are not well informed on the risks and benefits associated with a managed futures investment, but one-sided pieces like this one do little to fix that. On the other hand, that’s where introducing brokers (the good ones, at least) come into play- they know these CTAs inside and out, and the honest ones are making money because their clients do.

Until managed futures is generally understood by the average investor, though, we have to agree with commenter Steve K: “You cannot dismiss managed futures for ALL investors, though dismissing them for the average investor with a caveat that they are not completely wrong for everybody is fine by me.”

We’ve addressed the other arguments you’ve made in this piece and its comments here-

Is managed futures an asset class? Based on current definitions in the literature base- yes, it is: http://www.attaincapital.com/alternative-investment-education/managed-futures-newsletter/investment_research_analysis/426

That Yale study is a poor piece of evidence in this debate: http://managed-futures-blog.attaincapital.com/2011/05/06/responding-to-the-latest-attack-on-managed-futures/

You’re right- CTAs go out of business. So do publicly listed companies. At a much more rapid rate. That’s why a lot of the arguments against managed futures indices are poorly formed: http://managed-futures-blog.attaincapital.com/2011/06/08/the-cme-pushing-a-gamble-think-again/

You’re right that wealth management specialists recommend managed futures… and with good reason (for the right people): http://www.attaincapital.com/alternative-investment-education/managed-futures-newsletter/investment-trading-education/417

Lauren,

First let me thank you for taking the time to write this long rebuttal. Even though we are not in agreement, I appreciate you offering counter-opinions.

Your opinions will come across much credible if you can buttress them with credible third party research, preferably published peer-reviewed academic research. All I see however, are links back to your firm. So you are basically proving your opinions with more of your opinions. That’s circular logic. I follow each of the links, and again, there are no citations of any third party research. In the rigorous academic world, these opinions simply will not carry any weight.

Then again, you are in sales and marketing, so rigor is not your purpose.

Michael

Michael,

Did you read the pieces we linked to? These aren’t just opinions thrown out there, nor circular logic. This is research backed by data and dozens of years of experience, replete with the degrees, licenses and certifications to back it up. Zweig is a journalist who studied art history. We’ve listed the numerous flaws in the Yale study. Where is the more credible information found, again?

If you take issue with any of our pieces, including the data therein, we are more than willing to engage in a productive conversation regarding the warrants behind your qualms, and share how we came to specific conclusions. That being said, we aren’t worlds apart- managed futures works for some and not for others.

Lauren,

Since you brought up Jason Zweig’s background, I am curious about what’s yours that makes you especially qualified to critique Yale’s research and Zweig’s opinion. I personally think Zweig is a rare sane voice in the financial media. Not to mention the two Yale professors are recognized authorities in commodity futures.

As far as reading your pieces at your website, I usually don’t spend time reading marketing pieces – the conclusions are foregone. However, I will find time to read them, just for good sport.

Michael

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



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