Before money, people traded grain and precious metals directly with one another. Today, corn, wheat, gold and other commodities are traded through futures contracts that guarantee the purchase or sale of a given amount of the underlying commodity for a stated price on a set date.
The first futures contracts allowed farmers to lock in prices for their crops well before they were ready for market, taking the edge off the price plunge that could come with the harvest glut. These contracts could also assure that a user like a bread maker would have ready access to the commodity it would need in the off-season.
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Nowadays most people who trade futures contracts have no intention of actually delivering or taking possession of the commodity involved. Because the contract values rise and fall with expectations about future prices, traders hope to make money on the contracts themselves. Instead of delivering a container of wheat, the trader can simply offset his obligation to deliver by purchasing a similar contract giving him the right to buy, hoping to make more on the sale than was spent on the purchase.
But it’s a complicated business and very tough for investors who may be comfortable with stocks and bonds but not with copper and sow bellies.
“Commodity trading is known to be extremely volatile and the risks are great,” says Braden Perry, a Kansas City, Missouri, attorney in the commodities futures industry.
So the markets have created another product, the managed futures fund or account, which works like an actively managed mutual fund for futures contracts. That leaves the heavy lifting to professionals called commodity trading advisors and commodity pool operators. CTAs operate an individually managed account for each client, while CPOs pool clients’ money like hedge funds.
In addition to agricultural products and precious metals, these funds may trade futures contracts for stock indexes like the Standard & Poor’s 500 index, Treasury bonds, currencies and energy products. They can go “long” to bet that prices will rise, or “short” to bet they will fall, and many will do both at the same time or try to profit from market trends.
“These funds can be beneficial to an investor’s portfolio, as the typical investor may not have expertise in dealing with futures contracts, or even know where or how to buy a futures contract in the first place,” says John Sedunov, assistant professor of finance at the Villanova School of Business. “Managed futures funds can grant access to an entirely different portion of the market in which the average investor hasn’t yet invested.”
The chief attraction, many experts say, is the chance to further diversify a portfolio, since the forces driving commodity prices can be very different from those for other investments. Futures for gold and silver, for example, may do well when inflation hammers stocks and bonds.
A report by Credit Suisse says managed futures returned 9 percent in the financial crisis of 2008 and 2009, while global equities lost 44 percent.
Futures have performed well in many periods of uncertainty, according to S. Michael Sury, CEO of Indorus Holdings and an adjunct professor of economics at the University of California.
“As an example, during the height of the recent Brexit crisis, June 23 to July 1, managed futures as a group gained 3.6 percent while the S&P 500 was very volatile and whipsawed, dropping over 4 percent by June 27 only to reverse course and erase those losses by the end of the month,” Sury says.
A managed futures fund is best for the investor with a long-term view, Sury says.
“I would suggest that for retirees or others focused on income, managed futures by themselves are not suitable investments,” he says. “Most investors should look to managed futures as part of an overall portfolio and consider its role principally as a diversifier, to smooth out returns.”
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Like hedge funds and private equity funds, CTAs and CPOs generally operate on an annual 2/20 fee structure, charging 2 percent of assets under management and 20 percent of profits. Mutual funds that invest in managed futures accounts may add their own fees as well.
“When you add the effect of fees, it makes the task of finding managers who consistently outperform very difficult,” Sury says.
For small investors, the entry cost can also be high, with many funds requiring a minimum investment of $25,000 and others demanding more.
Picking the right manager is critical.
“There are many (fewer) CTAs than traditional asset managers or stock brokers,” Perry says, “and finding one that can evaluate a portfolio as a whole is necessary.”
CTAs and CPOs are fiduciaries, meaning they are legally required to put the client’s interests ahead of their own, he says.
“To find out about a CTA (or CPO) and whether it is properly registered, read its disclosure form,” Perry says. “This form will include information on any disciplinary information as well as educational background and work history. You should also view the online portal the (National Futures Association) maintains, which includes this information as well.”
CTAs and CPOs are required to furnish investors a disclosure document that, like a stock prospectus, describes the fund’s strategy and risks. Those include the maximum “drawdown,” which is the largest peak-to-valley loss the fund shares have suffered, and the annualized rate of return net of fees.
Sury says that, “In addition to the standard due diligence items, it is particularly important to understand what exactly the manager’s strategy is, under what conditions the strategy is expected to perform well (or poorly), what authority the manager has to deviate from the stated strategy, what fees and expenses will be assessed, the fund’s liquidity and redemption terms, and perhaps most importantly, the fund’s risk management framework.”
Despite all the risks and costs, a number of market conditions make managed futures particularly appealing today, he says.
“Among them are increased levels of geopolitical uncertainty, the fallout from Brexit, currency devaluations and the resulting inflationary pressures, and a somewhat complacent market landscape,” Sury says.
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Alternatives to managed futures include investing in mutual funds or exchange-traded funds that hold managed futures or trade stocks in commodities-related industries. Daring investors can buy and sell futures contracts on their own, but that takes a fat account, lots of study and a cast-iron stomach.
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