Choosing a Managed Futures Investment
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Posted On :
Oct-05-2010
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Article Word Count :
1412
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Over the last seven years, investment in professionally managed futures has more than quintupled. According to hedge fund tracking firm Barclays, assets under management rose from approximately 41 billion dollars in 2001
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Over the last seven years, investment in professionally managed futures has more than quintupled. According to hedge fund tracking firm Barclays, assets under management rose from approximately 41 billion dollars in 2001, to more than 219 billion dollars today! This is a trend that we expect to see continue, not only as the demand for commodities continues to rise on an international level, but also as more investors, individual and institutional, start to see commodities as a sensible investment vehicle.
This steady growth has also raised the need for greater discretion in selecting a Commodity Trading Advisor. In this article, we will outline what we believe are some of the best tools and methods available to the individual investor when choosing a managed futures product.
Let's first define what managed futures are and what they are not. Managed futures are not merely stocks or ETFs that invest in commodities. Managed futures accounts are investments in which the funds invest mainly in leveraged, future dated contracts for either commodities or financial instruments. Commodities may include sectors such as food, energy, and raw materials, and financial instruments may include interest rates and stock indexes. The leverage of these investments means that risks and rewards can be, but are not always, substantially higher when investing in futures markets than when investing in the stock market.
The National Futures Association and the Commodity Futures Trading Commission handles regulation of managed futures investments in the United States, unless, the firm or fund has exempt status. Regulated firms hold either a Commodity Trading Advisors license (CTA license) or a Commodity Pool Operators license (CPO license). Keep in mind, however, that just that a firm carries a license is in no way an endorsement of that firm’s future performance. Because futures’ trading has the potential to come with large risks, it is not cut out for just any investor. Investors should be familiar with all the risks involved before investing.
Finding lists of potential managers to sort through can be a fairly easy task for an investor if he knows where to look. Firms such as Barclays Trading Group, Stark Research, Autumn Gold, and Altegris Investments have large databases of manager information available. One resource we personally like can be found at autumngold.com. Autumn Gold offers a free summarized online database of over 450 programs. Although their site requires registration, the programs are of excellent quality and may be sorted by a wide range of parameters including minimum account size, funds under management, and various other measurements of performance.
The only problem we see with online databases is that it can become somewhat overwhelming to try to narrow down so many choices. To help simplify the process, we would like to share what we think are some of the all around best performance metrics.
The first recommendation is to forget about return. A manager’s return is often the least significant statistic! How can that be? Well, what matters is RISK ADJUSTED RETURN. Just because a manager bet the farm and got lucky does not mean it was a nifty idea. When a manager has a habit of betting too aggressively, it is only a matter of time before the inevitable wipe out will occur.
There are many traditional ways of measuring risk-adjusted returns, the most popular of which is the Sharpe Ratio. The Sharpe Ratio measures the relative value of return in comparison with the underlying volatility in the investment. Although we are largely in agreement with the logic of the Sharpe Ratio, we feel it has one serious flaw. The Sharpe Ratio confines one to measuring only past volatility; it does not try to predict future volatility. Because of this, we feel the Sharpe Ratio does not give an adequate view of the potential risks involved in a program.
One clear illustration of this flaw comes from the world of those who sell options, also known as “option writers.” Since most options end up expiring worthless, it is not uncommon for managers involved in selling options to have excellent Sharpe Ratios. Many with smooth looking equity curves that appear to have produced well for many years, but just because an equity curve looks smooth and consistent does not mean it will stay that way. What happened previously is meaningless if a manager cannot produce the same results with new investors. Option sellers with longer term excellent track records tend to have quick, spectacular “blowups.” The problem is that past volatility is not a reliable predictor of future volatility.
What is a reliable way of predicting future volatility? One of the best predictors of volatility is something known as the Margin to Equity Ratio, or MTE. The MTE tells an investor roughly how much of his investment is for margin purposes. Although this number will vary day-by-day for any given manager, investors can get a clear picture by looking at the average range. If, for example, a manager’s MTE weighs in at 10%, this means that for every $100,000 invested the manager uses about $10,000 for margin.
Keep in mind that the exchanges set margins based on their approximations of risk. The higher risk in a contract, as perceived by the exchange, the higher they set the margin. We encourage investors to think just like an exchange and raise their expectations for potential risk as the MTE goes higher. If we go back to the example of option writers with exceptional Sharpe Ratios, investors will also see that these same managers often have high MTE ratios. We believe that these high MTE ratios, had there been more attention paid to them, could have tipped off the investors and avoided many disastrous scenarios. Once again, to clarify, as the exchanges often set their margin requirements higher when expecting volatility to rise, we too see a direct correlation between a high MTE ratio and the potential for high volatility (risk).
Another important use of the MTE comes down to pure math. If two managers each made returns of $30,000, yet one used $30,000 in account margin to do it, and the other used $60,000, the results turn out to be different. Based on margin usage, the first manager’s return was twice as high as the second. This is essential to keep in mind because although managers can often appear to have similar performances, doing a bit of digging down into their margin usage can show large differences.
What is an ideal MTE? Personally speaking, we do not like to see any Margin to Equity Ratio go too far above 10%. This number is on the low end of the spectrum for managed futures accounts and, cuts out most managers. Although it is true that low MTE ratios are no guarantee of lower risk, we feel that, for a manager, having a low MTE ratio is at the least possibly a decent gauge of sound risk management. Once again, we believe that as the MTE rises so does the potential for risk.
In summary, we suggest that potential investors do not base their calculation of the quality of a manager solely on the returns he reports, but instead base it on those returns when weighed against his Margin to Equity Ratio. Risk and drawdown should also be computed in the same way. Such reckoning will level the playing field and allow for a more accurate comparison.
We are also in favor of being on the conservative side of the MTE spectrum. We would most likely reject any manager with an MTE ratio above 10%. One benefit of using this method is that it can help to rather quickly whittle down the long list of choices available to a more manageable number. Once the list narrows down, take a look and compare all the other risk adjusted performance measures of the remaining names to help further refine the selection. (To cut the risk of this article being too long, we will save the discussions on the other measurements of risk-adjusted performance for future installments).
Once again we would like to note that, in the end, no measure is a 100% guarantee or assurance against risk or losses. Past performance is not necessarily 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
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Article Source :
http://www.articleseen.com/Article_Choosing a Managed Futures Investment_36259.aspx
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Author Resource :
This article was written by Commodity Trading Advisor Dean Hoffman. TO find out more about Hoffman Asset Management or managed futures accounts please click the links.
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Keywords :
Commodity Trading Advisor, managed futures,
Category :
Finance
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Finance
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