Friday, October 11, 2013

Managed Futures: A Case Study of Alternatives Going Retail

Managed Futures: A Case Study of Alternatives Going Retail

Managed futures are funds that invest in futures and options on futures on all sorts of esoterica, including commodities, interest rates, equities, and currencies.  The funds enter into both long and short positions.  The best-known managers are known as Commodities Trading Advisors (CTAs).  A group of these funds established enviable track records in the 1990s, which encouraged investors to start making large bets on managed futures.  David Evans has written a detailed article for Bloomberg Markets Magazine that warrants your attention.  “How Investors Lose 89 Percent of Gains from Futures Funds” shows how these funds failed to generate promised returns after large amounts of money started to flow into them.  It also exposes how the fees charged to retail investors by major banks outstripped the gains.[1]
Grading People (2009)
Mr. Evans digs through the SEC filings for a series of funds offered by Morgan Stanley, Bank of America (Merrill Lynch), and others in order to show the anemic returns earned by investors and the billions of dollars charged in fees.  I won’t attempt to replicate his detailed analysis.  Read the article, and if you thirst for more, Mr. Evans even provides convenient links to the SEC filings.

My purpose is to remind you of the common pattern that occurs all too often in the world of investing.  Let’s review the seven steps:

1.     A group of managers generate compelling returns based on a limited amount of capital.
2.     The returns do not appear to be correlated to the stock market, so the investment appears to add diversification to investors’ portfolios.
3.     Endowments begin to invest in these funds with decent success.
4.     The managers, having already gotten wealthy on fees and carry, see an opportunity to compound their wealth by soliciting large institutional investors.
5.     Big money starts to flow into the strategies, the returns become anemic, and correlation benefit shrinks.
6.     The managers approach the brokerage and mutual fund industry to expand the benefits of their investment strategy to retail investors, which of course, entails large fees.
7.     Investors lose, regulators express outrage, and the money managers walk away far wealthier than when the game began.

In my view, the CTAs present a particularly egregious case of money management malpractice.  As I’ve written on several occasions, commodities are not an asset class.[2]  In the long run, the real return of commodities is zero.  Granted, there are plenty of ups and downs in the various markets for oil, precious metals, industrial commodities, and agricultural products, but there isn’t an income stream to produce a real return.  A friend of mine in risk management points out that a group of CTAs including Bruce Kovner[3], Paul Tudor Jones[4], an Louis Bacon[5], made millions trading commodities, which ultimately drew institutional money into the strategy and made them billionaires.  However, as my friend points out, CTAs have now turned into a battle of thousands of computer algorithms, which only seems to roil up the commodities markets without producing any value for investors.

Investors ought to heed Mr. Evans cautionary tale.  However, I’m betting that the money management marketing machine will continue to seduce investors even if the lessons are overwhelmingly clear.

[2] See, “What About Commodities?” (February 2, 2013) and “ETF Speculation Taken to Another Level: Bitcoins” (July 3, 2013)
[3] Founder of Caxton Associates and worth $4.7 billion according to Forbes
[4] Founder of Tudor Investment and worth $3.7 billion according to Forbes
[5] Founder of Moore Capital Management and worth $1.4 billion according to Forbes

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