|Monday, July 30, 2007|
Becalmed No More
Managed Futures: Changing Course
By GREG NEWTON
IF THE INVESTMENT WORLD HAS A RODNEY DANGERFIELD, it's managed futures.
Disrespected for their allegedly exorbitant costs, their perceived riskiness, their widespread reliance on inscrutable black-box trading systems and all manner of other things, these funds bear a heavy burden: almost five consecutive years of underperformance against just about every equity benchmark.
But a funny thing has happened on the way to hell. The assets invested in managed futures, now widely regarded as a subset of the hedge-fund universe, have more than tripled since 2002, the last year they beat the S&P 500. As of March 31, investors had an estimated $172 billion in this sector, according to Barclay Trading Group, a data provider based in Fairfield, Iowa. One reason: The markets appear to be becoming more volatile, and managed futures thrive on volatility.
Just look at what's happened to the John W. Henry & Co. Financial and Metals Portfolio. On March 31, it was down almost 20% for 2007 and in the midst of a three-year, 40% slump that was the longest and one of the deepest in its 22-year history. The decline and resulting investor redemptions, cost the firm -- controlled by John W. Henry, principal owner of the Boston Red Sox -- more than 80% of its assets, which now stand at little more than $500 million.
In the second quarter, however, the portfolio surged 25%. Ironically, Merrill Lynch (MER) ended a long-term relationship with Henry in April and pulled its mostly retail investors' assets out of his fund -- almost exactly at the portfolio's nadir.
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Henry declined to comment for this article. But his managed-futures operation certainly wasn't alone in performing poorly over most of the three past years. Barclay Trading Group founder Sol Waksman, who has followed managed futures since 1985, says this span was the most unusual he's seen. Other than funds that invested heavily in energy, none seemed to have a trading strategy that worked well, regardless of whether their focus was long-term (which in this world means several months) or short-term (a week or a day).
"PERFORMANCE HASN'T been good, and once upon a time, that would have meant big redemptions and people going out of business. Instead, we've seen this huge growth in assets, and those new investors being willing to stay committed," Waksman observes. "Perhaps they've got the message about the strategy's diversification benefits" for investors in stocks and bonds.
And perhaps some of it is a perception disconnect. Managed futures are widely viewed as a proxy for commodities. Its managers are regulated as "commodity-trading advisers" and "commodity-pool operators" ultimately by the Commodity Futures Trading Commission. Yet it's been a long time since commodities dominated the holdings of advisers specializing in managed futures.
The long-running Campbell & Co. FME Large strategy -- the acronym stands for financials, metals and energy -- currently has about a third of its $10 billion-plus assets in currencies, and much of the rest in roughly equal chunks of stock indexes and interest-rate instruments. Commodities rarely account for more than 20% of its positions.
Many commodity markets are simply too small to accommodate the positions that large managers need to move the needle. In fact, few managers overseeing more than $1 billion trade as much as half their assets in commodities, including the more liquid energy and precious metals. Most of those with $2 billion or more are heavily weighted toward the deeper, more liquid, financial-instrument market.
Although the going has been challenging for managed-futures managers over the past few years, some have excellent long-term records. Among them: Renaissance Technologies, a New York-based quantitative shop founded by James Simons. Its Renaissance Medallion Fund, long closed to new investors and essentially a managed-futures vehicle, has returned more than 35% annually for almost 20 years, after subtracting a very hefty 5% management fee and a 44% incentive fee on any profits.
RENAISSANCE IS gearing up to open a new managed-futures fund in the fall. (Simons declined to comment for this article, citing regulatory concerns.) In early July, the industry newsletter Hedge Fund Alert reported that the new vehicle is designed to manage up to $25 billion, and would take a longer-term approach than famously frenetic Medallion. It's reportedly modeled on the Renaissance Institutional Equities Fund, which has amassed about $30 billion in assets in barely two years. The projected size of the fund implies that it will trade only the most liquid futures markets around the world.
The new fund probably offers a range of fee structures less startling than Medallion's, and even the sector's standard 2/20 structure -- 2% management, 20% incentive. Renaissance Institutional Equities Fund's fees range from a fixed 2%, with no incentive fee, up -- or down -- to an option of a fixed fee of 0.5%, along with an incentive fee of 35% for any gains over the Standard & Poor's 500 index's (dividends included).
To invest in the new fund, investors will have to shell out a very sizable minimum sum -- Renaissance Institutional Equities demands $25 million. Some financial institutions provide access to that product through pooled vehicles with lower, although still substantial, minimums, but it's unclear whether Renaissance will allow that for the new fund.
In less rarified air, long-standing efforts to make managed futures more accessible, and less expensive, for retail and "mass-affluent" investors are finally putting products on the investment shelves. Historically, those investors got in through retail-brokerage offerings that larded rich layers of additional cost, including sales charges and management fees, onto the strategy's already high fee structure.
FUTURES OBLIGATE participants to sell or buy commodities or financial instruments at a specific time, and they allow them to make big leveraged bets, which can be dangerous if they backfire. Relatively few individuals trade futures on their own, viewing them as too risky.
Asset Alliance, a New York-based boutique, has announced plans for a hybrid closed-end fund aiming to replicate the Barclay Group's BTOP50, an index reflecting the net trading performance of 23 large trading advisers. The fund will require only a $10,000 minimum, and even allow monthly redemptions, at net asset value. Designed to be sold through a network of wealth managers and brokerages, the fund is expected to be launched in October.
In March, the Rydex Managed Futures1 Fund (RYMFX) became the first conventional mutual fund to use a managed-futures strategy. With a $2,500 minimum investment, daily liquidity, a 1% redemption fee on shares owned for less than 90 days and a 1.65% expense ratio, it's already attracted $150 million in assets.
Instead of investing in managed-futures advisers, it aims to replicate the performance of the S&P Diversified Trends Indicator, a long-short futures investment benchmark based on 24 U.S. exchange-traded contracts in 14 sectors, divided evenly among commodity and financial futures.
The DTI is based on technical indicators and is "positioned each month...based on price behavior, relative to its moving average" -- allowing it to capture profits in both up and down markets, according to an S&P white paper.
It claims, accurately, both low volatility and a low correlation with stocks and bonds. But it does include some rules that few, if any, managed-futures advisers would implement. For example, it doesn't invest in stock-index futures (thus reducing its correlation to the equities market), and it doesn't short energy issues, which can jump quickly on any inkling of tight supply.
Rydex says that that the pro forma risk-return profile of the DTI is more conservative than that of actively managed futures funds. Its annual compound return of 11%, with a 6% standard deviation (a measure of riskiness), compares with the BTOP50's yearly 9.44% return and 13.5% standard deviation over the past two decades.
SINCE THE DTI went live in January 2004, it has outperformed the BTOP50, and its correlation with the S&P 500's total return remains extremely low, at just 2%. In contrast, the BTOP50's correlation with the stock-market benchmark has been almost 60% since 2004, undermining one of the most important selling points for managed futures -- diversification. (Over 10 years, the correlation is a negative 17%.)
Managed futures probably will never be a mainstream investment, but the availability of new ways to play them, combined with the return of market volatility, is bringing them more respect.
GREG NEWTON is a free-lance writer, based in Stratford, Conn.