While every investment asset class struggled mightily during 2008 – the U.S. stock market alone eradicated $7 trillion in shareholder wealth in its worst year since the Great Depression – managed futures provided investors with a significant bright spot last year.

Managed futures programs – alternative-investment vehicles that enabled professional money managers to take positions in a wide variety of securities and derivatives – posted strong returns in a year that was marked mostly by investment losses. The average managed futures program returned about 14%, according to the Barclay CTA Index, and 11.4% as measured by the Stark 300 Traders Index.  By comparison, theStandard & Poor’s 500 Index and the tech-laden Nasdaq Composite Index each plummeted nearly 40% in 2008, while the Dow Jones Industrial Average nosedived 33.8%.

“Managed futures funds like drama and volatility, so 2008 was a banner year,” said Curtis Lyman, managing director of HighTower Advisors LLCand principal of its West Palm Beach, Fla.-based Alpha Wealth Division.  “While I don’t know what is going to happen tomorrow, some of the major dislocations in the marketplace still exist, which could offer the potential for a good environment for this strategy moving forward.”

While investors who participated in managed futures programs reaped significant performance benefits both on an absolute and relative basis last year, many retail investors and even some institutional players are still unaware of this product and the characteristics that contributed to the lofty returns.  And while the entire asset class still only holds about $225 billion, according to Barclay Trading Group (NYSE ADR: BCS), it has grown significantly over the past two decades as investors learn about its performance history and strong diversification features.

“Managed futures, as an asset class, is still relatively unknown,” said Paul Wigdor, president of Superfund USA Inc., a public managed futures fund that oversees $1.7 billion in assets apportioned across 18 countries.  “We are trying to build this asset class  by educating advisors, investors, and the media about this product.  We are not trying to replace the more traditional asset classes, but merely to educate people about the need to diversify beyond just stocks and bonds.”

The Lowdown on Managed Futures

Before making an investment in a managed futures account, an investor must first develop some insights on the overallfutures market. Afutures contract is considered a derivativeinstrument, whose value is determined by the movement of the underlying asset or market. The contract represents an agreement to buy or sell an underlying asset at a predetermined price and date in the future.

Managed futures funds are managed by commodity-trading advisors, or CTAs, who monitor and trade in up to 150 to 200 different futures markets that range from equities to fixed income to currencies to agricultural products to energy to metals.  The positions can either be “long” (buy the underlying asset) or “short” (sell the underlying asset) based on expectations of future price movements.  These managers often employ “leverage” – using borrowed funds to buy on margin – which allows them to maintain larger positions in the underlying assets than they otherwise would be able to if they paid upfront in full. Buying on margin is a tactic that can dramatically increase returns when the manager has made the correct market call, but which likewise magnifies the losses when the investment manager is wrong.

CTAs typically charge investors management fees in the range of 1.5% to 2%, and may also earn incentive fees of 20% to 25% on any new profits generated by the managed-futures fund.  While some investors may claim that such fees seem excessive, performance is always quoted on a “net of fees” (after fees have been paid) basis, so the returns these funds generate can be accurately compared to the gains or losses generated by more-traditional investment vehicles.

Other factors that are important to note:

• The managed-futures industry is highly regulated by the U.S. Commodities Futures Trading Commission (CFTC).
• The future exchanges offer tremendous liquidity,
• And the existence of clearinghouses to guarantee transactions reduces the counterparty risk.

“Our fund is publicly registered and regulated by the SEC and CFTC,” said Superfund’s Wigdor.  “In light of Madoff and other scandals, our clients take great comfort in its transparency.  We file 10-Ks and 10-Qs; our auditor is Deloitte & Touche and our [net asset value] is computed by PNC Bank (NYSE: PNC).”

A Look Back at the Beginning

While managed futures remain an untapped market in many investment circles, the earliest futures market was actally formed in the mid-1800s when the Chicago Board of Trade was established to provide an outlet for Midwest farmers to sell their products to East Coast merchants.  The farmers were able to lock in prices and often hedge their operations against poor weather conditions or other situations that could adversely impact future sales.

In the early days, agricultural-based contracts dominated the futures markets and the first financial futures were not introduced until 1975. Today, more than 70% of all futures transactions are based on financials as their underlying securities, with contracts related to stocks and interest rates among the most frequently traded, according to Man Investments.

The Joys of Non-Correlation

For most investors, the main appeal of a managed futures account is its ability to provide significant diversification to a well-balanced portfolio.  Because the managed-futures asset classes are largely non-correlatedwith stocks and fixed-income products, an allocation can reduce the overall portfolio risk, while offering the potential for yield enhancement, particularly during challenging times for traditional assets like those experienced in 2008.

Hightower’s Lyman agrees that non-correlated assets can be a welcome addition, which is why he incorporates managed futures into portfolios of his more-sophisticated clients.  He believes managed futures play an important role in his clients’ overall risk-adjusted returns.

“The addition of managed futures offers the potential to smooth out portfolio performance because of their low correlation with equities,” Lyman said, noting that he builds client portfolios that are designed to provide consistent returns over time and that are broadly diversified across various asset classes.

Managed-futures assets can be particularly beneficial during some of the stock markets roughest stretches, he said.

“Since we are always looking to reduce volatility through the inclusion of low-correlated asset classes, managed futures represent an investment we need to consider,” said Lyman.  “From a performance standpoint, if you look at the 10 worst months for stocks since 1987, managed futures on average have dramatically outperformed.”

However, it’s important to note that investors use managed futures as only one piece of a well-diversified portfolio. In fact, due to the highly regulated nature of the futures markets, most investors will limit this part of their portfolio to no more than 10% of their total assets. And as the various asset classes rise or fall in value over time, investors will need to periodically rebalance their holdings to make sure that they do not exceed that 10% allocation limit.

Lyman has not experienced any problems working within the regulatory framework and says the portfolios of his most-aggressive clients tend to allocate an average of 5% to 7% of their holdings into managed futures.

Source: Managed Futures Can Put Investors in the Black – Even When Stocks Are Deep in the Red