Stock market performance in the recent past has clearly damaged the “buy-and-hold” strategy, which worked well in previous decades. Any financial advisor could present an Ibbottson chart showing the long-term performance of equities and cite the expected 10% return from investing in equities that had historically had the answer to meeting the plan of the client.
The problem with this is that a chart showing a track record since the end of the eighteenth century just did not match the client’s life span. Even using a rolling 10-year track record to provide a basis for planning was impaired. The past three years of the current 10-year rolling average return will show a return that does not meet the required growth rate of assets to be attained for future usage.
One asset class has been the savior of several institutional and high-net-worth individuals. Managed futures, as a group, have clearly outperformed equities and fixed income investments, especially during 2008. The reason for this is the non-correlation of managed futures returns to the returns of equities and fixed income. A simple difference between this alternative asset class and the traditional asset classes is that while equity and fixed income returns are highly dependent on the cash flow of the issuing entities, managed futures returns are based on the skill of the manager entering into futures contracts and correctly taking positions that are profitable while controlling the risks associated with losing positions.
According to the CME Group, in the past 30 years, the assets under management in managed futures programs have grown 800 times. “Managed futures” is a broad title for a variety of programs and structures that allow investor access to the futures markets. Currently, direct exposure to these markets is possible through the engagement of a Commodity Trading Advisor (CTA) to handle a separately managed account under the guidance of the strategy disclosure document, or by placing funds with a Commodity Pool Operator (CPO), who accepts the combined deposits and manages the entire pool as one account. The CPO is required to issue statements to the individual clients on a regular basis and file copies with National Futures Association (NFA). A CPO may offer a bundled program and hire more than one CTA, so as to diversify the risk by using different strategies under one program.
The growth of the industry has created additional methods to enter into these programs. FINRA-registered limited partnerships that pool funds to allocate to external CTAs that meet the pool’s due diligence requirements is one method. Another method that has gained acceptance is the fund-of-funds approach. This is similar to the limited partnership in that the pooling of interests and allocating to various CTAs according to program requirements is consistent. Both of these structures assess their operational costs and fees to the investors. This layering of fees reduces the net returns that the investor receives. The difference is that the limited partnership approach issues a K-1 at the end of each tax year. This may complicate an individual’s tax situation.
The benefits of using managed futures on a portfolio level have been academically proven to enhance overall return and reduce risk as a result of diversification into this non-correlated asset class. When a financial advisor chooses to allocate into this area, the choices may be limited. Those advisors that operate under a FINRA-registered broker/dealer are subject to using what is available on the platform. This is a significant disadvantage because the track record of publicly offered managed futures programs has underperformed the private programs that are not subject to registration and securitization. There are two main reasons for this. As stated earlier, the layering of fees and costs in the programs that are subject to both FINRA and NFA registration reduce returns and the other reason is capacity constraints. Futures and options on futures are highly leveraged instruments. The markets where such instruments are traded vary in size. Examples of the smaller markets include live cattle and frozen concentrated orange juice. Because of the small number of market participants in such markets, it is difficult for a pool to make an allocation that allows for diversification based on the amount of assets it holds into a market that has limited trading liquidity. Consequently, such extremely large public pools are limited to the markets that have the size and depth capable of handling the size of positions held. Markets that are large enough to accommodate such participants are limited to the equity indexes, fixed income instruments, and possibly currencies. This structural limitation defeats the purpose of finding a method that offers returns that are non-correlated from equities and fixed income.
Fee-based planners operating under a RIA platform will have greater latitude in accessing these markets. Platform custodians may offer a selection of programs that give a broader dimension to meeting the client needs. Most likely, these programs will be is a fund-of-fund or limited partnership structure. Similar to a mutual fund that has high operating costs, this creates a situation where performance over the higher hurdle is necessary before the program can deliver value and diversification to the portfolio. Another method that these planners may not be aware of is that by partnering with an NFA registered Introducing Broker (IB), the ability to access the full spectrum of registered CTA and CPO programs is available. Working jointly with an IB is an outsourcing function that engages an IB to select a program or programs that can meet the planner’s and client’s goals. Engaging an IB in this structure is further enhanced when the referring planner is included in all discussions, correspondence, and ongoing reporting on the account performance.
There remains one other participant in the futures industry that has not been presented, the Futures Commission Merchant (FCM). The FCM is the party that is the custodian of all funds used in futures trading. Services the FCM provide are order entry, confirmations of trading instructions, daily and monthly statements, plus the segregation of customer funds. Clearing FCMs transmit via the central clearing house all daily margin adjustments on a net funds transfer basis. Futures trading is a zero-sum activity. For each contract that has a buyer, there is an opposing seller. Entering into a futures contract requires a margin deposit. This deposit is posted by both parties. As the value of the contract shifts in favor of the buyer or seller, the cash used to margin the contract is transferred to the winning position from the losing position. This back office function is then broken down to the individual accounts at the FCM level.
A partnership between a fee-based planner and an IB is a joint effort. Both professionals are concerned about finding the proper mix of asset strategies that give the best risk-based returns the client desires. Communications between these parties facilitates mutual growth. When the functions of all parties are understood, relationships can grow.
Jeff Stouffer is the principal of Mercantile Capital Group in Herndon, Va. As a practicing financial advisor serving the needs of individuals and small businesses, he believes in using a wide range of investment strategies, including alternative investments. He can be reached at email@example.com
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