Managed Futures: An Overview

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By: Laurie A. Belew, MBA, MS, CFP®
What are futures?
Futures began in the mid-19th century with the establishment of central grain markets, where farmers could sell their products either for immediate delivery or forward delivery. These “forward contracts” between two parties to buy or sell at a certain future time for a specified price became the forerunners of today’s exchange traded futures contracts.

Imagine a cotton farmer with certain fixed costs, who wants to lock in the price of his crop before harvest. He may enter into an agreement with a textile manufacturer to deliver his crop in the future for a specified price. The farmer has hedged against the risk of falling prices for his product, while the textile manufacturer has mitigated his risk of the rising cost of materials.

While forward contracts are negotiated directly between the buyer and seller with terms that may vary from contract-to-contract, futures contracts are bought and sold through an exchange and terms are standardized. The price of the contract is determined daily through an auction-like process on the exchange

The first futures contracts were designed to mitigate risks associate with agricultural commodities; however, futures have expanded to include metals, energy, currencies, equity indexes, treasuries, and interest rates. Advancements in technology have enabled efficiency and provided more transparency into futures markets, as most trading is now done electronically.

Who Trades Futures?

Hedgers use futures markets to reduce their exposure to adverse price movements by transferring their exposure to others. Their goal is long term price certainty.

  • Agricultural companies, mining firms, banks, and others who want to protect themselves against falling prices of assets they need to sell.
  • Manufacturers, food processing companies, financial firms and others who want to protect themselves against rising prices of raw materials or financial assets they need to buy.
  • Multi-national companies need to protect themselves against the unfavorable currency fluctuations.

Speculators accept price risk in hope that they will profit from correctly anticipating price movement and direction.

  • Banks, hedge funds, proprietary trading firms, and individual traders.

Why Trade Futures?

Managed futures provide an easy, cost effective way to access financial and commodity markets and participate in market trends. We believe the strongest case for adding the investment class to a portfolio is that it reduces overall portfolio volatility through the benefits of diversification and low correlation.
Futures provide exposure to all major asset classes: currencies, stock indexes, interest rates/treasuries, commodities, energy, and metals. Further, research shows that this exposure has historically been achieved with a very low correlation to other asset classes, meaning managed futures do not behave similarly to other investments in the portfolio under the same market conditions.

As technology improves, so has transparency and liquidity in the managed futures markets. The exchanges provide a centralized marketplace, where price and transaction data is distributed in real time. Trading is open and fair, and because a wide spectrum of products is available on a single platform, the exchanges attract many participants who trade millions of contracts in a single day. This large volume enables traders to transact quickly and efficiently with daily pricing – the definition of a liquid market.

Futures traders can control large contract values with a relatively small amount of capital. This utilization of leverage improves flexibility and capital efficiency to the trader. Further, the use of strict stop-loss limits by most managers effectively limits potential investment drawdowns.

Finally, futures markets have certain tax advantages when compared to frequent trading in other asset classes. Profits are taxed as 60% long term capital gains and only 40% ordinary income, even if trades are technically short term.

Futures as an investment class

By providing a unique way to gain exposure to the particular asset classes mentioned above, this investment class adds an additional component of diversification to a portfolio.

Our clients are able to gain access to managed futures through limited partnerships, which oversee professional money managers, known as commodity trading advisors (CTAs). The CTAs are registered with the Commodity Futures Trading Commission, undergo extensive background checks, and provide thorough disclosure documents and audited statements to regulatory agencies.

CTAs manage assets using systematic, rules-based trading systems that seek to profit from market trends. Their ability to trade in a market by going either long or short creates profit potential in both rising and falling markets. The success of the fund will not be dependent upon economic prosperity or interest rate or currency stability. In general, the trading systems tend to make profits when market prices move in a continuous direction, up or down, for a sustained period of time. Of course, where there is profit potential, there is also risk of loss.

We will be addressing whether managed futures is an appropriate investment for you at an upcoming periodic review meeting. As always, if you have questions or comments, please let us know.

Sources:
Steben & Company, Inc.

Futures Portfolio Fund, L.P. Brochure

CME Group Futures for the Individual Trader
www.cmegroup.com