The following copyrighted information was prepared and provided by the Chicago Board of Trade (CBOT). The information is provided to you by ND Global Trading for educational purposes only.

Why Managed Futures?

Managed futures, by their very nature, are a diversified investment opportunity. Trading advisors have the ability to trade in over 150 different markets worldwide. Many funds further diversify by using several trading advisors with different trading approaches.

The benefits of managed futures within a well-balanced portfolio include:

• opportunity for reduced portfolio volatility risk
• potential for enhanced portfolio returns
• ability to profit in any economic environment
• opportunity to participate easily in global markets

1. Reduced Portfolio Volatility Risk

The primary benefit of adding a managed futures component to a diversified investment portfolio is that it may decrease portfolio volatility risk. This risk-reduction contribution to the portfolio is possible because of the low to slightly negative correlation of managed futures with equities and bonds. One of the key tenets of Modern Portfolio Theory, as developed by the Nobel Prize economist Dr. Harry M. Markowitz, is that more efficient investment portfolios can be created by diversifying among asset categories with low to negative correlations.

Table 1 compares the correlations between managed futures, bonds, and domestic stocks from January 1995 through December 2004. As you can see, managed futures are essentially uncorrelated to the other asset classes.

2. Potential for Enhanced Portfolio Returns

While managed futures can decrease portfolio risk, they can also simultaneously enhance overall portfolio performance. For example, chart 1 shows that adding managed futures to a traditional portfolio improves overall investment quality. This is substantiated by an extensive bank of academic research, beginning with the landmark study of Dr. John Lintner of Harvard University, in which he wrote that "the combined portfolios of stocks (or stocks and bonds) after including judicious investments... in leveraged managed futures accounts show substantially less risk at every possible level of expected return than portfolios of stocks (or stocks and bonds) alone."

1 Table 2 shows that when viewed as an independent investment, managed futures have compared favorably with U.S. stocks and bonds, as well as international stocks, in 2003 and 2004. In addition, the potential for higher returns using managed futures compares well with other asset classes in terms of risk. One way to compare risk is to measure the magnitude of the worst cumulative loss in value of an investment from any peak in performance to the subsequent low. This worst-case, peak-to-valley scenario is called a drawdown in the futures industry. Chart 2 shows that managed futures outperformed U.S. and international stocks during the worst peak-to-valley drawdowns of the S&P 500®, the NASDAQ®, and the MSCI® Europe, Australasia, and Far East (EAFE®) Index.

3. Ability to Profit in Any Economic Environment

Managed futures trading advisors can take advantage of price trends. They can buy futures positions in anticipation of a rising market or sell futures positions if they anticipate a falling market. For example, during periods of hyperinflation, hard commodities such as gold, silver, oil, grains, and livestock tend to do well, as do the major world currencies. During deflationary times, futures provide an opportunity to profit by selling into a declining market with the expectation of buying, or closing out the position, at a lower price. Trading advisors can even use strategies employing options on futures contracts that allow for profit potential in flat or neutral markets.

4. Ease of Global Diversification

The establishment of global futures exchanges and the accompanying increase in actively traded contract offerings (see table 3) have allowed trading advisors to diversify their portfolios by geography as well as by product. For example, managed futures accounts can participate in at least 150 different markets worldwide, including stock indexes, financial instruments, agricultural products, precious and nonferrous metals, currencies, and energy products. Trading advisors thus have ample opportunity for profit potential and risk reduction among a broad array of noncorrelated markets.

The Efficiencies of the Futures Markets...

Domestic and international corporations, banks, insurance companies, mutual fund managers, and trading firms use the futures markets to manage their continuous exposure to price changes. Futures markets make it possible for these hedgers to transfer that risk exposure to other market participants. Speculators assume risk in anticipation of making a profit; in doing so, they add liquidity to the market.

In a market without these risk-takers, hedgers would find it difficult to agree on a price, because sellers or short hedgers want the highest possible price while buyers or long hedgers want the lowest possible price. When speculators enter the marketplace, the number of ready buyers and sellers increases, and hedgers are no longer limited by the hedging needs of others.

In addition to providing liquidity, speculators help to ensure the stability of the market. For example, by selling futures when prices are high, speculators decrease demand and help to lower prices. By purchasing futures when prices are low, they add to demand and help to raise prices. The volatile price swings that might otherwise occur are thus tempered by active trading.

...Benefit Those Who Use Managed Futures

Managed futures trading advisors can benefit from the structural efficiencies of the futures markets.

Liquid markets facilitate entering and exiting market positions. For example, the average daily trading volume in the 10-year U.S. Treasury note futures contract was about 750,000 as of 2004.

With a notional value of $100,000 per contract, this volume represents an average daily transfer of about $75 billion. This depth of liquidity usually allows traders to enter or exit the Treasury note futures market at the minimum price change of one tick. Traders in futures may benefit from transaction costs lower than those for comparable cash market transactions. For example, the transaction fee charged for one stock index contract is substantially less than the transaction fee for trading an equal dollar amount of stock. Typically, this cost is 1/10 to 1/20 of the comparable cash market execution cost.

Lower market impact costs also benefit the futures trader. Large-block equity orders sent to the stock exchange often create a supply-demand imbalance that increases the bid-ask differential and the cost of the trade. The effect of a comparable dollar order executed in the futures market is usually less significant. This is understandable when one considers the greater liquidity of stock index futures, where the daily dollar volume is concentrated in a single standardized contract representing a basket of stocks. In contrast, the daily dollar volume at a stock exchange is distributed over many stocks.

The disciplined use of leverage enables traders to control large dollar amounts in the futures markets with a comparatively small amount of capital. To ensure performance of the terms of the futures contract, both the buyer and seller are required to deposit a performance bond margin in an account at their brokerage firms. (Note that in the futures industry, the term margin represents a security deposit, whereas in the stock market, margin represents a down payment.) The amount of daily maintenance margin required by brokerage firms fluctuates with the daily value of the futures position.

Types of Investment Opportunities According to the Barclay Trading Group, Ltd. in 2004, it was estimated that over $130 billion was under management by futures trading advisors worldwide. Currently, there are three primary categories of managed futures.

Individual Accounts are usually opened by institutional investors or high net worth individuals. These funds usually require a substantial capital investment so that the advisor can diversify trading among a variety of market positions. An individual account enables institutional investors to customize accounts to their specifications. For example, certain markets may be emphasized or excluded. Contract terms may include specific termination language and financial management requirements.

Private Pools commingle money from several investors, usually into a limited partnership. Most of these pools have minimum investments ranging from approximately $25,000 to $250,000. These futures partnerships usually allow for admission-redemption on a monthly or quarterly basis. The main advantage of private pools is the economy of scale that can be achieved for middle-sized investors. A pool also may be structured with multiple trading advisors with different trading approaches, providing the investor with maximum diversification. Because of lower administrative and marketing costs, private pools have historically performed better than public funds.

Public Funds or Pools provide a way for small investors to participate in an investment vehicle usually reserved for large investors.

Participants in the Managed Futures Industry

There are several types of industry participants qualified to assist interested investors. Keep in mind that any of these participants may, and often do, act in more than one capacity.

Commodity Trading Advisors (CTAs) are responsible for the actual trading of managed accounts. There are approximately 800 CTAs registered with the National Futures Association (NFA), which is the self-regulatory organization for futures and options markets. The two major types of advisors are technical traders and fundamental traders. Technical traders may use computer software programs to follow pricing trends and perform quantitative analysis. Fundamental traders forecast prices by analysis of supply and demand factors and other market information. Either trading style can be successful, and many advisors incorporate elements of both approaches.

Futures Commission Merchants (FCMs) are the brokerage firms that execute, clear, and carry CTA-directed trades on the various exchanges. Many of these firms also act as CPOs and trading managers, providing administrative reports on investment performance. Additionally, they may offer customers managed futures funds to help diversify their portfolios.

Commodity Pool Operators (CPOs) assemble public funds or private pools. In the United States, these are usually in the form of limited partnerships. There are approximately 1,500 CPOs registered with the NFA. Most commodity pool operators hire independent CTAs to make the daily trading decisions. The CPO may distribute the product directly or act as a wholesaler to the broker-dealer community.

Investment Consultants can be a valuable institutional investor resource for learning about managed futures alternatives and in helping to implement the managed fund program. They can assist in selecting the type of fund program and management team that would be best suited for the specific needs of the institution. Some consultants also monitor day-to-day trading operations (e.g., margins and daily mark-to-market positions) on behalf of their institutional clients.

Trading Managers are available to assist institutional investors in selecting CTAs. These managers have developed sophisticated methods of analyzing CTA performance records so that they can recommend and structure a portfolio of trading advisors whose historic performance records have a low correlation with each other. These trading managers may develop and market their own proprietary products or they may administer funds raised by other entities, such as brokerage firms.

Assessing Performance from an Investor's Perspective

There are several indexes that measure managed futures performance. Investors may wish to review each index to determine which one provides the most appropriate performance criteria for their needs.

The following is a list of some of the more familiar indexes:

Managed Futures Indexes* (Actively Managed)
Barclay CTA Index
MLM (Mount Lucas Management) Index™
CISDM Managed Futures Benchmark Series

Commodity Market Indexes (Passive)
Reuters-CRB® Total Return Index
Goldman Sachs Commodity Index (GSCI®)
Dow Jones-AIG Commodity IndexSM (DJ-AIGCISM)

How the Fee Structure for Managed Futures Works

Total management fees in the managed futures industry tend to be higher than those in the equities market. These fees, however, may be partially offset by the lower commission costs for comparable dollar transactions in the futures industry. While management fees do vary by the type of managed futures account and may be negotiable, there is a general fee structure. Investors should understand that performance information for a managed futures account or fund is almost always expressed net of all such fees.

Typically, the trading advisor or trading manager is compensated by receiving a flat management fee based on assets under management in addition to a performance ?incentive" fee based on profits in the account. The performance fee is almost always calculated net of all costs to the account, such as management fees and commissions. The performance fee is thus based on net trading profits, which are usually paid only if the account or fund exceeds previously established net asset values.

A few trading managers assume the "netting risk," whereby the performance results of all trading advisors in the account are netted before the investor is charged a performance fee. The trading manager assumes the netting risk by paying each CTA according to his or her individual performance. In addition to management and performance fees, an account or fund pays transaction costs or brokerage commissions. These expenses reflect the cost of executing and clearing futures and generally are calculated on a per-round-turn basis.

Source: CBOT

Futures and options trading involve substantial risk.