Managed Futures Funds Reeling After Mass Exodus

Futures Funds

Once the darling of the market, producing consistent gains twice that of stocks for 30 years, managed futures funds have fallen upon hard times. They still might have their place.

Managed futures funds seem like such a great idea on paper. The potential return with futures trading dwarfs what anyone could make with stocks, and three-digit annual returns isn’t uncommon with some of the best traders.

Few investors are up for even dabbling in such a thing, and without the proper training, those who do find out quickly how much better they need to be in order to be successful at this. If they could get professionals to do the trading for them, and do this without paying all that much extra in management fees, that might even seem almost too good to be true.

It’s a whole different story trying to do this at the scale needed for a fund though, so before anyone gets too excited about this sort of thing, they need to be aware that this is nothing like their trading a futures account themselves and especially distant from what successful professional futures traders do.

The secret to trading futures is all in the leverage, at least as far as commodity futures go. Commodities, and bonds as well, just don’t move like stocks do, and generally trade within a pretty well-defined range. There are very few home runs, and the bread and butter of futures traders are capturing a good piece of some of the small moves these assets provide, multiplied many times.

If you get a 1% move with a stock, that just gives you 1%, which isn’t much at all of course. With a futures trade though, this 1% can turn into 20%, and considering that you can get a move like this in as little as a few hours, this makes the potential of these trades pretty potent indeed, and in the right hands, they definitely are.

There are some big reasons why this doesn’t work so well when you try to do this with a fund, and these things are limitations of all funds, but restrict futures trading in particular.

Let’s continue to look at our 1% move as our example. On our own, we could have traded this particular trade pretty easily, if we know what we are doing, and be in and out of the trade with a single mouse click and book our profits.

In this case, the total size of the move was 1.5% we’ll say, with a quarter percentage of slippage on each side. We’re defining slippage here as the difference between where you would enter looking at the chart after the move was over, and where you would exit knowing perfectly how it moved, and then comparing where you could have traded this if you were trading optimally but under the practical consideration of needing to wait for the move to develop and fail.

It moves the quarter point on the reversal, we like the way this looks, and we place an order. It’s moving up this time, and while we could add if we wished, as we do, it’s going to cost us more. There is a certain amount of volume that can be traded in our direction before the move fails, and the more contracts we want or need to buy, the less profit there will be.

This is especially the case given that we need to exit the same way, more gradually, where we get our target price for the first lot and then less for each one. The break-even point for our size will be the amount that we can put in and exit without a loss on the way back, and this is going to limit our average return per contract.

The biggest return we can get will be what we can buy at the current trading price, without paying more, and the good plays will be moving so if we don’t pay more, we shouldn’t even probably be adding because now we’re in a situation where the trade may already have failed, and we really can’t mess around with trading in the opposite direction of price with futures and that can be deadly in fact.

If a 1% loss will cost you 20%, you aren’t going to be able to handle a loss this big and expect to be around for very long, as a little bad luck or skills less than adequate will have you wiped out in short order, maybe even the same day. You have to go with the momentum and get out very quickly if the trade doesn’t move your way right away to have a risk-reward ratio that is even sensible.

Trading Futures with a Fund is a Much More Challenging Game

The first thing that should come to our minds is that funds just can’t afford to use the same kind of leverage as we can, and it’s not just due to the fact that these trades will require closer management than the fund manager, the trader essentially, can dedicate to them, it is because their slippage is so much higher and this takes a lot of the potential return off of the table that is necessary to make sense of magnifying our losses with lots of leverage.

They can use some, but they just aren’t going to be able to shoot for anything close to what we can as individual traders. Funds will also have their size limited by practical concerns, and while there is plenty of liquidity in these assets for us, funds have a much bigger need for this, with billions of dollars of principal needing to be deployed with at least some leverage, multiplying these big numbers several times.

We might be happy trading one or two assets at a time, the best-looking ones at any given point in time, but there just isn’t enough action with these for funds, and they have to dilute things by needing to be in many things. A lot of positions that need to be traded on a pretty short-term timeframe creates huge problems and this requires that the trades be left to run longer than it would be ideal to or even safe to, which means dialing down the leverage even more.

The longer you hold something, the more room to the downside you need to give it, because it doesn’t matter if you want to hold something for months if you need to exit at any sign of weakness, including signs that would simply represent noise to your trading system. If you are looking to make a buck but need to get out when you lose a few cents, that’s just not going to work because you’ll see this size of loss every step along the way.

Commodity prices also don’t go up over time like stocks do, aside from the effects of inflation or other longer-term influencers such as losing production to climate change or other factors. The goal with these things is to get in and out, something that favors traders who can make sense of such a strategy and execute it well, but not so well suited to futures funds.

With stocks, funds will tend to buy dips when they want to buy and sell into strength when they want to sell, but this does not work well at all with futures and can get them into a whole lot of trouble. There is no underlying bias in either direction so you can’t just hold these contracts over time like you can with stocks and expect good things, and due to the way that funds need to enter and exit these contracts, that will make it tough to not lose money.

While commodities aren’t generally known for their volatility, there are times where they are more volatile than in other times, and volatility is what we want here generally, although having this volatility expressed in a stable enough way is even more important. It will do us no good to want to ride a wild bull which might move up a lot but bounces so much along the way that all it would do is stop us out over and over, and if we try to stay on the bull and ride it out, our risk would be excessive and dangerous.

This all sounds pretty tough, and it is, but even so, there was a time where these funds were able to produce some pretty nice returns. In the 30-year period between 1980 and 2010, managed futures funds averaged an annual return of 14%, twice that of what stocks yielded over this time.

Times have really changed though, and these days, managed futures have fallen upon hard times. They have averaged a net loss over the last 5 years, and we know what stocks have done over this time. They are telling us that the moves they are seeing aren’t near as big as in the old days, and from our discussion, we can understand how we need moves of a big enough size to make up for all that extra slippage. Lately, this hasn’t been happening.

When putting your money under your mattress earns a better 5-year return than a particular investment, that’s not good, and people are pulling their money out of these funds in droves lately as they exceed their patience levels. This is the case even though this is really just used as a hedge these days, for the sake of diversification they say, even though it never makes sense to select alternatives that are so inferior merely for the sake of looking to manage risks that have not materialized.

The Word is to Hold This During Bear Markets Only, which is Only Sensible

What may be most interesting about the way that the investment community is viewing these funds is that we are actually seeing people recommend it as a hedge only during bear markets, which happens to be the only sensible time for any hedge, but they are at least understanding this with one, which is perhaps a start.

When advisors and fund analysts are both telling you this, to stay away from something unless a bear market comes, you know that the investment has no real redeeming value otherwise.

We should be understanding other forms of hedging the same way, bonds for instance, where we should be asking ourselves why we think it makes sense to shoot to average 3% on your money when we have a bull market going on with stocks. Wiser investors wait until there is a need for this, when the bull market grinds to a halt and things don’t look so rosy anymore, but to do this sort of thing while it’s still rosy is a pretty crazy idea actually, if only we stopped to think about this enough.

At least if the past is any indication though, managed futures may be barely breathing now, but they really come to life during bull markets or big pullbacks. During the crashes of 2000 and 2008, managed futures shot up in a big way and turned some very big losses in stocks to some very nice gains.

There may not even be a better hedge against a bear stock market than this in fact, although this all happened during the glory days of managed futures where they were already beating stocks and just hammered them instead during the pullbacks, and we therefore would need them to prove themselves again sufficiently before we ever consider jumping in with both feet.

An even better idea though is to get in on futures ourselves during these times, and we don’t even have to worry or care how commodities are doing because we know that there is one type of futures contract that will be flying high, which are stock index futures. There’s no better way to profit from stocks going down than being on the other side of this and amped up with leverage as well.

When things really turn sour with indexes, these trades can be entered with a level of confidence that you do not even see at any other time. A dropping stock market is as reliable as they come, the real drops that is, and you can see this by observing how indexes drop on their worst days during a bull market. This happens even more dramatically and reliably when downside momentum really picks up.

This means that we can use leverage with more confidence, as we can set our stops tight and there will be a lot less chance we will get stopped out when things are moving downhill this fast and we are on the side of the big slide.

Without knowing anything else, we already can know with certainty that these managed futures fund traders do not know much about what they are doing, or may not even care about pursuing a positive return. If they are complaining about a lack of volatility with what they like to trade, there’s some things that have had plenty of this, indexes for instance, or oil, or even gold lately.

There’s also the fact that if they can make so much money during a bear market, why can’t they do the same during a strong bull market like we’ve had over the last 10 years? These funds can do anything they want, so why aren’t they picking better trades, and are ending up with ones so bad that they lose overall?

This is one of the reasons why we worry a bit about how well they would actually do these days with a bear market in stocks, as the things that get more volatile during these times are the ones that are more volatile anyway. If they really were shooting for this, as they must, why has it failed so miserably over the last 5 years?

One of the possible reasons could be just how much more hedge fund money gets put into these managed future funds, and this is by far the biggest source of inflows these days. Perhaps the hedge funds aren’t out for return with this, but only to hedge, and even though that sounds crazy, not all hedge fund managers think enough about what they are doing. This would have them avoiding volatility instead of seeking it, and that’s going to indeed spell the end to this kind of investment producing even half-decent returns.

Why this wouldn’t be such a good idea for them is that if they really wanted a hedge, even bonds make more sense, and bonds have kicked these futures funds lately, as terrible as bonds have been relative to stocks. Bonds are also a true hedge, as the asset itself is the hedge, but with futures, its hedging value all comes down to how well the fund is traded during these times, with no guarantees or even all that much confidence.

In the meantime, managed futures are taking a real beating both with the outflows they are experiencing and their terrible returns. The only good thing about the outflows is that the less money you need to manage, the greater the potential for return, as the more money you use, the harder it is to make money percentage-wise.

This still might be worth keeping an eye on if it does become time to take some money out of stocks, but it needs to show us that it can still wake up and provide the kind of bullishness it showed us during other bear markets, and is at a disadvantage now given that it has to rise all the way from the grave to where we want it to go. This sure makes it seem less likely, but maybe a big enough horror show can indeed wake up this Frankenstein enough to want to bet on him.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: eric@marketreview.com

Areas of interest: News & updates from the Commodity Futures Trading Commission, Banking, Futures, Derivatives & more.