Many investors search for alternative investments when there is a lackluster outlook for U.S. equity markets or to diversify even when there isn't. As they do, they might look to managed futures. However, good guides on them can be hard to find. Here, we get you started with a primer on how these investments might be good for diversification, what studies on their returns suggest, and how to evaluate different professionals in the field for handling your investments.

Understanding Managed Futures

Managing futures is a 50-year-old specialization for financial managers known as commodity trading advisors (CTAs). These professionals are registered with the Commodity Futures Trading Commission, have undergone an FBI-aided background check, and need to supply rigorous disclosure documents and independently audited financial statements to be in their positions. The National Futures Association (NFA), the industry watchdog, also reviews them and has its own regulations.

CTAs generally manage their clients' assets using trading methods that are algorithmic, hands-on discretionary, or, typically, both. This may involve going long or short on futures contracts in metals (gold, silver), grains (soybeans, corn, wheat), equity indexes (S&P 500, Dow, and Nasdaq 100 futures), soft commodities (cotton, cocoa, coffee, sugar), foreign currency, and U.S. government bond futures.

The minimum account equity requirements can vary dramatically, ranging from about $10,000 to some stretching to seven figures.

Most investors turn to managed futures as a way to diversify their portfolios. In theory, exposure to managed futures should mitigate the risk in one's portfolio when stocks underperform and hedge fund returns flatten. Managed futures firms have marketed themselves as an alternative to hedge funds, which, before and since the rise of managed futures, have often been seen as providing cover during market turmoil. Since managed futures are seen as alternatives to hedge funds, a question often raised is whether they perform better, especially as CTA fees can eat up much of the client returns.

Managed Futures vs. Hedge Funds

Hedge funds pool capital from investors and offer complex portfolios and risk management techniques. Hedge funds are known for their flexibility, being less regulated (they are often offshore), and using leverage and derivatives to boost returns and manage risk. Both CTAs and hedge funds have less regulation (futures are based on contracts, so don't have the usual securities requirements), have similar fees, and use leverage and complex financial instruments that are not manageable for everyday investors.

They tend to differ in strategy. CTAs primarily employ trend-following strategies and are active in commodity and financial futures markets. In contrast, hedge funds work in a broader variety of financial markets with more financial instruments. Those who invest in hedge funds face two specific risks often noted (among others):

1. Illiquidity: Many hedge funds have lockup periods when you can't withdraw your funds, plus they may also have investments in illiquid assets.
2. Credit risk: Hedge funds leverage their moves by borrowing vast sums. While this can increase profits, it also increases the risk of losses and the potential for default, especially in volatile market conditions.

CTAs, who trade in highly liquid and credit-protected futures markets, are less exposed to these risks. Indeed, CTAs often market themselves as filling this gap.

Also, unlike investors in a hedge fund, investors in CTAs have the advantage of opening their accounts and viewing all the trading on an up-to-date basis. Typically, a CTA will work with a particular futures clearing merchant and doesn't get commissions. It is important to ensure that the CTA you are considering does not share commissions from their trading program since this poses a conflict of interest.

What the Research Says About Managed Futures

Since the 1980s, researchers have studied how managed futures perform once enough historical data was available from the rise of CTAs the decade before. In general, during bearish markets, the research suggests that commodity funds, a type of managed future, have had better downside risk protection than hedge funds. But others have found they offer returns like what you'd get from risk-free Treasurys, particularly if their data covers the 1990s and early 2000s. This means they don't return their expected risk premium, the amount you'd expect in potential gains over far less risky investments like Treasury bonds.

While there is no shortage of studies on the matter, a difficulty is that many studies are engaged in fundamental finance debates, using managed futures as a proxy in these broader battles. This is akin to looking for data on the effect of federal tax policies. There are very good studies and data available, but behind many articles, there are more significant controversies over the size of government in society. There are probably no more foundational debates in finance and investing than between those who ground their work in the efficient market hypothesis and those who don't and between those who side more toward fundamental analyses and those who think market prices are best understood through technical charts and historical prices. Academic articles on managed futures often end up embroiled in these debates.

Debates over futures precede the existence of CTAs, and discussing them helps us more quickly and easily describe the debates over managed futures. The existence of futures was the point of the so-called "Telser-Cootner debate" of the 1950s and early '60s. This centered on the fundamental question of whether futures markets offer a risk premium to investors. Lester Telser, the late University of Chicago economist, argued that there could be no risk premium in futures markets—no extra returns you get for risking your money in futures rather than putting them in Treasurys. His view was based on the efficient market hypothesis, which suggests that market prices fully reflect all available information. If markets are efficient, futures prices should be impartial predictors of future spot prices, meaning that, on average, they neither overestimate nor underestimate the future spot price. After all, futures traders should, over time, have the same information as other traders, so prices should converge. Conversely, if futures traders had insights others didn't, the market would soon catch up in balancing supply and demand.

Thus, for Tesler, there should be no systematic way to profit (receive a risk premium) from trading futures. (Cootner, of course, disagreed.) Moving forward, you can see why the whole idea of futures management—a sector premised on beating the market—ends up frequently being academically studied to update an old debate about whether markets are efficient purveyors of information.

CTAs are also known for their trend-following strategies, aligning them with the finance technical analysis camp. If CTAs are successful (or not) over time, this could help answer another major divergence in finance between fundamental and technical analyses. That's why, today, the notion of a risk premium is still studied—not just because researchers are interested in investment returns for this or that vehicle over time, which they are, but also because it touches on these debates.

Nevertheless, the research into managed futures funds and CTAs does provide some insights for investors. First, most studies have found that managed futures funds do tend to be trend followers who employ time-series momentum strategies where investment decisions are based on the recent price trends of assets. Thus, it's no surprise that this approach is strongly connected with the returns of managed futures. It suggests that much of their success can be chalked up to effectively capitalizing on market trends.

The upshot for some researchers seems to be that investors can replicate many of these strategies without the fees. One group of researchers calls much of the work these funds do "simple, implementable trend-following strategies." How "simple" or "implementable" such strategies are depends on the trader, but if none of this strikes you as so easy, it's likely worth the fees CTAs charge rather than attempting something best left to more experienced traders in this area.

Benefits of Managed Futures and CTAs

Here are some of the benefits researchers have found for investors:

• Crisis alpha: The term is not just a great sci-fi movie title waiting to happen, but was coined by the investment analyst Kathryn M. Kaminski after the Great Recession to describe how managed futures tend to perform relatively well, on her account, during market downturns. This concept is particularly marketed by managed futures as a tail-risk strategy, offering downside protection in portfolios by reducing capital losses during significant market declines, albeit with somewhat reduced performance during bullish market periods. Managed futures, as a subclass of alternative investments, claim to deliver this crisis alpha by effectively managing risks during turbulent market conditions.
• Portfolio diversification: Managed futures have shown they can be particularly valuable for downside protection, especially during crises when most other assets like stocks and bonds are taking a beating, which should supply some significant diversification benefits. For instance, in inflationary periods, managed futures can focus on specific commodities or foreign currencies that can hedge against the impact on traditional equities and bonds.
• Flexibility: Their trend-following nature lets these funds potentially capitalize on both upward and downward market trends.

Downsides of Managed Futures and CTAs

Meanwhile, compared with hedge funds and other alternative investments, some studies have concluded that managed futures do not always come out ahead. They usually point to these, among other reasons:

• Dependence on clear market trends: The effectiveness of CTA strategies varies with the market conditions. In markets without clear trends, these strategies might be less effective. Often, this is precisely when investors turn to managed funds for help.
• Manager performance: While some managed futures funds have shown high returns (alpha), studies suggest these returns are often because of their trend-following strategies rather than the unique managerial skills of individual CTAs. When these strategies are accounted for, the extraordinary performance of many managers diminishes.
• Fees and other costs: CTAs charge transaction and management fees that can greatly impact net returns, especially in periods when managed futures are a match for much less risky investments like Treasurys.

Considerations for Investing in Managed Futures

Pulling this all together, we can now apply these as lessons to use when reviewing potential CTAs to invest with:

• The importance of understanding the CTA's underlying strategies: These funds tend to perform well when they can capitalize on clear market trends, either upward or downward. As part of your due diligence, you'll already be keen to assess particular firms' past success (or not). But those numbers mean little outside the context of those returns. Since the success of managed futures funds and CTAs is primarily attributed to time-series momentum strategies, the returns you'll see for a particular firm might mean this was the general trend during the period the fund has highlighted for you. Understanding this reliance on trend-following strategies is thus crucial.
• Setting realistic expectations: Studies have found that those CTAs who have diversified across multiple futures markets, where gains in some markets can offset losses in others affected by a crisis, perform best. But once you account for momentum found across different market sectors over time, their success is likely lower. Hence, you should set realistic expectations about the unique talents of fund managers and understand that high returns might not always be due to extraordinary management skills but from following market trends effectively. That in itself, though, is no minor skill.

Evaluating CTAs

Before investing in any asset class or with an individual money manager, you should make some critical assessments. You should also consider the CTA's industry reputation, compliance history, and outstanding performance or red flags.

Much of the information you need to do so can be found in the CTA's disclosure document, which they are required to provide when you ask. Standardized by the NFA, this document outlines the CTA's trading strategy, fees, and other essential details. We'll walk you through some of what you'll be reviewing:

Trading Strategy and Approach

Understand the CTA's trading plan, including the markets they trade in, the instruments used, and their overall investment philosophy. Ensure their strategy aligns with your investment objectives and risk appetite—or at least those for the section of your portfolio allotted to managed futures.

A key step in the evaluation is to learn about the CTA's trading program. Normally, these will be either trend-following or market-neutral strategies. Trend followers use proprietary strategies that offer directions for when to go long or short in certain futures markets. Market-neutral traders typically rely on spreading strategies to generate profits.

Writing options might be part of their trading program. Another type of trading in market-neutral programs is options premium selling. Both spreading and options premium selling aim to profit from nondirectional trading strategies.

Past Performance

Assess the CTA's historical returns to gauge their success in different market conditions. While past performance does not automatically indicate future results, it can help you understand the CTA's expertise and ability to offer good returns:

• Drawdowns: Essential information to look for in a CTA's disclosure document is the maximum peak-to-valley drawdown. This represents the money manager's largest cumulative percentage decline in portfolio value and should give you an idea of the risk investors in this CTA have faced. It will also show how long it took for the CTA to recoup those losses. Obviously, the shorter the time required to recover from a drawdown, the better the performance profile.
• Returns: Another factor you want to look at is the annualized rate of return, which must be presented as net of fees and trading costs. However, the numbers in the disclosure may not represent the most recent months of trading, which you can request. Dispersion, or the relation of monthly and annual performance from the average, is typically used for evaluating CTA returns. You'll also want to look at the Alpha coefficients, from which you can compare each CTA's performance against standard benchmarks like the S&P 500.

Risk Management

Once you've determined the trading program (trend-following or market-neutral), what markets the CTA trades, and the potential returns based on past performance (using annualized returns and maximum peak-to-valley drawdown), you'll want to assess the CTA's approach to managing risk. This includes understanding how they mitigate losses, use leverage, and their strategies for protecting capital during market downturns.

An important measure is risk-adjusted returns. This is valuable because a CTA with an annualized rate of return of 30% looks more favorable than one with 10%. However, the comparison would be deceptive if they have a radically different dispersion of losses. Many CTA tracking data services have these numbers for easy comparisons. A CTA with a 30% annual return may have average drawdowns of -30% per year, while one with a 10% annual return may have average drawdowns of only -2%. This means the risk required to obtain the respective returns is quite different: the 10%-return program has a return-to-drawdown ratio of five, while the other is one. Using this, one can see that the CTA with the 10% annual return has a better risk-reward profile.

Prospective CTAs should also provide other risk-adjusted return data, such as the so-called Sharpe and Calmar ratios. The former shows the annual rates of return (minus the risk-free interest rate) in terms of the annualized standard deviation of returns while the latter is the annual rates of return in terms of maximum peak-to-valley equity drawdown.

Fees

CTAs usually charge an annual management fee and a performance fee. Management fees range from 1% to 3% of the account size. The percentage will reflect the CTA's experience level, with more seasoned CTAs usually charging higher fees. Performance fees, which can be between 15% to 30% of profits, should help align the CTA's interests with your own, providing a greater incentive for a strong performance. Look for extra fees, such as those for individual trades.

CTAs are allowed to assess incentive fees only on new net profits. They must clear what is known in the industry as the "previous equity high watermark" before charging further incentive fees.

The Bottom Line

Having more information never hurts, and it could help you avoid investing in CTA programs that don't fit your investment objectives or your risk tolerance, an important consideration before investing with any money manager. Given the proper due diligence on investment risk, however, managed futures can be a viable alternative investment vehicle for small investors to diversify their portfolios and thus spread their risk. If you are searching for ways to enhance risk-adjusted returns, educating yourself on managed futures might be helpful.