Funds that thrive on drama
In 2008, when asset values plummeted, one group of investments shone out - managed futures accounts and funds, which trade in derivative contracts predicting the prices of a diversified basket of assets.
The average managed futures programme returned about 14% compared with a drop of 32% for the FTSE All-Share index. These funds thrive on drama and volatility, so 2008 was a fantastic year.
Their good performance in such a dreadful period highlights their merits as portfolio diversifiers and investments that can make money whatever the circumstances.
Traditionally, managed futures accounts were a specialist product only available to expert investors, and the minimum investment required for an individual, segregated account remains as high as $100,000 to $250,000, or $25,000 to $50,000 for units in a pooled fund.
However, some investment managers are opening up their products to small private investors, as part of an ongoing industry-wide trend that is blurring the boundaries between institutional and retail products, and hedge funds and mutual funds.
A traditional high entry-point managed futures fund is managed by a firm of commodity trading advisers (CTAs), who trade in up to 200 different futures markets, ranging from fixed income and currencies to individual commodities such as cocoa and gas.
Positions can be long (benefiting when the asset rises) or short (benefiting when it falls). Managers often employ leverage, which magnifies returns when the manager has made the correct market call and also the losses when the wrong call is made.
CTAs typically charge management fees of between 1.5% and 2%, and a performance fee of up to 25%.
One reason why new funds aimed at the small investor can now be offered is that the EU's Ucits regulations have been opened up to allow the use of a certain amount of derivatives.
The spin-off funds offer the attractions of managed futures products run by CTAs - such as the ability to take advantage of both rising and falling markets - and also daily liquidity, transparency and lower fees.
One such fund is Man Group's AHL Diversity fund, which was launched in September 2009. It is run by Man's CTA subsidiary, AHL, which claims it has made 17% a year net of fees for the past 20 years.
The system is based on proprietary mathematical models to identify trends, and it actively watches 90 markets and 29 exchanges.
"Managed futures managers, or trend followers as we call them, exploit persistent trends and other inefficiencies in a systematic way using liquid futures markets, and they aim to perform well whether prices trend up or down," says Clive Selman, head of distribution at Man Group.
"For example, most CTAs made money on oil in 2008 as it went from $40 to $147 and then fell back. Trend following consistently delivers returns that are relatively uncorrelated with stocks and bonds, and the practice has proved itself during the big market crises of the last 20 years."
The fund, which has a minimum investment of £100, is currently on the Transact platform and will be added to other popular fund platforms in 2010, says Selman. The target is a double-digit return net of fees. The fund has a 2% management fee and 20% performance fee.
The Royal Bank of Scotland also chose September to launch a Ucits III-compliant fund, which tracks exposure to a managed futures index, the Trader Vic index (TVI) fund. The TVI was developed by Victor Sperandeo, known as Trader Vic, who runs the Enhanced Alpha Management LP hedge fund.
The company claims that back-testing shows the fund would have produced a 13% annualised return since 1990, and a 23% gain in 2008 alone.
The fund is based on an investable index of liquid futures contracts consisting of 24 components spread across physical commodities, global currency and bonds.
The drawback is that the indexing process lags real events and sometimes does not look good over a month or two.
Nordic bank SEB has entered the UK market with its Asset Selection range, which uses futures and other derivatives to play four asset classes: stocks, bonds, currencies and commodities.
The strategy, which is available at three risk levels and return targets, includes the SEB Asset Selection Defensive fund, the SEB Asset Selection fund and the SEB Asset Selection Opportunistic fund, all managed by Hans-Olov Bornemann, head of the bank's global quant team.
The most aggressive of these is the Opportunistic fund, which targets a return equal to cash plus 10% per year after fees. The funds have no minimum investment.
While managed futures funds were one of the few bright spots in a loss-making industry over the past two years, many dipped in the third quarter of 2009.
This was because the strategy makes money by latching onto sustained rises or falls in futures markets and it can be hurt by short-term reversals.
In the autumn of 2009 they suffered from a lack of clear trends in markets, and from the sharp sell-off in equity markets in October in particular.
However, they are now recovering and offer good potential, as long-term market dislocations still exist and big sustained trends tend to emerge following periods of uncertainty.
"During the crunch, many hedge funds turned out to be glorified mutual funds and were highly correlated to indexed equity performance, but a large number of managed futures funds returned 20% plus in 2008 while equity indices tumbled," says Scot Billington, co-founder of managed futures account manager Covenant Capital Management.
"CTAs are trend followers and do well when there are large sustained moves and there is volatility. The last few months have been pretty flat across the board, but many groups made money in the first quarter because crude oil and interest rates were both choppy."
Another proxy to managed futures accounts are funds of exchange traded funds (ETFs), such as those offered by Marlborough Fund Managers and Seven Investment Management, which get their exposure to a range of asset classes not by buying futures contracts but by actively trading ETFs based on a variety of asset class indices.
Marlborough Fund Managers has been running the Marlborough ETF Commodity fund since July 2006.
It is built on a proprietary software-based investment process, providing actively managed exposure to all sorts of commodities, both underlying commodities and commodity-related shares.
"The fund is aimed at investors seeking active management in what can be a highly technical arena. It provides diversification benefits by investing in the global commodities market via ETFs, rather than seeking pure exposure through equity markets," says Nigel Baynes, the fund's joint manager.
The fund made 0.89% in the year to November 2009, but rose 17.28% in the year to 1 November 2008 and 11.1% in the year before that. The minimum investment is £1,000.
Seven Investment Management also markets funds of ETFs that can be accessed by small investors. Its CF 7IM AAP Balanced fund, launched in March 2008, made nearly 20% in the year to November.
It is made up of three portfolios - a core international equity and bond portfolio, a core portfolio of alternative investments and a tactical overlay from any asset class.
It carries a 4% initial charge and a 1.4% annual management charge. The minimum investment is £1,000. "I believe funds of ETFs will be a strong growth area,' says Manooj Mistry, head of db x-trackers UK.
"Asset allocation is becoming the key to constructing a portfolio and ETFs provide the perfect tools for this. Portfolio managers can design portfolios with different objectives."
They can be cautious, balanced or aggressive, for example. ETFs provide low-cost building blocks for strategic and tactical asset allocation."
Doing it yourself
One sustained trend the private investor might have played on their own in the past year has been the weakening dollar, which has advanced various commodity markets.
At the end of 2009 there was reduced trade in Brent and US WTI crude oil as they found a range. However, here was a sustained trend for gold to move in an inverse direction to the dollar.
Using this trend, DIY investors could buy both dollars and gold to hedge the risk that a strengthening dollar would cause the price of gold to fall.
On 2 November, when news of India's massive $6 billion gold spending spree was breaking, you might have bought gold and taken out a hedging position by buying the dollar against both sterling and the euro, making a nice profit if you fortuitously closed out your position when gold reached a new high of $1,178 on 25 November.
2 November: Buy £1 per point Gold Rolling Daily @ 1050.0.
25 November - 1178.0. Profit £1,280.*
2 November: Sell £1 per point GBP/USD Rolling @ 1.6350
25 November - 1.6420. Loss £70.
2 November: Sell £1 per point Eur/USD Rolling @ 1.4750.
25 November - 1.5000. Loss £250.
*The profit on gold is quoted to the tenth of a dollar. This means a $1 move in gold would result in a £10 movement in your position.
In this example, gold is $1050 per ounce, converted to a spread price of 1049.5 to 1050.0. Because it is traded to the tenth of a dollar, the decimal point is ignored, so the spread is 10495 to 10500.
This article was originally published in Money Observer - Moneywise's sister publication - in February 2010
A type of derivative often lumped together with options, but slightly different. The original derivative was a future used by farmers to set the price of their produce in advance before they sowed the seeds so that after the harvest, crops would be sold at the pre-agreed price no matter what the movements of the market. So a future is a contract to buy or sell a fixed quantity of a particular commodity, currency or security (share, bond) for delivery at a fixed date in the future for a fixed price. At the end of a futures contract, the holder is obliged to pay or receive the difference between the price set in the contract and the market price on the expiry date, which can generate massive profits or vast losses.
A sophisticated absolute return fund that seeks to make money for its investors regardless of how global markets are performing. To that end, they invest in shares, bonds, currencies and commodities using a raft of investment techniques such as gearing, short selling, derivatives, futures, options and interest rate swaps. Most are based “offshore” and are not regulated by the financial authorities. Although ordinary investors can gain exposure to hedge funds through certain types of investment funds, direct investment is for the wealthy as most funds require potential investors to have liquid assets greater than £150,000m.
An Exchange traded fund is a security that tracks an index or commodity but is traded in the same way as a share on an exchange. ETFs allow investors the convenience of purchasing a broad basket of securities in a single transaction, essentially offering the convenience of a stock with the diversification offered by a pooled fund, such as a unit trust. Investors buying an ETF are basically investing in the performance of an underlying bundle of securities, usually those representing a particular index or sector. They have no front or back-end fees but, because they trade as shares, each ETF purchase will be charged a brokerage commission.
A term applied to raw materials (gold, oil) and foodstuffs (wheat, pork bellies) traded on exchanges throughout the world. Since no one really wants to transport all those heavy materials, what is actually traded are commodities futures contracts or options. These are agreements to buy or sell at an agreed price on a specific date. Because commodity prices are volatile, investing in futures is certainly not for the casual investor.
A financial instrument where the price is “derived” from a security (share or bond), currency, commodity or index. The price of the derivative will move in direct relationship to the price of the underlying security. They often referred to as futures, options, warrants, interest rate swaps and contracts for difference (CFDs). They are mainly used for financial certainty – to protect against spikes in the prices of commodities – as a hedge, whereby investors can buy a derivative that bets the market will move against them so they protect themselves against potential losses. Derivatives are also a tool of speculation as they enable banks, traders or investors to bet on price movements without having buy the actual physical assets. As derivatives cost only a fraction of the underlying asset price, they are “geared” (leveraged in the USA) so if the price of the asset moves £1, the value of derivative could change by £10.
Annual management charge
If you put money in an investment or pension fund, you’ll not only pay a fee when you initially invest (see Allocation Rate) but also a fee every year based on a percentage of the money the fund manages on your behalf. Known as the AMC, the actual percentage varies according to the particular fund, but the industry average for active managed funds is 1.5%.