Picking CTAs for the Mass Affluent
Richard Bornhoft is a pioneering investor in managed futures. He founded The Bornhoft Group in 1985 and constructed multi-manager futures portfolios for pension plans and other institutions. In recent years he's been in the vanguard of creating products for a larger market. He started Equinox Fund Management LLC and launched publicly available The Frontier Fund family in 2004.
About a year ago, he started another venture, a mutual fund that invests in commodity trading advisors-see Regulators in this issue. Here he talks about how he selects CTAs for multi-manager portfolios.
"Many institutions as well as financial advisers use mutual funds as their main tools, so I think such products will help the industry."
Opalesque Futures Intelligence: How did you become a manager of CTA portfolios?
Richard Bornhoft: Initially, I worked on the hedging side of futures, creating hedges for banks and large agricultural companies, among others. I became a CTA myself, traded for a couple of years and then realized there were other CTAs who made more money than I could as a CTA! So, I left trading and hedging and started to evaluate other CTAs in order to allocate assets to multiple-CTA portfolios. We were fortunate to enter the industry in the early 1980s, a time when managed futures was coming to its own.
OFI: Who are your clients?
RB: Managed futures can potentially benefits most portfolios, whether institutional or individual. In the 1990s, almost all of our business was with large pension plans, for whom we put together portfolios of CTAs. I came to feel that there was a void for individual investors in this area. At that time, there were very few managed futures products available in the US for individual investors; the selection was limited and the expenses were high. In 2004, we brought institutional-quality managed futures portfolios to individual investors and their financial advisers with the launch of The Frontier Fund. This is a registered, public 1933 Act fund that offers daily liquidity.
OFI: What about your new product?
RB: In addition to The Frontier Fund, we are offering MutualHedge. This fund obviously has daily liquidity but also the ease of use of a mutual fund. Similar to The Frontier Fund, MutualHedge Frontier Legends Fund is available only through financial advisers.
OFI: Can managed futures profitably deploy large flows of capital?
RB: The capacity issue has been discussed for years. In the 1990s, a CTA that managed $500 million to $1 billion was considered very large and it was doubted that they could manage more than that. Today, we continue to analyze potential capacity of CTA's, but the numbers are much larger. Today, the biggest CTAs manage $10 billion to $25 billion. What helped accommodate more money was the expansion of global futures markets and currencies. There are now many more futures exchanges around the world and volume continues to grow. In 1990s a diversified CTA portfolio had around 30 to 50 contracts; today it might have 75 to 250 contracts.
OFI: What do you like in a futures program?
RB: The answer has many facets to it. Currently, we track over 1600 CTA programs and that number is always growing. We have periodic rankings of the whole database to hone in on those with the best risk-adjusted returns. Using qualitative and quantitative filters, we identify the top tier. CTAs we allocate to must pass our due diligence, which includes an assessment of the trading systems and manager backgrounds. We won't be able to work with advisors that don't pass our due diligence test, but that does not mean we won't follow them. We will keep them in our database. The object is to have a database that is as comprehensive as possible in tracking every CTA in the world.
OFI: Do you consider new CTAs?
RB: Newer CTA firms where the founders already have experience are of interest. We look for traders that worked at a successful established CTA or at another financial institution, where they gained experience in managed futures, then started their own CTA.
OFI: How do you choose from the top tier of CTAs for a certain portfolio?
RB: In constructing a portfolio we look for diversification. Unlike other asset classes, in managed futures you find a wide variation in trading approaches among CTAs. We try to capitalize on that distinctive feature. Within the top tier, we look for programs that are non-correlated or negatively correlated to the other programs we have in a portfolio.
OFI: What are the different styles you look at?
RB: Diversification can come from combining a broad range of styles. For example, here are different types of momentum models with trend followers in varying time horizons. We put short-term traders in a strategy bucket of their own. Pattern recognition is another category. While most CTAs are systematic, a minority of CTAs are discretionary and do fundamental research on market trends predicting market direction. That's another strategy bucket we employ.
OFI: What do you not like in a futures program?
RB: Diversification is the only free lunch any investment strategy has. Managed futures is the most broadly diversified investment strategy available. It is difficult to be successful in the long term if you restrict your trading to one sector. So a program confined to a single sector is not what we want. Most of our portfolios are diversified across all six managed futures sectors. But there are some exceptions. Sometimes an investor will want a certain sector exposure for their portfolio. They might want CTAs that trade only in currencies, stock futures or energy. Those are specialized situations.
OFI: Why did managed futures disappoint in 2009?
RB: Performance cycles in managed futures have unique characteristics. The difference between stock market and managed futures cycles is that the stock market has longer down or up trends, with greater volatility. A down trend in equities may continue for a few years or even longer. But a down trend in managed futures often ends after 12 -18 months. As an example, there was a strong uptrend in managed futures performance starting in September 2007 that continued into February 2009. Then we went through a down cycle of about 12 months. Managed futures is now in an uptrend that began in February of this year.
OFI: Why are investors and their advisers puzzled by managed futures?
RB: Financial advisers can have a tough time adapting to the cyclical pattern in managed futures because it is different from equities, which is what they're used to. They expect a prolonged uptrend or downtrend, as in stocks. Another characteristic of managed futures is that it will often go sideways for the majority of the year, and then have a strong surge for two to three months, making most of the return for the year in that time. Financial advisers are not used to that.
OFI: What do these aspects of managed futures mean for investors?
RB: Because of these characteristics, managed futures, in my opinion, should be a permanent part of the portfolio. We do not suggest financial advisors attempt to time the investment, thinking they can predict when the returns will occur. Managed futures does not have the extended up or down trends as in stock markets that may allow timing. You want it in the portfolio when it moves sideways or even down because you want to be there when the big gains happen.
OFI: How much of an allocation to CTAs does a diversified portfolio need to take advantage of the upside?
RB: There are two answers to that question. From an analytical standpoint, most optimizers across most time windows want to allocate a substantial percentage, probably 10% to 25%, because managed futures can reduce risk or increase return. From an experiential standpoint, we see pensions and financial advisers allocating approximately 2% to 10%. Many institutions have a minimum objective of 5%. In reality, allocating 1% or 2% to an asset class or investment strategy provides little value to the portfolio.
OFI: How does the future look?
RB: One strength of CTAs is that they're adaptive, whether to an event like the subprime crisis or prolonged economic trends. When the subprime crisis hit in 2007, CTAs initially lost money for a couple of months but adapted and in 2008 did very well. Managed futures is the right type of investment at a time when there is heightened geopolitical as well as economic risk. I expect asset growth to accelerate. Another very promising development is the growth of products like our new mutual fund that brings CTAs to a wider investor population. Many institutions as well as financial advisers use mutual funds as their main tools, so I think such products will help the industry.