Managed Futures Mutual Funds Appear to Clear Significant Hurdle
Broad distribution of managed futures through a mutual fund structure, which at one point faced an uncertain future, appears to be moving forward, according to Dan Driscoll of industry regulator National Futures Association (NFA). At a recent closed door meeting in Chicago, the NFA brought together top industry participants with divergent interests, from commodity pool operators (CPOs) to existing managed futures mutual fund operators, who, with NFA encouragement, worked out differences to craft potential rule changes that will now go to the Commodity Futures Exchange Commission (CFTC). It is the group's hope that the CFTC, who writes final rules, will consider recommendations from the NFA and industry participants.
As you will see, this issue has several interesting angles. What is at stake is much wider distribution of an uncorrelated investment, with the potential for underperforming mutual fund products to under-represent the broader industry, a statistical fact widely discussed inside the managed futures industry.
For instance, Ken Steben, founder of Steben Funds, one of the oldest and largest managed futures commodity pools investing in individual CTA investment programs, he offers a pointed look at the issues.
Speaking to the CFTC when the issue first emerged early in 2010, Ken concisely put the issue into perspective, highlighting the traditional investment structure and outlining the issues:
Why Weren’t Managed Futures Funds Packaged As Mutual Funds from Their Start?
1. Commodities trading income is not permitted:
Income generated from commodities trading (like agricultural commodities, metals and energy), is not treated as “good” (i.e., qualifying) income under the Internal Revenue Code tax sections that apply to mutual funds. This includes income derived from trading in futures contracts on commodities, as well. Mutual funds can only have a limited amount of non-qualifying income under these tax code provisions. While this barrier previously led commodity pools to affirmatively seek to avoid mutual fund status and regulation, the new mutual funds use a “controlled foreign corporation” structure to convert their commodities-related (i.e., “non-qualifying”) income into qualifying income. Regulators are now looking at whether this is an appropriate device given the tax code provisions and the general limit on commodities income placed therein on mutual funds.
2. Incentive fees are typically not permitted:
In general, investment advisers to mutual funds that are publicly offered to investors are not permitted to charge a performance based fee for their services (i.e., one that is based upon the investment gains produced by the adviser). Nearly all futures trading advisors charge a fee of this type. In managed futures strategies, an investor is buying manager skill to a greater degree than in traditional investments. Futures trading advisor scan go long or short, can control the leverage (or “gearing”), from 1:1 up to 50:1, and can trade in 150 or more different contracts in many market sectors around the world. Our experience tells us that most investors seeking exposure to managed futures are best served allocating to highly-experienced trading advisors with established long term track records. As far as we know, all the top trading advisors with long established track records require investors to pay an incentive fee.
In the past, this prohibition served to make commodity pools that employed top tier trading advisors poor fits for the mutual fund structure. Now, some of the new mutual funds deal with the performance fee limitation by investing their assets in separate funds managed by trading advisors, which funds pay performance fees to the advisors (thus, as the funds argue, breaking the link between the investing fund and the performance fee payment to the adviser). Other such funds have established trading accounts through or under their controlled foreign corporations, and pay performance fees to the trading advisors managing these accounts directly from the accounts. These funds seem to be taking the position that this is not a payment of performance fees by the fund to an investment adviser.
3. Disclosure document requirements different: The information required to appear in mutual fund prospectuses differs from that which must appear in commodity pool disclosure documents.
Commodity pool disclosure is governed at present by the CFTC, while mutual funds follow the requirements of the SEC. These two regimes are different, to say the least (although the NFA’s efforts mentioned above were aimed at trying to harmonize the two). Commodity pool offering documents are required to provide investors with more risk disclosure (including conflict of interest disclosure), trading approach disclosures and fee transparency than mutual fund prospectuses. For instance, commodity pool disclosure documents are required to display a breakeven table showing all the costs associated with investing in a managed futures pool, including execution (i.e., brokerage) costs; this practice is not required of mutual funds. In addition, under the CFTC’s rules an investor must receive a disclosure document for a commodity pool prior to or at the time that they invest in the pool. Each investor must sign an acknowledgement when subscribing for an investment stating that he received the current disclosure document and the accompanying risk disclosures. This requirement reflected the fact that funds trading futures may not be using carefully designed systematic trading programs with built in risk control mechanisms. It is possible that they could instead employ some very risky strategies that have the potential to lose money fast. Investors should know this before they invest, and should have all the relevant facts. By way of contrast, investors can purchase mutual funds directly and are only required to be sent a prospectus with their confirmation of purchase.
Editor Issue Analysis:
The NFA initiative to pull together an advisory group and attempt to craft a consensus proposal to the CFTC was interesting, to say the least. Some CPOs had openly expressed concerns about the managed futures mutual fund structure that limits the typical 2%/20% fees many active trading advisors rely on. Some industry voices claimed such reduced fees would keep away the more talented managers and pool operators. To support this claim, many of the managed futures mutual funds have underperformed industry benchmarks.
Managed futures mutual funds and their uncorrelated investment benefits became a target for the CFTC, which last year indicated that the CFTC rule that allowed them to comply with only the mutual fund fee and risk disclosure regime required a closer look. Talk inside the industry had eyed the potential to shut down the managed mutual fund through elimination of the controlled foreign corporation mechanism referenced above that allowed the income from trading futures contracts to be transformed into qualifying income. Existing managed futures mutual fund operators, for their part, might have breathed a sigh of relief that the NFA proposal did not cut their legs from underneath by suggesting the effective elimination of the controlled foreign corporation structure. It will be interesting to see how the final rules are crafted at the CFTC, as the industry of high alpha investing, detailed disclosure requirements and transparency meets a high beta, low fee mutual fund in need of truly uncorrelated investments.
Another important area to watch is the IRS treatment for these managed futures mutual funds. The IRS has publicly halted the grant of private letter rulings to funds seeking to use the controlled foreign corporation mechanism to transmogrify their commodities income into qualifying income. If the IRS goes thumbs down on the “CFC” gambit, the managed futures mutual funds have no way to qualify for mutual fund tax treatment, which could lead to dramatic changes and/or their disappearance from the scene. Stay tuned.
The topic is continued in the professional investor protected section of the web site. In this section Ken discusses his investment selection criteria, risk management and diversification methods.