This interview is with Ken Steben, who founded Commodity Pool Operator Steben & Company, Inc. in 1989, when industry assets under management were but $7 billion. As Ken has watched the industry grow to $299 billion over the last 22 years, he offers an interesting perspective on managed futures investing.
The first section of the interview focuses on the managed futures mutual fund, with the premium section of the interview focusing on his fund management and selection methodology. Ken has an interesting look at manager evaluation, focusing on risk management first.
Opalesque OFI: Managed futures mutual funds have the potential to open this uncorrelated investment to a much broader distribution model, but there are significant issues. How do you see the future of the managed futures mutual fund playing out?
Ken Steben: Well, it is a little difficult to see what the regulators are going to do right now with regard to managed futures mutual funds. The CFTC has stated that they will bring the mutual funds that are really managed futures funds back under CFTC registration requirements. That will make a change, the impact of which is hard to know right now. Will the standard commodity pool regulations be implemented for those mutual funds, which will change the way they can be purchased and their disclosure requirements, or will they give the mutual funds some special treatment?
If they get special treatment then the publicly offered limited partnership managed futures funds will all be begging for comparable or equal treatments. The CFTC is pretty tied up with the Dodd-Frank issues and with requirements being designed for the derivatives markets, so this is not their primary focus right now, However they have indicated they are going to make changes so it is just a matter of time.
As you know, Mark, I wrote a white paper discussing the structural and regulatory differences between managed futures limited partnerships and managed futures mutual funds. The CFTC was interested in that and they had our General Counsel and me come to their offices to discuss the issues with them. Our meeting with them took place last summer. They have not issued any specific guidelines or rules yet. We are waiting to find out what happens there.
While specific details are not yet known, we believe that the CFTC will bring the managed futures mutual funds under CFTC regulation within a year or less. This will bring these funds under some requirements they don’t have now. The exact nature of those requirements remains to be seen, but at the very least we think that the disclosure requirements will be significantly greater than they are now. It is possible that they will change the way the mutual funds are offered in some ways.
With regard to offering rules, for example, the question is whether they will require the investor to receive a disclosure document at the time of sale or before sale, since that is the current policy they have for traditional commodity pools. Investors can purchase a mutual fund and receive the prospectus later in the mail.
Another issue that is very significant is the fact that the IRS has stated they will no longer give private letter rulings on this type of mutual fund. Mutual funds are not allowed to have significant amounts of commodity trading income. The new funds get around this restriction by doing the trading in a controlled foreign corporation which converts that income into the tax consequences of owning a foreign equity. The question is whether this statement by the IRS is an indication that they may be reconsidering their allowing this strategy. Whether managed futures mutual funds can continue to exist in their current form is dependent on the IRS acceptance of the trading of commodities in the controlled foreign corporations.
It’s also important to understand the advantages and disadvantages of the mutual fund structure as it is now being used for managed futures funds, versus the traditional limited partnership managed futures fund structure. The advantages, of course, are the liquidity and the fact that you can buy them like a security with a ticker symbol making them easy to use. Financial advisors like this, because they do not have to get their client to sign any paperwork. Whether that remains the same after they come under CFTC regulation we don’t know yet.
The most significant disadvantage of these funds is that their structure causes them to be what we might call “managed futures lite”. If you are hiring third party commodity trading advisors, which we believe is the best way to access managed futures, then in order to get around the IRS tax regulations and SEC restrictions on the payment of incentive fees, you have to do the trading within the off-shore controlled foreign corporation. You are only allowed to have 25% of the fund in that. Since all of the third party CTA trading needs to take place in the controlled foreign corporation (“CFC”), and since that is only 25% of the fund, you have to instruct the trading advisors to trade the account at a greatly increased notional leverage. You need to ask them to trade it four to one, which is really unwieldy from a structural standpoint. So, in reality the fund operator is going to trade in the CFC at leverage levels less than four to one, which means that the fund itself is generally getting only 75 or 80% of the normal trading level for the trading programs. Most people investing in these funds have no understanding of this issue.
In contrast, a limited partnership traditional managed futures fund generally increases the notional allocation for the fund as a whole so that $1 invested in the fund is typically getting $1.20 or $1.25 in exposure to the trading programs of the commodity trading advisors. So, whereas the mutual fund structure may have 75 cents trading for one dollar, the traditional fund may have $1.20. You could have a difference of up to 50% in the net profit (and loss) potential of the trading programs between traditional managed futures funds and mutual fund managed futures funds. That will have a very significant effect for the investor over the long term.
For some financial advisors and investors, the liquidity advantages of the mutual funds may be worth sacrificing a portion of the profit potential, but at this time few investors understand that there is a significant tradeoff.
Another disadvantage of the mutual funds is the disclosure requirements for investors. Many of these funds do not fully disclose the fees that are buried in the controlled foreign corporation. So, you do not really see the management and incentive fees paid to the trading advisors. Some of these funds have been starting to disclose it, at least partially, since they are very cautious to not explicitly say they are paying advisor incentive fees, since this is ordinarily prohibited for mutual funds. For some of these funds, their sales people are just telling the overall fund sponsor fee and not disclosing the underlying fees to the managers that they are hiring. So the investor thinks these funds that are using third party trading advisors are less expensive than the traditional managed futures funds, which is not the reality.
While one would think that mutual funds would be more transparent, in many cases what we are seeing is that they are not. The standard CFTC full disclosure requirements including expense break even tables are not required at this time.
So, while there are advantages of the mutual fund structure in liquidity and ease of use, there are structural, transparency and investor disclosure disadvantages that should be understood to make an intelligent investment decision. At Steben & Company we believe managed futures investments should be thought of as long term investments of 5 years or more, even though there is liquidity over the short term. Liquidity convenience pales compared to the long term impact of structural exposure to the full profit potential of the trading programs. We think the primary criteria of investing in managed futures should be the effectiveness of the vehicle for delivering the managed futures returns.
I want to be clear that I am not saying that all managed futures mutual funds are not a good choice for some investors. I am saying that one should be aware of these issues. As certain regulatory requirements change, there may be risk that the current mutual fund structure will change, and there is even a chance that these funds as they exist now will not be allowed to continue in that form. We are of the opinion that if you are really attempting to get full managed futures allocation you are better off in a traditional managed futures fund. That being said, we realize that the structural convenience of the mutual fund format will be very appealing to a lot of people.
One other item that is also really important to consider is that many of these funds that are being recently launched are coming out with very simplistic trading systems. Based upon our 30 years of experience with managed futures, we believe that systems that just trade once a month like the S&P Diversified Trend Indicator (DTI) are likely to significantly underperform the managed futures indices over the long term. People are buying the managed futures concept because the managed futures track record over the long-term of the investment class has been very good. However they then choose a product for convenience rather than for the best way to access managed futures. The best way to participate in managed futures is to gain access to some of the world’s top trading advisors in a fund that gives you the total investment power of the underlying CTAs. Most investors and even financial advisors don’t know how to evaluate the best way to accomplish this.
OFI: It is interesting you say that. In speaking with S&P regarding their new indicator, I go around and around with them a number of levels, but I keep coming back to the issue that a single algorithm represents the managed futures experience and I just do not know that a single formula can give you the diversity that is the managed futures investing experience. What are your thoughts?
KS: It’s correct to say that the bulk of returns in managed futures comes from continuing price trends either up or down in a broad range of markets, but how various top trading advisors decide when to go long or short and how to allocate between the different markets is much more sophisticated than a single algorithm.
If it was that easy, anyone could do it. This is like the argument that MLM made years ago when they had what they called the MLM Index, which was a trading program (system). They said it was an Index of the managed futures investment class. It was also a very simplistic system that traded once a month. It took some years for the marketplace to realize that it was not closely tracking the managed futures index and that it was underperforming the managed futures indices.
When you are getting into managed futures, you are buying manager skill and not an asset category. In managed futures the trading advisor can go long or short across a wide range of different markets. They can vary the leverage and they can change the system for getting in and out. This is not an asset per se. It is not like buying a portfolio of real estate properties or a portfolio of equities or a portfolio of bonds which is going to track the underlying asset category. People should realize that the results are totally dependent upon the manager’s trading skill. You want to find a manager who has an established long-term track record with a significant amount of customer money. The single most important element of investing in managed futures is manager selection. Good manager selection takes experience, thorough due diligence and ongoing monitoring, so most investors will be best served selecting a good experienced and successful manager of managers in the managed futures field.
We have found over the years that investing with emerging commodity trading advisors is a risky business and we do not do it. We only hire trading advisors that have a great deal of experience where we can really examine what they have done over the long-term. We do a lot of due diligence before allocating money to a trading advisor.
With very challenging equity markets creating a huge appetite for truly non correlated investments, the marketplace has exploded with interest in managed futures. People are buying new managed futures funds with little experience in knowing what they are looking at. They are just buying them because it sounds good, but often the products they are buying do not have established long-term track records with large amounts of customer money. This is a riskier way to get involved. Unfortunately, we think many financial advisors and investors will wind up getting disappointed if they do not make good choices.
OFI: Where do you see the industry going in the next 3-5, 10 years, what is your projection on the future given logical analysis?
KS: I see a couple of things happening. One is the mutual fund issue. If the IRS and or the CFTC put either an overt or unspoken seal of approval on the mutual funds, then more of the managed futures industry will move in that direction. If it becomes clear that the regulators are not going to change the current treatment of these funds, and if we feel we can produce a mutual fund product that is good for the investor, then we will also produce a managed futures mutual fund. That said we would want to fully disclose to investors the issues and everything that was going on in any fund we produce. Those wanting optimal allocation to managed futures will probably still prefer the traditional managed futures fund limited partnership structure.
Obviously at this time we do not know what is going to happen. It is every bit as possible that these funds will not be able to operate in the current way that they are, so that whole end of the industry could change. We think the coming year will tell that story - whether the mutual funds that are hiring third-party CTAs can continue as is or whether they continue with changes or whether they do not continue. We believe that by the end of 2012, it will be clear.
The second thing that I see happening is there is going to be a big sorting in the managed futures space. People are jumping headlong into managed futures and not knowing what they are doing. So many of them are selecting these Johnny-come-lately funds that are using over simplified trading systems, and we believe they will be disappointed in the results over the long-term. So, I think people will begin to realize that they need to be careful in their fund selection and they will hopefully learn more about how to decide where to invest their managed futures allocations.
There is some chance that because they get in and they get disappointed in managed futures over time that they do not come back to managed futures. That would be unfortunate because the benefits of managed futures are unique and important for investors seeking real diversification and non correlation. We hope that the way the new products perform causes them to look deeper and does not cause them to just run away.
KS: Yes. There is of course the possibility that one or more of these funds might blow up. There could be a fund or two out there that performs very badly and the investor will not understand why their fund selection was bad. They may just indict the whole investment class rather than understand why that fund had such problems.
OFI: Survivor ship bias is an important point. In managed futures published estimates have indicated survivorship bias in managed futures is around 18%, while the stock market is closer to 10%. That is a key point for diversification. I think frankly the blow-up is something that anyone needs to be concerned about and I think anyone who relies on one manager is quite frankly putting a fair amount of risk. There are many CTAs who have stood the test of time, and there are others that have had difficulty. Long Term Capital Management is a good example of a short volatility strategy utilizing often naked options lacked a hedging mechanism. The strategy can work very well, but under certain market environments it may experience enhanced risk. It is understanding these market environments that can be interesting. It’s also generally one of the arguments made in favor of a multi-advisor approach of different individual managers. There are also arguments in the concept of investment concentration, but many books and studies have highlighted the enhanced manager risk with a concentration strategy.
KS: We think it is a good idea to have a multi-advisor approach when investing in managed futures. Even more importantly we think a manager of managers that has a great deal of experience is a wise choice for those that do not have the time, experience or resources to evaluate on their own which commodity trading advisors to pick.
Some of the best advisors in the world have very high minimums. Some have minimums of $50 million or $100 million to get a direct managed account. So the question is, how do you access trading advisors? Even if the trading advisor has a sub-fund of their own, a lot of times the minimum investment is half a million or a million dollars to invest with them.
We think a good multi-advisor fund with a good manager of managers is the best way for most investors to access managed futures. We believe there is going to be a continued interest in this area and there will be a sorting out of the good from the bad. There has been an explosion of new funds. We hear about a new fund, it seems like every week or two. There were so many years where we hardly saw any new players in this field. The results will be mixed. Many of these new players will not survive, but they may be capitalizing on this interest right now and will move on to capitalize on the interest in the next category of funds that heats up.
OFI: It is interesting, I have seen more equity-based firms, traditional stock and bonds, wire houses, broker dealer’s move in this direction. How do you think the equity industry is going to embrace managed futures? Right now, the last numbers I was looking at is financial advisors still have less than 1% of their client’s assets allocated towards managed futures. It just seems to me that there is a tremendous opportunity there.
KS: Yes, no question. Also equity markets are much more challenging and difficult today than they were through the 80s and 90s, of course. I was just reading an analyst from a major firm about six weeks ago that was talking about how bullish they were on equities, and how they are so undervalued. Of course, today, here in October, it is more undervalued than it was then.
We are possibly looking at very slow growth in the world’s economies over the coming decade. This means equity returns will not be on a par with what they were in the 80s and 90s, and that portfolio construction is going to have to be much more carefully done. This means difficult times for financial advisors if they stick to traditional long only portfolios.
They are going to need to diversify not just among equities and bonds, but also among strategies to help their investors reduce risk and to increase the chance that they achieve what their long term goals.
OFI: At what point do you think that financial advisor, in general, is going to recognize managed futures and recognize the concept that the strategy drivers are different than stocks. I think it is at this point the 1% assets under RIA management number startto expand to up to around 20%.
Ken Steben: Well, we would love to see it get up to 20%, but it will take a long time. The success of the world’s top trading advisors is from being able to capitalize on price trends, either up or down, caused by imbalances in supply and demand. Those big trends don’t happen every month. Success in managed futures requires a long term approach, and the placement of the investment with the best possible managers. Those investing in managed futures need to think in five year time horizons which should be the truth for any growth investment.
People are less patient in very liquid investments and the more liquid it is, it seems the less patient they are. This is why sometimes people do better in real estate because they do not think, hey, I am going to buy this portfolio of properties now, and I want to be sure in three months I can sell it for a profit. They think I am going to hold this for five or ten years.
You need to think that way about managed futures strategies and then the probability of success goes way, way up. When we look at the top trading advisors, we see that historically 60 months or five year windows have all been profitable. That doesn’t say this is a guarantee of any kind for the future, and of course there is risk, but it shows the historical pattern.
What we have had in the last few years is an explosion of interest and a lot of money going helter-skelter to any new fund that hangs out a managed futures shingle.
OFI: Is there anything else you would like add?
KS: Well, in summary, the bear markets in 2000-2003 and 2008 have illustrated the potential value of having managed futures in a portfolio. Equities have been so very difficult even recently. A lot of money has gone into fixed income, into lower grade bond funds with longer maturities in order to achieve yield. This of course has its risks also, particularly if somewhere down the line, interest rates rise.
Investors need to consider other strategies, like managed futures because there is a risk traditional investments don’t have attractive returns for a while. it doesn’t look like the volatility in the equity markets will end anytime soon. There will come a day of reckoning in the fixed income markets where inflation and interest rates rise again, which will be very unpleasant for bond investors. There is significant risk in long only investing which can be mitigated by using by including managed futures which has the potential to participate in declining markets, as well as rising markets. Managed futures have historically offered true non correlation of a kind that is tough to find in today’s markets.
OFI: Well, thank you Ken. It has been insightful again.
To download Ken’s comments to the CFTC on the issue, click here:
CFTC RISK DISCLOSURE: PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. THE RISK OF LOSS IN TRADING COMMODITIES CAN BE SUBSTANTIAL. YOU SHOULD THEREFORE CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR FINANCIAL CONDITION. THE HIGH DEGREE OF LEVERAGE THAT IS OFTEN OBTAINABLE IN COMMODITY TRADING CAN WORK AGAINST YOU AS WELL AS FOR YOU. THE USE OF LEVERAGE CAN LEAD TO LARGE LOSSES AS WELL AS GAINS. YOU COULD LOOSE ALL OF YOUR INVESTMENT OR MORE THAN YOU INITIALLY INVEST. IN SOME CASES, MANAGED COMMODITY ACCOUNTS ARE SUBJECT TO SUBSTANTIAL CHARGES FOR MANAGEMENT AND ADVISORY FEES. IT MAY BE NECESSARY FOR THOSE ACCOUNTS THAT ARE SUBJECT TO THESE CHARGES TO MAKE SUBSTANTIAL TRADING PROFITS TO AVOID DEPLETION OR EXHAUSTION OF THEIR ASSETS. THE DISCLOSURE DOCUMENT CONTAINS A COMPLETE DESCRIPTION OF THE PRINCIPAL RISK FACTORS AND EACH FEE TO BE CHARGED TO YOUR ACCOUNT BY THE COMMODITY TRADING ADVISOR ("CTA"). THE REGULATIONS OF THE COMMODITY FUTURES TRADING COMMISSION ("CFTC") REQUIRE THAT PROSPECTIVE CUSTOMERS OF A CTA RECEIVE A DISCLOSURE DOCUMENT WHEN THEY ARE SOLICITED TO ENTER INTO AN AGREEMENT WHEREBY THE CTA WILL DIRECT OR GUIDE THE CLIENT'S COMMODITY INTEREST TRADING AND THAT CERTAIN RISK FACTORS BE HIGHLIGHTED. THIS DOCUMENT IS READILY ACCESSIBLE AT THIS SITE. THIS BRIEF STATEMENT CANNOT DISCLOSE ALL OF THE RISKS AND OTHER SIGNIFICANT ASPECTS OF THE COMMODITY MARKETS. THEREFORE, YOU SHOULD PROCEED DIRECTLY TO THE DISCLOSURE DOCUMENT AND STUDY IT CAREFULLY TO DETERMINE WHETHER SUCH TRADING IS APPROPRIATE FOR YOU IN LIGHT OF YOUR FINANCIAL CONDITION. YOU ARE ENCOURAGED TO ACCESS THE DISCLOSURE DOCUMENT. YOU WILL NOT INCUR ANY ADDITIONAL CHARGES BY ACCESSING THE DISCLOSURE DOCUMENT. YOU MAY ALSO REQUEST DELIVERY OF A HARD COPY OF THE DISCLOSURE DOCUMENT, WHICH WILL ALSO BE PROVIDED TO YOU AT NO ADDITIONAL COST. THE CFTC HAS NOT PASSED UPON THE MERITS OF PARTICIPATING IN ANY OF THESE TRADING PROGRAMS NOR ON THE ADEQUACY OR ACCURACY OF ANY OF THESE DISCLOSURE DOCUMENTS. OTHER DISCLOSURE STATEMENTS ARE REQUIRED TO BE PROVIDED YOU BEFORE A COMMODITY ACCOUNT MAY BE OPENED FOR YOU. MUCH OF THE DATA CONTAINED IN THIS REPORT IS TAKEN FROM SOURCES WHICH COULD DEPEND ON THE CTA TO SELF REPORT THEIR INFORMATION AND OR PERFORMANCE. AS SUCH, WHILE THE INFORMATION IN THIS REPORT AND REGARDING ALL CTA COMMUNICATION IS BELIEVED TO BE RELIABLE AND ACCURATE, NOT WARANTEE RELATIVE TO SAME IS AVAILABLE. THE AUTHOR IS REGISTERED WITH THE NATIONAL FUTURES ASSOCIATION.
Opalesque Futures Intelligence
Wednesday, November 16, 2011
Founders Q&A: Ken Steben of commodity pool operator Steben Funds discusses the managed futures mutual fund as well as CTA investment selection process .