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Opalesque Futures Intelligence

Futures Lab: Learn about ways to control the risks associated with managed futures.

Tuesday, February 24, 2009


Risks and Controls

We present a review of certain risks associated with managed futures and ways of monitoring and controlling these risk. This discussion summarizes part of a longer and more detailed study by Man Investments, an arm of Man Group. The terms managed futures and commodity trading advisors are used interchangeably.

Managed futures have historically provided excellent diversification, strong returns and good downside protection. As with all investments, however, there is the possibility of loss.

A future or forward contract is a derivative instrument, the value of which depends on the value of an underlying asset. Trading in futures is a speculative activity and futures prices can be highly volatile. Market prices are difficult to predict and are influenced by many factors, including changes in interest rates, weather conditions, government interventions and political and economic events.

Variations and Volatility

The managed futures style is generally characterized by wide variations in returns. We see this in the monthly distribution of the Stark 300 Trader Index, compiled using the top 300 trading programs from Stark's database of CTA programs. For the period January 1994 to November 30, 2008, the monthly distribution of returns for this index ranged from (-)6.39% to 8.16%.

That does not capture the entire range of possible returns that are typical for a single CTA manager. When we applied Monte Carlo modeling, we found a probability distribution showing expected annual returns ranging from around (-)30% to over 50%.

Moreover, variation across managers may grow. Managed futures managers continuously research new technologies and trading approaches in order to identify and profit from these trends. The scientific approach to managed futures trading has spawned a wide variety of different trading strategies, which today allow certain traders to capture even small trends.

The introduction of electronic trading allowed managed futures managers to execute their trades efficiently and, when needed, generally reduce their positions quickly, thus making shorter-term and smaller-scale opportunities accessible. It thereby expanded the investable universe for the investment approach.

This combination of market growth, persistent trends and ongoing research means that there is still substantial room for development in the managed futures industry. However, as strategies become more sophisticated and the race to develop new techniques and trade infrastructure heats up, the gap between the most developed trading managers and the following pack may widen further.

The wide range of possible returns is indicative of CTA managers' high volatility targets.Compared to other hedge fund styles, managed futures have the highest return potential but also high volatility and downside deviation. They have lower Sharpe and Sortino ratios than other hedge fund styles, reflecting their greater volatility.

However, as managed futures typically have a low correlation to other hedge fund styles, the strategy tends to enhance the overall Sharpe and Sortino ratios of a diversified fund of hedge funds portfolio.

Investors might note that Sharpe and Sortino ratios are not the only statistical measures one should look at. As managed futures are not normally distributed, these statistical figures may not correctly capture the complete risk/return profile of this style. Hence higher moments such as skewness should also be taken into account.

Another point to keep in mind is that the distribution of managed futures returns is positively skewed. This is an attractive feature of trend-following CTA programs.


Futures and forwards are traded on margin – meaning that only a small deposit is required to take a position. Depending on the volatility of a commodity, margins can vary between 0.05% and 5% of the notional value of the commodity. One can therefore achieve 100% investment exposure with just a fraction of the capital required through the inherent leverage of futures contracts. This frees up capital can be invested elsewhere or used to adjust the leverage of one's portfolio to match the client's risk appetite.

Because margin requirements are low, there is inherently a high degree of leverage, which can increase returns but will also magnify losses. A relatively small movement in the price of a futures contract may result in immediate and substantial loss or gain to a fund holding a position in such contract.

A fund may also invest in forward contracts, options, swaps and over-the-counter derivative instruments, among others. Like other leveraged investments, trading in these securities may result in losses in excess of the amount invested.

There is also the risk that counterparties will be unable to fulfill their obligations, whether due to insolvency, bankruptcy or other causes, which could result in losses. If a Futures Commission Merchant retained by a manager were to become bankrupt, it is possible that the fund would be able to recover none or only part of its assets held by that FCM.

Risk Measures

Risk management is crucial and increasingly more complicated, requiring a significant portion of a manager's time. To mitigate the dangers CTAs apply risk controls and mostly trade with counterparties on risk-averse financial exchanges. At the end of the day a CTA's infrastructure is key. Only managers that stay at the forefront of new research and trading ideas will be able to cope with the challenges of monitoring and limiting risk.

Today's trading systems are complex and rely on different techniques to analyze the vastquantities of data available. The zero-sum game of futures trading forces all participants to continuously research the behavior of their peers and to adapt their strategy in an effort to stay ahead in the pursuit of excess returns.

In many respects research and risk management go hand in glove, as new trading ideas will often require new or additional risk monitoring tools. Of course, there is no guarantee that a manager's risk controls will be successful.

The major risk monitoring measures and focus areas are:

  • Stress testing - measures current market positions against historical price data. This allows the CTA to see how his current position sizes would have performed historically, especially during periods of market stress.
  • Implied volatility - is a forward-looking measure of potential risk that is analyzed for each market
  • Leverage - if levels approach certain multiples of prevailing net asset value, a review is triggered.
  • Margin-to-equity ratios – if initial margin requirements relative to prevailing net asset value reach pre-defined levels, a review is undertaken that may result in a reduction in positions.
  • Net exposures to sectors and different currencies.
  • Value-at-Risk (VaR) - measures the expected maximum loss from an investment portfolio when futures markets conditions are similar to those in the model. The value is determined for a specific time interval and certain level of confidence.

Diversified Trading

The increasing liquidity of new instruments and markets such as credit derivatives, emerging markets, exchange-traded funds and swaps has generated many more trading opportunities for CTA managers, emphasizing the importance of strong research capabilities. In order to detect new trading opportunities CTAs must constantly develop their systems.

Exposures across a wide range of sectors may help to smooth returns, as individual sectors often tend to exhibit different behavioral characteristics. The factors affecting the world commodity markets, for example, differ from those influencing financial futures. While in both cases long-term trends are usually driven by economic growth and stability, short- or medium-term movements in commodity markets are sensitive to seasonal effects as well as sudden changes in supply or demand that result from environmental or political factors.

Hence there is a high degree of uncertainty in commodities markets and futures trading allows investors to reap gains (or experience losses) from the sometimes fervent upward and downward price movements that result from the uncertainty.

Geographical diversification can help reduce risk. The significant growth in the number and diversity of futures markets in recent years has facilitated a broadly diversified approach across regions and asset classes. This approach aims to control risk by avoiding over-concentration within particular sectors and markets.

Understanding the Strategy

Some people call managed futures black box trading. A black box is an input/output device such as a transistor. Many users are not familiar with the logic inside a black box. The term black box suggests that investors cannot understand CTA trade strategies. This criticism is misleading.

CTAs are characterized by rule-based investment strategies. Trading strategies are hard coded and often programmed into computer algorithms. To prevent their proprietary ideas from being stolen, managers are typically reluctant to divulge the exact composition of their trading models.

However, while a managed futures manager will not be asked to reveal the exact programming for his trades when being screened by a fund of hedge funds manager, it is crucial that the developer understands and explains the trading strategy and the associated risks. Investors can have comfort in evaluating past performance only when the manager adheres to a predefined strategy and explains that strategy to investors.

Compared to managed futures, most traditional equity portfolio advisors such as mutual funds make their investment decisions from a changing mix of fundamentals, news and technical data. To this end, their cause and effect may be much more unpredictable than systematic CTA models, which are not based on ad hoc trading decisions.

Thus the systematic approach, if properly explained and adhered to, gives investors a better basis for estimating future returns and risk.

Top 30 Derivatives Exchanges
Ranked by Number of Contracts Traded and/or Cleared

  Jan-Oct 2008Change from 2007
CME Group2,901,709,5739.91%
Korea Exchange2,343,607,538(-)2.03%
Eurex 1,907,749,03018.50%
Chicago Board Options Exchange1,033,816,153 33.40%
Liffe915,891,375 14.63%
International Securities Exchange883,864,86835.66%
BM&F Bovespa642,499,555 (-)8.80%
Philadelphia Stock Exchange472,640,50645.52%
National Stock Exchange of India467,212,14448.75%
JSE (South Africa)409,534,08264.58%
NYSE Arca Options368,630,879 42.39%
Dalian Commodity Exchange258,453,51795.85%
Russian Trading System Stock Exchange 208,858,25393.83%
American Stock Exchange 181,632,092(-)9.60%
Zhengzhou Commodity Exchange168,556,419 144.66%
Boston Options Exchange152,666,60347.27%
Osaka Securities Exchange138,099,321 58.69%
Moscow Interbank Currency Exchange128,008,86174.48%
OMX Group124,575,959 3.18%
Taiwan Futures Exchange 114,452,85419.66%
London Metal Exchange94,713,908 23.05%
Shanghai Futures Exchange94,442,77444.90%
Hong Kong Exchanges & Clearing 89,384,94024.92%
Australian Securities Exchange83,840,354 (-)13.01%
Tel-Aviv Stock Exchange78,334,573(-)8.53%
Multi Commodity Exchange of India 75,373,29032.49%
Mercado Espaol de Futuros Financieros 68,089,89675.31%
Mexican Derivatives Exchange 62,282,005(-)69.38%
Tokyo Financial Exchange 59,400,463 (-)9.86%
Source: Futures Industry Association

This article was published in Opalesque Futures Intelligence.
Opalesque Futures Intelligence
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