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Rekenthaler Report

Managed-Futures Funds: A Mess

Bad timing, a limited investment strategy, and high costs.

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Three Strikes
Managed-futures funds have done it all wrong. 

Fortunately, such funds don't have many assets, but what monies they do possess have come in the past five years. As is so often the case, investors extrapolated from a sample size of one: Managed-futures funds profited in 2008; nothing else save for long Treasuries made money that year; thus, managed-futures funds were good to own.

You know how that story played out. Stocks rebounded such that every U.S. stock-fund category has more than doubled in value over the trailing five years (through Oct. 31, 2013). Every bond-fund category has also profited nicely, with staid intermediate-bond funds up about 60% in aggregate and the aggressive bond categories of high yield, emerging markets, and general corporate bond (which often owns a number of lower-quality credits) faring even better. Managed-futures funds? Down for the period.

Part of the problem for the investment category has been the lack of a stock bear market: These funds look their best when other assets are struggling. Another part has been the behavior of commodity prices. Most managed-futures funds use trend-following strategies that have them hopping aboard rising commodities and then getting out when the price starts to decline. That tactic worked spectacularly well in 2008, when commodities rose en masse in the first half of the year, and then fell in the second half. Since then, though, commodities have bounced to and fro, leaving managed-futures funds chasing their tails.

So far, one could blame the category's results on bad fortune. That would be generous, as managed-futures funds were marketed heavily after the bear market, not before. Also, if managed-futures funds depend so heavily on the single tactic of trend-following, that calls into question the robustness of their investment approach. The third strike, however, settles the matter. The category has extremely high costs.

In a recent article, Fleeced by Fees: How Investors Lose 89% of Gains from Futures Funds, Bloomberg showed just how high those costs can be. For the decade ended 2012, a managed-futures limited partnership (that is, hedge fund) named Morgan Stanley Smith Barney Technical LP made $490 million in pre-expense gains for its investors, from a combination of trading profits and money market income. The fund's all-in expenses were $499 million. Thus, those who created, packaged, managed, and sold the limited partnership took in just under $500 million for the decade, while those who owned the fund lost $8 million.

In all, the author, David Evans, gathered the data for 63 managed-futures hedge funds and found that of the $11.5 billion in aggregate gross profits generated by those funds over the previous decade, $10.3 billion--the 89% of the article's headline--went to those who made and sold the funds, with only $1.2 billion left for the fund's owners.*

*As the article did not mention, but probably should have, these figures are affected by the pattern of the time period. They held relatively few assets early in the period, when the funds did indeed give their investors profits after expense, and were relatively large later on, when the funds continued to charge their annual expenses but did not generate profits because of a weaker performance environment. As written earlier, the category has been unlucky as well as undeserving.

Besides the limited partnerships' high costs, they also fail at other aspects of stewardship. Evans points out that, per one fund's prospectus, the investment manager is permitted to trade against the fund. Yes, that's correct--for his personal account, the manager is permitted to be the counterparty for the fund's trades. (So that's why they're called hedge funds...) In another case, a managed-future hedge fund provider refused to disclose the names of the subadvisors that it hired, even after a request from the SEC for that information.

To which you might respond, Who cares? The Bloomberg article addressed unregistered funds rather than registered mutual funds. Let those who own hedge funds redistribute their wealth. The mutual fund owner pays less, receives better disclosure, and has greater legal protection. It's a different situation.

Yes and no. The problem is that about half the managed-futures mutual funds get their exposure through hedge funds. Rather than run their managed-futures programs directly, such mutual funds receive their investment exposure by entering into swap contracts that give them the performance of various hedge funds. (For tax and legal reasons, they do so via swap contracts rather than directly investing in the underlying funds.) Because the value of these swap contracts depends upon the after-expense performance of the hedge funds, such mutual funds effectively incorporate the expenses--and fiduciary concerns--of those funds.

That is, such managed-futures funds cost much more than their official expense ratios would suggest.

Take Altegris Futures Evolution Strategy (EVOIX), for example. The Institutional Shares have an expense ratio of 3.47% annually--painful enough! However, that only accounts for the first layer of the fund's fees. The second layer, that of the underlying hedge funds, is likely at a similar level but is not incorporated into the fund's expense ratio*. Thus, the fund's overall cost is probably somewhere near 7% annually.

(Correction: The 3.47% expense ratio cited in the previous paragraph was from 2012, when the fund followed different accounting practices from those cited in the 2013 prospectus, shown below. That 3.47% was an all-in expense ratio that includes the effects of the costs of the underlying funds. 

The fund's 2013 expense ratio is 2.24%. From that 2.24% figure, there are additional, unstated costs that are not included. Judging from the 2012 all-in figure, these costs will likely be considerably less than the 3.5% or so that I had estimated, as managed futures have not performed well recently and thus are not collecting performance fees. However, in a stronger market, with the performance fees being charged, those expenses will rise.)

*Per the fund's prospectus--(2) The cost of swap(s) and structured note(s) include only the costs embedded in the swap(s) and note(s) that reduce returns of the associated reference assets (i.e., Underlying Pools), but do not include the operating expenses of those reference assets. Returns of swap(s) and note(s) will be reduced, and their losses increased, by the operating expenses of the Underlying Pools used as reference assets, and such operating expenses may include management and performance fees of CTAs engaged by Underlying Pools, as well as Underlying Pool operator, administration and audit expenses. One or more of the Underlying Pools used as a reference asset for a swap(s) or note(s) may pay a performance fee to a CTA, even if the return of other reference assets associated with the swap(s)/note(s) is negative. The operating expenses of reference assets, which are not reflected in the Annual Fund Operating Expenses table above, are embedded in the returns of the associated swap(s)/note(s) and represent an indirect cost of investing in the Fund. Generally, the management fees and performance fees of CTAs employed by the Underlying Pools that may be used as reference assets range from 0% to 2% of assigned trading level and 15% to 25% of the returns, respectively.

Given that burden, it is to the fund's credit that it has lost only about 3% of its value during its two years of existence--a period that has been unkind to managed-futures strategies. That the fund has beaten most of its peers during that time period and has almost overcome its expense burden, however, is Pyrrhic praise. This, we can comfortably say, is not what Jack Bogle has in mind when he advises shareholders to get the odds on their side.  

I wrote that half the managed-futures mutual funds are, in effect, funds of hedge funds. What about the other half? Might they be better because they don't carry those high underlying costs?

I asked that question of Morningstar's Alternative Funds team and was told: A couple are. Longer-term price-trend-following strategies haven't worked since 2008, and no one knows when they will come back into favor. The managed-futures funds that have performed better in the last several years incorporate shorter-term price-trend-following or countertrend (mean reversion) strategies. If a fund's strategy is out of favor, the best thing a manager can do is not lose money for investors. Charging lower fees helps in this regard. 

In my view, one way would be to find a mechanical version at a lower cost, that is an index fund. There aren't many index managed-futures funds out there, though. There are questions about the ability of index funds to handle even a moderately large asset base. Although very liquid for the largest trades, such as those conducted in the currency and Treasury markets, most commodity futures can pretty easily be pushed around by a large order. Indexing a managed-futures strategy is a much trickier business than indexing a large-company stock index fund.

Which brings this article back to the beginning: Managed-futures funds are a mess. Currently, Morningstar analysts only have one positive recommendation in the category.  AQR Managed Futures Strategy (AQMIX) runs its money in-house, thereby avoiding the double layer of fees and keeping costs to a moderate 1.25% per year, all-in, for the Institutional share class. In addition, AQR is a large investment house that, in the view of Morningstar's analysts, does possess the requisite capability. So far, the fund has placed very near the top of its category over the past three years. It earns a Morningstar Analyst Rating of Silver, the second highest on the five-point rating scale.

I wouldn't rush out to buy the fund myself, but if somebody did, I could see the point. One of these days, commodities will put together a trend, stocks and bonds will slide, and managed-futures funds will shine again. If so, the AQR offering looks like the way to go.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.