Investing in 1994: COMMODITY FUNDS
TAKING SOME OF THE FEAR OUT OF FUTURES
Diversification has long been part of the investors' credo. But until recently, only the brave would consider futures contracts for their diversified portfolios. After all, commodities have a justly deserved reputation as a zero-sum game in which there's a loser for every winner, and more mften than not, it's the retail investor who winds up with the short end of the stick.
Now, the game is changing. By buying into managed futures funds, individual investors can get the benefit of diversification while keeping the risk of the pits at bay. Generally, futures funds do well when stocks are taking it on the chin. True, the funds can be volatile, but over the years, managed funds have shown returns that top those of other portfolio-diversification vehicles, such as gold, real estate, and the like. And because these funds often employ several trading firms to make investment decisions, investors are not reliant on the hot hand of just one manager.
HOUSEHOLD NAMES. Futures funds are attracting an increasing number of investors. Today, an estimated $30 billion is invested in futures funds--triple the level of just three years ago. Such household names as Dean Witter Reynolds, Merrill Lynch, and Shearson Lehman Brothers are among the firms sponsoring commodity funds that trade in agricultural as well as financial futures. And while futures investors generally have a high-roller image, many of these funds will accept initial investments of as little as $2,000 from an Individual Retirement Account.
What kind of return is that money buying? The 514 futures funds and commodity pools tracked by industry newsletter Managed Account Reports posted an average 12% gain through October, the latest date for which results are available. Fund managers cashed in on volatility in the currency markets, the steady decline in interest rates, and a sizable drop in energy prices. This year's results are down from the industry's 1987 return of 46.9% but better than the 11.5% loss posted in 1986, the worst performance since MAR began tabulating results in 1979. This year, investors who chose the top fund, JWH Global Strategies Series H, saw a 63% return thanks to the fund's savvy trading in Japanese financial instruments.
With stocks at all-time highs, futures funds could be especially attractive, and the right fund could serve as an insurance policy against a stock market dive. "What futures funds have going for them is that they can trade on both sides of the market," figures Rutherford R. Romaine, executive vice-president of RXR Group in Stamford, Conn. "They can make money when prices go up and make money when they go down." That's also true for hedge funds, but because futures funds invest only in futures, their results are not influenced by the performance of individual stocks and options, as hedge funds might be.
COSTLY GUARANTEES. For those who want diversity but still don't trust commodities, some firms offer guaranteed funds in which investors can never lose their principal. But there's a trade-off: They probably won't make much money, either, because the fund managers typically invest more than 70% of the fund's assets in safe instruments, such as medium-term Treasuries. "Guarantees dilute the performance of the fund," says Richard Pike, president of RP Consulting Group in St. Petersburg, Fla.
Managed futures are typically broken into two groups: funds and pools. Private pools are unadvertised limited partnerships. They may have an unlimited number of "accredited" investors who have net worths of $1 million or annual incomes greater than $200,000. The partnership may accept up to 35 investors with less sterling credentials. Minimum investments start at just $25,000 for newer pool operators and can run well over $2 million to invest in pools managed by marquee names, such as Paul Tudor Jones II or John W. Henry & Co. Futures funds attract a broader clientele and typically require a minimum up-front investment of around $5,000. Unlike pools, funds have hefty disclosure documents that regularly run to 200 pages and more.
In many ways, managed-futures funds operate like mutual funds. They pool investors' assets and enable them to share the costs, risks, and returns of trading. But futures funds have some significant differences. They tend to have higher cost structures. They rely on more than one manager for investment decisions. And while their returns can be predictable over long time periods, their performance often varies widely from month to month. "For some people, volatility is just too painful," says Mark Hawley, head of managed futures at Dean Witter Reynolds Inc. "A futures fund might help diversify their portfolio, but their temperament isn't suited for it."
Their pocketbooks may not be suited for the funds' rather sizable costs either. Up-front charges, or loads, can average 4% of an individual's investment, and trading advisers usually earn a management fee equivalent to about 1% a year. It's also typical for advisers to earn an incentive fee for profitable trading that can top 3% of the fund's assets. Futures markets often involve more active trading than equities, so trading commissions add up fast. And because most futures funds are closed-end investments, the cost of exiting early can be substantial.
SHOTGUN. Costs aside, there's one chief characteristic that sets futures funds apart: the multimanager structure. Unlike equity mutual funds, which typically rely on one manager, the sponsors of futures funds normally hire three er more trading firms, or "commodity trading advisers." The fund sponsors allocate a portion of the fund's assets to each adviser. Then, they routinely add and withdraw funds, depending on how the managers perform. In some instances, they may fire the fund managers altogether.
The multimanager approach has definite benefits: It enables the fund to tap different trading styles, invest in a wider array of markets, and spread risk among more than one investment manager. But investors sometimes find that the multiple-manager approach makes the investment decision more challenging. First, investors must learn what they can about the performance of each fund manager. They must also divine whether the fund sponsor is inclined to switch managers frequently or stick with them even through rough periods.
CHOOSE YOUR WEAPON. The managers are likely to practice one of two main strategic approaches: system trading or discretionary trading. System traders typically rely on signals from computer programs they have designed to track market trends based on price changes, trading volume, and other factors. They do well in predictable markets but can be caught short when markets whipsaw as they did last year because of big moves in currencies and agricultural prices. Discretionary traders follow fundamental factors and pick their spots rather than take signals from a computer. When markets show a strong trend, they are prone to make more mistakes than their system-following brethren.
Whatever the trading method, investors should look for the "standard deviation," or the amount of volatility the trader produces. Another key indicator: each fund manager's biggest "drawdown," or the biggest move from peak to valley throughout their trading careers. That measures how big a loss that trader may take before correcting for mistakes. Such information is available in disclosure documents or can be obtained easily through firms that track fund managers.
"The biggest decision investors make is choosing the individual trading advisers," says Sol Waksman, president mf Barclay Trading Group. The second-biggest, that is, after the decision to jump into what can be the rewarding but volatile world of futures.David Greising in Chicago