Futures Imperfect

The Virginia Retirement System thought it was on to a good thing: After its outside commodity-fund managers recorded a 17.6% gain last year, the $16 billion pension outfit tripled its investment in the futures markets, to $460 million. Alas, the bottom fell out. With the stakes higher than ever, the Virginians lost 7.3% during the first three months of the year--and by mid-August, they had decided to pull out entirely. They were not alone. On average, commodity funds have declined 1.35% through July 31.

It's stacking up as a lackluster year for commodity funds, pools, and trading advisers, collectively known as "managed futures"--which are like mutual funds except that they invest in markets ranging from interest rates and currencies to grains and metals. And that's surprising. With stocks and bonds floundering and with a whiff of inflation in the air, investors were betting that 1994 would be a terrific year for commodity funds, whose performance tends to run independently of the capital markets. After all, in years such as 1987 and 1990, when stocks were lagging, commodities funds paid off well (chart). That's a big selling point for investors who want a potential source of gains even when other markets are struggling. "That's the Holy Grail," declares Richard A. Pike of rp Consulting Group Inc., who works with Virginia.

REBOUND PRAYERS. Virginia's Aug. 18 decision to dump its managed-futures program took out the industry's biggest U.S. pension customer just as the flow of capital from other sources had started to slow. After soaring to $23 billion last year, up from $11 billion in 1991, the amount of money in futures funds inched up barely 2% between January and mid-August, according to Managed Account Reports, a New York industry newsletter. With the boom now subsiding, insiders are praying for a rebound. "People usually liquidate just in time to miss a big up move," notes Sol Waksman, president of Barclay Trading Group Ltd.

That could be wishful thinking. Markets have proved treacherous this year, confounding traders with sharp reversals. While fund managers generally thrive on volatility, many make their money following trends. The biggest losers this year have been trend-following commodity-trading advisers (ctas), who use computer models that dictate their market moves. "They need a direction. It doesn't matter if it's up or down," explains Jack D. Schwager, director of futures research at Prudential Securities Inc.

But the trends have been fickle, bobbing when they were expected to weave--and landing body blows to the commodity funds. A case in point were the choppy moves in currency prices earlier this year. At the Chicago Mercantile Exchange, yen-dollar futures rose during 10 trading sessions in January--and fell during 11 sessions, often on alternate days. That spelled trouble for trend-followers such as Colorado Commodities Management Corp., which usually sticks with its positions even when the market reverses. "Most of the time, that helps. This past year, it hasn't," concedes Tenny Lode, president of Colorado, which is down 33% for the year.

It was a different story at R.G. Niederhoffer Capital Management, which has posted a 20% gain this year using short-term trading tactics instead of slavish trend-following. When March futures contracts in the yen plunged 95 points on Friday, Jan. 28, and then jumped 121 on Monday, Jan. 31, Niederhoffer sold out its long position at a profit. A trend-follower would have added to the position on Monday--and lost money when the market reversed later in the week, according to Roy G. Niederhoffer, who heads the firm. He says: "It's because we're doing something different that we don't get caught in the same trades as trend-followers."

Other markets have stung trend-followers as well. Confusion over Federal Reserve interest-rate policies shook U.S. and foreign government-bond futures. Stock-index futures showed no clear direction. And even coffee, a tiny sleeper of a market that provided one of the year's few strong rallies, reversed abruptly in July, hurting fund managers who jumped in late.

Many say the trading techniques of fund managers have exacerbated problems this year. Since their systems tend to be similar, technical traders often make the same moves at the same time. That exaggerates price changes, a phenomenon visible in the tempest-tossed grain markets this spring. "Most of the volume comes in on one side of the market. It makes it a lot more difficult to trade," says Jacob Morowitz, who heads Chicago Board of Trade member firm usa Trading.

PRAIRIE DOWNPOUR. When grain and oilseed prices plunged in May and June amid favorable weather forecasts, the drop came in fits and starts: July soybean futures soared nearly 30 cents per bushel, to $7.32, on Monday, May 23, then plunged 37 cents the next day, as rain pelted the grain belt. (They are trading at about $5.80 now.) Hedgers and commercial users such as ConAgra, Central Soya, and Cargill sold into the rallies, coming away with rich trading profits, market sources say. But funds were caught in long positions as the markets peaked, and floor traders were swamped as funds readjusted their positions.

That was the last straw for Daniel Markey of AgriAnalysis Inc. in Evanston, Ill., who quit managing funds for customers after grain prices collapsed. Convinced that tight stockpiles would provide support, Markey bought corn futures at $2.90 a bushel early in the year, then rode the market down to $2.20 before selling out. "It's a time that washes out the trashy ctas," says Markey, who wryly adds: "That may include me." He now is focusing his energies on a consulting business for commercial hedgers.

Indeed, some industry insiders expect a shakeout. As money under management soared, the number of active managers has doubled since 1991, to about 500, according to Barclay Research. "There's more money than there are good ctas to handle it," declares Steve K. DeCook of Fundamental Futures Inc., a Dallas trading adviser founded in 1984.

UNSCHOOLED. One reason for the swelling ranks of ctas: Steep fees and incentives make it a lucrative business. Even after negotiating special rates based on its huge size, the Virginia Retirement System has paid about 4% annually in management fees and commissions. Smaller customers investing in public funds pay about 6%, industry sources say. And most advisers can pocket additional incentive payments based on their performance--25% of trading profits is not unusual. Those payouts are justified because results depend heavily on individual trading decisions rather than the performance of an asset class such as stocks or bonds, advisers contend.

While Virginia complained about high costs, its decision to end a three-year experiment with managed futures turned on overall performance, says O. Kemp Dozier, the system's chief investment officer. In three years, the program returned about 6% annually after fees, nearly three percentage points below Standard & Poor's 500-stock index in the same period. Although the appointment of a new board unschooled in futures also weighed against the program, Dozier says: "If we had been hitting some home runs, I'm sure they would have been willing to wait another year."

Meantime, fund managers blame board politics for the decision. Virginia pulled the plug even as its goals of diversification and noncorrelation with securities markets were being met, they say. And it didn't give the program enough time. "These investments don't make sense unless you have a five-year time horizon," suggests Aladin T. Abu-ghazaleh, of ata Research in Dallas.

For Conrail Inc., which invested $30 million of its $1 billion pension in managed futures this spring, Virginia's move hasn't changed anyone's mind about sticking with the investment. Declares Thomas J. Conroy, Conrail's director of pension assets: "We're not going to do anything rash." Such patience may pay off--if, that is, the commodities markets come to their senses and start to live up to their glorious contrarian history.

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