What Are Futures Funds?
A futures fund is a type of pooled investment called a managed futures account (MFA). MFAs are professionally managed investment vehicles that trade futures contracts and options on futures. Individuals have had access to MFAs since 1980. In the U.S., the Commodity Futures Trading Commission (CFTC) oversees the futures industry. Investors may find MFAs attractive because they exhibit a low correlation to equity markets, facilitating diversification of assets. Many MFAs are organized as hedge funds.
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Background
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A futures contract binds two counterparties to the future exchange of a commodity for an agreed cash payment. Options on futures are contracts that allow but don't compel the buyer to purchase or sell a futures contract for an agreed price. MFAs trade futures and options on futures for individual and institutional clients. Futures contracts are standardized financial instruments that trade on futures exchanges. Unlike mutual funds, MFAs are private investment pools, and they're allowed to take short positions. A short position, in which an investor sells borrowed securities, benefits from a price decline.
Fund Managers
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MFAs engage two different types of CFTC-licensed professionals, known as commodity trading advisers (CTAs) and commodity pool operators (CPOs). The National Futures Association (NFA) is the industry trade group with which CTAs and CPOs register. A CTA is the manager responsible for selecting and trading futures contracts for an MFA; a CPO is a broker that solicits funds from investors and places the funds into MFAs. In 2010, there were more than 800 CTA firms in the U.S., and more than $219 billion was invested in MFAs worldwide. CTAs are required to undergo Federal Bureau of Investigation (FBI) checks and must provide extensive disclosure documents that are reviewed by the NFA.
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Futures Trading
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Futures exchanges set up standardized futures contracts and regulate their trading. These exchanges ensure that trading counterparties comply with their obligations to maintain collateral during the life of a futures contract and to settle futures contracts upon expiration. Futures exchanges act as central clearinghouses: They interpose themselves between counterparties to eliminate the risk of nonperformance at settlement. MFAs funnel trades to futures exchanges via futures commission merchants (FCMs), who handle futures contract orders and may offer credit financing to customers. Futures exchanges regulate investor margin by transferring collateral at the end of each trading day: An investor who sustains a loss for the day on a futures contract is assessed additional collateral that's deposited with his counterparty. Exchanges ensure the settlement and delivery of physical commodities or cash --- depending on the settlement procedure for a particular contract --- when a futures contract expires. Forward contracts are similar to futures, except they trade away from an exchange and aren't standardized.
Fund Types
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Futures trading was initially established to help manage the risks associated with agricultural commodities. Many different types of commodities and financial instruments are now traded via futures contracts. The most important futures markets are metals, grains, equity indexes, soft commodities --- e.g., sugar, cotton --- foreign currencies and government bonds. Public funds are open to individuals with at least $5,000 to invest and who meet minimum state requirements, as of October 2010; these requirements vary by state but usually involve a net worth of at least $75,000. Private funds are open to wealthy investors and usually require a minimum investment of $100,000. Futures funds can be organized to trade one or many different futures markets. MFAs trade for two basic motivations:
1) Hedging: Futures are used to partially transfer the risk associated with a holding a particular commodity. For instance, a consortium of wheat farmers may seek to hold short positions in wheat futures in case prices decline.
2) Speculation: Futures are used to bet on the future price direction of a commodity. Many MFAs uses proprietary algorithms to predict future commodity prices and take corresponding long or short positions via futures contracts and/or options on futures.
Risks and Rewards
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Finance theory suggests that portfolios with poorly correlated assets provide better risk-adjusted returns than those with highly correlated assets. Research shows that MFAs offer returns on a par with equity and debt funds but experience smaller peak-to-valley drops than other investment vehicles. A portfolio with a mix of equity, debt and commodity funds is well diversified and thus less risky than portfolios omitting one of these asset classes. However, MFAs use varying amounts of leverage to increase returns --- a strategy that increases risk by borrowing funds to purchase additional assets. Often, MFAs will be self-hedging: They take a position in a futures market but take the opposite position using options on futures. Depending on the hedge ratios, self-hedging provides a degree of upside potential with downside protection. MFA risk-adjusted returns take into account the extra riskiness introduced by leveraging and can be researched on a number of Internet websites.
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