Public commodity pools are basically the managed futures version of mutual funds. They are sold in increments as low as $1,000 and there are few restrictions as to who can invest in them. But that is where the similarities end. Public commodity pools are regulated by a web of regulatory agencies including the Securities and Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC), National Futures Association (NFA), the Financial Industry Regulatory Authority (FINRA, which replaced NASD) and all 50 states. In addition to that burden, the NASD in 2004 reversed a policy exempting public commodity pools from Rule 2810, which limits the level of underwriting compensation for selling agents of all direct participation programs (DPPs, which the pools fall under) to 10% of gross proceeds. This change caused concern in the industry that it would limit the creation of new pools and that selling agents could switch end users to different vehicles once their trail commissions ended.
Investors in public pools are not subject to suitability requirements like “accredited investor” or “qualified purchaser” status, which are required for private placements. There has been an ongoing debate at the SEC and industry lobbying groups about those requirements. The SEC has wanted to raise the bar because the accredited investor threshold, due to inflation, has grown to include retail participants. They want a higher bar for retail investors to access sophisticated investment vehicles. Many of these private placements are beyond the scope of the retail investor, whether through regulation or simply due to minimum investment levels of several hundred thousand and beyond.
To understand these vehicles an investor must read and sign off on offering material or disclosure documents that often run between 25 to 50 pages. So what does the ultra retail investor — the one too unsophisticated to invest in private alternative investment vehicles even when they are offered within their investment means — have to sign off on? Well, the prospectus for the Frontier Fund family of public commodity funds is 535 pages long. That’s right, 535. While lengthy because they encompass multiple funds, typically the offering materials for public pools are much larger and include more complex material than those for private placements.
It is because of this overarching regulatory barrier that most successful alternative investment strategies, managed futures in particular, are out of reach of the retail investor. It also is the reason why there is not a rush to create additional products for retail. Who wants to pay a minimum of $1 million to go through the hassle of setting up a retail fund and deal with a smorgasbord of regulators including all 50 states? It is a lot easier to set up a private CTA and sell your strategy in $1 million chunks.
“We have a number of retail products,” says Walter (Tom) Price III, chairman and CEO of Price Futures Group. But the ruling by NASD (now FINRA) in 2004 that limited trail commissions has affected their offering. Price has closed the Price 1 Fund to new investments and began offering it as a private placement. “You are not going to see any new public funds. As a private fund you can charge anything you want to, you can structure it any way you want, you are not regulated to the extent [public pools] are,” Price says.
Those who dare
There are, however, a few hardy souls who are venturing into this arena. Christian Baha, founder of Superfund Asset management, launched his retail trend-following managed futures programs in Europe in 1996 and in the United States in 2002. Baha has been a huge advocate for the expansion of retail hedge fund strategies in general and managed futures in particular. “We think that retail needs diversified products that can lower their overall risk and increase their performance at the same time and we can achieve that in the best way with managed futures funds based on systematic trend-following,” Baha says.
Baha has put his money where his mouth is, increasing the firms’ resources towards education and opening store fronts in New York and Chicago where retail investors can come in off of the street and learn about diversification.
Another relatively new entrant into the public commodity pool arena is the Frontier Fund. Frontier is a family of public managed futures funds sponsored by Equinox Fund Management. Richard Bornhoft, chairman and chief investment officer of Equinox, says, “We tried to create a new paradigm for public commodity funds.”
Bornhoft was in the process of registering the funds when NASD changed the rules but still saw it as an opportunity. Frontier, which offers both fee and commission based structures, tried to fill the anticipated void due to the regulatory structure. While many in the public fund space decried the new rules, Bornhoft saw opportunity. “There was a very limited selection of public commodity fund products,” he says.
Frontier has attempted to fill that void with single and multiple manager products, low fees and more flexibility. “I wanted to take public funds to a new paradigm,” Bornhoft says. He is doing that by offering daily liquidity, a family of funds, diversification within the asset class and the ability to easily transfer money within the family of funds. He estimates the breakeven cost for most of his products to be 2.25%.
“We are actively supporting our selling agents. Our distributors know we are committed to this space,” he adds. Frontier and Superfund have added energy to a public fund space that had been written off by many insiders. “We are committing ourselves long-term to the public commodity space,” Bornhoft says. Frontier has $460 million in their various funds, which is an impressive number given that the funds have been offered in a difficult period for managed futures. “To us that is a testament that we are doing it right,” he adds.
For Baha, it is all about education and he is encouraged that the Managed Funds Association will make more of an effort to reform regulation. “They are trying hard to convince the lawmakers to make some changes. It is education that this is the greatest asset class in the world [that is needed],” Baha says.
Baha does not want to be exempt from regulation, “Just to implement the same kind of framework for hedge funds that there is for mutual funds. Not to discriminate hedge funds anymore from the public. Why not? It is less risky,” Baha says.
Hedged mutual funds
But the universe of alternatives is not limited to public commodity pools. The Rydex mutual fund family has been successfully offering alternative products for several years and more recently has ventured into the managed futures space. Rydex Investments claims to be the first mutual fund company to offer alternative products to retail. They offer numerous alternative products including their Absolute Return Strategy Fund, which includes long/short equity, equity market neutral, merger arbitrage, fixed income arbitrage and global macro.
Edward Egilinsky, managing director of alternative investments at Rydex, says they have seen a lot of interest in their managed futures fund. The Rydex Managed Futures Strategy Fund reached the $500 million benchmark quicker than any of their products, getting there in a little over a year.
“Most CTAs have an emphasis on financial futures,” Egilinsky says. The Rydex fund tracks the daily performance of the S&P Diversified Trend Indicator (S&P DTI) that is comprised of 14 sectors and has a 50% allocation to physical commodities. The S&P DTI compares favorably to the S&P 500 over the last 22 years on a risk-adjusted basis despite it encompassing a huge bull equity market (see “A better alternative”).
Rydex does not trade actual futures but rather structured notes that try to replicate the underlying commodities. Baha doesn’t view the Rydex success as competition as much as confirmation of his philosophy. “You can call it competitors but I call it allies [in] this education we are conveying together. This is the asset class that should be in every portfolio because it is first highly diversified, second you can make money in up and down cycles and [third] it doesn’t correlate to any equity strategy. It does not correlate to any other hedge fund strategy and you cannot find any other hedge fund strategy [that can say that]. It is an undiscovered asset class.”
Bornhoft argues, “It doesn’t do an investor good to have diversification if he doesn’t pick-up meaningful non-correlation.” Not only does managed futures not correlate with equity strategies but there is evidence that it is negatively correlated with equities during bear market conditions (see “Port in a storm”).
High net worth retail
In addition to the public commodity pools, hedged mutual funds and ETFs, there are a limited number of CTAs who offer their strategies at lower minimum investment levels. While about 50% of CTAs have minimums of a half million or more, there are an increasing number of CTAs with reasonable minimum investment levels (see “More selection”).
CTAs with lower minimums usually involve funds, single market programs, option writers and forex funds. Forex programs can offer strategies with lower minimums because there is no set contract size.
Rick Gallwas, president of RJO Futures, is attempting to offer the advantages of managed futures to high- end retail by offering lower minimum CTAs and trading systems for minimums of less than $50,000. “The shelf life of retail traders is short and we try and preserve their equity by introducing them to retail products,”
“Our goal is to get people into diversified products,” Gallwas says. RJO does this by creating portfolios with a diversified group of CTAs. But even this is bringing them to the high end. Gallwas says that the minimum investment for a group of CTAs would be $250,000. While not traditional retail, the vast majority of CTAs have minimums of several hundred thousand, so he is serving a niche.
Peregrine Financial Group also is trying to fill that niche and is actively searching out emerging CTAs with lower minimums, says Russ Wasendorf Sr. “We are able to take these CTAs and give them proprietary capital to develop their track records,” says Wasendorf. PFG runs contests for emerging CTAs that reward them with allocations. “The goal is to build low barrier to entry products,” Wasendorf says.
The purpose of regulation, especially on the retail side, is to protect John Q. Public from unscrupulous players attempting to take advantage of less sophisticated investors. While a noble goal, it is one that has failed. A simple perusal of CFTC enforcement actions will indicate that there is no shortage of bad apples out there. And some may suggest these onerous rules have served to protect powerful interests to the detriment of retail investors, who as a result have less diversified portfolios.
The good news is that while they are more difficult to find, there are alternative products that retail investors can access to diversify their portfolios. However, those attempting to offer alternative investment products to retail have to go through a gauntlet of regulators and retail investors, and ironically must be much more sophisticated and industrious to find these products than the supposedly more sophisticated high net worth individuals.