For many, 2008 was a wake-up year in terms of portfolio diversification. Equities stumbled badly, housing cratered and most equity-based alternative investments underperformed.
What did perform well as an asset class was managed futures. Specifically, trend-following strategies that tend to exploit market dislocations for profit, the type of dislocation that causes most other investments to lose big.
Not only was 2008 one of the best years for managed futures (the Barclay CTA Index was up more than 14%), it did it while nearly everything else suffered. It performed its function as an alternative investment well and showed what many inside the industry believed and some research has indicated: That managed futures tend to be non-correlated to equities in good times and negatively correlated in bad times (see "What you are missing"). More importantly, it caused institutional and retail investors alike to ask: "Why didn’t I have this in my portfolio?"
The answer to that question is different depending on who is asking. If you are a retail investor, chances are you had little opportunity to access it.
Commodity trading advisors (CTAs) have been around since the 1970s; in the early days many of those managers were also commodity pool operators (CPOs) who offered public commodity pools to retail investors. But as the industry evolved, retail futures product regulation became tougher — it was easier to offer products with high minimums to high-net-worth and institutional investors — and fewer public pools were offered. The public certainly couldn’t access managed futures as easily as they could broad-based mutual funds that can be marketed to the general public and are much less expensive and burdensome to operate.
"Public commodity pools are one of the most heavily regulated security offerings," says Campbell & Company General Counsel Tom Lloyd. Not only are they regulated by the Commodity Futures Trading Commission (CFTC) and National Futures Assocation (NFA), but also the Securities and Exchange Commision (SEC), Finra and all 50 states.
Public pools also are deemed Direct Participation Programs by FINRA, so the trail commissions selling agents can charge for them are capped at 10%.
Opportunity comes knocking
In 2003 — a much different regulatory environment than today — the CFTC amended its Rule 4.5 to exclude certain otherwise regulated persons from the definition of "commodity pool operator." One such group was an investment company registered as such under the Investment Company Act of 1940.
Prior to the change, a much more limited exemption from CPO registration existed for mutual funds. Futures positions had to be part of a "bona fide" hedging position or subject to a 5% de minimis level and they could not be marketed as commodity pools.
There is some debate on the intent of the 2003 rule change, but it really doesn’t matter as it allowed financial innovators to offer managed futures products to a much wider audience in a less burdensome way.
One person who was determined to find a way to offer the benefits of managed futures to retail was Rich Bornhoft, founder and CIO of Equinox Fund Management.
While many other CPOs were raising their minimums or waving a white flag in the face of a tilted regulatory playing field, Bornhoft was developing his Frontier Fund, a public commodity pool that offered many of the attributes of a mutual fund.
"We launched the Frontier Fund in 2004. The Frontier Fund is a family of managed futures funds that offers daily liquidity," Bornhoft says. "It has certain mutual fund features, like daily liquidity and a daily NAV, which provided us substantial experience over several years of operating a family of managed futures funds with such a structure. Mutual funds that access managed futures are just a logical evolution of investments."
In the beginning
The first benefactors of the 4.5 exemption were large institutions offering long-only commodity fund products in a mutual fund format.
"Over the last several years, the long-only commodity indexes — Goldman, Dow Jones [etc.] — have found their way into mutual funds, they have found their way into ETFs (see "Would managed futures by any other structure...")," Bornhoft says. "In addition to that, there have been a number of indexed strategies that have found their way into mutual funds in the last two to four years."
Standard & Poor’s created its Diversified Trend Indicator (DTI) that attempts to replicate a trending approach to a group of 24 physical and financial futures. It has been licensed as a mutual fund to Rydex and as an exchange-traded fund to Wisdom Tree.
Bornhoft says these products helped lay the legal groundwork for actively managed mutual funds like Equinox’s MutualHedge Frontier Legends Fund launched in early 2010, which offers exposure to five CTA programs (see “A legend in the making”).
Others have followed. Altegris Investments launched its first registered Investment Company (RIC) fund in September and it is already managing $350 million.
As these products expanded, the NFA saw a problem. Many of these products looked, sounded and felt like public commodity pools, but because of the 2003 amendments to Rule 4.5, RIC funds were launched and operated without any oversight from the NFA or CFTC. "Legally, they are not commodity pools; structurally, they are commodity pools," says NFA General Counsel and Secretary Tom Sexton. So last summer the NFA asked the CFTC to seek comment on a petition to amend rule 4.5. The NFA recommended returning to the less broad pre-2003 exemptions.
Many commented. Some argued against the change, claiming it would create duplicative rules and potentially eliminate products that provide valuable diversification. Several entities who already offer CPO products supported the petition, arguing that the exemption put them at a regulatory disadvantage to products that were structurally very similar.
It turns out both are right. Mutual fund requirements free these products from certain disclosure rules required of CPOs, but applying them would run afoul of the SEC.
In its comment letter, Campbell & Company made two points: Investors in funds seeking exposure to managed futures should receive comparable information regardless of the registration scheme; and any operational relief offered to these RIC funds also should be granted to public commodity pools.
"We really would like to have the prospectus of both types of fund set side by side and have the financial advisor or investor be able to compare them on as close to an apples-to-apples basis as possible," Lloyd says.
David Matteson, partner at Drinker Biddle and a member of its Investment Management Practice Group, says there needs to be some meshing of the rules. He places them in two different buckets. One is simply logistical, where the two set of rules conflict, the other includes legitimate investment protection issues regarding disclosure requirements of CPOs. For instance, CPOs must come up with a breakeven analysis of their fund; there is nothing comparable at the SEC. "Harmonization is key because the CFTC is adamant to ensure investor protection through its disclosure standards," Matteson says.
Both the NFA and supporters of the rule are sensitive to the concerns of those offering RICs. The NFA stated in its letter to the CFTC, "NFA does not seek to eliminate these product offerings as long as they are subject to appropriate regulatory oversight…" adding, "NFA also encourages the commission to consider granting similar relief to public commodity pools to avoid giving one structure a competitive regulatory advantage."
Even those who support amending the exemption realize that managed futures mutual funds have opened up the space to a larger pool of participants. Annette Cazenave, executive vice president of R.J. O’Brien Fund Management, says, "This brings the whole industry mainstream. The whole industry changed in the last quarter of last year as these funds became more widely accepted."
Campbell Managing Director Tracy Wills-Zapata says, "It is positive overall because I don’t see why retail investors should not have access to these kinds of investments, but again with the proper disclosures."
Despite everyone’s good intentions, the rule proposal published by the CFTC in February, if passed, could make it impossible for an RIC to operate, barring rule harmonization between the CFTC and SEC.
While it is the NFA that has recommended the rule change and a CFTC rule that would put these managed futures mutual funds back under their jurisdiction, it is securities-side regulations on CPOs that often are overly burdensome. One potential solution would be for these products to come under CPO rules on the futures side and 40 Act rules on the securities side. "That would be the optimal solution," Sexton says.
However, to do that would require rule harmonization between the CFTC and SEC because certain disclosure rules conflict. For instance, certain past performance numbers are required in CPO rule reporting but are restricted in mutual funds.
"I don’t think any of these issues are insurmountable," Sexton says, but adds, "If they change 4.5 without harmonizing the regulations, then it is very difficult if not impossible for these guys to operate."
Despite the threat that rules may change, Bornhoft is not slowing down efforts to work on adding products.
"We understand that regulators may be trying to achieve additional disclosure," he says. "We are not holding off; we are not curtailing any of our business activities. We welcome additional disclosure if that is what the SEC dictates. We believe the [managed futures] mutual funds are here to stay, as there is a long list of mutual funds that employ futures, whether it is these long-only commodity funds or the index-based mutual funds as well as mutual funds like ours that have CTA programs employed."
While there is conflict and differences of opinion regarding the regulatory structure of various investment models offering managed futures, there also is quite a bit of agreement on some core principles. Perhaps more important, these products are in great demand. "Everybody on both sides of the aisle wants these products," Matteson says. "People are buying these up. People are going to work hard to find a solution."
Would managed futures by any other structure…
Tim Pickering, president of Auspice Capital Advisors, is offering managed futures through an ETF, which he says is less expensive, more transparent and a superior structure. "I don’t endorse the mutual fund structure, I endorse the ETF structure," Pickering says.
The Calgary-based CTA is offering a simplified version of their program that is published as an index by the NYSE and licensed to Claymore Guggenheim to create the ETF with Auspice as the sub-advisor.
"My job is developing strategies that produce superior risk-adjusted results; we have done that in the CTA space and now we are doing that with strategies that are transparent and liquid and applicable for ETF strategies," Pickering says.
"Is it our alpha program? No, we call it enhanced beta," he says. "It is a transparent approach to managed futures that is trend following, [uses] quantitative risk management [and] roll optimization; all elements from our Alpha CTA program."
The ETF is based on Auspice’s Broad Total Return Commodity Index and traded on the Toronto Stock Exchange. It is trend following but only takes long positions on a group of 12 physical commodities. Their Managed Futures Excess Return Index, which adds nine financial markets to the same portfolio and will take short positions, also will be offered through an ETF.
The ETFs also are completely transparent. You might guess that would be a deal-breaker for a systematic trader, but Pickering is ok with it.
"Part of the trade-off in running an ETF is it has to be transparent. In order to go down that path, I am not giving you our flagship product. What I am doing is giving a simplified version of that that I am willing to make transparent. Is it the keys to the castle? No. It is the keys to a really nice house," Pickering says.
He adds that ETFs need to be transparent not only for the investors but also for the liquidity providers because they need to be liquid. "The underlying market participants: The equity traders, ETF trading desks, institutional trading desks — they have to be able to replicate that strategy, that is key to the success of an ETF. Those transparencies don’t have to exist in the mutual funds space," Pickering says, adding, "ETFs are transparent, liquid and cost-effective. If you can provide those things to the retail public they are better off for it."