MANAGED FUTURES STARTER KIT

Transcription

1 MANAGED FUTURES STARTER KIT

2 Managed Futures: Portfolio Diversification Opportunities Enhance returns and lower overall volatility. Courtesy of Daniels Trading

3 In a world of increasing volatility, CME Group is where the world comes to manage risk across all major asset classes interest rates, equity indexes, foreign exchange, energy, agricultural commodities, metals, and alternative investments like weather and real estate. Built on the heritage of CME, CBOT and NYMEX, CME Group is the world s largest and most diverse derivatives exchange encompassing the widest range of benchmark products available. CME Group brings buyers and sellers together on the CME Globex electronic trading platform and on trading floors in Chicago and New York. We provide you with the tools you need to meet your business objectives and achieve your financial goals. And CME Clearing matches and settles all trades and guarantees the creditworthiness of every transaction that takes place in our markets. Futures trading is not suitable for all investors, and involves the risk of loss. Futures are a leverages investment, and because only a percentage of a contract s value is required to trade, it is possible to lose more than the amount of money deposited for a futures position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any one trade because they cannot expect to profit on every trade. All orders are entirely at your risk, and it will be your responsibility to monitor these orders. There are limitations to the protection given by stop loss orders therefore we give no assurance that limit or stop loss orders will be executed, even if the limit price is met, in full or at all.

4 CME Group Managed Futures: Portfolio Diversification Opportunities WHAT ARE MANAGED FUTURES? The term managed futures describes an industry comprised of professional money managers known as commodity trading advisors (CTAs). These trading advisors manage client assets on a discretionary basis using global futures markets as an investment medium. Trading advisors take positions based on expected profit potential. TRADITIONAL ASSET CLASSES Cash Bonds Equities Real Estate INVESTMENT UNIVERSE ALTERNATIVE ASSET CLASSES Hedge Funds Managed Futures Private Equity Credit Derivatives Managed futures are an asset class in their own right, separate from traditional investments such as stocks and bonds. In the last 10 years, assets under management for the managed futures industry have grown an unprecedented 700%. USD (in billions) THE GROWTH OF THE MANAGED FUTURES INDUSTRY Source: BarclayHedge, Ltd. Managed futures have been used successfully by investment management professionals for more than 30 years. Institutional investors looking to maximize portfolio exposure continue to increase their use of managed futures as an integral component of a welldiversified portfolio. With the ability to go both long and short, managed futures are highly flexible financial instruments with the potential to profit from rising and falling markets. Moreover, managed future funds have virtually no correlation to traditional asset classes, enabling them to enhance returns as well as lower overall volatility. For the purposes of this booklet, managed futures do not include futures accounts where futures are used in risk-management programs or hedge funds. Those funds may be used to dynamically adjust the duration of a bond portfolio or to hedge the currency exposure of a foreign equity portfolio. Recent growth in managed futures has been substantial. In 2002, it was estimated that more than $45 billion was under management by managed futures trading advisors. By the end of 2007, that number had grown to more than $200 billion. 1

5 cmegroup.com BENEFITS OF MANAGED FUTURES By their very nature, managed futures provide a diversified investment opportunity. Trading advisors can participate in more than 150 global markets; from grains and gold to currencies and stock indices. Many funds further diversify by using several trading advisors with different trading approaches. The benefits of managed futures within a well-balanced portfolio include: 1. Potential to lower overall portfolio risk 2. Opportunity to enhance overall portfolio returns 3. Broad diversification opportunities 4. Opportunity to profit in a variety of economic environments 5. Limited losses due to a combination of flexibility and discipline In this example, the overall risk is reduced by almost 82 percent from 41.0 percent to 7.5 percent and the return also increases almost 20 percent from +7.4 percent to +8.9 percent. This is mainly due to the lack of correlation and, in some cases, negative correlation between some of the portfolio components in the diversified portfolio. There is even negative correlation between stocks and managed futures as the two markets move independently from each other. COMPARISON OF A STOCKS ONLY VS. DIVERSIFIED PORTFOLIO 33.3% Dow Jones 20% Managed Futures ANNUAL RETURNS AND MAX. DRAWDOWNS 10% 7.4% 8.9% 0% 33.3% Nikkei 225 STOCKS ONLY 33.3% MSCI World 40% Stocks DIVERSIFIED PORTFOLIO 40% Bonds 10% 20% 30% 40% STOCKS ONLY 7.5% DIVERSIFIED PORTFOLIO Correlation: Dow Jones Nikkei 225: 0.42 Dow Jones MSCI World: 0.81 MSCI World Nikkei 225: 0.67 Correlation: Stocks Managed Futures: 0.05 Managed Futures Bonds: 0.23 Bonds Stocks: % Annual Return Max. Drawdown Managed futures: CASAM CISDM CTA Equal Weighted; Bonds: JP Morgan Government Bond Global; Source: Bloomberg 2

6 CME Group Managed Futures: Portfolio Diversification Opportunities 1. Potential to lower overall portfolio risk The main benefit of adding managed futures to a balanced portfolio is the potential to decrease portfolio volatility. Risk reduction is possible because managed futures can trade across a wide range of global markets that have virtually no long-term correlation to most traditional asset classes. Moreover, managed futures funds generally perform well during adverse economic or market conditions for stocks and bonds, thereby providing excellent downside protection in most portfolios. CORRELATION OF SELECTED ASSET CLASSES* Managed futures Bonds U.S. stocks Managed futures Bonds U.S. stocks One of the tenets of modern portfolio theory, as developed by Nobel prize-winning economist Professor Harry M. Markowitz, is that more efficient investment portfolios can be created by diversifying among asset classes with low to negative correlations. Adding a managed futures fund to a portfolio of traditional stocks and bonds has the potential to reduce risk and improve performance. *Based on a 10-year period ending December 31, ) Managed futures: Barclay CTA Index; 2) Bonds: Lehman Brothers Long-Term U.S. Treasury Index; 3) U.S. stocks: S&P 500 Total Return Index; Source: BarclayHedge, Ltd. 2. OPPORTUNITY TO ENHANCE overall portfolio RETURNS While managed futures can decrease portfolio risk, they can also simultaneously enhance overall portfolio performance. The following chart illustrates that adding managed futures to a traditional portfolio improves overall investment quality while also potentially reducing risk. This has been substantiated by an extensive bank of academic research, beginning with the landmark study by Dr. John Lintner of Harvard University in which he wrote: the combined portfolios of stocks (or stocks and bonds) after including judicious investments in leveraged managed futures accounts show substantially less risk at every possible level of expected return than portfolios of stocks (or stocks and bonds) alone. 1 OPTIMUM PORTFOLIO MIX (01/ /2008)* Increase returns 12% 11% 10% 9% 8% 7% RETURN P.A. 6% 20% Managed Futures 40% Stocks 40% Bonds 50% Bonds 50% Stocks 100% Managed Futures VOLATILITY 7% 8% 9% 10% 11% 12% Reduce risk *1) Managed futures: CASAM CISDM CTA Equal Weighted; 2) Stocks: MSCI World; 3) Bonds: JP Morgan Government Bond Global; Source: Bloomberg Including up to 20 percent of total investments in managed futures funds enhances portfolio diversity and therefore promotes greater independence from general market moves. 1 Lintner, John, The Potential Role of Managed Commodity Financial Futures Accounts (and/or Funds) in Portfolios of Stocks and Bonds, Annual Conference of Financial Analysts Federation, May

7 cmegroup.com 3. Broad diversification opportunities Many different futures markets Managed futures are highly flexible financial instruments traded on many regulated financial and commodity markets around the world. By broadly diversifying across global markets, managed futures can simultaneously profit from price changes in stock, bond, currency and money markets, as well as from diverse commodity markets having virtually no correlation to traditional asset classes. DIVERSIFICATION OF FUTURES MARKETS FX (4%) Australian Dollar Brazilian Real British Pound Canadian Dollar Chinese Renminbi Euro FX Metals (4%) Copper Palladium Platinum Energy (6%) Ethanol Crude Oil Natural Gas Commodities (9%) Corn Oat Soybean Wheat Japanese Yen Korean Won Mexican Peso New Zealand Dollar Swiss Franc Rough Rice Random Length Lumber Wood Pulp Butter Frozen Pork Bellies Lean Hogs S&P-GSCI Livestock 1-Month LIBOR 30-Day Federal Funds Eurodollar Euroyen Individual Equity (9%) Deutsche Telekom Allianz SAP Deutsche Bank Munchener Ruckversicherung Banco Comercial Portugues Stock Futures Brisa Autoestradas de Portugal Stock Futures Bovespa CAC 40 Dax Dow euro stoxx50 Hang Seng Interest Rates (44%) 10-Year U.S. Treasury Note 30-Year U.S. Treasury Bond CME 10-Year Swap Rate Futures Equities (24%) MSCI EAFE MSCI Emerging Markets S&P MidCap 400 S&P 500 S&P SmallCap 600 International futures exchanges are continuing to adapt to growing consumer demand with more and more new futures contracts entering the market. In recent years, futures contracts were issued on ethanol, water and even the weather. The above list is only a partial list of the futures products currently available around the world. Source: FIA

8 CME Group Managed Futures: Portfolio Diversification Opportunities EASE OF GLOBAL DIVERSIFICATION The substantial growth of futures exchanges across the globe afford trading advisors countless opportunities to diversify their portfolios by geographic markets, as well as by product. Trading advisors thus have ample opportunity for profit potential and risk reduction among a broad array of non-correlated markets. Investing in managed futures on a global scale provides protection against geospecific variables such as poor weather or political unrest, which could affect some commodities or financial futures more than others. MOST ACTIVELY-TRADED FUTURES CONTRACTS NORTH AMERICA CME Group Corn Soybeans 30-Year Treasury Bond 10-Year Treasury Note E-mini Dow Jones Eurodollar Euro FX E-mini S&P 500 Index E-mini NASDAQ-100 Light, Sweet Crude Oil Natural Gas Gold Unleaded Gasoline Mexican Derivatives Exchange (MexDer) TIIE 28 SOUTH AMERICA Bolsa de Mercadorias & Futuros (BM&F) U.S. Dollar One-Day Inter-Bank Deposit ASIA Dalian Commodity Exchange (DCE) No.1 Soybeans SoyMeal Tokyo Commodity Exchange (TOCOM) Gold Gasoline National Stock Exchange of India (NSE) S&P CNX Nifty Index All Futures on Individual Equities Korea Futures Exchange (KOFEX) KOSPI 200 AUSTRALIA Sydney Futures Exchange (SFE) 3-Year Treasury Bonds EUROPE London International Financial Futures and Options Exchange (LIFFE) 3-Month Sterling 3-Month Euribor Long Gilt FTSE 100 Index All Futures on Individual Equities London Metal Exchange (LME) High Grade Primary Aluminum Copper Grade A International Petroleum Exchange (IPE) Brent Crude Oil ParisBourse (formerly MATIF and MONEP) Copper Eurex (formerly DTB and SOFFEX) Dax DJ Euro Stoxx 50 Euro-BUND Euro-BOBL Euro-SCHATZ Source: FIA

9 cmegroup.com 4. OPPORTUNITY to profit in a variety of economic environments Managed futures trading advisors can generate profit in both increasing or decreasing markets due to the their ability to go long (buy) futures positions in anticipation of rising markets or go short (sell) futures positions in anticipation of falling markets. Moreover, trading advisors are able to go long or short with equal ease. This ability, coupled with their virtual non-correlation with most traditional asset classes, have resulted in managed futures funds performing well relative to traditional asset classes during adverse conditions for stocks and bonds. For example, during periods of hyperinflation, hard commodities such as gold, silver, oil, grains and livestock tend to do well, as do the major world currencies. Conversely, during deflationary times, futures provide an opportunity to profit by selling into a declining market with the expectation of buying, or closing out the position, at a lower price. Trading advisors can even use strategies employing options on futures contracts that allow for profit potential in flat or neutral markets. This ability to accommodate and protect against unpredictable events can be invaluable in today s volatile global markets. Managed futures vs. a traditional portfolio during stock market declines 8% 6% 4% 2% 0% 2% 4% 6% 8% OCT 87 AUG 88 MAR 90 Managed futures: CASAM CISDM CTA Equal Weighted; Stocks: MSCI World; Bonds: JP Morgan Government Bond Global; Time scale: 01/ /2008 When critical events occur (01/ /2008) Long-Term Capital Management lost $4.6 billion (1998) Black Monday AUG 90 MANAGED FUTURES SEP 90 Persian Gulf War (1990) AUG 97 U.S. STOCKS JAN 00 Managed futures Traditional portfolio of 50% stocks and 50% bonds FEB 01 MAR 01 September 11, 2001 Managed futures: CASAM CISDM CTA Equal Weighted; Stocks: Dow Jones Index; Logarithmic scale; Source: Bloomberg SEP % +1200% +1000% +800% +600% +400% +200% As the above chart shows, during the stock market crash in 1987, panic hit the stock markets following the largest one-day loss in history. Managed futures reported above 20 percent returns. Similarly after the terrorist attacks of 9/11, the stock market plummeted 16.3 percent. In contrast, managed futures gained 8.3 percent in the same period. 0% 6

10 CME Group Managed Futures: Portfolio Diversification Opportunities 5. LIMITED LOSSES DUE TO A COMBINATION OF Flexibility and discipline Potential to limit drawdowns Drawdowns, or the reduction a fund might experience during a market retrenchment, are an inevitable part of any investment. However, because managed futures trading advisors can go long or short and typically adhere to strict stop-loss limits managed futures funds have limited their drawdowns more effectively than many other investments. As the following chart shows, drawdowns for managed futures have been less steep than those for major global equity indices. Worst drawdowns in comparison 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Managed Futures Dow Jones (index) S&P 500 Total Return (index) MSCI World (index) FTSE 1000 INDEX DAX (index) Managed futures: CASAM CISDM CTA Equal Weighted; Time scale: 11/ /2008; Source: Bloomberg Nikkei 225 (index) The chart above shows the worst historic drawdowns for each of the indices from 11/1990 through 02/2008. NASDAQ Comp (index) ABILITY TO RECOVER QUICKLY Additionally, managed futures generally have shorter recovery times from drawdown periods. This is due in part to the ability to use short trading to take advantage of falling markets, as well as the fact that managed futures often have lower losses to recover. Unable to use short trading to take advantage of falling markets, traditional stock indices may experience extreme drawdowns in bear markets. With reference to the previous chart, the maximum drawdown for stocks was 44.7 percent during the period of 09/2000 through 09/2002. It takes much longer to make up for such large drawdowns. To simply recover, the stock index needed to regain almost 80 percent of its new low level. DRAWDOWN DURATIONS IN COMPARISON % 5% 10% 15% 20% 25% 30% 35% 40% 45% MANAGED FUTURES 01/ /1992: 9.3% STOCKS 09/ /2002: 44.7% 7

11 cmegroup.com The efficiencies and performance of futures markets While managed futures are new to some, banks, corporations and mutual fund managers have used futures markets to manage their exposure to price change for decades. Futures markets make it possible for these companies to hedge or transfer their risk to other market participants, including speculators, who assume this risk in anticipation of making a profit. Without speculators, price discovery would only occur when both a producer and an end user want to execute a transaction at the same time. When speculators enter the marketplace, the number of ready buyers and sellers increases and hedgers are able to execute larger orders at their convenience without effecting a dramatic change in price providing additional liquidity, which helps ensure market integrity. By selling futures when prices are rising and purchasing as prices fall, their activity can have a stabilizing effect in volatile markets. Comparison of Performance (01/ /2008) +5,500% +5,000% +4,500% +4,000% +3,500% +3,000% +2,500% +2,000% +1,500% +1,000% +500% 0% $10,000 Managed Futures 1 $513,467 U.S. Stocks 2 $287,890 International Stocks 3 $111, ) Managed futures: CASAM CISDM CTA Equal Weighted; 2) U.S. stocks: S&P 500 Total Return; 3) International stocks: MSCI World; Source: Bloomberg; All material is property of MSCI. Use and duplication subject to contract with MSCI. Over the past 27 years, managed futures have outperformed almost every other asset class, including high-performing S&P 500 Total Returns. Looking back over the past few decades, managed futures have consistently outperformed other asset classes such as stocks and bonds. Consider an initial investment of $10,000 invested in If placed in a U.S. stock fund mirroring the S&P 500, the investment would have been worth approximately $288,000 as of early Allocating the same amount to a basket of international equities reflecting the Morgan Stanley Capital International Index of world stocks, the initial investment would have grown to nearly $120,000. But the same investment in managed futures, based on the Center for International Securities and Derivatives Markets weighting, would now be worth more than $513,000. 8

12 CME Group Managed Futures: Portfolio Diversification Opportunities Managed futures trading strategies Fund managers investment strategies tend to fall into one of two primary categories: the major group is known as trend followers, while the other is comprised of market-neutral traders. Many trend followers use proprietary technical or fundamental trading systems which provide signals of when to go long or short in anticipation of upward or downward market moves (trends). While some trend followers employ discretionary systems based on fundamental data and the discretion of the fund manager, the majority use fully automated technical trading systems based on a highly objective, disciplined set of rules predefined by the fund management. By removing human emotion, such as fear and greed, from trading decisions, fully automated trading systems rely on predetermined stop-loss orders to limit losses and let profits run. Market-neutral traders tend to seek profit from spreading between different financial and commodity markets (or different futures contracts in the same market). Also in the market-neutral category are option-premium sellers who use deltaneutral programs. Both spreaders and premium sellers aim to profit from nondirectional trading strategies. Types of investment opportunities A) Retail or public pools The recent introduction of low minimuminvestment levels for retail funds or public pools provides a way for small investors to participate in an investment vehicle formerly exclusive to large investors. In the United States, fund managers business conduct and trading activities are supervised by the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA). In addition, offerings of managed futures funds to the general public are regulated by the CFTC, NFA, the Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA) and individual state regulatory agencies. Public managed futures funds must be audited by independent account firms and follow strict disclosure requirements. B) Individual accounts Individual accounts are customized accounts for institutional investors or high net-worth individuals. These funds usually require a substantial capital investment so the advisors can diversify trading among a variety of market positions according to the investors specifications. For example, certain markets may be emphasized or excluded. Contract terms may include specific termination language and financial management requirements. C) Private pools Private pools combine money from several investors and usually take the form of a limited partnership. Most of these pools have minimum investments that can be as high as $250,000. These accounts usually allow for admission and redemption on a monthly or quarterly basis. The main advantage of private pools is the economy of scale that can be achieved for mid-sized investors. Each of these alternatives may be structured with multiple trading advisors with different trading approaches, providing the investor with maximum diversification. 9

13 cmegroup.com Participants in the managed futures industry There are several types of industry participants qualified to assist interested investors. Keep in mind that any of these participants may, and often do, act in more than one capacity. Commodity Trading Advisors (CTAs) are responsible for the actual trading of managed accounts. There are approximately 1,750 CTAs registered with the NFA, which is the self-regulatory organization for futures and options markets. The two major types of advisors are technical traders and fundamental traders. Technical traders may use computer software programs to follow pricing trends and perform quantitative analyses. Fundamental traders forecast prices by analysis of supply and demand factors and other market information. Either trading style can be successful and many advisors incorporate elements of both approaches. Futures Commission Merchants (FCMs) are the brokerage firms that execute, clear and carry CTA-directed trades on the various exchanges. Many of these firms also act as commodity pool operators and trading managers, providing administrative reports on investment performance. Additionally, they may offer customers managed futures funds to help diversify their portfolios. Commodity Pool Operators (CPOs) assemble public funds or private pools. In the United States, these are usually in the form of limited partnerships. There are approximately 1,250 CPOs registered with the NFA. Most CPOs hire independent CTAs to make trading decisions. CPOs may distribute their funds directly or act as wholesalers to the broker-dealer community. Investment Consultants can be a valuable resource for institutional investors interested in learning about managed futures alternatives and in helping implement a managed fund program. They can assist in selecting the type of fund program and management team that would be best suited for the specific needs of the institution. Some consultants also monitor day-to-day trading operations (e.g., margins and daily mark-to-market positions) on behalf of their institutional clients. Trading Managers are available to assist institutional investors in selecting CTAs. These managers have developed sophisticated methods of analyzing CTA performance records so they can recommend and structure a portfolio of trading advisors whose historic performance records have a low correlation with each other. These trading managers may develop and market their own proprietary products or they may administer funds raised by other entities, such as brokerage firms. 10

14 CME Group Managed Futures: Portfolio Diversification Opportunities Evaluating risk from an investor s perspective As with any investment, there are risks associated with trading futures and options on futures. The CFTC requires that prospective customers be provided with risk-disclosure statements, which should be carefully reviewed. Past performance is not necessarily an indicator of future results. When choosing a managed futures fund, it is important to ensure the fund manager has a proven track record. Before investing, it is also advisable to check the magnitude and duration of the fund s worst drawdown, or cumulative loss in value from any peak in performance to the subsequent low. In addition, there are several indices that measure managed futures performance. Investors may wish to consult each index to determine which provides the most appropriate performance criteria for their needs. At right is a list of some of the more familiar indexes. Managed Futures Indexes (Actively Managed): Barclay CTA Index MLM (Mount Lucas Management) Index CISDM Managed Futures Benchmark Series Commodity Market Indexes (Passive): Goldman Sachs Commodity Index (GSCI) Dow Jones-AIG Commodity Index (DJ-AIGCI) Reuters-CRB Total Return Index How fees are structured for managed futures Total management fees in the managed futures industry tend to be higher than those in the equity markets. While management fees do vary according to the type of managed futures account and may be negotiable, a general fee structure exists. Investors should fully understand that performance information for a managed futures account or fund is almost always expressed net of all such fees. Typically, the trading advisor or trading manager is compensated by receiving a flat management fee based on assets under management, in addition to a performance incentive fee based on profits in the account. The performance fee is almost always calculated net of all costs to the account, such as management fees and commissions. The performance fee is thus based on net trading profits, which are usually paid only if the account or fund exceeds previously established net asset values. A few trading managers assume the netting risk, whereby the performance results of all trading advisors in the account are netted before the investor is charged a performance fee. The trading manager assumes the netting risk by paying each CTA according to his or her individual performance. In addition to management and performance fees, an account or fund pays transaction costs or brokerage commissions. These expenses reflect the cost of executing and clearing futures trades and generally are calculated on a per-round-turn basis. 11

15 cmegroup.com Investor safety is paramount in the futures MARKET Protecting the interests of all participants in the futures market is the responsibility of exchange and industry members as well as federal regulators. Working together, they ensure the financial and market integrity required by investors. A brief overview of CME Clearing will illustrate why the credit risk of exchange-traded products is minimal for futures investors. The market integrity of CME Group CME Group rules and regulations are designed to support competitive, efficient and liquid markets. These rules and regulations are reviewed continuously and are periodically amended to reflect the needs of market users. Making sure that trading practices and regulations are followed is the responsibility of the exchange s Market Regulation and Audit Departments, which work to prevent trading irregularities and investigate possible violations of exchange and industry regulations. The departments provide daily on-site surveillance of trading activity, continuous monitoring of member firms trading practices with state-of-the-art technology and prompt, thorough investigations of any customer complaints. Combined with the financial integrity of CME Clearing Clearing operations are another mechanism used by exchanges to uphold the integrity of the futures markets. CME Clearing 1) acts as a guarantor to clearing member firms for trades it maintains; 2) reconciles all clearing member firm accounts each day to ensure that all gains have been credited and all losses have been collected; and, 3) sets and adjusts clearing member firm margins for changing market conditions. CME Clearing settles the account of each member firm at the end of the trading day, balancing quantities of contracts bought with those sold. In clearing trades, the clearinghouse substitutes itself as the opposite party in each transaction, essentially eliminating counterparty credit risk. It interposes itself as the buyer to every seller and the seller to every buyer and becomes, in effect, a party to every clearing member transaction. Because of this substitution, it is no longer necessary for a buyer (or seller) to find the original seller (or buyer) when offsetting a position. A market participant merely executes an equal and opposite transaction, usually with an entirely different party, and ends up with a net zero position. One of the most important financial safeguards in ensuring performance on futures contracts is the performance bond, which is a deposit clearing member firms must post and maintain against their open positions. These performance bonds, also referred to as margins, are set by CME Clearing based on each product. Your broker may require a larger deposit for your account. CME Clearing settles its accounts daily. As closing or settlement prices change the value of outstanding futures positions, the clearinghouse collects from those who have lost money as a result of price changes and credits those funds immediately to the accounts of those who have gained. Thus, before each trading day begins, all of the previous day s losses have been collected and all gains have been paid or credited. In this way, CME Clearing maintains very tight control over performance bonds as prices fluctuate, ensuring that sufficient money is on deposit at all times. 12

16 For more information: About the futures market CME Group is dedicated to helping investors learn more about the benefits of using the futures market. It offers a wide variety of educational publications and research materials that can be reviewed and ordered online at About managed futures Contact the sources listed here for information about other topics related to managed futures: Regulatory Agencies Industry Associations Research and Reporting Services Commodity Futures Trading Commission Three Lafayette Centre st Street, NW Washington, D.C Fax: National Futures Association (NFA) 300 South Riverside, Suite 1800 Chicago, IL Fax: Futures Industry Association (FIA) 2001 Pennsylvania Avenue NW Suite 600 Washington, D.C Fax: Managed Funds Association (MFA) 2025 M Street NW, Suite 610 Washington, D.C Fax: Barclay Hedge Ltd th Street, Suite 1B Fairfield, IA Fax: Center for International Securities and Derivatives Markets (CISDM) Isenberg School of Management University of Massachusetts 121 Presidents Drive Amherst, MA Fax: For information on the performance of public managed futures funds, go to Futures Magazine s Public Funds Summary at Futures trading is not suitable for all investors, and involves the risk of loss. Futures are a leveraged investment, and because only a percentage of a contract s value is required to trade, it is possible to lose more than the amount of money deposited for a futures position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any one trade because they cannot expect to profit on every trade. All references to options refer to options on futures. CME Group is the trademark of CME Group, Inc. The Globe logo, Globex and CME are trademarks of Chicago Mercantile Exchange, Inc. CBOT is the trademark of the Board of Trade of the City of Chicago. NYMEX, New York Mercantile Exchange, and ClearPort are trademarks of New York Mercantile Exchange. Inc. COMEX is a trademark of Commodity Exchange, Inc. All other trademarks are the property of their respective owners. S&P 500, S&P Asia 50, S&P MidCap 400 and S&P SmallCap 600 are trademarks of The McGraw-Hill Companies, Inc., used under license. MSCI and EAFE are trademarks of MSCI, used under license. NASDAQ-100 is a registered trademark of the Nasdaq Stock Market, Inc. and is licensed for use by the Chicago Mercantile Exchange Inc. Dow Jones, AIG, Dow Jones-AIG Commodity Index and DJ-AIGCI are registered trade marks or service marks of Dow Jones & Company, Inc. and American International Group, Inc. (AIG). MLM Index is a trademark of Mount Lucas Management Corporation. This information has been compiled by CME Group for general purposes only. CME Group assumes no responsibility for any errors or omission. Additionally, all examples in this brochure are hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience. All matters pertaining to rules and specifications herein are made subject to and are superseded by official CME, CBOT and CME Group rules. Current rules should be consulted in all cases concerning contract specifications. Copyright 2008 CME Group. All rights reserved.

17 CME Group headquarters CME Group global offices 20 South Wacker Drive Chicago, Illinois cmegroup.com Chicago Washington D.C. New York Hong Kong Houston London Singapore Sydney Tokyo HF111.7/0/0409

18 Research and product development Why Managed Futures? By John W. Labuszewski, Managing Director Research and Product Development

19 cmegroup.com The Best Risk Management Starts with Security In today s market environment, effective risk management requires an ever-greater emphasis on limiting counterparty credit risk. At CME Group, we believe our financial safeguards system, designed for the benefit and protection of all participants in our markets, is second to none. CME Group s benchmark futures and options contracts, backed by our centralized counterparty clearing model and comprehensive set of risk management services, offer powerful solutions for navigating confidently through an uncertain world. Central counterparty guarantee of CME Clearing that ensures the financial integrity of every trade Segregation of customer funds and a $7 billion financial safeguards system Twice daily mark-to-market and a zero debt system 24-hour monitoring by an experienced risk-management team Whether you are executing strategies in individual products, or implementing managed futures programs, CME Group provides you with the security, transparency and confidence you need to operate, invest and grow. How Clearing Models Manage Risk With a central counterparty model, the clearing house is the buyer to every seller and the seller to every buyer. So, if Trader A defaults, the default is contained between Trader A and the clearing house, protecting everyone in the green circles below. The over-the-counter market s bilateral model works differently. If Trader A defaults, neither Trader A, Trader B, nor the others they transact business with are protected from the default, leaving everyone in the orange circles at risk. For more information about CME Clearing visit 2

20 Why Managed Futures? Futures have become increasingly popular as risk management and speculative trading tools. But they are not necessarily for amateurs. Some investors have turned to the managed futures industry for trading services offered by skilled professionals. The Managed Futures Industry The futures markets trace their origins back hundreds of years and are generally rooted in agricultural and other physical or tangible commodity markets including grains, livestock, precious metals and energy products. The late 1970s and early 1980s witnessed dramatic developments, however, as the concept of futures was extended to financial markets including equities, fixed income securities, currencies and other exotic derivative items. The futures industry expanded rapidly as institutions, both in the United States and abroad, embraced the power and utility of the futures markets. Futures may be used to manage the risk of volatile investments and to capitalize on speculative opportunities associated with that volatility. But the fast-paced and increasingly sophisticated nature of futures markets renders it difficult for all but the most adept institutional and retail investors to take full advantage of these markets. As a result, many prospective investors have turned to managed futures as a means by which to harness the best professional trading talent in the pursuit of profitable futures trading opportunities. The managed futures industry flourished in the 1980s through the current day as a logical outlet for such speculative demand. It is our intent to describe that growth and the substantial reasons driving that growth. Investors have accessed managed futures for almost 60 years. The first managed futures account is attributed to the noted technician Dick Donchian dating back to Much of the early interest came from retail investors who would open up separately managed accounts with particular professional commodity traders, commonly referred to as Commodity Trading Advisors (CTAs). In more recent years, however, institutional investors such as corporate and public pension funds, endowments, trusts, and even banks have driven the expansion of the managed futures industry, recognizing that managed futures represent an important component of a well-diversified portfolio. In recent years, institutional investors such as corporate and public pension funds, endowments, trusts, and even banks, have driven the expansion of the managed futures industry. Commodity Pools While one may still access CTAs by opening separately managed accounts, it has become more commonplace to participate in a fund or limited partnership designed to facilitate speculative futures investments and managed by single or multiple CTAs under the direction of a Commodity Pool Operator (CPO). Today, there are a wide variety of active Commodity Trading Advisors (CTAs) managing funds using many diverse trading styles. 3

21 cmegroup.com Managed futures funds, commodity funds or commodity pools (these various terms are synonymous) aggregate the monies of multiple investors for the purpose of speculating in futures and options markets. These funds or pools are organized and managed by CPOs. CTAs may be employed by the CPO to direct the day-to-day trading of the fund or a portion thereof. This leaves the CPO free to concentrate on other significant activities including fund raising, accounting, evaluation and on-going monitoring of CTA performance relying upon the professionalism and experience of CTAs devoted to trading activities. One may invest in a diversified commodity fund or pool that employs the services of multiple CTAs. These pools may be operated by registered Commodity Pool Operators (CPOs). A CTA may be thought of as performing the same function as a stock manager or mutual fund manager. The investor effectively employs, or assigns power of attorney over his funds to the CTA to manage his investment on a discretionary basis. CTAs typically utilize the global futures markets as their primary investment or trading vehicles in the pursuit of profitable opportunities. Managed futures investments may also be referred to as commodity funds, futures funds or commodity pools. The terms CTA, CPO and commodity pool originate with the United States Commodity Futures Trading Commission (CFTC) and may generally be applied to describe these specialized endeavors. However, other regulatory jurisdictions may apply somewhat different nomenclature to describe these activities. Perhaps the most articulate argument in favor of a managed futures investment was put forward by Harvard Professor John Lintner who found that managed futures reduces volatility while enhancing return. Growth of Industry Concomitant with the growth of the futures industry in general, investment in managed futures has skyrocketed since the early 1980s. Managed Accounts Reports (MAR) is a publication that covers the industry and estimates that investment in managed futures grew from less than $310 million in 1980 to an estimated $234.1 billion as of the 2nd quarter The trading activity of CTAs is often guided by technical trading systems. These systems are based on historical price patterns, and may include moving average, price channel, and momentum systems. Generally speaking, these systems may be thought of as trend following in nature the ability to detect reversals in market momentum, i.e., to successfully apply contrarian systems, being rather rare and extraordinary. 4

22 Why Managed Futures? Why Managed Futures may be a Good Investment The argument in favor of managed futures as an investment vehicle was perhaps best and most succinctly stated by Professor John E. Lintner of Harvard who found that inclusion of futures in an investment portfolio reduces volatility while enhancing return. Further, that such portfolios have substantially less risk at every possible level of return than portfolios of stocks, or stocks and bonds. Potential for Enhanced Portfolio Returns Professor Franklin Edwards of Columbia investigated the performance of managed futures in order to assess their utility as an asset class. His conclusion was that managed futures make both attractive stand-alone investments and portfolio assets. In order to test that proposition, we examined the returns associated with investments in stocks, bonds and commodities during the 20+ year period from January 1987 through August Specifically, we used the following indexes as measures of returns in the U.S. equity, fixed income and managed futures markets, respectively. The managed futures industry has grown from virtually nothing in the late 1970s to a $234.1 billion industry today. The Standard & Poor s 500 is widely recognized as the leading benchmark for measurement of domestic equity investments. We utilize a version of the S&P 500 that is inclusive of both price fluctuations and accrued dividends as a proxy for equity returns. The Lehman Brothers U.S. Aggregate Bond Index represents a composite index aggregating the total returns associated with U.S. Treasuries, agency obligations, corporate bonds and notes, mortgage instruments and other investment grade U.S. dollar-denominated fixed income securities. The Lehman Index represents the leading benchmark by which to measure the returns associated with domestic fixed income investments. We reference the Barclay CTA Index as a leading industry benchmark of representative performance of commodity trading advisors. There are currently 491 programs included in the calculation of the Barclay CTA Index for the year 2008, which is unweighted and rebalanced at the beginning of each year. To qualify for inclusion in the CTA Index, an advisor must have four years of prior performance history. Additional programs introduced by qualified advisors are not added to the Index until after their second year. These restrictions, which offset the high turnover rates of trading advisors as well as their artificially high short-term performance records, ensure the accuracy and reliability of the Barclay CTA Index. 5

23 cmegroup.com Monthly Return Summary (January 1987 August 2008) Managed Futures Bonds Stocks Average 0.76% 0.59% 0.93% Standard Deviation 3.52% 1.15% 4.25% Maximum Return 27.40% 3.87% 13.47% Minimum Return -8.23% -3.36% % We decided to test Lintner s proposition by comparing returns in stocks (measured by the S&P 500), bonds (measured by the Lehman Bond Index) and managed futures (measured by the Barclay CTA Index). The table above summarizes the monthly returns associated with these three investments over a 20+ year period from January 1987 August As we can see, the average monthly return associated with the Barclay CTA Index was 0.76 percent which is superior to the 0.59 percent associated with a bond investment albeit not as attractive as the 0.93 percent associated with stock returns. As might be expected, however, the volatility of managed futures investments as represented by the standard deviation of monthly returns likewise exceeds the volatility associated with a bond investment but is somewhat less than the standard deviation of stock returns. Over the 20+ year period from January 1987 August 2008, stocks turned in the best return but exhibited the most volatility. Bonds turned in the least returns but with the lowest volatility. Managed futures exhibited returns and volatility between that of stocks and bonds. 6

24 Why Managed Futures? Managed futures may generate returns in any kind of economic environment bull or bear. Profit in any Economic Environment CTAs have the capacity to go long or short on any particular commodity traded in the form of a futures contract. As such, CTAs may profit in either a bullish or bearish economic environment. During periods of high inflation, for example, hard or tangible or physical commodities including items such as gold, silver, crude oil may rally significantly. During periods of deflation or recession, one may very well take short positions in the same markets to profit from anticipated price declines. Finally, it is very possible to utilize options on these and other commodities to seek profit opportunities in flat or non-trending markets. Reduced Portfolio Volatility A key benefit of utilizing a managed futures investment as a component of a well-diversified portfolio is found in the form of reduced portfolio volatility. This phenomenon is attributable to the fact that managed futures tend to carry a very low or slightly negative correlation with traditional stock and bond investments. Note that the monthly returns of the Barclay CTA Index were essentially not correlated at all with returns associated with the S&P 500 during the period January 1987 August 2008 as shown below. The Barclay CTA Index displayed slight and insignificantly positive correlation with the Lehman U.S. Aggregate Bond Index during the same period. Managed Futures Correlation Matrix of Monthly Returns (January 1987 August 2008) Managed Futures Bonds Bonds Stocks Stocks Of great interest may be the fact that managed futures investments have historically been uncorrelated with returns in stock and bond markets. 7

25 cmegroup.com Managed futures may be a key component in a diversified portfolio in an attempt to balance risks and returns. We simulated the returns associated with portfolios comprised of equal parts stocks and bonds and, equal parts of stocks, bonds and managed futures. While returns in the latter portfolio were slightly less than that of the former, the large decline in portfolio volatility seemed to offset the slight decline in returns. The central premise of Modern Portfolio Theory, as articulated by the Nobel Prize winning economist Dr. Harry M. Markowitz, is that efficient investment portfolios may be created through the process of diversification amongst asset classes with low or negative correlations. In order to test that proposition, we created pro-forma portfolios comprised of equal initial investments in stocks and bonds. Or, of equal initial investments in stocks, bonds and managed futures. Note that the inclusion of managed futures in the portfolio has the effect of increasing the average monthly return while diminishing the volatility of monthly returns as measured by standard deviation. It is noteworthy that while managed futures investments did not quite keep pace with equity investments over the past 20 years a period of unusually dramatic advances in stock prices they did of course exhibit correspondingly less volatility. Managed Futures, Bonds and Stock Performance Managed Futures S&P 500 Lehman 1,200 1,000 December 31, 1986 = Dec-86 Dec-87 Dec-88 Dec-89 Dec-90 Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 8

26 Why Managed Futures? Monthly Return Summary (January 1987 August 2008) Managed Futures Bonds Stocks Stock and Bonds Stocks, Bonds and Managed Futures Average 0.76% 0.59% 0.93% 0.77% 0.74% Standard Deviation 3.52% 1.15% 4.25% 2.77% 2.28% Maximum Return 27.40% 3.87% 13.47% 7.65% 13.51% Minimum Return -8.23% -3.36% % % -6.83% Of greater import may be the fact that managed futures were essentially not correlated with stocks. In particular, note that the dramatic decline in equities in the very early 2000s, as the high-tech bubble burst, was accompanied by a nice advance in the value of managed futures investments. Thus, a prudent investor who included managed futures as a component of his investment portfolio would have been at least partially insulated from the bearish stock market in the early 2000s. Lintner reinforces these notions combined portfolios of stocks (or stocks and bonds) after including judicious investments... in leveraged managed futures accounts show substantially less risk at every possible level of expected return than portfolios of stocks (or stocks and bonds) alone. Global Diversification Globalization is a term that applies readily to today s futures markets. International futures exchanges invite diversification on the part of CTAs amongst a wide variety of products and currencies. A typical managed futures portfolio may hold positions in upwards to 50 different markets worldwide, covering stock indexes, interest rates, currencies, agricultural products, energy products, precious and base metals, and others. Thus, CTAs have much opportunity to partake of the risk reducing benefits and profit potential associated with diversification as a stand-alone investment. Managed futures allow one readily to gain exposure to global markets, further diversifying one s investment portfolio. 9