An Analysis of Exchange Traded Funds and Managed Futures

By Neil Behrmann

October 06:- Gold and commodity indices have outperformed managed futures funds over the past five years. 

Over a ten year period, however, managed futures, also known as Commodity Trading Advisors (CTAs), beat gold and most other commodities. CTAs on average achieved much improved results over the longer time span because the ten year period includes the late nineties when they did well. Gold and commodities, in contrast, under performed in the second half of the nineties.

The past decade has experienced a major turnabout in the commodity cycle. A remarkable boom followed the bleak years of 1996 to 2002. It is now timely to compare gold and other commodity exchange traded funds with managed futures. 

Exchange Traded Gold & Commodity Funds

The ETF universe has now reached around $500 billion according to State Street Global Advisors.  The amount of capital invested in commodity ETFs are currently estimated to be around $15 billion. About 70% of the funds' market capitalisation are gold ETFs.  StreetTRACKS Gold Shares (GLD) is by far the biggest product, with a market capitalisation of around $7.5 billion. Next in line are Gold Bullion Securities, $1.8 billion and iShares Silver trust, $1.3 billion. Trading in commodity ETFs are likely to expand rapidly in coming years.  ETF Securities launched 29 products on the London Stock Exchange recently, ranging from energy and base metals to soft commodities and grains.  

Commodity ETFs have already proved that they are a cost effective way to trade gold. Annual management charges are only 0.4% and since they are securities, investors, traders and hedge funds can go long and short.  Unlike futures and options, a purchase of a Gold ETF can avoid leverage and margin calls. Since the security can be loaned, an investor can also obtain income. Gold ETFs, backed by specifically allocated gold in the vaults of a bullion bank, are liquid.

An investor or trader must make their own decisions on timing or take advice, similarly to dealings in other securities.  An ETF thus suits an independent investor.

Managed Futures Funds (CTAs)

Global managed Futures funds have been in existence for about three decades and now manage around $150 billion, having grown from around $25 billion a decade ago.

The key difference between ETFs and managed futures is that investors must select Commodity Trading Advisors to manage their funds. Fees are expensive. Annual management charges are invariably 1.5% and performance fees, 20%. The liquidity of a particular fund depends on the prospectus.  Investors in many cases must give the CTA one month's notice before money can be withdrawn.

Trading strategies cover the full derivatives variety from gold, silver, platinum energy, metals, grains, soft commodities to financial, currency and stock index futures and options.  They vary considerably. Some of the funds use systematic programs to follow price and volume momentum.  Gains can be huge, but even the most sophisticated systems can lose money when markets suddenly change direction.  Others rely on their own judgement and market feel using technical or fundamental analysis or a combination of both.  Large funds employ quantitative specialists who change and adapt trading systems.  Funds switch from market to market following trends. Many managed futures funds out performed gold and commodities in the nineties, for example because they traded equity derivatives in a booming market.

The key is to choose the right manager

An investor thus has to make a choice about the fund and the manager to justify the fees and risks.  It is not a decision of being bullish or bearish about commodities.  It is about trust and confidence in a manager and his business. Intensive due diligence is essential.  Investors must study the prospectus carefully and try and find out as much as possible about the managers' trading strategies, leverage, discipline and risk controls. Administration and the back office must be sound.

Amaranth Advisor's debacle, in which a trader lost $6,400 million jolted hedge fund investors who forgot that past performance was most certainly no guarantee for the future.  Amaranth did exceedingly well prior to 2006.  The extent of its gains in its good times, however, indicated that the fund was taking large bets and leverage was extensive.  Wise investors withdrew from the fund before the crash.

Similarly to any occupation, the investor has to detect the talented individual from the crowd that contains mediocre managers and charlatans. In Barclays Group's data base only 373 of the 838 CTAs reported positive results in September and 438 were in the red.  The CTA index fell by 0.2% in September, but the fund with the highest rate of return rose by 35% and the worst dropped by 36%.  It is hardly surprising that the highly talented CTAs who are consistent over a lengthy period, attract most of the money. 

Conclusion

ETF commodities and managed futures are very different investment products. Investors buying gold ETFs, for example, are taking a view that gold will rise.  It is a pure directional investment. An investor who is bullish on gold and other commodities does not need to invest in a managed futures fund. If the investor is confident and has a good advisor, ETFs are low cost liquid products that can achieve this aim. 

An investment in a managed futures fund should be based on the trading skill of the Commodity Trading Advisor and the management of the company.  The fund should be chosen on the basis that the manager has the ability to consistently make money in rising and falling markets. High fees are paid for the skill, but it is best to thoroughly research the fund, the manager's background and business.

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