Managed futures have been a source of frustration for investors in recent years. After losing 1.44 percent in 2015, these alternative investments finished 2016 with an aggregate return of 0.67 percent, according to Atlanta-based firm eVestment.
That doesn’t mean, however, that investors are backing off.
In the first quarter of 2017, total assets under management in managed futures strategies rose 2.2 percent. According to eVestment data, net inflows of managed futures could hit $19.7 billion by year’s end.
The numbers suggest that managed futures, which are managed by a commodity trading advisor and may include investments in foreign currencies, precious metals and commodities, may be poised for a growth spurt, but is now the right time to buy?
Weigh the pros and cons to help determine whether managed futures belong in your portfolio.
[See: The Fastest Ways to Lose Money in the Stock Market.]
Enhanced diversification. Most investors understand that diversification is essential for maximizing returns and minimizing losses, but few people may realize that investing in managed futures is one of the best ways to diversify, says Adam Taback, head of global alternative investments for Wells Fargo Investment Institute.
In a market correction, managed futures can act as an insurance policy when stocks veer off-course. In times of market stress, Taback says that a 5 percent managed futures position could protect a client’s portfolio and “feel like more of a 15 percent position,” given the strong lack of correlation to traditional markets.
That lack of correlation is often what attracts investors to managed futures, says Adam Harding, principal and lead adviser at Adam Harding Investments & Planning in Scottsdale, Arizona. That’s particularly true when rising rates cause bond prices to fall.
Having assets in your portfolio that don’t track the movements of a broader market index can work in your favor during periods of stock market volatility. When equities begin to struggle, managed futures can deliver positive returns.
For example, Cliff Stanton, co-chief investment officer at Denver-based 361 Capital, says that in each of the four calendar years in which the Standard and Poor’s 500 index posted a negative return over the last two decades, the Credit Suisse Managed Futures Index has advanced. In 2008, the index was up 18.3 percent, while the S&P 500 fell 37 percent, illustrating the value of managed futures when stocks are unstable.
Sarah Potter, founder of She Can Trade, an online options trading source, says futures contracts may open up new asset classes for investors.
“Each year, the futures market grows, with new contracts being added all the time,” Potter says, citing 30-year Treasury Note futures and coffee futures as examples.
She likens the asset allocation of managed futures contracts to that of mutual funds in that the underlying investments may have very different risk and performance profiles. The challenge for investors is choosing managed futures products that reflect their risk tolerance and goals.
Downside risk. Managed futures can act as a buffer against a falling stock market but they have risks.
Taback says these investments tend to do better in times of steady volatility and higher interest rates. When rates are low and volatility is episodic, managed futures struggle.
[See: 7 ETFs for a Solid Portfolio Defense.]
This can wreak havoc on managed futures strategies, he says, because “managers tend to take losses on the downside, reduce their leverage exposures and miss the rebound, which has them locking in losses.”
Managed futures share some of the same downside risks as stocks. The main risk, says Potter, is that the futures contract you’ve invested in doesn’t move in the direction you anticipated.
In other words, taking a short or long position in futures can threaten your portfolio if your gamble doesn’t pan out. She says it’s also important to have a clear exit strategy when investing in futures.
“Futures are unique in that they have a limited life,” Potter says, and when you buy a futures contract, “you need to be aware of its expiration date.”
If a futures contract is due to expire, you’d have to decide whether you want to close it out, or roll it into a new one. To close a contract, you simply assume the opposite position. For example, if you’re short, a buy order would close you out, whereas selling would accomplish the same end if you’re long.
One way to manage the risks is to avoid overweighting your portfolio with managed futures.
Taback recommends limiting these investments to 5 percent of your portfolio. For Stanton, a meaningful allocation is 10 percent or more.
He says investors should consider the long-term market outlook when determining how much to invest in managed futures.
“What matters in building portfolios today is the future, and we know that after four decades of declining rates, the next 10 years won’t be the same,” Stanton says.
Investors will need assets that provide diversification and strong returns. While recent performance has been lacking, managed futures could pay off if the market takes a turn.
Choose wisely. Before investing in managed futures, do your homework.
Harding says one mistake investors make is assuming that all managed futures funds are categorized the same way. In reality, many different strategies exist, and you should understand the process of the strategy you’re considering.
For example, there may be a sizable gap in performance between the worst- and best-performing managed futures funds. The cost of investing in managed futures can also vary.
“Costs are a major part of investing,” Harding says, and it’s wise to consider how cost might hinder portfolio performance or whether it’s worth paying premium fees.
The quality of the team behind a managed futures strategy also matters.
“Manager selection is by far the most important decision,” Taback says, and whether a strategy’s performance has been successful can give you an idea of how talented the team is.
He advises investors to consider the number of models used in a managed futures strategy, as that defines how many markets are traded across asset classes, sectors and instruments. Investors should also question how much risk exposure a manager incorporates into the strategy.
[See: 10 Skills the Best Investors Have.]
Asking yourself why you want to invest in managed futures can help you decide if it’s the right move.
“If you’re looking for a pure hedge against a certain type of volatility, consider the various ways to pursue that,” Harding says. “If you’re looking to pick up some alpha in an asset class that has underperformed, then be sure to acknowledge that mean reversion is never a certainty. Finally, if you’re simply looking to numb the potential for portfolio-wide volatility, remember that cash as a strategic allocation also generally has a low correlation to stocks and bonds.”
More from U.S. News
High-Tech Investing: 7 Sectors to Watch
13 Money Hacks to Turbocharge Your Investments
7 ETFs That Let You Invest With the ‘Smart Money’
Are Managed Futures Funds Worth a Look? originally appeared on usnews.com