Hedge Fund Strategies: Managed Futures

When you think of futures, you may think of the famous Chicago Mercantile Exchange, and dozens of traders screaming out orders for commodities such as soybeans, pork bellies or grains. While these commodities are part of the futures market, today’s futures traders generally focus more on financial products such as interest rates, equity indexes, precious metals, government bonds, and currencies.

A Managed Futures Account (MFA) or hedge fund is a form of alternative investment that takes long or short positions in futures contracts. Investment jobs known as “commodity trading advisors” (CTAs) buy and sell these futures contracts.

The commodity trading advisors who run these funds are compensated on a performance basis, usually between 15% and 30% of profits. Many CTAs also charge a management fee of 1% to 2% per year, based on the size of the account.

What are Futures Contracts?

A futures contract is a standardized contract to buy or sell a specific commodity or “basket” of commodities at a certain date in the future, and at an agreed-upon price.

Futures contracts differ from options in an important way. An option is the “opportunity” to buy or sell a security or commodity at a future date and price. You can choose to exercise the option, or not. However, a futures contract obligates you to make or take delivery under the terms of the contract. You must fulfill your obligation on the future – or settlement – date.

According to Jaeger, this difference between the trade date and the settlement date of a contract is common in many markets. For example, when you buy a house, the closing date might be several months after you and the seller agree on the price and other terms. In the futures market, the delay between the transaction and settlement can be as long as several months or even several years.

On the settlement date, the seller must deliver the underlying asset to the buyer. Or, if it’s a cash-settled futures contract, cash is transferred from the futures trader who lost money on the trade to the one who made a profit.

Futures contracts (often simply referred to as futures), are therefore exchange-traded derivatives. The exchange acts as a clearinghouse and as a counterparty on all contracts. It sets the margin requirements for buyers and sellers and provides a mechanism for the settlement of trades.

Types of Commodity Trading Advisors

There are approximately 800 CTAs registered with the National Futures Association (NFA), a self-regulatory body for futures and options markets.

Most CTAs follow one of two investment styles. They are either technical traders, using sophisticated computer trading programs to follow price trends and quantitative analyses. Other CTAs are more fundamentally oriented, preferred to forecast prices by analyzing supply and demand trends and other macro economic factors.

Next time, we’ll look at the advantages of investing in managed futures.

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