Managed Futures Vs Hedge Funds

Are you in the market for an alternative				withdraw funds as defined in the disclosure
investment? If you are one of the prudent				document of each hedge fund.
investors who is seeking to allocate a portion of				Almost all hedge funds have a lock up period. This
assets to strategies not normally employed by				period can range from as little as three months to
the investing public this article is a must read.				longer than two years. Generally the more
There are primarily two forms of alternative				established the fund the longer the lock up period.
investment management, hedge funds and				A lock up period is generally good for managers
managed futures. Hedge funds are invested in a				and not so good for investors. If a manager has
vast number of products, both exchange listed				a lock up period of one year and immediately
and Over-the-Counter (OTC) derivatives. Managed				after making an investment the trading starts to
futures are generally only invested in exchange				go poorly, that manager has a right to continue
listed commodity futures contracts, regulated by				trading that money until the lock up period is
the Commodity Futures Trading Commission				over; because the investor has previously agreed
(CFTC). Be careful! If the wrong investment is				to the terms and conditions in the disclosure
chosen the investor may be left with a bad				document he or she is not able to request
experience of alternative investment products.				redemption until the specified time period is up.
This article will focus on the very important issues				Managed futures products are different. Most
of transparency, liquidity, lock ups, returns and				managed futures products do not have lock up
taxes in regards to the alternative asset class.				periods. There are a few that have lock ups
Readers should leave with a better understanding				ranging anywhere from three months to a year,
of a few of the primary issues involving any				but this is not the status quo in the industry. If an
alternative asset investment.				investment in a managed futures product needs
TRANSPARENCY				to be redeemed it can generally be taken care of
Transparency is an issue with any investment.				within a few hours. This is very beneficial if you
Most investors want to know exactly what their				have taxes due, college tuition that needs to be
money is doing at all times. Giving money to				paid or any unexpected expenses that comes up.
someone who claims to have returns of X				Lock up periods will be foreign to most investors
without knowing what the manager is actually				who have not invested in alternative investments
doing is generally a bad idea. Transparency is				before. Make sure when reading the disclosure
becoming more and more of an issue as the				document that the lock up and withdrawal periods
universe of investable products grows				are properly discussed. Also, note that in many
exponentially. The recent hedge fund "blow-ups"				cases the lock up period is an area that can be
are a case in point.				negotiated to the investor's benefit.
Hedge funds are alternative investment vehicles				RETURNS
that can be invested in anything from Johnson				Returns are returns, right? Wrong! Returns are a
and Johnson common stock to over the counter				very deceiving form of analysis for any
derivatives based in Zimbabwe. The universe of				alternative investment. Most investors make
products is virtually limitless. When an investor				investment decisions based on previous returns,
becomes a limited partner of a hedge fund, in				but this is a flawed concept. The main issue is
most cases he/she is giving it free reign over the				that past returns have absolutely nothing to do
funds they have invested. If the manager				with future returns. This has been proven time
chooses to, he/she could invest in waffles and				and time again as managers that were once
chances are the investor would never have any				out-performing begin to under-perform and
idea. Hedge funds are not required to tell				managers that were struggling rise to the top.
investors exactly where capital is being deployed.				Wise investors will not base their investment
To make matters worse, many of the products				decisions on past returns or assumptions made
do not have a closing value at the end of the				about future returns.
day, so even if the investors knew what the				The fact of the matter is that no manager really
funds were invested in they would have no idea				knows what returns will be from year to year.
what their investment was actually worth on any				Managers can target a certain return but there is
given day. There is absolutely no transparency. All				absolutely no guarantee that the goal will be
the investors get is a quarterly statement				achieved. If any manager, whether hedge fund or
informing them of gains or losses and maybe				CTA, specifically promises a return that is a sign
some commentary if the manager is not too				to seek a different manager. Likewise, if a
busy. In some cases investors hear that, virtually				manager touts his/her past returns it is a sign he
overnight, more than 50% of their funds have				she does not fully understand that returns are
been lost. Long-Term Capital Management is the				completely unrelated to each other and have no
most infamous case of a hedge fund "blowing up,"				bearing on the future.
but recently there have been quite a few more				There are numerous databases in which
that are going down in history, such as				managers can post monthly returns and potential
Amaranth's $6 billion loss in 2006, Absolute Capital				investors view them, but this is completely the
Groups' 30-40% loss and Focus Capital's 80% loss				wrong way to make any investment decision.
in early 2008.				Chasing returns leads investors down the wrong
The story is much clearer if the investor is				path and can have devastating effects on their
involved in a managed futures product, or with a				capital (see "Transparency").
Commodity Trading Advisor (CTA). A CTA				What investors need to do is search through
generally has a very specific strategy that is				these alternative investment managers by
defined in the investor's disclosure document,				strategy, not by returns. The investor should pick
which is similar to a prospectus. The CTA is				a few advisors from each category after reading
required to state exactly what products the				about the managers' approach to the market.
investor's money will be invested in as well as				Once a few are decided on, the investor should
exactly how the manager plans to invest. What's				call each manager and request more information
more, once invested with a CTA investors will				and/or a meeting. All managers will have a
receive a statement every time a trade is placed.				disclosure document and possibly some marketing
At the end of every day the products in which				material that can be given to potential investors.
investor capital is deployed are marked with a				Meeting the manager of a hedge fund can be a
closing price determined by the exchange. This				difficult task unless the investor is placing a very
allows the investor to know exactly what his/her				large sum. CTAs, however, are generally much
investment is worth.				more open and willing to meet with investors, so
It is really up to the investor as to what makes				getting a meeting with them is entirely possible.
him or her comfortable. If one person does fine				Once the proper due diligence is done and the
not know where his assets are invested then the				investor likes the manager's strategy and
transparency issue may not need to be				approach, an investment can be made. Be careful
considered, but for most of us it is of the utmost				not to invest too many assets with any one
importance.				manager or specific style, as that is not proper
LIQUIDITY				diversification. It is wise for the investor to build a
Liquidity: a business, economics or investment				portfolio of alternative asset managers over a
term that refers to an assets ability to be easily				wide range of strategies, as this may reduce the
converted to cash through an act of buying or				risk of any one particular manager or style.
selling without causing a significant movement in				TAXES
the price and with minimum loss of value. (defined				Hedge funds often provide the investor with very
by wikipedia.org)				unfavorable tax treatment because they are
Liquidity can be an issue with both hedge funds				invested in many different products all over the
and managed futures, but a good manager will				world. This may have a vast array of
tend to avoid instruments that are illiquid or				consequences on the investor's overall taxes.
difficult to trade in and out of.				Hedge funds uniformly report investors' gains or
As stated previously, hedge fund managers can				losses in August after each tax year, forcing an
and do invest in a vast array of products. Many				extension of filing. Additionally, the tax returns are
of these products are OTC derivatives or				very complex, often over 30 pages for each fund
products that are traded between banks and the				invested in. To try and explain all the possible tax
hedge funds directly. If the hedge fund buys an				consequences of a hedge fund would probably
OTC derivative from a bank, and later decides it				require an entire book. In the interest of time the
needs to sell that particular product back, the				entire spectrum of hedge fund tax accounting
bank alone determines what they will buy it back				simply cannot be delved into at this point.
for, or worse, if they can buy it back at all. In				For managed futures products the tax accounting
that case the hedge fund may not be able to get				is very simple. Since most trades take place
out of a losing position.				within Regulated Futures Contracts (RFC)
Liquidity is an issue that has gripped a number of				regulated by the CFTC, contracts receive Internal
hedge funds lately. Many have been forced to				Revenue Code Section 1256 treatment. In this
shut down because they were invested in highly				case 60% of profits are taxed at the long-term
illiquid derivatives linked to sub-prime mortgages.				capital gains rate and 40% are taxed at the
When the counter parties began to refuse to buy				short-term capital gains rate. For a profitable
the products back the funds had no choice but to				managed futures product this effective tax rate
liquidate their portfolios at extremely discounted				of 23% provides a 12% advantage over hedge
prices and shut their doors, or refuse investors'				funds that trade frequently. This can, however,
requests to withdraw their money.				be a stumbling block in the case of large losses.
Unfortunately liquidity can be an issue for				When a loss is recorded and 60/40 treatment
managed futures as well. Most managers only				has been elected the investor is only allowed to
trade in highly liquid commodities; however, there				carry forward $3000 of those losses every year.
are times when even the most liquid commodity				If the investor's loss is large this can be a real
can become illiquid very fast. Illiquidity can be				headache, as he/she will be carrying forward
caused by many factors, from politics to supply				losses indefinitely. There is a bright side, and that
and demand imbalances to general investor fear				is if the investor has created a portfolio of
and greed. A prudent manager will prevent				managed futures products and another manager
investors from being too exposed to liquidity risks				has produced gains the investor can write off the
by implementing some sort of hedge,				loss against the gains of that other manager.
diversification or proper position sizing of the				In the end calculating taxes for a managed
account.				futures product is much simpler than for a hedge
When dealing in listed markets, as most managed				fund. For some investors this may not be an
futures products do, the counter party to any				issue, as their CPAs will manage everything, but it
trade usually has a number of other counter				would be important to consult with the CPA prior
parties willing to buy or sell at specified prices. This				to investing to make sure he/she fully
kind of open auction system generally allows for				understands the implications involved with the new
prices to be fair. To give investors even more				investment.
comfort each account is guaranteed by the				WHAT IS THE CONCLUSION?
exchange clearing house through customer margin				As a responsible investor it is prudent to have up
deposits, meaning that the chance of a counter				to 20% of assets invested in the alternative
party defaulting on any given transaction is				investments. This can be achieved by utilizing
drastically reduced. However, when dealing with				hedge funds or managed futures products. It is
obscure OTC markets, as many hedge funds do,				the investor's choice as to which is better suited
most of the time there is only one counter party				for their portfolio. It is important to not be too
to the trade, meaning it is not guaranteed by				heavily invested in one particular alternative asset
anyone, which not only makes the chance of				manager or specific alternative asset strategy.
default higher but at the same time makes the				Investors are encouraged to create a portfolio of
likelihood of getting a fair price on any given trade				alternative asset managers, just as they create a
much less.				portfolio of mutual funds, stocks and bonds.
When investing in a hedge fund or managed				Numerous studies have shown how diversification
futures product it is important to understand how				into alternative assets can, over time, smooth out
liquidity can affect the investment. If a manager is				the volatility of an investor's portfolio.
using too much leverage or is consistently				The topics discussed above represent only a small
involved in thinly traded OTC products that are				portion of the differences between these two
less liquid it may be a sign that investing in that				popular alternative investment styles. Proper due
vehicle at that time is not wise.				diligence is the sole responsibility of the investor
LOCK UP PERIOD				and requires a much closer look than these few
A lock up period is the time after the initial				issues. Careful consideration of one's own financial
investment in which the investor is not allowed to				condition must be taken into account, as the risk
withdraw funds from that particular vehicle. After				of loss can be substantial in any alternative
the specified lock up period investors are free to				investment.

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Managed Futures Vs Hedge Funds