HOW DO MANAGED FUTURES WORK?
When reading through your first few items of Managed Futures literature you may be a little confused. First, it is important to understand what Managed Futures is NOT. It is not a stock of a commodity driven company, it is also not a mutual fund of various commodities that are expected to rise, and lastly it is not an ETF (exchange traded fund).
So what is it exactly? When you invest in a Managed Futures investment, you are basically selecting a (or a group of) professional money managers (CTA’s) to manage your assets on a discretionary basis. Most of these CTA’s manage client assets based on a trading methodology or investment approach that they have developed in which they use the global futures market as their investment medium.
The Concept of Notional Funding
Notional funding gives the investor the ability to leverage their managed futures account. Notional funding in Managed Futures is favored by investors because it capitalizes on the free cost of leverage. The leverage is free because the notionally funded amount is not borrowed or deposited – the funding level is a good faith deposit for the full value of the account.
For example, if you wanted to invest with a CTA that had a minimum investment of $100,000, you could either fully fund the account with a $100,000 or, if notional funding was offered, you could partially fund your account – say, with only $50,000 – but still have it traded as if it was funded with a $100,000. The trading level in this case would be $100,000 with the account funded 50%. If the CTA returned 10% that year, you would have made $10,000 (a 10 % gain on the trading level), but it would be a 20% gain on the notional funding level. While it sounds great in theory, the same is true on the downside. Therefore, using the same example above, if the CTA lost 10% that year, it would be a $10,000 loss, but it would equal a 20% loss on your notionally funded amount.
While many investors may like notional funding (due to the reasoning provided above) other investors are wary of the opportunity because of the increased volatility that it brings. By notionally funding an account with 50% of the funds, all returns and losses present in a performance track record of the CTA, are doubled on a cash basis. Therefore, if an investor cannot handle that much volatility, then notional funding is not right for them.
UNDERSTANDING THE FEE STRUCTURE
Management and Incentive Fees
When investing in Managed Futures, the investor should be concerned with two major fees associated with managed accounts. The first fee is referred to as a management fee, which usually ranges from anywhere on the low end of 0% to a high of 3% (annually). The type of program and the experience of the CTA will help determine the percentage (0%-3%) the investor must pay annually to be in the program. Generally, a prorated portion of the management fee is deducted from the investor’s account on a monthly basis.
The second fee that investors should be aware of is the performance fee or more commonly known as the incentive fee. Prior to the CTA accepting a new account they will negotiate a certain percent of profits that they will keep, giving the CTA an incentive to make the investor money. As the investor makes more and more money so does the CTA. This incentive fee will normally range anywhere from 20% to 30% depending on each CTA. This helps ensure that the CTA will look out for the best interest for your account, because the CTA knows they only make money when the investor is profitable. The incentive fee is a CTAs main source of income.
When a CTA or money manager applies a high water mark to an investor’s money, it means that the manager will only receive performance or incentive fees on that particular account of invested money, when its value is greater than its previous greatest value. Should the investment drop in value then the CTA or money manager must bring it back above the previous greatest value before they can receive incentive fees again. In short, CTAs only receive incentive fees on net new profits.
What is a Disclosure Document?
Investors interested in a managed futures program must review and sign off on the commodity trading advisor’s disclosure document. The disclosure document, or D-Doc as it is commonly referred to, outlines all of the risk factors inherent in managed futures and specifically in the commodity trading advisor’s program. The D-Doc also includes an agreement whereby the client authorizes the CTA to direct trading in the client’s commodity account, and it summarizes any and all management and incentive fees to be charged to your account by the CTA.
All gains earned from managed futures accounts are taxed as if they were made up of 60% long term capital gains and 40% short term capital gains. Therefore, 60% of the gains are considered long term capital gains are subject to a maximum federal income tax of only 15%, compared to the short term capital gains which are subject to a top tax rate of 35%. Unlike many other investments, such as stocks, which need to be held for at least 12 months before they gain the coveted long-term capital gain rights, managed futures investments do not have to be held for a specified period of time in order for the “60-40” rule to apply.
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Bluenose Capital Management – Washington DC Alternative Investments / Managed Futures – (703) 842-3323
Past performance is not necessarily indicative of future results. Futures and options on futures trading is speculative, involves substantial risk and is not suitable for all investors. Prospective investors should carefully read the disclosure document of BLUENOSE CAPITAL MANAGEMENT, LLC before making any investment decision. COMMODITY TRADING INVOLVES SUBSTANTIAL RISK OF LOSS.