More investors are moving into managed futures investments as they seek greater asset class and strategy diversification, accompanied by the reward of higher returns.

According to BarclayHedge data, the amount of money invested in managed futures increased by almost $30 billion to $247 billion as of the third quarter 2010. Of this amount, the largest allocation is to managed futures funds following systematic and diversified trading strategies.

After three consecutive profitable months, the Barclay CTA Index, a popular benchmark for managed futures performance, increased 4.53% from January through October 2010 compared to a 4.50% increase in the S&P 500 index over the same period. While this performance may not be stellar, there are more compelling reasons for managed futures.

Managed futures should not be confused with hedge funds. Managed futures are considered a sub-set of hedge funds, but are more regulated, transparent, exchange-traded, liquid and investor-friendly. From a regulatory perspective, Commodity Trading Advisors, or futures fund managers, are required to be registered with the Commodity Futures Trading Commission and to be members of the National Futures Association.

The Basics of Managed Futures

All of this continued popularity merits a refresher course in managed futures.  Here are some of the basic operating rules.

• Fees: Due to the characteristics of the investment, managed futures charge two types of fees: management and performance. Management is often 2% a year and covers administrative expenses. The more significant is the performance fee, usually a hefty 20% or 30% of new profits. While that is high, the burden is on the manager who must post a return which is higher than the previous quarter in order to receive the performance fee. If the fund trades frequently, it can incur high trading costs. You also may have to pay an “introducing broker” as much as 6% to get into the fund, but if you shop around, this can be avoided. Overall, costs can hit 6% to 8% annually.
• Strategies: BarclayHedge categorizes managers by what they primarily trade: currencies, agriculture, diversified, financial-metal, or by their strategy, systematic, or diversified.  Systematic traders use computer models to identify patterns, such as trends on historical market and economic data.
• Leverage:  Some, but not all, managed futures funds use leverage. Fund managers that use leverage buy contracts by putting down a fraction of their face value in the form of an initial margin.
• Access to different asset classes: Managed futures programs offer access to futures on a variety of financial instruments (interest rates, currencies, equity indexes, fixed income), and agricultural commodities (grains, live cattle, oil, coffee, cotton).

The Academic Rationale

Managed futures, like the futures exchanges where they were traded, were traditionally considered the financial equivalent of the Wild West.

But these products received a major endorsement in 1983 when Harvard Business School Professor John Lintner released a breakthrough academic study, “The Potential Role of Managed Commodity-Financial Futures Accounts (and/or Funds) in Portfolios of Stocks and Bonds.” Lintner found that when traditional portfolios comprised of stocks and bonds were combined with managed futures, they showed substantially less risk at every possible level of expected return than portfolios of stocks or bonds alone.

Another academic endorsement was provided by Thomas Schneeweis, professor of finance at the University of Massachusetts, who found that managed futures offer an enhanced return to risk ratio when they are part of a diversified portfolio.

A more compelling, recent case was made by Gary Gorton and K. Geert Rouwenhorst in a 2004 paper, “Facts and Fantasies About Commodity Futures,” which found that fully-collateralized (or non-leveraged) commodity futures “have historically offered the same return … as equities.”

Additional studies have found that the variety of alternative strategies found in managed futures provides access to asset classes that can provide diversification and risk management techniques not found in traditional stock and bond portfolios.

Total Returns: The Big Attraction

Along with diversification, managed futures can offer an outsized performance potential.

The most recent top-rated managed futures fund (as of November 2010) is the D2W Capital Mgmt., LLC (Radical Wealth Managed FX) which has posted a YTD return of 95%, according to BarclayHedge data.

The Radical Wealth FX program is a specialized fund that trades currency spreads. It requires a $100,000 minimum investment and carries hefty fees: a 2% management fee and 30% of profits. Since it was founded in April 2006, the fund boasts a 1265% compound annual return.

Not For Everyone

Investors in many managed futures programs must be prepared for greater volatility, large drawdowns and returns which are eroded by performance and trading fees. Any managed futures investment requires an examination of the fine points contained in some common industry ratios, such as drawdowns, and time to recovery. For instance, drawdowns are the loss in equity in a specific period of time. Another caveat is that some funds may not allow investors to redeem their investment for a certain period called the “lock up.” There is also a significant attrition rate among newly-launched managed futures managers with an estimated 20% of new managed futures funds failing within their first year.

The best advice: Invest in funds with established track records, which have weathered a few market cycles.