Q&A with Neil Fern: Vice President, Alternative Assets, RMB Group

: When an investor is on-boarded as a client at RMB, is diversification an “early and often” conversation?

Neil Fern: The discussion about broad-based diversification typically occurs before our clients become active in this alternative asset class. While managed futures can be attractive in their own right, the idea of diversification is what brings many investors to the table. Building a portfolio of assets that perform independently of each other is a cornerstone of Modern Portfolio Theory and one that managed futures can be a perfect match for.

Many investors think that because their portfolios have a nice mix of stocks and bonds and perhaps a few gold or silver ETFs, they are properly diversified. This isn’t necessarily the case. All of these investments can go south at the same time. It happened as recently as 2008 when nearly every asset class got killed.

Adding managed futures can provide an extra, critical level of diversification to your portfolio. One of the reasons managed futures are not correlated with stocks, bonds and nearly everything else is they are not “long only.” Commodity Trading Advisors (CTAs) typically don’t carry consistent long positions. Instead, they are in and out of trades as market conditions change and adjust exposure depending on market dynamics.

CTAs can “go short” just as easily as they go long. This ability to capitalize on bear markets in any sector is what adds an extra level of diversification to a client’s holdings and can potentially smooth out performance when a pullback occurs in any traditional asset class: gold, silver, the US dollar, agricultural commodities, bonds, stock indices – you name it.

This is why we do our best to match CTA money managers to what our customers already have in their portfolios and why we encourage clients to keep us informed when they rebalance substantial portions of their investment portfolios. This enables us to provide feedback on how a client’s existing holdings with the RMB Group continue to complement a portfolio or we can make recommendations for change.

Editor: What does a diversified asset basket look like? Give us an example.

Neil Fern: It varies from individual to individual. When discussing diversification using managed futures, the most common metric is against the S&P. Using statistical analysis, the ranking agencies can provide us a correlation, expressed in percentages, as to how the performance of a particular CTA matches up to the S&P. That means our mission for most clients involves finding managers whose trading is uncorrelated and behaves independently of the broad stock market index. Generally these are funds that rank within a positive 20% to negative 20% correlation to the S&P.

Often I hear clients express concern for the economy and the outlook for our market. In exploring their concerns, it becomes clear that most are worried about the stock market, overall economy and sometimes the real estate sector. While some commodity markets tie in to the overall economy (think gold and silver), others like livestock and agricultural commodities tend to have their own micro and macro economic cycles.

Mixing a CTA who trades stock indexes with one who trades agricultural commodities is an example of diversifying within the managed futures universe itself.

Each of the CTAs we follow has their own specific trading style. We try to gain even more diversification by mixing trading styles. These include fundamental, momentum, pattern recognition, trend following, arbitrage and counter trend. (Editors’ Note: click here to read more about CTA trading styles.)

In our January 2016 blog (Editors’ Note: click here to read) we explored a sample diversified managed futures portfolio using just two complementary money managers: Wharton (agriculture) and Goldenwise (volatility and global stock indices).  These two programs trade in completely uncorrelated markets and use different trading styles. Together their performance carries a correlation to the S&P of just 12%. While six months is not a big sample size, the performance year-to-date has met all of our expectations – exhibiting very little volatility throughout the entire Brexit crisis.

Editor: Can we track the performance of this portfolio online?

Clients can track the performance of these money managers separately, along with a whole host of other CTAs by going to the RMB Group homepage, scrolling down and clicking the “Take a Test Drive” icon. Investors interested in tracking the hypothetical portfolio in our blog can call me at 800-644-1013 toll free or 312-373-4974 direct.

Editor: Does RMB Group have a unique methodology or view on diversification –perhaps different from other firms?

Neil Fern: I think everyone has their own take on diversification. Saying “don’t put all your eggs in one basket” is too simplistic. We want to mitigate market risk. In general, this can be done by hedging or diversification. I view hedging like insurance; it is a losing proposition for most and the payout can be less than the cumulative premiums paid over time.

For example, based on the current cost of e-mini S&P 500 put options, the cost to hedge against an S&P 500 decline of 10% or greater from now through the middle of December is 1.8% or nearly 4% on an annualized basis. To break even on this hedge, stocks need to rally 1.8% or fall 11.8% (or more) in the next 164 days. If they rally, the hedger’s gain will be clipped by 1.8% to cover the cost of the hedge. If they fall, the hedger still loses 11.8% — but no more.

This is why we favor diversification over direct hedging and suggest allocating 5-15% of your investment portfolio to alternative assets like professionally-managed futures. Our goal is to help our clients smooth systemic risk to their portfolio by allocating across various asset classes with an intent of reducing portfolio volatility.

We personally interview and vet all the CTAs our clients work with. Disclosure documents (much like a mutual fund prospectus) can be convoluted or ambiguous. By personally speaking with the advisors, we can get additional clarification on items like trade strategy and risk management and relay this information to our clients.

Editor: As a manager, how often do you shift sector weightings in a typical client’s portfolio?

Neil Fern: Not often. Frequent shifting of assets may make sense in a long-only stock account – chasing hot products and sectors.

With stock or real estate, wealth is created when the markets go up  This is because there are more people long these markets than short and most investors only use half of the possible strategies to capture profits in the markets. When those assets appreciate in value, wealth is created. Since fewer people are short those assets, only a select few make money when prices contract.

In contrast, all futures products and their options have one person long for every one person short. This results in a zero sum effect – wealth is neither created nor lost based on a directional market move; it is simply transferred. Professional traders can trade both sides of the market. Think of it this way, you want every professional working for you to be able to use all of their tools in their trade.

Editor: With more diversification options (products) being introduced in the markets, is diversification easier or more complex?

Neil Fern: For many the recent influx of alternative asset products makes diversifying more complex.

Investors need to scrutinize hybrid products with hidden fees, conflicts of interest, ineffective returns/diversification, poor performance to industry benchmarks, convoluted performance statements, products that generate regulatory scrutiny and dealing with firms with a lack of appropriate security measures for your personal information.

For our clients the process is pretty straightforward:

Fees: There are no account setup, sales or load fees – no exit or redemption fees. No tie up, restricted redemption periods or liquidity issues. Most CTAs charge 2/20: 2% annual management fee and a 20% incentive fee on capital gains above the previous high-water mark.  Participating in performance keeps them vested in YOUR account’s success.*

All CTAs need a brokerage firm to hold client funds, process trades, provide transaction statements and online access to your account. Commissions charged by the brokerage vary by the program but are generally quite low. CTAs aggressively negotiate the commission rate changed by the brokerage. Since they participate in the capital gains, it is in their interest to minimize trading expenses. In addition to commission there may be a few dollars charged for regulatory, exchange fees, etc. The reported performance provided by the CTA is after their fees. This makes it easy to compare to other products.

Conflicts of interest: Most CTAs do not participate in the commissions generated so they have no incentive in over-trading your account. Since the potential bulk of their compensation is from sharing profits (incentive fees), it is possible they could be aggressive in searching for high rates of return and take on higher degrees of risk.

Ineffective returns/diversificationWhile the performance of an individual CTA may vary, it is widely accepted that a well-balanced basket of CTAs can outperform the stock market regardless of the general economic trend.

Security: These are investment-grade exchange regulated products and the CTA and brokers answer to the following regulatory authorities – Financial Industry Regulatory Authority (FINRA), National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC).  We respect and value your privacy.  Like all insurance, bank or brokerages you will receive a copy of our privacy policy.

Performance statements: Our statements contain a wealth of information but provide an easy to read summary titled Account Value at Market.  In addition we offer real time, online access to your account. Unlike mutual funds or other opaque investments (you may see shares of your Fidelity fund but not the actual shares like Disney, Apple, Google, etc.), your RMB Group account shows the actual positions you are in (cattle, corn, unleaded gas, etc.).

Products that generate regulatory scrutiny: Managed futures products have been around for decades. They are not a new investment or a get-rich-quick scheme. Managed futures are a logical way to provide diversification outside of the stock market. They use liquid assets which may provide some tax advantages compared to other alternative assets. Currently around 400 billion dollars are invested in professionally-managed futures; those assets carry the potential to control approximately 8 trillion worth of assets.

Editor: Any final comments for those interested in pursuing managed futures?

Managed futures are not for everyone. You need to be comfortable having professionals managing your funds. If you invest in REITS, limited partnerships or even mutual funds you already have someone managing at least part of your portfolio.

Account minimums vary by programs. Some CTAs require investors to be qualified eligible persons (QEPs), while others do not. There are around 1000 programs out there and having a professional help you navigate through this asset class is beneficial. However if you are a DIY type of person, feel free to browse our database.

We are not affiliated with any particular program, and our clients can work with most of the programs in existence. We do not charge for helping you find the diversification that best fits your needs and there are no set up fees. In addition, we provide brokerage services, process the transactions in your account, review account activity, monitor performance, provide online account access and watch for risk management.

If you want to know more about managed futures, go to our website and download our free pamphlet, “Opportunities Outside the Stock Market.” It is written in plain language and easy to follow.

Editor: Thank you, Neil.